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Home arrow Business & Finance arrow The art of RF (riba-free) Islamic banking and finance
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RIBA-FREE BUSINESS TRANSACTION MODELS

The following is an abbreviated list of the RF finance models used to finance commercial transactions. This is not a comprehensive list. It is designed to familiarize the reader with the concepts used in the different models. A more detailed list with explanation of each model is presented in Chapter 13. It is important to note here that it is preferred to call these models by the names that describe them in English — the language used in this book — and may be in another language that is understood and spoken popularly in the concerned market. The reader will notice that the original Arabic name was included next to the English name of each model for the sake of completion and reference.

Cost-Plus (Murabaha)

The cost-plus (murabaha) model is mainly used for commodity and trade financing. In a cost-plus contract, the client would approach the RF finance institution to finance the purchase of a certain item, such as a cargo of soybeans, a car, a house, a commercial building, a business, or a franchise, because the client does not have the funds to purchase it in cash. Here is a brief summary of the steps taken according to this model of financing:

1. The customer issues an order to the RF bank or finance company to buy the items on the customer's behalf.

2. The RF finance institution buys the item in its own name first. The title of that item transfers from the seller to the RF finance institution.

3. The RF finance institution discloses the purchase cost to the ultimate buyer. Then, the RF finance institution sells the item to the customer at a mutually agreed-upon price, which includes a disclosed and agreed- upon profit element, to be paid over a period of time long enough to pay that price back on an affordable monthly basis, for example. The sale price charged by the RF financial institution to the customer is equal to the fully disclosed original purchase price/cost incurred by the RF bank, plus a profit element for the RF bank. As a result of this sales step, the title transfers from the RF finance company, or bank, to the client.

It is important to note here that the profit element should be agreed upon in light of the RF Marking-to-Market Discipline discussed earlier, not to simply take the prevailing interest rate (the price of renting money), calculate the profit element, and proceed to call it profit!

It must be stressed here that the sale price agreed upon between the RF finance institution and the customer, as well as the period of time (term) to pay back, is final, as are the terms of payment. For example, if the term of payment was agreed upon to be five years and the customer had a legitimate excuse to extend it over a longer period of seven years, the agreed-upon sale price would stay the same and there would be no increase — otherwise, the transaction would be deemed a riba (riba-al jahiliyah or riba al-nassee'aa, meaning a time-based prohibited riba), which is divinely prohibited (haram).

However, if the customer wants to expedite payments so that he or she pays over a two-year period instead of a five-year period, the agreed-upon price would still be the same unless the RF finance company agrees out of its own free will to reduce the price to accommodate a special request from the customer. This request can be denied, which is acceptable under the Judeo-Christian-Islamic Shari'aa law and is deemed halal, meaning it can be accepted.

There are a number of issues and concerns that are associated with the cost-plus (murabaha) transaction:

■ The two buy/sell steps (from seller to RF finance company and then from the finance company to buyer) constitute, theoretically, two changes of title. This will trigger two tax events that would call for the double taxation of the transaction (a tax due on the sale from the seller to the finance institution, and another tax due on the sale from the finance institution to the ultimate buyer who is financed by the RF institution), making it more expensive to finance in many Western societies. The RF finance institution selling to the customer at a higher price may be considered a capital gain, subject to capital gains taxes in the United States and many other countries. The tax burden in this case may be onerous. That is why many of the cost-plus models used by “Islamic” institutions in the West include a rider or another contract that contains a condition that makes the ultimate buyer — not the RF bank — responsible for any capital gains taxes that may be applied by the government at any future date if it renders the transaction a taxable transaction. This solution is unfair to those who want to abide by their faiths. It is also unfair that the RF bank claims to be Islamic while throwing all the risk back to the customer.

■ Banking institutions are not allowed by the banking laws and regulations in the West to participate in direct transactions as principles or to take title of properties (unless the property is repossessed; however, such properties are handled and recorded on the balance sheet of the RF institution in a special way, and banks are expected to dispose of them as soon as is practical). To get around this rule and to appear to satisfy the legal aspect of the RF law while potentially sacrificing the spirit of RF law, many attorneys resort to using structured financial tools by involving, in most cases, a separate but expensive-to-operate and maintain offshore company called a special-purpose vehicle (SPV), which buys the property and sells it back to the customer on paper, as is usually done for tax planning that helps some affluent taxpayers in the West to reduce their tax burden. On paper, this approach helps the RF institution to avoid the violation of the banking laws and regulations while appearing to fulfill the requirements of the RF law.

■ The well-known banking regulation called Regulation “Z” (Truth in Lending Act; TILA) in the United States requires disclosure of an (implied) interest rate that includes in the process of calculating it all costs involved in any consumer lending transaction.

Cost-plus transactions bear a striking similarity to regular interest- based banking transactions because of the way the profit element is figured out and calculated. This profit is usually tied to the prevailing interest rate in the market. Frankly, it looks like, smells like, and feels like it is riba (a process which includes renting money.)

These issues will be further addressed in Chapters 10 and 11.

 
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