D o w J o n e s I S L A M I C M A R K E T I n d e x e s
Dr. Shariq Nisar
Purging of Impure Income: An Appraisal of Current
Shari’ah Practices
At a time when stock markets in some countries are looking set
for revival, it is natural that Islamic banks and financial institutions,
which are much better placed in terms of liquidity than most of their
conventional counterparts, may expand their investment horizons
to capitalize on this growing opportunity.
The issue of liquidity management has assumed more significance
in the light of the ban on “organized Tawarruq” by the Islamic Fiqh
Academy. Its most recent decision in this regard has put the ball back
into the court of Islamic banks and financial institutions to search for
alternate sources of liquidity and treasury management. Stock markets,
being the most liquid, may provide one of the best options.
This write-up is aimed at taking up issues related to stock market
investments, which, though not yet as controversial as Tawarruq, have
the potential of becoming so if remedial measures are not taken in
earnest now. The current standard of AAOIFI on this issue leaves much
to be desired.
AAOIFI Shari’ah Standard 21 deals with investment in financial papers
(shares and bonds). Clause 3/4/4 of Shari’ah Standard 21, while
setting the limits for stocks of companies whose primary business
is Shari’ah-compliant, says, “The amount of income generated from
prohibited components does not exceed 5% of the total income of the
corporation, irrespective of the income being generated by undertaking
a prohibited activity, by ownership of a prohibited asset or in some
other way….” The AAOIFI ruling gives the impression (and rightly so)
that in no case can the amount of impure income be tolerated beyond
5% (putting all impure components together). This obviously includes
interest income, as well. But unfortunately, AAOIFI standard’s failure to
mention “interest income” (there is no doubt about its impure nature)
has, if not encouraged, at least allowed many Shari’ah screening
service providers to do away with the “interest income” screen itself.
Some other service providers have opted for criteria like “impure
income other than interest income of less than 5%.” Here again, the
purpose is defeated, as the income from interest is not taken into
account at all. In the absence of this criterion, companies whose
income from interest is as high as 20% may qualify as “Shari’ah-
compliant” under some Shari’ah screens. A company with income as
high as 80% from interest-based investments was found on the list
of Shari’ah-compliant stocks under a particular Shari’ah screen. Its
income includes income from interest and dividends from debt-based
mutual funds. In such a scenario, a genuine question arises: Do we
really need Shari’ah filters?
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Another issue that is also very pertinent is the purging of impure
income. Many investors think that they are required to purge the
impure income from the dividend declared by the company. But this
conception is fraught with serious lacunae. As we all know, companies
do not always declare dividends. Often, profits are fully retained, apart
from the cases in which companies fail to earn profit. In such cases,
too, the companies have earned impure income, and the Shari’ah-
compliant owner cannot abdicate his responsibility to purge his share
of impure income.
Dr. Shariq
Nisar
Dr. Shariq Nisar,
Director,
TASIS
Sometimes, the method adopted requires the investor to purge from
the dividend that portion of the dividend that is equal to the ratio the
impure income bears to total income. This is entirely erroneous and
cannot lead to complete purging, as the dividend is but a small part
of the total income. This method appears to be just window dressing,
whereby as and when a dividend is declared/distributed, a small
amount of income is purged to solace the conscience of the Shari’ah-
compliant investor.
The correct purging methodology is given by AAOIFI in its Shari’ah
Standard 21. Clause 3/4/6/4 reads, “The figure, whose elimination is
obligatory on the person dealing in shares, is arrived at by dividing the
total prohibited income of the corporation whose shares are traded
by the number of shares of the corporation; thus, the figure specific
to each share is obtained. Thereafter, the result is multiplied by the
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number of shares owned by the dealer—individual, institution, fund or
another—and the result is what is to be eliminated as an obligation.”
Thus, as far as computation of impure income is concerned, we
agree with the AAOIFI methodology; but when it comes to bearing the
actual cost of purging, AAOIFI puts the total burden on someone who
has held the share on a particular date (i.e., the end of the financial
year). AAOIFI Shari’ah Standard 21, clause 3/4/6/1, confirms, “The
elimination of prohibited income is obligatory on one who is the owner
of the share, whether an investor or a trader, at the end of the financial
period…Accordingly, elimination is not obligatory for one who sells the
share before the end of the financial period.”
The problem with this criterion is that it may encourage the investor or
the fund manager to sell the stocks on the eve of the financial year-
end, and buy them back on the first day of the next year. This may be
a way to avoid the purging of impure income. It is also feared that fund
managers or investors not willing to go through the hassle of purging
and risking their fund performance may exit before the end of the
financial year. This may create volatility if fund managers sell the stock
before the due date (financial closing). Fund managers or investors may
also weigh the cost of purging against the cost of selling the stock. This
may create unnecessary arbitrage opportunities.
Even for those whose intention is not to avoid purging, the criterion
is not good, nor does it fulfill the objective of Shari’ah. It is not correct
to expect a person to purge the impure income that arose when
someone else was the owner of that share. It is quite possible that
a person owned a share for a very short period on or around that
particular date (of financial closing), whereas, for the rest of the year,
the share was held by someone else—who is not supposed to be
responsible for purging at all.
In AAOIFI methodology, one person’s liability for Shari’ah
noncompliance is put on the shoulders of another who is/becomes
the owner of the share on a later date. The burden of Shari’ah
noncompliance is put on one single owner of the stock, whereas it is
not unlikely that the same share was held by multiple owners during the
course of the year. This is against the clear Quranic injunction that every
person has to bear his own burden, not to mention that it flies in the
face of simple logic, too.
India-based Shari’ah advisory firm TASIS follows another
methodology, which is explained here for the benefit of all concerned,
including practitioners and the Shari'ah scholars associated
with AAOIFI and other Islamic financial institutions. Readers are
encouraged to send their comments/suggestions, if any, to the email
address of the author of this article. Shari’ah scholars are requested
to share their comments on the given methodology, and in the event
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they find it more scientific and more in accordance with Shari’ah
objectives and principles, it is hoped that AAOIFI will make necessary
amendments to its relevant Shari’ah standard.
The following methodology developed by TASIS may help resolve the
anomaly found in current practices. This is also expected to better
meet the Shari’ah objectives.
Purging of impure income (including interest) involves determining/
estimating the quantum of impure income, which has to be purged
by the owner of the stock/equity (whether it is an individual or a fund
manager). If the fund manager is not doing the purging himself, then
he has to communicate to the end investor the amount that needs to
be purged. He can do this by informing the investor, in the form of a
ratio (as demonstrated below), the amount to be purged. An investor
handling his own portfolio directly needs to go through the calculation
given below only part of the way.
Methodology for Computing the Purification Amount:
Let us say:
x (Impure income per day per share for a particular scrip)
= Impure income earned by the specific scrip during the
year (i.e., the total number of shares issued * 365 days)
y (Impure income on account of all the shares of that
scrip in the portfolio for that year)
= x * Number of days during which that scrip was held by
the Fund * Number of shares of that scrip that was held
z (Total impure income to be purged collectively)
=∑y (In the case of an individual investor, the calculation
will stop here)
p (Ratio of interest income to be purged by subscribers of
the Fund)
= z / 0 (Average number of units of the Fund outstanding)
Average Outstanding Units:
The calculation of outstanding units of the Fund is as follows:
Let us assume the fund or portfolio has an opening balance of
units “n” for the year beginning, and later, say after 100 days,
additional scrips/units are subscribed, which can be assumed as
“n’” and, after a further 100 days, a few scrips/units are redeemed,
(say “n’’”). There is no further change in the subscription until
the close of the year. Then, the average number of scrips/units
outstanding during the year ("O") is calculated as follows:
O = {(n) * (365) + (n’) * (265) - (n’’) * (165)} / 365
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The above amount, i.e., "p" will be communicated to the investor,

who further has to multiply it by the number of scrips/units he
has held and the number of days during which he has held them.
Let us say an investor has held 50 units of the fund for 210 days.
Then, the impure income (Q) he has to purge is:

Q = p * 50 * 210

Dr. Shariq Nisar (Ph.D. in Economics) is director of India-based Shari’ah advisory firm TASIS.

He can be contacted at shariqnisar@tasis.in.