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RESEARCH PAPER (No: 42/2012)

A FRAMEWORK FOR ISLAMIC FINANCIAL INSTITUTIONS TO DEAL WITH SHARAH NONCOMPLIANT TRANSACTIONS
ASSOC. PROF. DR ASYRAF WAJDI DUSUKI MOHAMMAD MAHBUBI ALI LOKMANULHAKIM HUSSAIN

A FRAMEWORK FOR ISLAMIC FINANCIAL INSTITUTIONS TO DEAL WITH SHARAH NON-COMPLIANT TRANSACTIONS Assoc. Prof. Dr Asyraf Wajdi Dusuki* Mohammad Mahbubi Ali** Lokmanulhakim Hussain***

ABSTRACT The concern over Sharah-compliant transactions is firmly entrenched in the activities and operations of Islamic financial institutions (IFIs). As a business entity established within the ambit of Sharah, an IFI is expected to be guided by values, principles, objectives and rulings of the Sharah. However, ensuring effective Sharah compliance is not a straightforward matter. As financial markets become increasingly sophisticated, heightened product innovations and engineering in Islamic finance entail genuine concern over the need to strengthen Sharah compliance throughout the product life cycle. This means that, while a product may be deemed Sharah compliant prior to its launch (ex-ante), the IFI must also be cognizant of the need to ensure that the entire ex-post processincluding contract execution, utilization of funds, investment activities, the audit and governance processare all in place. This paper focuses on the framework for dealing with Sharah non-compliant transactions in Islamic finance. The framework delineates the concept of illegitimate income and its sources from the Islamic perspective in order to develop a coherent approach to dealing with diverse non-compliance situations based on established principles of the Sharah. Although it is not expected that an IFI will deliberately involve itself in illegitimate activities, any incident of non-compliance needs to be immediately addressed, rectified and reported. This is not only to ensure the purity of the income earned but, more importantly, for IFIs to put in place adequate systems and controls to ensure such that non-compliance with Sharah rules and principles can be averted. Keywords: : Sharah non-compliant, illegitimate income, fsid, bil, contract rectification, income purification
Assoc. Prof. Dr Asyraf Wajdi Dusuki is the Head Research Affairs at International Sharah Research Academy for Islamic Finance (ISRA). He is also a Sharah Advisor to AIA AFG Takaful Bhd. He can be contacted at asyraf@isra.my ** Mohammad Mahbubi Ali is a Researcher at International Sharah Research Academy for Islamic Finance (ISRA). He can be contacted at mahbubi@isra.my *** Lokmanulhakim Hussain is a Researcher at International Sharah Research Academy for Islamic Finance (ISRA). He can be contacted at lokman@isra.my
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ISRA RESEARCH PAPER (NO. 42/2012) Asyraf Wajdi Dusuki, Mohammad Mahbubi Ali & Lokmanulhakim Hussain

1. INTRODUCTION
Strengthening the robustness of the Sharah governance framework and practices has become more imperative for Islamic financial institutions (hereafter IFIs) because an IFI is an institution governed by Sharah rules and principles. Institutions offering Islamic financial products and services are starting to realize the negative repercussions of paying inadequate attention to the whole process of Sharah compliance. Indeed, failure to comply with the Sharah not only invokes financial risk but may eventually expose IFIs to the risk of breaking the trust and confidence of investors and depositors. This inexorably leads to dire consequences, including massive withdrawal and insolvency risk. As a case in point, governance failure cost Dubai Islamic Bank USD50 million in 1998 when a bank official did not conform to the ethical requirements of advancing financing. This resulted in a run on its deposits of USD138 millionrepresenting 7% of the banks total depositsin just one day (Warde, 2000). In Malaysia, the endeavor to reinforce sound Sharah regulation and supervision led Bank Negara Malaysia to issue its Sharah Governance Framework for Islamic financial institutions on January 1st, 2011. The main objective of this guideline is to enforce and strengthen the IFIs Sharah governance structures and processes in order to ensure that all of their operations and business activities are consistent with the requirements of the Sharah. The Guideline requires IFIs to institute clear internal controls and a process for holistically addressing the issue of Sharah non-compliance. In other words, Sharah compliance should not only focus on product structuring and issuing Sharah pronouncements; rather, it covers the whole spectrum of IFI operations, both ex-ante and ex-post aspects of Islamic financial transactions. There is a general misperception in the market today that should a bank fail to act in accordance with the Sharah rules, the transaction is null and void from a Sharah viewpoint, that all income derived from it is tainted, and that everything must be channeled to charity. However, the obligation resulting from Sharah non-compliant transactions is not always purification of the tainted income by channeling it to charity. There are also instances in which the proceeds generated must be returned to the original owners. In other instances, only the prohibited portion is supposed to be channeled to charity while the remaining portion can be retained as income. In certain situations, the transaction can be rectified and the proceeds can still be recognized as the IFIs income, provided all the necessary amendments have been made.

A FRAMEWORK FOR ISLAMIC FINANCIAL INSTITUTIONS TO DEAL WITH SHARAH NON-COMPLIANT TRANSACTIONS

Against this backdrop, this study focuses on the approach and methodology for dealing with non-Sharah compliant transactions or non-all income. Specifically, the paper sets out to provide answers to the following research questions: What is non-all income? What are the categories of non-all income? How should each category of non-all income be treated from a Sharah perspective? It is hoped that, by providing the answers to these three fundamental questions, the paper can propose a framework for income purification for Islamic financial institutions in line with the requirements set out in Bank Negara Malaysias Sharah Governance Framework. Following this brief introduction, the paper is organized according to the following structure: the next section examines the concept of illegitimate income (ml arm) from the Sharah viewpoint. Various sources of illegitimate income are identified and then organized into two major categories: arm li dhtihi (prohibited due to its essence) and arm li ghayrihi (prohibited due to external reasons). The third section then elaborates the approaches to dealing with various sources of illegitimate income. The principle of income purification is deliberated in detail so as to construct a robust, relevant and practical framework that can be adopted by Islamic financial institutions in addressing various potential Sharah non-compliant transactions. The fourth section provides sample scenarios for how Islamic financial institutions could treat their tainted income, while the final section concludes the study.

2. AN OVERVIEW OF ML HARM 2.1 The Concept of Ml in the Sharah Literally, ml (wealth) is defined as everything that may be possessed by an individual (Ibn Manr, 1414AH, 11:635; al-Zabd, n.d, 30:427). Technically, classical jurists have provided various definitions of ml. Ibn bidn of the anaf School defines ml as anything human beings desire that can be stored to be utilized when needed (Ibn bidn, 1992, 4:501). Majallat al-Akm al-Adliyyah, in Article 126, includes

ISRA RESEARCH PAPER (NO. 42/2012) Asyraf Wajdi Dusuki, Mohammad Mahbubi Ali & Lokmanulhakim Hussain

movable and immovable items as forms of ml (Hawwin, n.d, 31). The anaf School, however, excludes usufruct (manfaah) from its definition of ml as it cannot be stored. Al-Shib of the Mliki School defines ml as anything that can be owned and controlled exclusively by the owner and acquired by legitimate means (al-Shib, 1997, 2:17). The Mlik definition of ml stipulates two criteria: first, it can be exclusively possessed. Hence, everything that cannot be owned, such as a bird in the sky, cannot be deemed ml. In contrast to the anaf view, the Mlik view recognizes usufruct as ml since it can be owned. Second, the method by which the wealth is acquired should be legitimate from the Sharah perspective. The Shfi School defines ml as something of value that is exchangeable (al-Shfi, 1990, 171). Al-Baht of the anbal School reiterates Ibn al-Najjrs definition of ml as anything permissible to take benefit from and acquire. This definition excludes items of no benefit or whose benefit is prohibited, such as alcohol (al-Baht, 1993, 2:7). Based on their definitions, the Shfi and anbal Schools argue that a Muslim who spilled a persons alcohol cannot be held liable for the value of the wine as it is not recognized as ml and has no value from an Islamic point of view (al-Qazwn, n.d, 11:258; Ibn Qudmah, n.d, 5:222-223). While the Mlik and anaf Schools agree with the Shfi and anbal Schools that alcohol cannot be considered wealth for Muslims, they recognize that it does have value for non-Muslims; hence, a Muslim is held liable if he spills alcohol belonging to a non-Muslim (al-Qarf, 1994, 8:277-278; al-Sarakhs, 1993, 11:103). Based on the various definitions given, there are two areas of controversy in defining ml: 1) the majority of jurists include usufruct in the definition of ml while the anafs exclude it; 2) there is disagreement whether items prohibited by the Sharah, but which non-Muslims recognize as having economic value, are subject to indemnification if damaged or destroyed. 2.2 The Concept of Ml arm Al-Ghazl defined ml arm as any property acquired by illegal means, such as theft, rib, hoarding, gambling, etc. (al-Bz, 2004, 39). Some contemporary scholars have defined ml arm as anything that the Sharah has prohibited a Muslim from appropriating due to a preventive factor (al-Bz, 2004, 39). Other scholars have defined it as wealth that the Sharah has prohibited the holder from utilizing in any way (Yasin,

A FRAMEWORK FOR ISLAMIC FINANCIAL INSTITUTIONS TO DEAL WITH SHARAH NON-COMPLIANT TRANSACTIONS

1414AH). These definitions, thus, differ regarding the locus of the prohibition: Is it utilization or appropriation? Jurists categorized ml arm into two major types: First, what is prohibited in it essence (li-dhtih) and second, what is prohibited due to external reasons (li-ghayrihi) (al-Bz, 2004, 39). 2.2.1 Prohibited in Essence (arm li Dhtihi) Muslim jurists considered certain items to be prohibited in themselves if the prohibition is due to their essence and nature. These include pork, wine and other impure items (al-Sarakhs, 1993, 11:102-103; Ibn Rushd, 1425/2004, 3:52; Ibn Rushd, 1408/1988, 18:492; al-Naww, n.d, 6:37, 14:283-284; Ibn Qudmah, 1388/1968, 9:162). Indeed, the majority of jurists do not consider such items to be ml at all. 2.2.2 Prohibited Due to External Reasons (arm li Ghayrihi) Another type of ml arm consists of items that are permitted in their essence (al) but become prohibited due to external reasons or an auxiliary attribute (waf). For instance, accumulating wealth is basically permissible, but if the method by which it is accumulated is illegitimate, the wealth is non-all (Ibn bidn, n.d, 2:292; al-Qarf, n.d, 4:108; al-Naww, n.d, 12:116; Ibn Taymiyyah, 1408/1987, 4:210). For example, trading is permissible, but it is prohibited during the hour of Jumuah prayers so any profits are illegitimate. Similarly, paper money in its essence is permissible, but if it is acquired from bribery or rib, the way it was earned changes the status of the money to unlawful. 2.3. Sources of Impermissible (Non-all) Income The preceding discussion explored the fundamental concept of ml and ml arm. Essentially, income-generating or wealth-accumulation activities that involve money do not invoke the issue of arm li dhtihi since money in its essence (ayn) is permissible. However, a particular sum of money may be deemed impermissible if it is derived from arm sources. As previously explained, this is known as arm li ghayrihi. The following discussion will shed further light on the possible sources of impermissible income (ml arm, hereafter referred to as non-all income) due to external reasons.

ISRA RESEARCH PAPER (NO. 42/2012) Asyraf Wajdi Dusuki, Mohammad Mahbubi Ali & Lokmanulhakim Hussain

In general, there are two external factors that make income non-all (al-Bz, 2004): (1) The income is acquired without the consent (bi ghayr ri) of the legal owner. Examples are income realized through theft (sariqah), usurpation (ghab) and deception. (2) The income is earned with the consent of the owner by a transaction that is not approved by the Sharah. In this regard, Ibn Taymiyyah further divided this category into two possible scenarios; (i) non-all income possessed through nominate contracts; and (ii) non-all income earned without having any specific contractual forms, such as income from rashwah (bribery), maysir (gambling), gifts to employees while executing their duties, etc. (Ibn Taymiyyah, 2005, 593-594). While income earned without a specific underlying contract is clear and easily understandable, the following discussion will delineate non-all income sources through specific nominate contracts. 2.3.1 Validity of the Contract In an Islamic transaction, validity of the contract is important in determining whether a transaction can be considered permissible or impermissible. A valid contract from an Islamic viewpoint is one in which all the essential pillars and conditions of the contract are fulfilled. This provides a parameter for determining the status of income derived from any transaction conducted. According to the majority of jurists, there are only two possible rulings on the status of a contract: valid (a) and invalid (ghayr a), and this latter category has other names (bil and fsid) which can be used interchangeably for it (Zuhaily, 2004). a is a contract that is good in its essence (al) and lawful in its external attributes (waf) (al-Rmi, 2004, 1:75). It is a contract in which all the essential elements (arkn) such as the contracting parties, subject matter, and offer and acceptanceand all the underlying conditions are fulfilled (al-Minyw, 2010, 1:34). For instance, fulfillment of all the contractual pillars that would make a sale contract valid would include the following: the parties to the contract are legally eligible to undertake contracts; i.e., they are sane, of the age of majority and of sensible conduct; the offer and acceptance are clear and made at the same session (majlis al-aqd), either

A FRAMEWORK FOR ISLAMIC FINANCIAL INSTITUTIONS TO DEAL WITH SHARAH NON-COMPLIANT TRANSACTIONS

actually or in a form recognized as such by the law; the acceptance is in conformity with the offer; the offer remains effective until the issuance of the acceptance; the asset is completely owned by the seller; it has value (mutaqawwam) and is deliverable (qudrah al taslm). From a Sharah point of view, a valid contract establishes all the legal implications that the Sharah has assigned to a contract of that type (al-Namlah, 1999, 1:412). For example, the buyer attains the exclusive right to possess and utilize the asset while the seller becomes entitled to the consideration. All income generated from this class of contract is deemed legal (all), and the contract becomes effective (nfidh) upon its execution. The majority of jurists hold the view that the effectiveness of a valid contract (a) may be suspended until the occurrence of a future event. In contrast, the Shfi School and some anbal jurists hold that a valid contract must become immediately effective upon its execution (Ayyub, 2007, 118). On the other hand, a contract that is invalid (ghayr a) is one that violates the pillars and Sharah conditions of the contract (al-Shawkni, n.d, 539). The following are examples of factors that render a contract invalid: the sold asset is an impure or prohibited commodity such as blood, pork, wine, a carcass; the asset is not fully possessed by the seller or is undeliverable; there is excessive uncertainty in the delivery date or price; or the contract is performed by parties without legal eligibility to execute contracts; i.e., one of the parties is insane, immature or not of sensible conduct. From the Sharah point of view, an invalid contract does not produce the legal effects of that contract. There is no exchange of financial rights and responsibilities due to it; the buyer does not have any right to dispose of the asset, while the seller cannot possess the income realized. Such a contract must be properly re-executed, starting from scratch. The majority of jurists do not distinguish between bil (void) and fsid (irregular) except in certain non-financial issues such as ajj (pilgrimage), marriage and khulu (Ibn Qudmah, 2002, 1:183). With regard to financial transactions, both terms are the opposite of a, having a single legal implication (al-Ramli, n.d, 25), and are often used interchangeably. Al-Jazr stated:

..... .

ISRA RESEARCH PAPER (NO. 42/2012) Asyraf Wajdi Dusuki, Mohammad Mahbubi Ali & Lokmanulhakim Hussain

Fsid and bil share a single meaning in relation to sale contracts; everything that is fsid is bil, and vice versa; i.e., one of the conditions or pillars is breached.Fsid sales are all interdicted, and it is incumbent upon people to avoid them (al-Jaziri, 2003, 3:224-225). The anaf School took a different position from the majority of classical jurists. They classified contracts into three categories: a (valid), fsid (irregular) and bil (void), and considered bil and fsid to be different in substance and ruling. Fsid, according to the anaf School, is an intermediary class of contract between a and bil (al-Bukhr, 1997, 1:379-380). The anaf position is premised upon the fact that the defect in a defective contract is due either to a fundamental element (al) or an accessory attribute (waf). The anaf School agreed with the majority that a defect in a contracts fundamental element (al) renders the contract void (bil) and that it cannot be rectified. However, a defect in an external factor (waf) will only make the contract irregular (fsid) (al-Bukhr, 1997, 1:380). It does not necessarily render it void (bil). According to Ab anfah, a sale contract has four fundamental pillars: the two contracting parties and the two counter-values. If the four pillars are satisfied and free from any Sharah prohibition, then the contract is valid. In contrast, if the contract is defective in any of its fundamental pillars, it is void (bil). However, if the defect is due to external factors attached to the pillars, the contract is irregular (fsid). The following are scenarios that elucidate the anaf view regarding the differences between a, bil, and fsid (al-Qarf, n.d, 2:83): (1) An insane person sells pork for a payment of wine to another insane person. In this case, all the fundamental pillars are defective and, hence, the contract is void (bil). A legally competent person sells clothes for a payment of pork to another legally competent person. In this case, one of the fundamental elements (pork) is defective, which renders the contract void (bil). A legally competent person sells one gram of silver in exchange for another gram of silver to another legally competent person. In this case all the pillars of the contract are sound and, hence, the contract is valid. Based on Scenario No. 3 above, assuming that one gram of silver is exchanged for two grams of silver, the contract is defective due to the existence of an

(2)

(3)

(4)

A FRAMEWORK FOR ISLAMIC FINANCIAL INSTITUTIONS TO DEAL WITH SHARAH NON-COMPLIANT TRANSACTIONS

external factor, i.e., an increment (ziydah). Since the defect is not in its pillars or fundamental elements (al), the contract is irregular (fsid) but rectifiable. Once the increment is removed, the contract becomes valid Since the anaf School agrees with the majority regarding the definition and legal implications of a a contract, the following discussion will further examine the anaf conceptualization of bil and fsid. 2.3.2 Bil Contracts According to the anaf School, bil is a contract that is invalid due to a defect in any of the essential elements (pillars) of the contract (al-Ksn, 1986, 5:305). The following are examples of such defects: if the contract involves impure or prohibited items as the subject matter; the subject matter has no value from the Sharah perspective; the asset is not fully owned by the seller; the acceptance is not in conformity with the offer; the contracting parties have not reached the age of maturity; the contract contains fraud, deceit, etc. The anafs and other schools identified some particular forms of bil contracts, which include (Zuhaily, 2004, 5: 3398-3431): (1) Selling impure items. All the schools stated that sales of pork, wine, carcasses or blood are void because these items are not considered to have value (mutaqawwam) from an Islamic perspective. (2) Bay gharar; i.e., a sale contract that contain excessive uncertainty, which will lead to probable loss to one of the contracting parties and, thus, to disputes. Jurists unanimously agreed that bay gharar is invalid. Some prominent forms of bay gharar are: (a) Selling something nonexistent at the time of the contract, such as sale of fruit before it begins to ripen, sale of sperm or a fetus, and sale of the offspring of a fetus. Technically speaking, some of these items may be existent at the time of the contract; however, they do not have economic value at the time of the sale; their value is only realized at some future date.

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ISRA RESEARCH PAPER (NO. 42/2012) Asyraf Wajdi Dusuki, Mohammad Mahbubi Ali & Lokmanulhakim Hussain

(b)

Selling something undeliverable, such as fish in the water or birds in the sky.

The anaf conception of a bil contract has the same implications as the majoritys category, ghayr a (invalid). A bil contract does not give rise to any legal consequences. The contract is treated as if it does not exist. Therefore, the buyer in a sale contract is not entitled to the asset while the seller has no right to the consideration. All income generated from a void contract is ruled as non-all; hence, it cannot be possessed or utilized (al-Bz, 2004). ussain mid assn said:


A void contract has no existence in the eyes of the Lawgiver. It does not confer a right, does not create obligations, and does not transfer property (assn, in Niazi, L.K, n.d, 79).

2.3.3 Fsid Contracts A fsid (irregular) contract is a unique class of contract recognized in the anaf Schools categorization scheme. Unlike a btil contract, the essential elements of a fsid are present, but the contract is tainted by a defect in an accessory attribute (waf) (Mahmd, 2000, 8:139; al-Zayla, 1313AH, 4:12; al-Bz, 2004, 94). anaf jurists identified various factors leading to a fsid contract, as highlighted below: (1) A problem with the deliverability of the asset. As mentioned earlier, if an asset cannot be delivered because the seller does not possess it, all the madhhabs agree that the contract is void (bil) (Mahmd, 2000, 8:147). In other cases, the seller owns the asset, but its delivery will cause him harm; for example, selling wood from the roof of his dwelling. anaf jurists consider such contracts to be irregular (fsid) because a contract does not justify harm (Wizrat al-Awqf wa al-Shun al-Islmiyyah, 1404-1427AH, 12:60). (2) Ignorance (jahlah); i.e., insufficient information. The jahlah may exist with regard to four matters:

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(a)

the asset; e.g., the seller says, I hereby sell you some of my cloth, and the parties disperse without the seller specifying which cloth is being sold. the price; e.g., the seller says to the buyer, I hereby sell this asset to you for RM 100 spot payment or RM 200 deferred payment and the parties disperse without the buyer accepting one of the prices in particular (al-Imrn, 2006, 80). the time of delivery. the guarantee, surety or the pledge; e.g., a seller stipulates a guarantee or pledge without specifying what it is (Zuhaily, 2004, 5:3444-3446).

(b)

(c) (d)

According to the anaf School, insufficient information about any of these four matters renders the contract irregular (fsid) because it will create a dispute between the contracting parties (Zuhaily, 2004, 5:3441-3446). However, if the lack of information entails excessive uncertainty about the delivery datee.g., selling an asset for delivery if rain falls or if a certain person comesthe contract is ruled bil according to all four schools of thought, including the anafs (al-Ksn, 1986, 5:178). (3) The existence of an invalid condition. The anaf School defined an invalid condition (shart mufsid) as a condition that is neither consistent with the nature and implication of the contract (muqta al-aqd), nor endorsed by textual authority, nor admitted by customary practice. In fact, the condition offers a benefit to only one of the contracting parties (or a third party) at the expense of the other contracting party (Zuhaily, 2004, 5: 3471). One example is tying a loan agreement to a sale contract; e.g., Al agrees to give a loan to Zayd on the condition that Zayd sells his asset to Al. In this case, Zayd may consider discounting the price in favour of Al due to the loan facility, resulting in a loan that extracts profit (Arbouna, 2007, 346). Another example is a purchase undertaking at par in a murabah-based product; this gives the capital providers a guarantee of their capital. Another example would be a seller who sells a slave on the condition that the buyer will free him. The existence of duress (ikrh). Jurists classified duress in the contract into two types: (i) mulji (ii) ghayr mulji. Mulji means that the duress comprises a threat of death or extreme harm to part of the body. In this case, duress

(4)

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renders the contract void (bil) because it nullifies freedom of choice (ikhtiyr) and consent (ri). Duress that is ghayr mulji entails a lower level of harm than the former; for example, threat of imprisonment or a comparable or lesser harm. In this case, according to the anaf School, the contract is fsid because it does not totally annul freedom of choice; rather, it nullifies consent (ri). From a fiqh perspective, consent is not a contract pillar, rather it is a condition for the validity of a contract (Wizrat al-Awqf wa al-Shun al-Islmiyyah, 1404-1427AH, 9:101). (5) The existence of an element of rib. The majority of jurists consider the existence of rib to invalidate the contract (make it bil). However, the anaf School holds that rib does not make a contract void (bil); rather, it makes it irregular (fsid) and, hence, rectifiable (Wizrat al-Awqf wa alShun al-Islmiyyah, 1404-1427AH, 9:101). Unlike a bil contract, the income from a fsid contract is not irretrievably illegal; it is irregular but rectifiable. Once the intolerable elements are eliminated, the contract becomes a; thus, the income becomes legal (all). Interestingly, while the anaf School clearly differentiates between bil and fsid in financial contracts, they do not distinguish between them in other areas, such as in marriage contracts and acts of devotional worship. It is stated in al-Ashbh wa alNair:


In our view, bil and fsid are synonymous with regard to acts of devotional worship and marriage contracts (Ibn Nujaim, 1999, 401). Indeed, the anaf approach to invalid contracts in financial transactions is not limited to them. It is also supported by some Mlik and Shfi jurists. Al-Qarf, of the Mlik School, acknowledged that the anaf approach is sound (al-Qarf, n.d, 2:83). Some Shfi scholars also differentiate between fsid and bil in certain contracts such as waklah, irah, and ijrah. Some even follow the anaf view regarding all types of contracts (al-Ramli, n.d, 25). Contemporary fiqh scholars have generally adopted the anaf view. Therefore, this paper has employed the anaf categorization of invalid contracts as the approach to designing the income purification framework for Islamic

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financial institutions. The authors view the anaf differentiation between bil and fsid to be more practical and relevant to the current context and the needs of market players. There are a number of reasons for that judgement: First, practically speaking, not every contractual defect is serious enough to warrant re-execution. Some defects are minor and can easily be rectified by removing the objectionable elements. Second, in the current context, re-execution of contracts creates practical complexity as institutions tend to use boilerplate contracts to undertake the same basic type of transaction with thousand of clients, and some contracts involve cross-border transactions. Adopting the majority view will undoubtedly impose hardship and difficulty on the market. Thirdly, the anaf categorization provides more options to the market players to apply the Islamic law of contract in modern financial operations. Exhibit 1 depicts the summary of the discussion so far pertaining to the sources of impermissible income. It is pertinent to be clear about the sources of impermissible income before developing a holistic income-purification framework for Islamic financial institutions. The following subsection shall delineate the approaches and mechanisms for dealing with various sources of impermissible income as discussed above Exhibit 1: Potential Sources of Impermissible Income.
Mahal aqd (Subject Matter) Khalal fi arkan (Defect in Other Pillars)

Batil (Void) Li Dhtihi Contract Ml arm (Prohibited Income)

Ria (Consent)

Fsid (Irregular)

Tas-hih (Rectifiable) No Tas-hih (Cannot be rectified)

Li Ghayrihi

Non-Contract

'Adam Rida (No Consent)

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3. DEALING WITH NON-HALAL INCOME


3.1 Treatment of Non-all Income In Islam, a Muslim is not supposed to enter into any transaction that is in violation of Sharah rulings and principles. However, in the event that he does transgress the boundary of Sharah principles, the Sharah requires the Muslim to repent and rectify the wrongdoings immediately. Repentance means that one should feel regret for having done the act, should stop doing it and resolve not to repeat it. In a financial or business transaction, repentance is not sufficient if one still possesses the impermissible assets or income. It is imperative that any income derived from impermissible sources undergo an immediate process of rectification or purification. However, the rectification and purification process may vary, depending upon sources and scenarios. Some non-all income may have to be purified by channeling all of the tainted money to charity while in some cases it may be required to return the wealth to the original owner. In certain scenarios, rectification can be made without resorting to channeling all the income to charity or the original owner. The following discussion examines the treatment of non-all income from various sources and scenarios identified in the preceding section. 3.1.1 Non-all Income Due to Its Essence (arm li Dhtihi) As described in the foregoing discussion, arm li dhtihi is what is prohibited due to the intrinsic nature of the item, such as pork, wine and other impure items (Ibn Rushd 2004, 3:52; Ibn Qudmah, 1968, 9:162). In this case, the Sharah does not recognize the items as assets having value that can be owned and treated as legal property by the holder. Hence, the holder should immediately rectify the wrongdoing by destroying the items (itlf); they should neither be returned to the original owner nor channeled to charity. It is narrated by Anas that Ab alah asked the Prophet (peace be upon him) about orphans who had inherited wine. Allahs Messenger (peace be upon him) told him:

: :
Pour it out. Ab alah asked if he could make vinegar of it. He replied, No. (Ab Dwd, n.d, 3:326).

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Nevertheless, if the original owner is a non-Muslim, the recipient may return these items to him, as these are recognized as property in the hand of a non-Muslim, according to the Mlik and anaf viewpoint. However, generating income or accumulating wealth through ownership or transacting items of this category of prohibition is completely prohibited from the Sharah viewpoint. 3.1.2 Non-all Income Derived from Elements Prohibited Due to External Reasons (arm li Ghayrihi) Within this category, there are two possible scenarios: the prohibited income is derived either with or without the original owners consent. The treatment of income for each of these two scenarios shall be discussed in brief. 3.1.2.1 Non-all Income Acquired without the Owners Consent (bi Ghayr Ri) This type of prohibited income is realized without prior consent from the legal owner, such as income derived from robbery, theft, etc. In this case, the income must be purified by returning it to the owner. The obligation to return the income back to the original owner is justified by a adth in which Rasulullh (peace be upon him) said:


Whoever oppresses his brother with regard to his honor or any other matter should seek his forgiveness today, before [repayment] is no longer in dinars or dirhams (Bukhr, 1422H, 3:129). Obviously, a thief who asks his victim for forgiveness without returning what he stole from him has slim chance of receiving it. It is also premised upon another adth:


The hand (i.e., person) is liable for what it took until it returns it (alTirmidh, 1975, 3:558).

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This adth is referred to in discussions of liability for a borrowed object; however, the generality of its wording makes it relevant to the issue of income generated without the consent of the original owner. Imam al-Bayhaq in Marifat al-Sunan wa al-thr mentioned it when discussing the issue of a thiefs liability to indemnify the stolen asset (al-Bayhaq, 1425AH, 12:422). Jurists unanimously agreed that any asset acquired without the owners consent must be given back to the owner. Ibn Qudmah says:


Whoever usurps something is obliged to return it as long as it remains [existent]. We know of no disagreement [on this ruling] (Ibn Qudmah, 1388AH, 5:177).

3.1.2.2 Non-all Income Acquired with the Owners Consent As indicated in the previous section, the non-all income acquired with the consent of the owner may be realized through either a nominate contract or a non-specific form of contract. The following discussion delineates the treatment of each scenario. 3.1.2.2.1 Consent via a Nominate Contract The anafs categorization of invalid contracts as bil or fsid is employed to deal with this type of income. Each type of invalid contract has a different treatment. 3.1.2.2.1.1 Treatment of a Bil Contract As mentioned earlier, the Sharah does not consider a void contract to be existent. Therefore, the transaction does not have any legal effects or implications. Hence, any income derived from this type of contract is unlawful and must be purified. A void sale contract, for example, does not cause any transfer of ownership. The seller should therefore refund the price while the buyer has to return the purchased asset. The Mlik jurist Ibn Rushd states:

- -

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Jurists unanimously agree that the ruling of an invalid salewhat the anafs call bilwhen it has been concluded and [the opportunity to undo it] remains, is radd (return): the seller returns the price while the buyer returns the asset (Ibn Rushd, 2004, 2:193). If the buyer sold the asset to another party after taking delivery, the first seller still has the right to reclaim the asset. That is because a void contract does not have legal effect; thus, no transfer of ownership occurred in the first sale (Wizrat al-Awqf wa al-Shun al-Islmiyyah, 1404-1427AH, 3:285). In the context of a void gift (hibah), the recipient does not possess the granted item (al-Shrz, n.d, 1:455). He must return it back to the donor. Likewise, if a rahn contract is ruled void, the murtahin (pledgee) does not have any right to keep the marhn (security) (Ibn Nujaim,1999, 338); thus, it must be given back to the rhin (debtor). Notwithstanding the above ruling, in case the transacted asset is an item clearly prohibited by the Sharah, such as pork, wine or other impure items, the counter-value of such asset must be channeled to public benefit (mali mmah) (Ibn Taymiyyah, 2005, 29:291) and is not to be returned to the original owner. This is in consideration of the Sharah principle that it is unlawful to assist others to commit sins. It can thus be concluded that a process of purification must be undertaken for a void contract (bil). Neither party can recognize the income realized from this form of contract. The process of purification may be divided into two scenarios: First, if the contract is ruled null because it has failed to satisfy one or more pillars or conditions of validity, purification is conducted by returning the income to its owner. A properly structured contract has to be re-executed from the beginning in case all the contracting parties want to continue with the transaction in a Sharah-compliant manner. Second, if the underlying asset employed in the contract is a substance prohibited by the Sharah, such as wine, pork, etc., the income acquired is purified by channeling it to public benefit (mali mmah). In this scenario, re-execution is not possible as the subject of the contract is prohibited by the Sharah. 3.1.2.2.1.2 Treatment of a Fsid Contract Unlike a void (bil) contract, a defective or irregular (fsid) contract, as promulgated in the anaf and contemporary fiqh approach, does not necessarily require re-execution of the contract. In most cases, the rectification process can be done in one of two ways.

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The first way is to eliminate objectionable elements that render the contract fsid. If such elements are eliminated, the contract becomes valid. This is based on the anaf legal maxim:

.
When the impediment disappears while the reason for the ruling is present, the [original] ruling returns (Wizrat al-Awqf wa al-Shun alIslmiyyah, 1404-1427AH, 12:60). The following are examples of objectionable elements, mentioned in the previous section, whose elimination may rectify their contracts (Wizrat al-Awqf wa al-Shun al-Islmiyyah, 1404-1427AH, 9:100, 9:101, 12:59): (1) Delivery of the asset would cause harm to the seller, such as selling the wood of his roof. anaf jurists consider such a contract irregular (fsid). If, however, the seller chooses to remove the wood and delivers it to the buyer before the contract is revoked, the contract becomes valid. Insufficient information about the asset, the price, or the time of delivery. In this case, according to anaf jurists, the contract is deemed fsid and may be rectified by providing the missing information. The parties must specify the asset to be transacted and determine the type of payment to be applied, either spot or deferred. Insufficient information about the time of delivery can be rectified by specifying the time. (3) The existence of an invalid condition. The contract can be rectified by removing the objectionable invalid conditions. The existence of the lesser level of duress (ikrh ghayr mulji), such as a threat of imprisonment. In this case, the contract is fsid but, according to the anafs, it can be rectified if the party under duress expresses his consent to it after the duress has been removed. In contrast, if the party under duress does not express his consent, the contract becomes void. The existence of a rib element. In this case, the contract may be rectified by removing the stipulation of rib from the contract or by returning the rib element to the original owner.

(2)

(4)

(5)

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The second method of rectification is to change the fsid contract into another suitable nominate contract that makes the contract valid. This is accomplished by looking into the substance and essence of the transaction. anaf jurists have discussed many examples of this process (Wizrat al-Awqf wa al-Shun al-Islmiyyah, 1404-1427AH,12:6162). They include: (1) A kaflah (guarantee) contract with the condition that the al (debtor) shall be free from any liability. The contract is fsid because this condition conflicts with the nature and legal effects of kaflah. However, it can be rectified by shifting the contract into awlah (debt transfer) with all its rulings and legal consequences. Once the contract is shifted to awlah, the contract will be valid. (2) Shirkah mufwaah. It is required that each partner in this kind of partnership provide equal contributions in the form of capital, work and liability. If the contract of partnership is established using shirkah mufwaah but the contributions are not equal, the contract is fsid, but it may be rectified by turning the contract into shirkah inn with all its legal rulings and implications. Murabah contract. The original ruling of a murabah contract is that the murib is a trustee and is not held liable for any financial loss unless he violates the agreed conditions or is negligent. Any profit is shared between the murib and the capital provider based on the profit-sharing ratio agreed up-front. However, if it is stipulated in the contract that all profit belongs to the murib and is not to be shared with the rabb al-ml, the condition makes the contract fsid. It may be rectified by turning the contract into qar with all the rulings and conditions of a loan. The reason is that, from a fiqh perspective, a person has an exclusive right to get the entire profit if he is the owner of the capital. Therefore, when a murib stipulates a condition that all profit belongs to him, the implication of his condition is that he is the owner of the capital. That means that he must treat the capital of the rabb al-ml as a loan to be repaid in kind (qar). (4) Wadah, too, is a trust-based contract. A custodian is not entitled to utilize the deposit in any way and is not held liable for any loss or damage except in case of negligence or misconduct. However, if the custodian stipulates the

(3)

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right to utilize or invest the deposit, the wadah contract becomes fsid. Like murabah, it can be rectified by recognizing that the transaction with this condition is in fact a qar (loan to be repaid in kind). As a consequence, the custodian is required to guarantee the sum of the deposit and indemnify it in case of loss or damage. It can be concluded that fsid factors do not necessarily nullify the contract in which they appear. Since they do not, it is not required to completely re-execute the contract. Rather, once the intolerable elements are corrected, the contract will then be valid. However, if the objectionable elements persist and the contract is not shifted to another contract that makes it valid, the contract becomes void, and all income generated and assets received must be returned to their original owner. 3.1.2.2.2 Existence of Consent without a Nominate Contract There are instances in which illegal income is derived with the consent of the owner from a transaction without using a specific nominate contract; for example, the income generated from gambling (maysir), bribery (rishwah), gifts to officeholders, etc. (Ibn Taymiyyah, 2005, 28:593-594). Jurists have different opinions with regard to the treatment of such income. Some scholars held that the income derived by illegal means with the consent of the owner must be returned to the original owner. This was the view of the anbal and the Shfi Schools in their authentic opinion, based on qiys (analogy) with an invalid contract (Ibn Taymiyyah, 1995, 28:593-594). Under this view, one who receives a non-all gift (rishwah) must return it to the donor (al-Mward, n.d, 128; al-Mardw, n.d, 11:212). Other scholars are of the view that the income should neither be returned to the original owner nor be possessed (al-Balkh, 1310AH, 3:236). It cannot be returned to the owner to avoid any form of assistance in committing sins (inah al maiyah). Likewise, the asset cannot be possessed by the recipient because a prohibited action cannot legally justify transfer of ownership (al-Bz, 2004, 351). Therefore, the income should be channeled to the Bayt al-Ml (the Public Treasury). This view was upheld by the anaf and Mlik Schools, and there is a narration attributing the same view to Imm Amad ibn anbal. It is supported by the adth of Ibn Lutbiyyah (al-Bz, 2004, 245):

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: : - : - : : : : : :
The Prophet r employed a man from the tribe of Azd named Ibn Lutbiyyah as a collector of zakh. When the employee returned (from his assignment), he said, (O Prophet!) This is for you, and this is for me; it was presented to me as a gift. The Messenger of Allah r rose upon the pulpit and praised and extolled Allah. Then he said, I employ a man to do a job, and then he comes and says, This is for you, and this has been presented to me as gift. Why did he not remain in the house of his father or the house of his mother and see whether gifts would be given to him or not? By Allah in Whose Hand is the life of Muhammad, if any one of you took anything wrongfully, he will bring it on the Day of Resurrection, carrying it on (his back): a grunting camel, or a bellowing cow, or a bleating ewe. Then he raised his hands till we could see the whiteness of his armpits. Then he said thrice, O Allah! Have I conveyed (Your commandments? (Muslim, n.d, 3:1643). In this adth, the Prophet did not request Ibn Lutbiyyah to return the gifts he had received. The adth indicates two rulings: (i) non-all income acquired from prohibited activities with the consent of owner is not to be returned to the owner; (ii) the recipient cannot recognize the income as his wealth. The authors prefer the second view. This view corresponds with the authentic and clear adth of Ibn Lutbiyyah and also acts to block the path that leads to sin (sadd aldharah).

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ISRA RESEARCH PAPER (NO. 42/2012) Asyraf Wajdi Dusuki, Mohammad Mahbubi Ali & Lokmanulhakim Hussain

Exhibit 2 is a diagram that summarizes the proposed framework for Islamic financial institutions to treat their non-all income based on the various scenarios mentioned in the discussion above. The corresponding Table 1 below also provides brief descriptions of the different treatments on income purification from various possible scenarios.

Exhibit 2: Framework of Income Purification

Source of Non-all Income


Li Dhtihi Mahal aqd (Subject Matter) Khalal fi arkan (Defect in Other Pillars) Tas-hih (Rectifiable) No Tas-hih (Cannot be rectified)

Purification
Destroyed Charity

Batil (Void)

Owner

Contract Ml arm (Prohibited Income)

Ria (Consent)

Fsid (Irregular)

No Purification

Destroyed

Li Ghayrihi

Non-Contract

Owner (Shafie & Hambali) Charity (Maliki & Hanafi)

'Adam Rida (No Consent)

Owner

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Table 1: Treatment of Non-all Income Types of Non-all Income

No

Treatments The items must be disposed of (itlf). 1. Returned to the original owner

1. arm li dhtihi 2. Without owner consent

2. Channeled to Bayt al-Ml if the owner is unknown 3. With owner consent by a All income must be returned to the original owner (buyer) if the invalidity of the contract is caused by bil contract a defect in the pillars or conditions of validity. All income must be channelled to charity if the contracted asset is prohibited in its substance by the Sharah. 4. With owner consent by a All income generated is legal (all) if the fsid contract objectionable elements are rectified, either by elimination of such elements or by turning the contract into another contract. All income must be returned to the original owner if the objectionable elements persist or the contract is not turned into another contract. 5. With owner consent but 1. Mliks and anafs - Channeled to charity not contracted 2. Shfis and anbals - Returned to the owner Source: Authors Own 3.2 Principles of Income Purification Jurists are of the view that a person cannot benefit from income derived by illegal means. Allah said:


O you who believe, do not consume one anothers wealth wrongfully; rather, let there be trade by mutual consent (al-Qurn, 4:29).

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Commenting on this verse, Ab Jafar al-abar stated that no one is allowed to consume the property of another by a means prohibited by the Lawgiver; for example, income gained from a rib-based transaction or gambling-based activities (al-abar, 2000, 8:206). Therefore, any non-all income should be purified.

:
Mamar asked al-Zuhr about one who obtains illegal property. Al-Zuhr said: If he wants to be absolved of it, he should get rid of it (Ibn Ab Shaybah, 5:380-381). Al-Subk provided a general guideline on how to purify non-all income. If a person knows the original owner, he must return it to him or his representative (wakl). If the owner dies, he must give it to the owners heirs. If the owner is unknown and it is impossible to find him, the wealth is channeled to the benefit of Muslims (mali mmah). If not, it should be donated to the poor (al-Nawaw/al-Subk, n.d, 9:351). Al-Subks view on channeling the illegitimate property or income for public benefit is supported by the majority of jurists. This was clearly mentioned by Ibn Taymiyyah:

.... .
If property was taken without right and cannot be returned to its rightful owners, as is the case with most of the rulers properties, then helping to channel such property for the benefits of Muslims at largefor instance construction of fortresses for defense of the frontiers, living expenses of soldiers, etc.is consider assistance in good deeds and piety....This is the majority view amongst the jurists; for example, Mlik, Ab anfah and Amad. It was also narrated from some of the abah and is supported by the Sharah evidence (Ibn Taymiyyah, 1418AH).

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In Islam, the income that requires purification is only that which clearly originated from non-all activities. An example is the income derived from an interest-based investment. In this case, the amount that needs to be purified is the interest only. A person still has a right to hold and benefit from the principal. This is the clear indication of the relevant verse of Srah al-Baqarah:


And if you repent, then you shall have your principal [without interest]. Wrong not, and you shall not be wronged (al-Qurn, 2:279). This verse indicates that a person who wants to repent from committing rib is entitled to get back his principal; no more and no less (al-Jawz, n.d, 3:257). In line with this verse, Ibn Taymiyyah stated that a person who holds a mixture of all and non-all income must purify the non-all portion only while the remainder is deemed all:


Whoever has mixed arm wealth with all wealth should remove the arm portion; the rest is lawful for him (Ibn Taymiyyah, 2005, 5:74). Ibn Taymiyyahs opinion is supported by his student, Ibn Qayyim al-Jawz:


If a person mixed his property with one or more arm dirhams, let him remove the arm portion, and the remaining balance will be all for him, without any reprehensibility. This is whether the dirham removed is the particular dirham earned from arm or its equivalent because the prohibition is not associated with the substance of the dirham but, rather, the method by which it was earned (al-Jawz, n.d, 3:257).

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If the level of non-all is not precisely known, then ijtihd (exercise of personal judgement) is necessary in order to measure and remove the portion that is not all.


If someone knows that [his property] includes some arm wealth, but he is unsure of the amount, he should remove the arm part by his ijtihd (al-Nawawi/al-Subk, n.d, 9:428). Based on discussion above, it is clear that any income generated by illegal means must be purified. However, it is important to note that the existence of non-all income does not affect the all portion. Table 2 below summarizes various scenarios of income purification: Table 2: Treatment of Income Purification

Scenarios
1.

Treatment

All income is non-all (i.e., accumulated from All income must be purified. transactions involving substances that are impure or prohibited). Mixed income (some of the income is arm Only the non-all portion needs and the rest is all, e.g., investing in mixed to be purified. companies) The principal is all, but the profit is non-all Only the profit portion must be purified. (i.e., interest-based activities) Mixture of all and non-all profit (e.g., Only the non-all profit must be dividends from mixed companies) purified. The principal and profit is all, but the profit Only the excess amount must be exceeds the actual cost (i.e., the late payment purified. charge exceeds the actual cost )

2.

3.

4.

5.

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4. INCOME PURIFICATION FOR ISLAMIC FINANCIAL INSTITUTIONS


The study on the principle of income purification together with the concept of ml arm (illegitimate wealth) has been a subject of wide discussion in the field of Islamic jurisprudence. As discussed in the previous sections, different sources of illegitimate wealth necessitate different treatments and purification processes. For the purpose of this study, we simplify the discussion by providing a summary of its application to Islamic financial institutions in Table 3. Examples of their application to various Islamic finance operational issues are also provided in the corresponding column to further illuminate our understanding of the concept and the various approaches to dealing with illegitimate income. Table 3: The Framework of Income Purification for Islamic Financial

Sources arm li Dhtihi 1.

Description In offering a trade facility based on 1. murbaah for the purchase orderer (murbaah lil mir bi shir), the IFI is found to have imported a mixture of goods 2. (all and arm). A portion of it is actually alcoholic beverages, which was only discovered after an audit was performed at the port by the Sharah auditor. Under the 3. facility agreement, the bank is supposed to enter into a sale contract with a customer who has undertaken to purchase once the goods are possessed and owned by the IFI.

Treatment The IFI needs to exclude the arm portion of the imported goods, i.e. the alcohol. The IFI can only proceed with the sale of the remaining all portion of the imported goods. The bank needs to dispose of the alcohol at its own cost.

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Sources arm li Ghayrihi A. arm income 1. derived from a void (bil) transaction due to a defect in the subject of the contract.

Description The IFI was found to have advanced 1. working capital financing to a wine manufacturing company or to finance the purchase of bottles for the wine. 2.

Treatment The IFI must channel all profits derived from the financing to charity. The principal amount can be retained. Re-execution of the contract is not allowed because the subject matter is arm. The IFI must immediately dispose of the non-Sharahcompliant stock. Any capital gain derived from the divestment process can be retained if the disposal took place on the announcement date made by the Securities Commission. If the disposal took place long after the announcement made, then only the principal amount can be retained while any capital gain from the announcement date until the date of actual divestment needs to be channelled to charity. The waklah contract is void for that transaction because the subject matter is an illegitimate activity. Only the fee earned on the gambling transaction needs to be channelled to charity.

2.

In managing a portfolio, it is found that 1. one of the securities which was previously classified by the Securities Commission as Sharah-compliant stock has been 2. reclassified as non-Sharah-compliant.

3.

3.

In an Islamic debit card transaction based 1. on waklah bil ujrah, the bank acts as an agent (wakl) to pay on behalf of the client (muwakkil) each time the client conducts a transaction by swiping his debit card. In 2. this form of transaction, the bank earns a fee for each of the clients transactions. In reviewing a quarterly statement of the clients debit card transactions, the IFI finds that the client used the Islamic debit card to pay for gambling activities in a casino.

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Sources B. arm income 1. derived from a void (bil) transaction due to absence in one of the pillars in the contract.

Description In extending a credit line or cash financing 1. to a company which previously enter into a Letter of Credit (LC) murbaah agreement with the IFI, it is found that the 2. second leg sales contract signed with the company does not involve any asset, but mere signing of a document.

Treatment The contract can be re-executed provided that the asset is still available. If the asset is no longer available (e.g., it has been consumed) or the transaction was completed long ago, the IFI must return to the client all profits earlier recognized from the financing. If the client cannot be traced, it should be channelled to the Bayt al-Ml. The principal amount can be retained. The APA contract is void. The profit derived from the transaction is deemed to be rib and, hence, must be returned to the client. If the client cannot be traced, the profit should be channelled to the Bayt al-Ml. The principal portion of the financing can be retained by the bank.

2.

In bay bi thaman jil (BBA) for a cash line facility to a corporation, as practised by many Islamic banks in Malaysia, the Asset Sales Agreement (ASA) must be executed first, prior to executing the Asset Purchase Agreement (APA). However, it is found that the APA was executed prior to the ASA, which effectively means the APA was executed without an underlying asset since the client had not become owner of the asset before selling it to the bank. Therefore, whatever amount of financing disbursed by the bank is now deemed a loan rather than originating from a sale contract. Hence, any amount repaid by client in excess of the principal is deemed rib.

1. 2.

3.

4.

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Sources C. arm income 1. derived from an irregular (fsid) transaction due to the presence of an alien condition that is 2. rectifiable.

Description In reviewing a sale contract, it was found 1. that a condition was imposed that the buyer would not have the right to take delivery of the asset purchased. In a takful product, it was found that a 1. company introduced a structure which invoked the issue of rib. For example, the contribution paid is treated like a 2. normal premium in an exchange contract rather than hibah contributed for mutual aid (i.e., there was no segregation of funds between the participants risk fund (tabarru) and the shareholders fund). In addition, contracted monetary benefits other than for mishaps and calamities were taken from the participants risk fund, which changes the whole structure from a tabarru concept to an exchange contract and, thus, invokes rib since it involves unequal exchanges of money for money (amount contributed and amount of benefits). In reviewing a bank guarantee (BG) facility document based on the kaflah contract, it is found that one of the clauses contains a condition that the client (the applicant for BG) shall be released from his debt to the creditor (BG beneficiary). This condition contradicts the nature of kaflah, which does not release the client from liability until debt settlement, either by the bank or the client himself.

Treatment The clause in which the condition is stated must be removed, and the customer must be notified of the rectification. The contribution should be segregated into participants fund and participants risk fund. Any surplus earned must be returned to the participants fund.

3.

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Sources D. arm income 1. derived from an irregular (fsid) transaction due to the presence of an alien condition that is not rectifiable.

Description In reviewing an inter-bank depositplacement scheme based on the waklah bil istithmr contract, it was found that a clause required the deficit bank (as agent or wakl) to guarantee a certain percentage of return to the Islamic bank as the principal (surplus bank). The contract has matured, and payment of both principal and profit has already been made and received by the IFI. 1.

Treatment The waklah contract is irregular due to the presence of the unwarranted condition. The contract is deemed a loan. The principal amount can be retained. The profit amount which was previously recognized needs to be clawed back and returned to the counterparty. The sale contract is irregular due to the presence of unwarranted condition. The contract is deemed a loan. The principal amount can be retained. The profit amount which was previously recognized needs to be clawed back and returned to the counterparty. Based on the Shfi and anbal Schools: - All gifts given must be returned to the client. Based on the Mlik and anaf Schools: - All gifts given must be channelled to charity to avoid invoking the issue of assisting others to do evil. Based on the Shfi and anbal Schools: - The entire amount of cash received must be returned to the client. Based on the Mlik and anaf Schools: - The entire amount of cash received must be channelled to charity to avoid invoking the issue of assisting others to do evil.

2. 3. 4.

2.

In reviewing London Metal Exchange 1. (LME) procedures and policies, it is found that physical delivery of commodities is not allowed. This affects the status of the 2. murbaah sales contract signed with the broker, which has a specific clause that 3. disallows taking delivery. 4.

E. arm income 1. derived from a transaction, albeit with consent of the owner, but without a specific nominate contract permitted by the Sharah. 2.

A Sharah auditor discovers that, in an 1. attempt to be selected as panel lawyers for an Islamic bank, some law firms have given gifts in the form of entertainment 2. packages to the regional managers of the Islamic bank. This inevitably impairs the banks integrity in the selection process of panel lawyers. The head of the commerce department 1. of an Islamic bank was found to have received a cash inducement that influenced his decision in approving a financing facility to a potential corporate client. This 2. transaction is a bribe, which an Islamic bank cannot tolerate, even though the bank employee received the money without the knowledge or sanction of the bank.

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Sources F. arm income 1. derived from a transaction done without the consent of the owner

Description An audit finds that the IFI charged a fee 1. for early settlement of a deferred payment sales agreement. The charge was never mentioned in the contract signed with 2. the client. This transaction is akin to theft by taking peoples money without their consent or awareness. An audit finds that the IFI imposed 1. a compensation (taw) charge on a delinquent client that did not reflect the actual cost incurred by the institution. 2. Moreover, the charge is higher than the maximum allowable taw charge stipulated by Bank Negara Malaysia, which currently stands at 1% of the outstanding balance without compounding.

Treatment The IFI needs to return the amount of the fee to the customer. The IFI is also required to send a letter notifying the customer of the mistake and offering its apology. The IFI needs to return the excess amount previously charged to the customer The IFI must also send a letter notifying the customer of the mistake and offering its apology.

1.

5. CONCLUSION
This paper has presented a framework of the income purification process for Islamic financial institutions. It started by delineating the concept of illegitimate income from the Sharah viewpoint. This includes identifying the various possible sources of illegitimate income derived from invalid and defective transactions from an Islamic commercial law perspective. Incidences of Sharah noncompliance should be promptly, effectively and efficiently dealt with in the manner appropriate to each type of noncompliance. The Islamic principles of income purification elucidated in this paper shed light on how an IFI can immediately act to rectify and remedy the situation. In a nutshell, as an organization based on Gods law, an IFI must adhere to the ethical and moral principles outlined by the Sharah at all times and in all places regardless of the economic and financial consequences. This demands the internalisation of Sharah principles on Islamic financial transactions in their form, spirit and substance. Furthermore, to truly promote the value propositions of Islamic finance, IFIs should develop a holistic corporate culture embracing the principles outlined by the Sharah. God-consciousness (the taqw paradigm) has to be instilled and reflected in all facets

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of an IFIs behavior including product structuring, documentation, contract execution, system control, internal relations, dealings with customers and other organizations, policies and procedures, business practices through dress, dcor, image, etc. The income purification framework discussed here is also an integral part of the taqw paradigm. Overall the framework presented here may benefit the practitioners of Islamic financial institutions, and even Muslim entrepreneurs in general, who need specific guidance to improve their exercise of Sharah-compliant practice and governance. The discussion on the diverse approaches to income purification not only provides adequate guidance to IFIs, who must decide which courses to take and how much to commit to them, but more importantly, assists them in constructing a robust Sharah-risk-management framework to prevent noncompliant transactions from actually happening. It is crucial that potential Sharah noncompliance exposure be understood and efficiently managed to ensure that IFIs continue providing Islamic financial services to their clients in a safe and sound manner. Such a framework can, therefore, be instrumental in enhancing stakeholders trust and confidence in the operations of IFIs. It is now commonly acknowledged that the consequences of a weak Sharah governance and compliance process are not only financial but also legal and reputational and can impact the economy as a whole. Hence, sound Sharah governance and compliance practices have become essential for the efficient, viable and sustainable growth of Islamic financial institutions. The fact that Islamic finance has become an integral part of the financial system in many countries means that the soundness of its operations is essential to maintaining the overall robustness of those economies.

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APPENDIX Illustration Rectification of a Fsid Murabah Contract Murabah is a partnership contract in which one party (rabb al-ml) provides capital and another party (murib) provides managerial skills. Profit, if any, will be shared according to a ratio agreed up-front while any financial loss will be borne by the capital provider. It is a trust-based contract, meaning the murib is not held liable to guarantee the capital or the profit. Let us assume that a capital provider stipulates a condition in the agreement that the murib must guarantee the capital. According to the anaf School, the condition will make the contract fsid because it will provide a benefit to only one party at the expense of the other. From the Sharah point of view, any benefit created at the expense of another party is called rib. However, a fsid contract does not necessarily require re-execution. anaf jurists held that it can be rectified. In this case, two forms of rectification may be employed: 1. Eliminating the guarantee clause. Once this objectionable element is eliminated, the contract becomes valid. The ruling of murabah then re-emerges: the murib is not held liable for any loss in the capital, and the profit is shared based on the agreed ratio. 2. Turning the murabah contract into a qar (loan to be repaid in kind) with all its rulings and legal implications. In this case, the murib becomes a debtor to the rabb al-ml. He is liable for the capital under any circumstance. However, as a consequence of the loan contract, any profit generated from the capital will belong exclusively to the murib, who will also bear any financial loss. Notwithstanding the above, if the guarantee clause is maintained and the contract clauses do not acknowledge that the transaction is a loan; i.e., the murib is required to guarantee the capital and at the same time the rabb al-ml stipulates a condition to still enjoy a portion of the profit, then the contract remains invalid (ghayr a). Once the contract is void, a proper re-execution should be undertaken if the parties want to continue the transaction.

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