Professor Dr. Aishath Muneeza

“…. This Shariah screening criteria used in Islamic finance for determining the Shariah compliance of companies and the challenges in purifying income from non-compliant sources, highlighting the lack of uniformity in screening methodologies and the importance of understanding these criteria for navigating the Islamic finance landscape….”

In the evolving landscape of Islamic finance, a perplexing lack of uniformity persists in the Shariah screening criteria applied to mixed companies. Likewise, a definitive standard for disposing of Shariah non-compliant securities and purifying income eludes the industry, leaving investors reliant on disparate screening methodologies. Navigating this intricate landscape demands a firm understanding of the diverse Shariah screening criteria, which originate from regulatory bodies, private entities, and standard-setting organizations This article sets out to explore the different criteria used to determine if a company is Shariah-compliant, as well as the rules for purifying income in this regard.

It is imperative to acknowledge that while a universally accepted Shariah screening methodology is lacking, the process typically comprises two primary phases: Business Screening and Financial Screening. During the initial Business Screening phase, companies engaged in activities deemed inconsistent with Shariah principles are typically excluded. Such activities encompass alcohol, pork, gambling, casinos, lotteries, movies, adult entertainment, weapons, tobacco, and conventional banking and financial institutions. Furthermore, companies may also face exclusion if, despite their core operations being Shariah-compliant, they become involved in Shariah-repugnant activities over time or acquire subsidiaries engaged in such practices.

Subsequent to the Business Screening phase, attention turns to Financial Screening, which involves a thorough examination of financial metrics to ensure Shariah compliance. Given the prevalent presence of interest-bearing transactions in today's financial environment, identifying companies entirely free of such transactions presents a challenge. Consequently, several benchmarks have been devised to limit revenue originating from riba-based sources. Key financial ratios commonly assessed include interest-bearing debt, liquid assets, interest income, and non-permissible income.

Shariah screening methodologies are formulated not only by private enterprises but also by regulatory bodies and a standard-setting organization: The Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).

Shariah screening methodologies developed by regulatory bodies aim to ensure that financial instruments and securities align with Islamic principles. In Malaysia, the Securities Commission (SC) utilizes a comprehensive approach that incorporates both two-tier quantitative and qualitative methods, formulated by its Shariah Advisory Council (SAC). Quantitatively, the SC utilizes benchmarks for business activities and financial ratios. These benchmarks determine the permissible threshold for revenue generated from non-Shariah compliant activities and the ratio of cash and debt to total assets. For business activity benchmarks, the SC has established two thresholds: 5% and 20%. The 5% benchmark applies to businesses such as conventional banking, gambling, liquor-related activities, and others deemed non-compliant according to Shariah. The contribution of Shariah non-compliant activities to the company's revenue or profit before taxation must be less than 5% for compliance. The 20% benchmark applies to activities like share trading and rental from Shariah non-compliant activities, with the contribution of non-compliant activities needing to be less than 20%. Regarding financial ratio benchmarks, the SC focuses on cash over total assets and debt over total assets ratios. Cash only includes funds in conventional accounts, excluding Islamic accounts, while debt encompasses interest-bearing debt, excluding Islamic financing or sukuk. To classify a company as Shariah compliant, both the cash over total assets and debt over total assets ratios must be less than 33%. Alongside the aforementioned two-tier quantitative criteria, the SAC also considers the qualitative aspect, which encompasses the public perception or image of the company's activities from the viewpoint of Islamic teachings.

In Indonesia, the Financial Services Authority (OJK) implements a screening methodology aligned with Islamic principles. This methodology includes criteria for issuer declaration and assessments of business activities, debt ratio, and non-permissible income. Companies must explicitly declare adherence to Shariah principles, and those that do not must meet specific criteria to be classified as Shariah-compliant. The criteria for non-declared issuers include ensuring that the ratio of interest-based debts to total assets is less than 45% and that the income generated from non-permissible activities is less than 10% of total revenue. Through these measures, OJK aims to ensure that stocks listed in the Indonesian capital market comply with Shariah principles, providing investors with opportunities for Shariah-compliant investments.

The Capital Market Development Authority (CMDA) of the Maldives has implemented regulations for Shariah screening of equity securities, as delineated in Regulation Number 2013/R-55, dated 21 July 2013. These regulations serve to establish transparent criteria for evaluating the Shariah compliance of equity securities belonging to listed companies or those aspiring for listing on the Exchange, in accordance with section 60(a) of the Maldives Securities Act (02/2006). In pursuit of this goal, CMDA has defined specific screening criteria, drawing upon recommendations from the Shariah Advisory Committee and international best practices. These criteria aim to ensure that the core activities or significant portions of a company's business do not involve practices contrary to Shariah principles. Activities such as financial services based on riba (interest), gambling, manufacturing or sale of non-halal products, or any other impermissible actions according to Shariah tenets are strictly regulated. For companies engaging in such activities, stringent limits are imposed, such as restricting revenue from non-compliant sources to 5% of total revenue and ensuring that interest-bearing debts and receivables remain below 33% of total tangible assets and total assets, respectively. In cases where a company meets the screening criteria but still generates revenue from non-compliant activities, it must contribute such revenue for charitable purposes. This requirement underscores the importance of social responsibility in Shariah-compliant investing and ensures that tainted income is put to beneficial use within the community. To facilitate the screening process, companies are mandated to submit essential documents, including annual reports, audited financial statements, and Shariah audit reports for initial evaluation. Compliant entities undergo semi-annual screening, with any deviations from the established criteria resulting in classification as a "disqualified company." Such entities are required to furnish quarterly reports to the Authority for further scrutiny. In addition to imposing strict screening measures, CMDA emphasizes transparency and accountability in its regulatory framework. Companies are obligated to maintain records of tainted or non-compliant income, earmarked solely for fulfilling social responsibilities and not for operational expenses. Furthermore, CMDA ensures public disclosure of screening outcomes, thereby fostering transparency and investor confidence. To cover administrative costs and facilitate the screening process, companies seeking evaluation must remit a prescribed fee to CMDA. Additionally, the regulations repeal previous guidelines concerning Shariah compliance reviews of Pre-IPO securities, underscoring CMDA's commitment to refining and strengthening its Shariah screening framework.