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What Is Musharakah?
Musharakah is a joint enterprise or partnership structure in Islamic finance in which partners share in the profits and losses of an enterprise. Since Islamic law (Sharia) does not permit profiting from interest in lending, musharakah allows for the financier of a project or company to achieve a return in the form of a portion of the actual profits according to a predetermined ratio.
However, unlike a traditional creditor, the financier also will share in any losses should they occur, also on a pro rata basis. Musharakah is a type of shirkah al-amwal (or partnership), which in Arabic means “sharing.”
Key Takeaways
- Musharakah is a joint partnership arrangement in Islamic finance in which profits and losses are shared.
- Profits from interest are not permitted in Islamic practice, necessitating the need for musharakah.
- A permanent musharakah is often used for long-term financing needs since it has no specific end date and continues until the partners decide to dissolve it.
Understanding Musharakah
Musharakah plays a vital role in financing business operations based on Islamic principles. For example, suppose that individual A wants to start a business but has limited funds. Individual B has excess funds and wishes to be the financier in musharakah with A. The two people would come to an agreement to the terms and begin a business in which both share a portion of the profits and losses. This negates the need for A to receive a loan from B.
Musharakah is frequently used in:
- Purchasing property and real estate
- Providing credit
- Investment projects
- Financing large purchases
In real estate deals, the partners request from a bank an assessment of the property’s value via imputed rent (the sum a partner might pay to live in the property in question). Profits are divided between partners in predetermined ratios based on the value that was assigned and the sum of their different stakes. Every party that puts up capital is entitled to a say in the property’s management.
When musharakah is employed to finance large purchases, banks tend to lend by using floating-rate interest loans pegged to a company’s rate of return. That peg serves as a lending partner’s profit.
Musharakah are not binding contracts; either party can terminate the agreement unilaterally.
Types of Musharakah
Within musharakah, there are differing partnership arrangements.
- Shirkah al-‘inan: a partnership in which the partner is simply the agent and does not serve as guarantors of other partners
- Shirkah al-mufawadah: an equal, unlimited, and unrestricted partnership in which all partners put in the same sum, share the same profit, and have the same rights
- Permanent musharakah: a partnership with no specific end date, which continues until the partners decide to dissolve it; often used for long-term financing needs
A diminishing musharakah, also known as a declining musharakah, usually takes one of two forms:
- A consecutive partnership, in which the share of each partner stays the same until the joint venture comes to an end; often used in project finance and especially home-buying
- A declining balance partnership, in which one partner’s share is drawn down while it is transferred to another partner until the entire sum is passed over
A declining balance musharakah is common in home-buying. The lender (generally a bank) buys a property and receives payment from a buyer (via monthly rent payments) until the whole balance is paid off.
In the case of a default, both the buyer and lender get a share of the proceeds from the sale of the property on a pro rata basis. This differs from more traditional lending structures, which have the lender alone benefiting from any property sale following a foreclosure.
Where Is Musharakah Practiced?
Musharakah is used in Islamic financing around the world. Its system of partnership is used by Islamic banks, as well as by debt and equity markets. Countries where it is common include Sudan, Kuwait, the United Arab Emirates, and Malaysia.
What Is Sharia in Finance?
Sharia is a set of Islamic religious laws. As well as religious rituals, these laws govern many day-to-day activities for Muslims. This includes the areas of finance, banking, and investments. For example, Sharia prohibits investing in tobacco- and alcohol-based businesses, as well as collecting interest.
What Is the Difference Between Mudarabah and Musharakah?
Musharakah is a type of joint partnership in which all partners participate in both the investment and the profits. Profits are shared proportionately based on the size of each partner’s investment. Mudarabah is another type of Islamic financing structure in which one partner provides the capital investment and the other provides labor or expertise. Profits are then shared according to a ratio that has been agreed on in advance.
The Bottom Line
Musharakah is a type of joint financial partnership in Islamic finance. Under Islamic law, profits from interested are not permitted. Mucharakah creates a structure in which all parties share in profits and losses. If there is a default, both lender and buyer receive a share of the proceeds from the sale of the property based on their investment in the partnership.
There are different types of musharakah, which can be used in transactions ranging from real estate to financing a large purchase. The arrangement can be temporary or permanent. A permanent musharakah has no specific end date and continues until the involved parties decide to dissolve it.