I was in the middle of explaining the components of periodic lease rent (or Ijarah installment) in a financial leasing transaction and had covered fixed and variable elements, representing the recovery of an Islamic bank’s capital investment and the return (profit) on investment respectively in piecemeal. There is a third component that was left to be elaborated to the readers. It is called the supplementary element.

In simple terms, the supplementary element of periodic rent is comprised of the cost of major maintenance incurred by the owner in providing the leased asset to the lessee in perfect working condition during the course of the entire financial lease.

Shariah principles dictate that the primary responsibility for the maintenance of the leased asset lies with the owner of the asset. In Shariah, the asset maintenance is categorized into two parts: major maintenance and minor maintenance.

Whilst major maintenance is such in nature that, without which, the leased asset would either cease to function at all or would not be able to provide the normal benefit or lose its effectiveness for the lessee. In this situation, the rent paid by the lessee will become questionable since the lessee is unable to fully enjoy the benefit arising from the asset. Examples of major maintenance are overhauling of an aircraft engine, dry-docking of a marine vessel or routine service of the centrally air-conditioned plant of a large real estate asset.

Shariah principles define that all maintenance classified as major are invariably the responsibility of the owner of the asset whereas minor maintenance related to the leased asset must be carried out by the lessee. What is minor maintenance? Examples of minor maintenance include changing the light bulb in a residential unit taken on lease by the tenant or watering the lawn, upkeeping of the aircraft with regular replenishment of all consumables such as engine fluids, fuel, oxygen, food, etc.

Further elaborating on major maintenance, imagine an Islamic bank providing financial lease of an aircraft to an airline: the staff of the Islamic bank would not know how to take care of the aircraft whereas the airline will have in its workforce aircraft engineers and other technical staff fully conversant with the requirements of keeping an airplane in the air.

The most logical step in this situation would be for the Islamic bank to appoint the airline as its technical agent to service the airplane so as to keep it in perfect working condition. As such, a servicing agency agreement shall be drawn to be signed between the Islamic bank as the principal and the airline as the agent pursuant to which, the airline will assume the responsibility of undertaking major maintenance of the airplane while at the same time to also perform minor maintenance in the capacity as the lessee.

In the articles on the same subject of Ijarah, I have earlier explained that Shariah principles do not allow elimination of risk from a financial transaction, yet it is completely alright to mitigate them in a Shariah compliant manner. Hence, the risk of not being able to carry out the major maintenance of the leased airplane owing to a lack of expertise can be mitigated by appointing the airline as the lessor’s agent to do so.

So far so good. Here comes the need to undertake a scheduled major maintenance of the airplane engine and other areas and we all know that it costs a lot of money. Who will foot the bill since the airline is simply acting as an agent of the lessor? The preferred Shariah position is defined below:
• The owner of the aircraft should pay the upcoming major maintenance cost to the agent beforehand;

• If the owner does not do so, the agent shall have the option to complete the major maintenance by utilizing its own money since it needs the airplane to remain in good working condition to support its operation;

• The agent should immediately claim the reimbursement of the amount it has spent on major maintenance by submitting the bill to the owner (acting as the principal in the technical agency agreement);

• The owner (acting as the principal in the technical agency agreement) should immediately reimburse the major maintenance cost to the agent.

I think most of the readers of this article will catch on by doing a little bit of mental math as you will arrive at the situation whereby the Islamic bank as the lessor is faced with a huge deficit upon entering into a financial lease. This is because while the rent on the airplane shall be market-oriented, the payment of the reimbursement amount on the account of major maintenance makes the Islamic financial leasing a disastrous offer.

Shall we leave it to next week to know that this is not the case and that the Ijarah is the most lucrative proposition for the Islamic banks and financial institutions?

The views and opinions expressed in this article are those of the author and do not necessarily reflect the opinions of the Dubai Islamic Economy Development Centre, nor the official policy or position of the government of the UAE or any of its entities. The purpose of this article is not to hurt any religious sentiments either consciously or even unwittingly.

Sohail Zubairi is the senior advisor with the Dubai Islamic Economy Development Centre. He can be contacted at [email protected]

Next week: The discussion on mitigating the Ijarah risks to an Islamic bank shall continue next week.