The Rulings of Using Certain Alternative Financing Mechanisms
This is composed of two sale transactions. In the first transaction, a seller sells an item for a particular price to be paid in deferred installments. In the second transaction, after taking possession of the item, the buyer sells the item back to the seller for immediate payment of a lower price, to be paid before the installments of the first sale are due.
While technically each contract is valid, this arrangement can be used/abused by lenders who want to charge interest on loans. For example, a bank wants to loan $700 to a borrower and take back $1000 in installments over time. This is categorically haram, as it is usury (riba). So instead, the bank will sell an item to the borrower for $1000 to be paid in installments. Then the bank will immediately buy back that item for $700, to be paid up front. While technically these are two valid sales, the arrangement is used to produce the same outcome of the unlawful loan, namely, $700 up front in exchange for $1000 deferred.
The overwhelming majority of scholars — including Imams Abu Hanifa, Malik and Ahmad ibn Hanbal — deemed this type of transaction unlawful, due to its close resemblance to usury and the potential abuse of it by lenders.
Also, what is prohibited according to the majority is if the second sale is for a lower price than that of the first sale. If the price of the second sale is equal or higher, then there is agreement that it is valid, as it then would not resemble usury nor be a means to it.
[Ibn Qudama, Mughni; Kuwaiti Fiqh Encyclopedia]
Tawarruq and Its Ruling
This is similar to bay’ al-’inah, except that instead of selling the item back to the original seller, the original buyer sells it to a third party that is completely independent of the original seller.
This sale is mentioned explicitly with the name ‘tawarruq’ only by the Hanbali jurists, the majority of whom deem it permissible. With respect to the other three schools, although the name of the sale is not explicitly mentioned in their legal texts, it can be deduced from inference that it is permissible. Some jurists such as Ibn Humam of the Hanafi school still viewed lending money without interest as more preferable.
As Mufti Taqi Usmani explains in his treatise on tawarruq, it can be concluded that the preferred view in all four schools of Islamic law is that tawarruq is permissible, while interest-free lending is more advisable. Having said that, the ruling of permissibility may change if the actual transaction is infiltrated by other elements that are problematic.
For example, if the original buyer of the commodity, after purchasing the commodity, appoints the bank as his agent to sell it in the market, then:
(a) If that agency had been stipulated in the original contract of sale as a condition, then the transaction is not valid;
(b) If, however, the agency was not stipulated in the original sale contract but rather independently carried out after the original sale, then the transaction is valid yet not advisable.
Not the Ideal Transaction
Moreover, if the tawarruq transaction is carried out through the international commodity exchanges, it is vulnerable to many potential violations of Islamic Law. There are many transactions in the international market that are not actual sales, such as futures, or are sales yet lack basic conditions of validity, such as transactions that entail gaining profit without having ever been liable, etc. This is one reason why scholars mention that the tawarruq transaction is limited to cases of genuine need.
If the conditions of a valid sale are met however, the tawarruq transaction would be valid, yet its extensive use is still not advised. This is because in essence, tawarruq is a transaction legislated as a loophole or “way out” for people in need of cash and are unable to get it otherwise, with interest-free loans being more preferable.
Despite being permitted though, such loopholes are legislated only for cases of genuine need, whether of individuals or sometimes companies. This is because they are not ideal transactions to serve as the foundation of large corporations, nor to form the basis of a healthy Islamic economy. Rather, according to the Sacred Law, the ideal financing mechanisms to form such a basis are transactions predicated upon profit and loss sharing, such as joint partnership (sharika/musharaka) and silent partnership [of capital and labor] (mudaraba).
[Mufti Taqi Usmani, “The Rulings of Tawarruq and Its Application in Banking”]
Cases of Genuine Need
With respect to what constitutes genuine need, this would have to be assessed on a case-by-case basis by a qualified scholar, to ascertain if it could be allowed for a particular individual or company.
Answered By: Shaykh Faraz Rabbani