Zakat is one of the foundational pillars of Islam, embodying principles of charity, social responsibility, and economic justice. It also holds significant spiritual and practical importance, serving as a means of purification for wealth and a mechanism for societal welfare.

Understanding Zakat's broader implications clarifies its relevance in economic spheres and financial markets. However, for investors, its impact on investment returns can be material and make the difference between investing in one asset class or another, a matter that could influence an entire investment strategy.

In this article, we discuss the main principles of Zakat while focusing on its application in private markets.

The Wider Zakat Impact

Zakat serves multiple purposes beyond fulfilling religious obligations. It acts as a mechanism for social welfare, facilitating wealth redistribution, fostering community solidarity, and alleviating poverty.

In the context of wealth, Zakat promotes investing instead of just accumulating money. The way Zakat is applied incentivizes putting capital to work to generate value rather than keeping it idle. The impact of this is not just on the growth of one’s wealth but also in advancing the economy as a whole.

Furthermore, Zakat brings discipline to the investment strategy by favouring long-term investments in value creating assets over non-producing assets.

The Principles of Calculating Zakat

While Zakat is consistently applied across regions, its administration does vary. Some governments collect Zakat instead of tax and take the responsibility of distributing it to those in need and who are eligible. In other areas where only tax is applicable, Zakat needs to be calculated individually and can be distributed either directly to eligible beneficiaries or through other channels facilitated by charities.

Zakat is not calculated on there venue or earnings generated each year. Instead, Zakat is worked out based on the value of assets. Each individual would have a specific date during the Hijri year to pay their Zakat. Just like there is a financial year end, there is also a ‘Zakat year end’. This is assigned based on when a person became owner of Nisab– the threshold for Zakat obligation.

The process of calculating Zakat involves identifying the Zakatable assets, which typically include cash, gold, silver and investments in Zakatable assets. However, exemptions exist for certain assets, necessitating careful consideration during the calculation process.

Zakat applies to assets that are not factors of production. Hence, for instance, land, fixed assets, plant, machinery, and equipment are not subject to Zakat. From the wisdom of Zakat, producing assets that add value to the economy are typically not subject to Zakat. Zakat is applied on non-producing assets that are hoarded and stacked, and it’s through applying Zakat that such assets can compensate for their economic impact.

Now that we understand what is included in the calculation, in general, it is simply the case of accumulating all Zakatable assets that are owned on the ‘Zakat-year end’, and calculating 2.5% of that amount (the amount can differ based on the type of asset – more details in the coming sections). Hence, Zakat functions as a snapshot calculation.

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Zakat on Investments

Zakat calculation is highly impacted by intentions, especially when determining the reason behind making a specific investment. Holding assets for the short term with the intention to trade is significantly different from holding investments for the long term. Short-term investments and trading assets are considered fully subject to Zakat without going in detail about their nature or composition.

Segregating the investment universe facilitates understanding the contributions of each type of investment and its intended impact on one’s portfolio. In the table below we show three main categories;(1) Growth Drivers (2) Income Generators and (3) Inflation Hedges, and the type of investments included:

When considering investing for growth, focus is over the long term, whereas investing for income is done to generate returns over a shorter, more regular time frame. Inflation hedges help maintain the real value of what we own.

Whether investments are public or privately held, the Zakat calculation should not differ but holding public investments begs the question if they are held for trading or for the long term. In private markets, investments are mostly held for the long term except for specific strategies which we, highlight below.

Navigating Zakat on Private Market Investments

Private market investments encompass several asset classes, ranging from private equity and venture capital to real estate and private debt in addition to commodities. We discuss here how Zakat is calculated for the main asset classes.

For Private Equity and Venture Capital and is the case with public equity that is held for the long term, a shareholder in a company is responsible to pay Zakat on its net Zakatable assets. This typically includes cash, stock and inventory and receivables due.

Whether ownership is 100% of the company or owning a share in the company that someone else is managing or even when investing in a private equity fund, Zakat is due on the share of ownership.

Typically, the current assets of a company are its Zakatable assets. To work out the Zakatable assets and the amount of Zakat to be paid, the following formula can be used:

Current assets x (Current Assets/Total Assets) x ownership percentage x 2.5% = Zakat

It may be a challenge to access all the information of the companies invested in, especially so if investing in a fund with multiple private equity investments. In this case, it is acceptable to use estimations or appropriate proxies in the most accurate way.

For Real Estate, it’s straightforward; property bought for personal use or as a long-term store of value are not subject to Zakat. As for properties that are leased, Zakat is not due on the property’s value, but the cash that remains from the collected rent by year end is subject to Zakat. As mentioned before, if the intention is to trade a property, the investment value is fully subject to Zakat.

Under Income Investments, There are Several Structures that are Worth Listing Here

• Sukuks can be structured differently; as an example, for the Ijara Sukuk, which is based on a lease, Zakat is paid on the income which is equivalent to rental income. A Murabaha structured Sukuk is fully Zakatable as it’s a receivable. Here, the impact on investment returns can be heavily felt; considering average returns expected on a traditional Sukuk, an additional 2.5%reduction could result in cutting total returns by half.  
• Equipment leasing: For a financial lease where the goal is to eventually sell the equipment to the end customer, Zakat is paid on the entire value as the intention is to sell the asset. If it’s expected to be eventually gifted to the user by the end of the term or kept and leased to another tenant, then Zakat is applied only on the lease income remaining.
• ‍Trade Finance and private lending: If the structure is a Murabaha then the Zakat is applied on the full investment amount which also includes the future expected returns as it’s considered as any other receivable. Even owning the underlying commodities directly is fully subject to Zakat, as the intention is to trade.

For Physical Commodities, only gold and silver are considered money equivalent and Zakat is payable on the full amount. All other commodities, simply bought as a store of wealth, are not Zakatable. However, if any commodity is purchased for trading purposes, then Zakat will be due on it, as is the case with any asset bought for trading.

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Zakat: Integrating Wealth with Impact

Zakat provides a form of identity for all those who contribute, both spiritually and economically. Beyond this, it’s a stimulus for the economy and empowers individuals to make a difference by contributing to the growth of their communities.

When making an investment, investors need to factor Zakat implications into their decision-making process. By incorporating Zakat considerations from the outset, investors can align their strategies with Shariah compliant principles, while optimizing financial returns. After all, as investment returns adjust, investors may end up with a higher return on specific assets after any Zakat payments.

Investors should remain aware about why they are paying Zakat. The process of calculating and paying Zakat is not simply a tick-the-box exercise. It’s about living the spirit of Zakat and being conscious of God throughout. By understanding the reasoning behind Zakat and the intention it embodies, investors can uphold their obligations while connecting with their community and supporting those in need.

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Co-Author

Mufti Faraz Adam

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Co-Author

Saad Adada, CFA

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