Dear IrfanMunir,
I would recommend you to read the book "Meezan Bank's Guide to Islamic Banking" written by Dr. Muhammad Imran Ashrad Usmani, son of Mufti Taqi Usmani. Chapter 20 "Ijarah (Leasing)" and Chapter 21 "Ijarah Wa Iqtina (Leasing and promise to gift)" deals in detail about your query.
The following is sourced from Page 153-155 of the above mentioned book.(i have done some editing, but i have made sure that the context of the author does not change).
An objection over the Ijarah mode of financing is the variables amount of rentals. KIBOR rate is used as a benchmark for determining the periodic increase in rent.
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1. <b>The first objection raised against it is that, by subjecting the rental payments to the rate of interest, the transaction is rendered akin to an interest based financing.</b>
This argument can be overcome by saying that the rate of interest is used as a benchmark only. So far as other requirements of Shariah for a valid lease are properly fulfilled, the contract may use any benchmark for determining the amount of rental. The difference between interest based financing and and a valid lease does not lie in the amount to be paid to the financier or the lessor. The basic difference is that in the case of lease, the lessor assumes the full risk of the corpus of the leased asset. If the asset is destroyed during the lease period, the lessor will suffer the loss. Similarly, if the leased asset looses its usufruct without any misuse or negligence on the part of the lessee, the lessor cannot claim the rent, while in the case of an interest based financing, the financier is entitled to receive interest, even if the debtor did not at all benefit from the money borrowed. So far as this basic difference is maintained, (i.e the lessor assumed the risk of the leased asset) the transaction cannot be categorized as an interest-bearing transaction, even though the amount of rent claimed from the lessee is equal to the interest. It is thus clear that the use of the rate of interest merely as a benchmark does not render the contract invalid as an interest based transaction. It is, however, advisable at all times to avoid using interest even as a benchmark, so that an Islamic transaction is totally distinguished from an un-Islamic one, having no no resemblance of interest whatsoever.
2. <b>The second objection to this arrangement is that the variations of the rate of interest being unknown, the rental tied up with the rate of interest will imply <i>Jahalah</i> and <i>Gharar</i> which is not permissible in Shariah. It is one of the basic requirements of Shariah that the parties must know the consideration in every contract when they enter into it. The consideration in a transaction of lease is the rent charged from the lessee, and therefore it must be known to each party right at the beginning of the contract of lease. If we tie up the rental with the future rate of interest, which is unknown, the amount of rent will remain unknown as well. This is <i>Jahalah</i> or <i>Gharar</i>, which renders the transaction invalid. </b>
Responding to this objection, one may say that the Jahalah has been prohibited for two reasons
<ul><li>It may lead to dispute between the parties. This reason is not applicable here, because both parties have agreed with mutual consent upon a well-defined benchmark that will serve as a criterion for determining the rent, and whatever amount is determined, based on this benchmark, will be acceptable to both parties. Therefore there is no question of any dispute between them. </li><li> The second reason for the prohibition of Jahalah is that it renders the parties susceptible to an unforeseen loss. It is possible that the rate of interest, in a particular period, zooms up to an unexpected level in which case the lessee will suffer. It is equally possible that the rate of interest zooms down to an unexpected level, in which case the lessor will suffer. In order to meet risks involved in such possibilities, it is suggested by some contemporary scholars that the relation between rent and rate of interest is subjected to a limit or ceiling. e.g it may be provided in the base contract that the rental amount after a given period, will be changed according to the change in the rate of interest, but it will in no case be higher than 15% or lower than 5% of the previous monthly rent.
</li></ul>
In our opinion, this is the moderate view, which takes care of all aspects involved in the issue.
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I hope this helps
Regards
Safwan Arshad