Islamic project finance has grown in significance and is now widely used to finance different projects (particularly large, longer-term infrastructure and power projects) in the Middle East. There is considerable potential for the Islamic finance industry to play an important role in the financing of major projects due to its ability to employ innovative financing structures which can make use of a project’s underlying assets.
This is the first part of a series of articles discussing Shari’ah-compliant structures used by Islamic financial institutions in project financing transactions. This article seeks to explain the structure predominantly used by Islamic financial institutions for project financing in Oman and the rest of the Middle East, namely, the Istisna’a – Ijarah structure.
Istisna’a – Ijarah
In an Istisna’a – Ijarah structure, the Islamic financial institutions use a combination of Istisna’a and Ijarah contracts to finance a particular project. The Istisna’a leg of the structure is employed during the construction phase and the Ijarah leg is used during the operations phase of the project.
An Istisna’a is a contract for the sale of an asset before it comes into existence. It is an order on the manufacturer/constructor to manufacture/construct a specified asset for the purchaser by a specified date. Istisna’a is one of the exceptions to the general Shari’ah principle pertaining to the sale of an asset (for there to be a valid sale in Shari’ah, the asset (intended to be sold) must be in the actual or constructive possession of the seller).
In project financing, under the Istisna’a contract, the project company undertakes to procure the construction and delivery of the project asset from the contractor by a specified date and the Islamic financiers agree to purchase the project asset upon completion of its construction. In parallel with the Istisna’a contract, the project company enters into a construction contract with the contractor responsible for the construction of the project asset. The requisite terms and conditions and the duties/ obligations of the project company under the Istisna’a contract are incorporated in the construction contract and passed on to the contractor.
By avoiding a direct contractual relationship with the contractor, the Islamic financiers are able to minimize their exposure to the construction, credit and performance risk of the contractor.
The Islamic financiers agree to pay to the project company an amount equivalent to the total cost of the project asset under the Istisna’a contract. Such amount is paid in a phased manner on the relevant dates associated with the construction milestones until the actual completion of construction of the project asset. Upon construction of the project asset, ownership (legal and beneficial) to the project asset is transferred to the Islamic financiers under the Istisna’a contract.
It can be noted that some scholars have allowed the use of a forward lease arrangement during the term of the Istisna’a. In such a scenario, the project company makes advance rental payments to the Islamic financiers during the construction period of the project asset which payments are usually calculated to cover the Islamic financiers’ cost of funding plus profit. Such an exception (forward lease arrangements are often not permitted under Shari’ah) is allowed by scholars only on the condition that if an event of default occurs prior to the completion of construction and delivery of the project asset so that the project company never has the benefit of leasing the project asset, the Islamic financiers must refund all advance rental payments to the project company. In order to offset such refund, the Islamic financiers require the project company to pay liquidated damages (equal to the amount of all advance rental payments made by the project company) for failing to construct and deliver the project asset as per the terms of the Istisna’a contract.
Upon the achievement of the commercial operations date (i.e., the start of the operations phase of the project), the Ijarah contract comes into effect.
An Ijarah is a lease contract for the transfer of the usufruct of an asset for an agreed period and at an agreed consideration. For Shari’ah compliance purposes, it is essential that the corpus of the leased asset remains in the ownership of the lessor and only its usufruct is transferred to the lessee. The lessor bears all the risks/liabilities associated with the ownership of the asset whereas the lessee bears the liabilities associated with the use of the asset.
The Ijarah contract is used by the Islamic financiers in project financing to lease the usufruct of the project asset to the project company against the payment of lease rentals. The lease rentals are calculated as a sum of:
- fixed rent (i.e., fixed element of the lease rental corresponding to the principal amount of a conventional loan);
- variable rent (i.e., variable element of the lease rental calculated on the basis of a benchmarkinter-bank offered rate plus a margin); and
- supplementary rent (equivalent to the service charge amount paid by the Islamic financiers to the project company (in its capacity as the service agent) under the service agency agreement (discussed below)).
The form of Ijarah normally used in Islamic project finance is known as an Ijarah wa Iqtina under which the Islamic financiers (as lessors) sign a separate promise to gift the leased/project asset to the project company (as lessee) upon the expiry of the lease term, provided that the project company has paid to the Islamic financiers all lease rentals and other amounts due and payable under the Ijarah contract.
C. Ancillary Issues
The Islamic financiers (as lessors and owners of the project asset) are responsible for all major maintenance, structural repairs and replacement of a part of the project asset without which the project asset could not reasonably and properly be used by the project company in the ordinary course of its business. Also, it is the responsibility of the Islamic financiers to bear all ownership-related taxes and obtain insurance coverage of the project asset during the lease term from companies offering protection under the Islamic concept of Takaful. On the other hand, the project company (as lessee) is responsible for ordinary maintenance/wear and tear of the project asset.
The Islamic financiers (as owners of the project asset) and the project company (as service agent) typically enter into a service agency agreement under which the Islamic financiers appoint the project company as their agent to carry out the services with respect to the major maintenance, insurance and payment of asset taxes relating to the project asset (discussed above). As consideration for the provision of the said services, the Islamic financiers pay a service charge amount (i.e., the expenses incurred by the project company in the course of providing the aforesaid services) to the project company on each service charge amount payment date (corresponding to a lease rental payment date). Such service charge amount is recouped by the Islamic financiers by the charging of supplementary rent (i.e., an amount equal to the costs of major maintenance, insurance and asset taxes incurred during a rental period) from the project company.
The documentation used in the Istisna’a – Ijarah structure also includes purchase and sale undertakings. Under the purchase undertaking, the Islamic financiers are granted the irrevocable right by the project company to require it to purchase, upon the occurrence of an event of default under the Ijarah contract, the project asset for an amount equal to the total amount outstanding under the said contract (i.e., acceleration of the Ijarah facility). On the other hand, the sale undertaking is for the benefit of the project company under which the project company is granted the right by the Islamic financiers to prepay all or part of the Ijarah facility.