Islamic Modes for Agricultural Financing PRODUCTS – Diminishing Musharakah Lahore 16 – 17 May, 2008

Al – Huda Training Programme

Muhammad Khaleequzzaman Head Islamic banking Department Int’l Islamic University Islamabad

Islamic Modes – Agricultural Financing

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Rules of Musharakah

Fulfillment of prerequisites of a contract Rules of contribution of equity Rules of profit and loss sharing Management of Musharakah/Relationship of parties Termination of musharakah

Uses of Musharakah:

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Agricultural enterprise financing

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Project financing

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Working capital financing, etc.

Islamic Modes – Agricultural Financing

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Musharakah

An equity participation contract under which IB and its client contribute jointly to finance an enterprise. Equity is owned according to each party's share in financing. Profit is shared in pre-agreed ratio and loss in proportion to the capital contribution. It is an ideal alternative to the interest-based financing with far reaching effects on both production and distribution.

Islamic Modes/Instruments – Participatory Modes:

Musharakah:

The Concept of Musharakah:

Meanings:

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Sharikah Arabic

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Shirkah Shirkat Partnership Arabic Urdu English Shirkah Definition : “commingling money or property (that no share can be distinguished) by two or more parties with an objective of sharing profits and contributing losses"

Islamic Modes/Instruments – Participatory Modes:

Musharakah:

1 . Shirkat ul Milk

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(co-ownership) The existence of thing in the joint ownership of two or more persons in an ascertained thing (ayn) or debt (dayn)

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Shirkat ul Jabr Shirkat al Ikhtiar 2 . Shirkat ul Aqd “Partnership through contract” (Partnership referred by law)

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Shirkat ul Amwal (Wealth)

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Shirkat ul amal (services) Shirkat ul Wujuh (liability/ c/w) Wider definition of Shirkatul Aqd: (Mudarabah).

“Contract between two or more people for participation in capital and its profits” “Participation in profits w/o partnership in capital”

Islamic Modes/Instruments – Participatory Modes:

Musharakah:

Distribution of Profit/Loss

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The proportion of profit to be agreed at the time of effecting the contract

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A partner, on the date of distribution, may surrender his part of profit in favor of other partners

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Fixation of lump sum amount for any partner is not allowed.

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The ratio of profit to be determined in proportion of the actual profit accrued and not necessarily in proportion to the capital invested

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The final distribution cannot be made based on expected profit. However, a partner can be given lump sum amount of profit or any proportion of investment provisionally, but the same has to be adjusted according to the agreed ratio at the time of calculation of actual profit.

Islamic Modes/Instruments –

Musharakah:

Participatory Modes: Distribution of Profit/Loss

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In constructive liquidation, assets are valued at market rate, receivables at cash after deducting an allowance for doubtful debts

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In above case, if no profit is actually earned or is less than anticipated, the amount drawn by the partner shall have to be returned.

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The ratio of profit may differ from the ratio of investment If a partner has not been declared as sleeping partner, he is entitled to get additional profit above the proportion of his investment, even if he did not work

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However, the share in profit of a sleeping exceed from his proportion of investment partner cannot Sharing of Loss:

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Each partner shall suffer the loss exactly according to the ratio of his investment.

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It is valid that one partner takes the responsibility of loss at the time when loss occurs, without any such prior condition

Diminishing Musharakah (DM)

Islamic Modes – Agricultural Financing Diminishing Musharakah (DM): A form of Musharakah where the financier and the client participate in a joint commercial enterprise or property. This enterprise is converted into undivided ownership of both the financier and the client. Over certain period the equity of financier, divided into equal value units, is purchased by the client. And ultimately the client becomes the sole owner of the enterprise.

Uses of DM

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Agric. Machinery and implements financing Storage facility construction/sheds Transport vehicles, etc.

Islamic Modes – Agricultural Financing

Diminishing Musharakah (DM):

Procedural details:

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Client requests the bank for DM Appraisal is accorded Approval is conveyed.

bank releases its share to become partner in the asset. And contract of Musharakah is

executed. [buying &selling not stipulated]

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This asset becomes undivided ownership of both the bank and the client

[Musha]

None of the parties can withdraw its equity till DM is terminated

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General rules of partnership apply

Islamic Modes – Agricultural Financing

Diminishing Musharakah (DM):

Procedural details: (contd..)

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At the same time, uni-lateral promise from client is obtained to purchase the units of bank’s equity. The price of one unit of bank’s equity is valued Ijarah Agreement is signed In case of Ijarah the rent is realized while in case of business or services profit and losses are shared

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Expenses connected to asset are borne by the partners proportionately

Islamic Modes – Agricultural Financing

Diminishing Musharakah (DM):

Procedural details: (contd..)

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Equity of bank is periodically purchased by the client

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Bank ’s share in the asset decreases while that of client increases – so happens to the rent or profit

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Ultimately the client becomes the sole owner of the asset [Bank ’s share reduces to zero]

DIMINISHING MUSHARAKAH Share in capital Partner 2 Share in capital Bank 3. Accruing Rentals Pays price of the units of bank’s equity 4 Sell its share in equity

Islamic Modes – Agricultural Financing

Diminishing Musharakah (DM):

Example – Financing Purchase of Tractor: A client wants to purchase a tractor by sharing of equity of Rs. 40,000 against price of Rs. 400,000. The bank shares rest of the price of tractor ie. Rs. 360,000. How his request can be accommodated by a bank?

Bank agrees to finance the purchase of tractor through DM.

Islamic Modes – Agricultural Financing

Diminishing Musharakah (DM):

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10% of the cost (Rs. 40,000) is paid by the client and 90% of the cost (Rs. 460,000) by the bank. [Musharakah Contract is signed]

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The rental of tractor is fixed according to certain reference price [Ijarah for future date is signed]

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The client promises (unilateral promise) the bank to purchase banks equity divided in to equal value units to

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Say, rent is fixed @ 15% p.a. The DM terminates after 3 years Installments can vary [Seasonal, quarterly, monthly]

Islamic Modes – Agricultural Financing

Diminishing Musharakah (DM):

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After acquisition, the client uses tractor and pays rent to bank for using bank ’s share in the property

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At the same time, purchases unit(s) of equity after expiry of each rental period

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The equity of bank diminishes to zero on expiry of three years, the rent as well, client becomes sole owner

Islamic Modes – Agricultural Financing

Diminishing Musharakah (DM):

Total value of Asset:

(Amount in rupees)

600000 Share of client Share of Bank No. of units 40000 360000 36 Value of one unit Rent per month 10000 4500 Rent per unit per month 4500 / 36 = 125

End of Month

0 1 2 3 35 36 Total

Rent

0

Value unit purchased Total payment

0 0 14500 125 x 36 = 4500 10000 125 x 35 = 4375 10000 125 x 34 = 4250 10000 125 x 2 = 250 10000 125 x 1 = 125 10000 ??

460000 14375 14250 10250 10125 ??

Remainin g units

36 35 34 33 1 0

Remainin g balance

460000 450000 440000 430000 10000 0