Well informed.

MurabahaIslamic Finance: Client Guidance Note 4

Introduction: The purpose of this Client Guidance Note is to provide a brief introduction to the Islamic financial product known as Murabaha. We shall explain the key features of the product, illustrate the contractual relationships involved and explain some of the factors that users of the product need to consider when participating in Murabaha financing transactions.

Nature of instrument: A Murabaha is a contract of sale. To achieve a financing effect, the financial institution acquires goods from the supplier for a known price (usually referred to as the cost price). Having acquired title to the goods the financial institution can offer them for sale to its customer for the sale price (which comprises the cost price and a disclosed additional amount known as the profit amount). The difference between the cost price and the sale price represents the financial institution’s profit in the transaction, whilst any agreement to defer payment by the customer creates the credit effect.

Terminology: The arrangement is generally referred to as a Murabaha financing but may also be called a cost plus financing.

Basis of approval: The reason why this arrangement is capable of being approved by Shariah scholars is because:

> Permissible activity – the buying and selling (or trading) of goods is generally considered a permissible commercial activity and is something the Prophet Muhammad (pbuh) engaged in when he was alive

> No uncertainty – there is no uncertainty because the subject matter, the price payable and the time for delivery of the goods are all known

> No interest – there is no interest because the profit amount built into the sale and purchase contract between the customer (as purchaser) and the financial institution (as seller) is derived from a trading activity rather than the lending of money and is part of the price being paid for goods

Use: The Murabaha can be used to facilitate the financing of real goods, plant and equipment, vehicles, raw materials, inventory stock and other supplies etc. The customer is usually appointed to act as the agent of the financial institution to deal with the supplier and arrange for the sale of the goods by the supplier to the financial institution. Ideally, that appointment should occur before the customer commences dealing with the supplier although in practice the customer may have been in discussion with his supplier before he approaches the financial institution for financial support.

Documentation: The Murabaha arrangement will usually be documented by way of a Master Murabaha Financing Agreement under which the financial institution and the customer can enter into multiple transactions over an agreed period of time (each usually called a Murabaha Contract) to provide a flexible facility capable of multiple-utilisations. Supporting documents will include the agency agreement (mentioned earlier) and the various notices that have to be exchanged in the correct sequence to set up the transactions involved in completing a Murabaha Contract for each utilisation. If the transaction is being syndicated, an investment agency or participation agreement will also be required and where security is being provided, the relevant security documents will also need to be completed.

Fixed price nature: To ensure certainty, the sale price payable under each Murabaha Contract has to be for an agreed fixed amount and there is no scope to adjust the price in the event payment is delayed for whatever reason.

Disadvantage: The fixed price character of each Murabaha Contract means that there are inherent constraints in using the technique for longer tenor financing and this is perhaps one reason why this method has become less popular than commodity Murabaha (see the Client Guidance Note 5: commodity Murabaha) which offers greater flexibility.

Murabaha illustrated: The following diagrams provide a visual illustration of the main contractual relationships involved in a Murabaha financing and show how they differ from the conventional lender/borrower relationship. The net economic effect of entering into each Murabaha Contract under the Master Murabaha Financing Agreement is substantially similar to drawing down a fixed term loan under a conventional loan agreement.

> The Islamic Financial Institution (IFI) purchases the asset (1) for cash for immediate delivery from the Supplier (2) in what can be referred to as the ‘funding’ limb.

> The IFI can then sell the asset to the Customer (3) at a disclosed, marked-up price payable in the future (4) with the deferral being known as Bai’ Mu ajjal creating the ‘credit’ limb of the arrangement.

Conventional loan arrangement

Murabaha arrangement

Introduction to Murabaha.Murabaha: the vanilla asset purchase and financing product.

Security interest

Principal

Interest

Ownersh

ip

Loan amount

Financial institution

Customer

Asset

IslamicFinancial

Institution (IFI)

Supplier

Customer

1

4

3

2

1. Original Purchase Price (immediate delivery)

2. Supplier sells goods to IFI (immediate delivery)

3. IFI sells goods to customer (immediate delivery)

4. Sale price = Original cost price + agreed mark-up

Payments can be deferred: lump sum or instalments on specified dates

Care needed: Although the Murabaha technique appears relatively straightforward, there are quite a few legal and Shariah issues that have to be considered when deploying the arrangement. We mention a few of them in the following paragraphs:

Murabaha: some things to consider.

Reliance Early settlement

Terminology

Although a Murabaha arrangement results in a credit effect, it is important to recognise that the debt created is to pay for goods as opposed to the repayment of money borrowed. The language of ‘loan’, ‘lending’, ‘lender’ and ‘borrow’, ‘borrower’ is not therefore appropriate and should be avoided.

Further advice: This Client Guidance Note is not intended to be a complete guide to the legal and Shariah issues involved in the product it discusses. Please do not hesitate to contact Linklaters for further advice and information on the Murabaha financing technique.

Because of the Shariah rule that a seller cannot sell what it does not own, the financial institution is required to acquire title to the goods before it is permitted to offer them for sale to the customer. To minimise the risk of the customer refusing to buy the goods after the financial institution has acquired them the arrangements need to be structured as a ‘Purchase Order Murabaha’ whereby the financial institution only acquires the goods from the supplier in reliance upon the undertaking of the customer to buy them when they are offered for sale in the future. A breach of that undertaking gives the financial institution a claim in damages against the customer for breach of undertaking.

Tax

Because the arrangement involves multiple purchases and sales of goods, there is a risk that Sales, VAT or other forms of supply taxes might apply on each limb of the arrangement. Unless the jurisdiction in which the transaction is being executed has expressly removed any such potential ‘double’ tax charges, the additional tax burden may render the method uncompetitive as a financial product. The other area where tax may be relevant concerns the treatment of the deferred sale price and its various components. In jurisdictions where interest is treated as deductible for tax purposes, a customer will be disadvantaged if they are not permitted to deduct the profit portion of the deferred sale price.

Sale of goods

As a sale of goods the financial institution may be exposed to additional risks arising from the supply of goods. Care has to be taken to mitigate such risks whether by providing for the goods to be inspected by the customer before delivery (Shariah generally applies the dictum ‘buyer beware’ and giving the buyer an opportunity to inspect can absolve the financial institution for liability) or for the onward transmission of warranties.

If the customer wishes to pay the sale price earlier than the scheduled payment date, the question arises whether or not it entitled to a discount, so as to ensure it is in the same position as it would have been had the financing taken the form of a conventional loan. The Shariah starting point is that the agreed sale price should be paid in full. For commercial reasons, this is not usually acceptable to the customer and so the market practice has evolved whereby the customer is given the right to claim a discount or rebate. To avoid this being construed as recognising the time value of money, the Murabaha agreement will never contain a formula for the relevant calculation but will instead reserve the right to determine the amount of the rebate or discount (if any) to the absolute discretion of the financial institution.

Increased costs

The fixed sale price due under each Murabaha Contract means the financial institution cannot unilaterally increase the amount payable by the customer if it incurs additional costs (whether for cost of capital or other reasons). Having said that techniques have developed where transactions involving multiple utilisations will permit the financial institution to add such costs to the sale price calculation of future utilisations.

Omar El SayedManaging Associate, DubaiTel: +971 4 369 5845omar.el_sayed@linklaters.com

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Linklaters LLP is a limited liability partnership registered in England and Wales with registered number OC326345. The term partner in relation to Linklaters LLP is used to refer to a member of the LLP or an employee or consultant of Linklaters LLP or any of its affiliated firms or entities with equivalent standing and qualifications. A list of the names of the members of Linklaters LLP and of the non-members who are designated as partners and their professional qualifications is open to inspection at its registered office, One Silk Street, London EC2Y 8HQ, England or on www.linklaters.com and such persons are either solicitors, registered foreign lawyers or European lawyers.

linklaters.com

Neil D MillerGlobal Head of Islamic Finance, DubaiTel: +971 4 369 5815neil.miller@linklaters.com

Reem Al SayeghAssociate, DubaiTel: +971 4 369 5852reem.alsayegh@linklaters.com

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