PURGING – AN IMPORTANT REQUIREMENT FOR FULLY SHARIAH COMPLIANT INVESTMENT

By S M Wasiullah for Maeeshat

As a principle investment in equity shares is considered Shariah compliant, if the business of the company is per se permissible. Then, some companies could also have a minor or even insignificant part of their income coming from impermissible sources such as from associated or subsidiary activities which are impermissible. Combining both the above types of impermissible incomes, we have the concept of ‘impure income’.

For an equity investment to be Shariah compliant, such impure income needs to be purged (by donating it to charity) by a Shariah compliant investor. Generally however, the minor impermissible income – other than interest income – is usually not reported separately in company accounts and therefore it is not possible to calculate and purge such impure income. Hence an investor should try to also avoid such companies which derive a minor part of their earnings from non-compliant lines of business, unless such earnings are insignificant, say less than a fraction of a percent of the total income.

Coming to the earnings from interest, due to the pervasiveness of interest transactions in modern times, practically over 90% of listed companies, including those whose business is permissible, do have some interest earnings in their income. Therefore it is not possible to build a viable equity portfolio, with only companies having zero interest income. Thus purging of interest income needs serious attention. In view of the above and the usual difficulties of determining the quantum of impermissible income of a nature other than interest, in this article we have limited the discussion on purging to only interest income.

From the Shariah perspective, ‘Interest Income’ is that income which accrues on bank deposits, on loans advanced and on interest-based investments. All such income flows are not always reported in company accounts as ‘Interest Income’. Income from interest based investments such as dividends on preference shares, returns on debt based mutual funds, returns on debt portion of other mutual funds, capital gains from trading of interest earning securities (such as bonds and debentures), etc are not reported in financial statements of companies as ‘interest income’, though from the Shariah perspective they too need to be treated as interest income. The company benefits from the accrued interest income by utilising it for meeting its costs or expenses on account of various operations or for paying taxes and dividends and creating reserves. An investor who owns equities automatically becomes responsible for the financial transactions of the company, and hence for such ‘interest’ income flows too, in the same manner as he does for the interest earned by the company.

There is no second opinion on the prohibition of interest (Riba) universally among the Shariah scholars. However, due to the unavoidable existence of interest based transactions in modern businesses (companies), Shariah scholars around the globe (including those on TASIS Shariah Board) have set a minimum compliance level for ‘interest income’, for those companies whose primary business is permissible.

For example, AAOIFI has set the minimum compliance level as 5% of the total income of a company whereas TASIS Shariah Board has set it at 3%. Investment in the equities of companies whose interest income remains below the ‘minimum compliance level’(and whose debt and liquid assets too are within permissible limits) are declared as permissible. Such equities are known as Shariah Compliant Equities. Despite being declared Shariah compliant equities the concerned companies may still be earning interest income up to3%or 5% of their total income.

It is to be noted that the minimum compliance levels set by the Shariah Scholars are not to make the prohibited interest income permissible but to utilise (benefit from) the permitted income while avoiding the prohibited one (specifically in case of equities). Hence, the interest income (even if it is below 3% of the total income) has to be removed from the income generated from Shariah compliant investments. This process of removing interest income from the total income realized from an investment is known as purging (also purification).

TASIS usually advises its clients to do purging of their investments (in Shariah compliant equities) to make their investments fully Shariah compliant. But it is found that most of the Shariah conscious investors while restricting themselves to Shariah compliant equities for investment ignore ‘Purging’, which is one of the important requirements of the Shariah when undertaking Shariah compliant investments.

In an environment where awareness regarding Shariah Compliant investments itself is very low, the lower inclination of investors towards purging is understandable. However, lack of awareness does not justify that one can benefit from the interest income inherent in one’s investment.

TASIS is currently the only organization in India which provides purging services to Shariah conscious investors. The method of purging adopted by TASIS is deemed more just and comprehensive than the other purging methods prevailing globally.

The TASIS method requires purging of impure (interest) income earned per share of a company held by an investor pro-rated over the period for which the shares were held in his portfolio by that investor.

The Purging formula can be written as:

Purging Amount = [(Interest Income/Total Outstanding Shares)*(No. of Shares Held)]*[(No. of Days {or Months} the shares were held/Total No. of Days {or Months} in the entire Accounting Period)]

In case a portfolio consists of various shares the same formula has to be applied individually for purging all the stocks held under the portfolio, taking into account the relevant holding periods for the various stocks.

In case of a financial instrument such as a unit of a Shariah-compliant mutual fund or pension fund the overall interest purification ratio for the fund needs to be calculated on the basis of the stocks held under the respective fund and converted into purging amount per unit/instrument. The purging ratio should be communicated by a Shariah mutual fund to individual holders or subscribers of the fund/scheme as a ratio (i.e., the purging amount per unit of the security held per day). In the event this information is not available, the investor should himself calculate the ratio by studying the details of holdings of the mutual fund released by it at the end of every month

Purging is a comprehensive process which is done on the basis of information collected from the investors, clients, company’s financial reports and other required reports.

Purging according to the right method is imperative for an investor who aspires to be Shariah compliant in his equity investments. He needs to donate for his holdings the pro rata amount of interest income earned per share by the company during the period he held the shares of the company, irrespective of whether the company or he himself made profits, and whether the company declared dividends or not. This is the purging method adopted by TASIS and it is logical and equitable. It enables complete purging by the investor of the interest income received by the company on account of the shares of the company held by him, thus ensuring his investment in the respective company/equity is fully Shariah Compliant.

 

[Mr. S M Wasiullah is Manager at Taqwaa Advisory and Shariah Investment Solutions (TASIS) Private Limited and also pursuing Ph.D in Management in the area of Islamic Finance from BSA Crescent University. He can be reached on wasi@tasis.in ]

 

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Posted Date: 28 April 2017

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