Income Purification

Income purification is the process by which an Islamic financial institution, fund or individual investor identifies income that is not compliant with Sharia and disposes of it, usually by donating it to charity, rather than treating it as profit. Typical examples are interest earned incidentally on a bank balance, the portion of a company's dividend that comes from prohibited business lines, and late-payment charges collected from customers.

Purification exists because full compliance is often impractical. Very few listed companies are entirely free of interest income or of minor revenue from impermissible activities. Islamic scholars have therefore permitted investment in companies that pass certain screening thresholds, on condition that the tainted share of income is removed.

Islamic law prohibits earning income from riba (interest), maysir (gambling) and the sale of prohibited goods and services such as alcohol and pork. Scholars generally hold that a person who receives such income unintentionally or unavoidably should not keep it, but should not leave it with the payer either if that would support the prohibited activity. The accepted solution is to pass it to charitable causes without expecting religious reward for it. Standards issued by AAOIFI on investment in shares and on the treatment of prohibited earnings set out this approach, and an institution's Sharia supervisory board approves the method and the recipients.

Sharia-compliant equity funds and indices first screen companies by business activity, excluding those whose core business is prohibited, such as conventional banking, alcohol, gambling or pork. They then apply financial ratio screens. Commonly used thresholds, which vary between standard-setters and index providers, include limits such as:

• interest-bearing debt below roughly one-third of market capitalization or total assets;
• cash and interest-bearing securities below a similar proportion;
• revenue from non-compliant activities, including interest income, below about 5 percent of total revenue.

A company that passes these screens may still earn some impermissible income. Purification removes that portion from the investor's return.

The most common method applies a purification ratio to dividends: the share of the company's total income that comes from non-compliant sources. The investor's purification amount is the dividend received multiplied by that ratio. Some scholars and funds also purify capital gains, on the reasoning that a share's price reflects retained impermissible income, while others consider dividend purification sufficient. Funds usually calculate purification at the portfolio level and disclose the total paid to charity in their reports.

An investor owns 1,000 shares in a company that pays a dividend of 2.00 per share, a total of 2,000. The company's annual report shows that 3 percent of its total revenue came from interest on cash deposits. The purification amount is 2,000 × 3 percent = 60. The investor keeps 1,940 as permissible income and donates 60 to charity. If the investor holds shares through a Sharia-compliant fund, the fund normally performs the calculation and pays the amount on investors' behalf, sometimes also calculating per-unit figures for investors who prefer to purify their own holdings.

Islamic banks and Islamic windows purify several types of income. Late-payment charges imposed on defaulting customers, which are allowed as a deterrent but may not be kept as profit, are paid into a charity fund. Income from a transaction that the Sharia board later finds non-compliant, one of the consequences of Sharia non-compliance risk, must also be purified. Interest received on balances with conventional correspondent banks, where it cannot be avoided, is treated the same way.

Purification is distinct from zakat, the obligatory annual alms on qualifying wealth, and from voluntary sadaqah. Purified amounts are not the investor's lawful property and cannot be counted towards zakat or claimed as a meritorious gift. They also should not be used to benefit the payer, for example to cover the fund's expenses or to fund promotional activity. Many institutions pay purified income to registered charities or to waqf endowments approved by their Sharia boards.