Zakat on Business: Inventory, Cashflow & Payables | Musaffa Academy

I have started to discover that running a business and meeting my annual zakat obligation was never going to be a problem – its actually a matter of seeing our accounts in a different way. Our accounts are always prepared on the generally accepted accounting principles (GAAP) to ensure compliance of taxation regulations. Business zakat presents a new set of questions. On my zakat anniversary date what zakatable wealth do I have?

The bad news is this: If you have any idea at all what makes something a tangible asset and what does not, you will find this to be a mystery. The good news is that once you figure that part out, it becomes relatively easy. Here is a breakdown of the inventory, cash, receivables and payables and you can use this yearly template to get an idea.

The Core Principle: Zakat on Circulating Business Wealth

The Shari‘ah has made adequate arrangements for assets of commercial transactions which are explained as ʿurūḍ al-tijāra or trade goods. The stipulation that Zakāt has to be paid on the goods which are bought for the sole purpose of selling them, has been prevalent from the very beginning. The rule is applicable in the present era for commercial transactions.

The word circulating in the key phrases is what is important. The business’s fixed assets — production equipment, the office building, and the trucks — are not merchandise and thus are not assets that are bought and sold. So they are simply tools for running the production and sales aspects of the business, and most scholars consider such assets to be non-zakatable (not to be included in one’s wealth to be taxed as Zakat). The liquid or near liquid assets, which in business include inventory, cash, and accounts receivable are the zakatable assets. All the major scholarly views agree on excluding the fixed assets in the business that are used to run its operations.

This is the cornerstone difference that defines all other variables in business zakat calculations.

What Goes In: Zakatable Business Assets

1. Inventory (Trade Goods)

Inventory is a key component when it comes to calculating zakat on a business. When assessing sales inventory at zakat date, businesses must take into account work in progress and stock in progress including materials which are still in the manufacturing stage, work in progress and finished goods which are ready for sale. Each of these items must be valued at the market value applicable on the date of the zakat calculation. The valuation required is the selling price (which can be the published retail price or an estimated price that could be obtained from customers in between. In any case the published retail price must be used in the event of there being any disparity between the two. The cost price of the items is of no importance to the zakat calculation – what is material is the selling price that could be obtained from customers at the date of calculation.

Most contemporary scholars argue that Zakat is payable on the market value of goods at a given time. The calculation of market value as opposed to the cost of the goods to the individual, being generally more practicable, safeguards that Zakat is calculated on the value of goods as they are marketable at the relevant time rather than some theoretical or book value. However, there is the option to calculate Zakat using the cost of the items rather than their market value. Although the latter option is not widely accepted in practice due to its complexities, there is a valid argument that it helps in uniformity and in keeping the computation of Zakat easy and simple. Using the cost value, which in any case would always be lower than the market value of the goods, is the more preferable method when the market value is not ascertainable.

Work-in-progress is recognised at its recoverable value. Material required for manufacture is recognised as trade goods, provided that the entity is engaged in a buying and selling operation.

2. Cash and Cash Equivalents

Cash held in the business, whether in bank accounts, the cash reserve or online with payment providers such as PayPal is all classifiable as cash for zakat purposes. Therefore, all cash that has been set aside or budgeted for future expenditures, but which has not yet been used or spent will be included in the amount of cash that is to be taken into account for zakat purposes on a particular date. The cash in the business on the zakat date is what is important, not the purpose for which it is held.

We are referring here to very short term deposits and money market instruments that are easily liquidated. Cash means that the assets can be liquidated without a penalty and made available to the firm.

3. Receivables (Money Owed to the Business)

Most Muslim accountants would agree that receivables arising from outstanding invoices and accounts receivable are zakatable provided that it is reasonably expected that they will be paid. Provided that a balance can be struck in respect of strong and weak receivables in a similar way as when accounting for personal zakat on debt and cash. Therefore, that which is reasonably expected to be collected (like creditworthy customers) will be zakatable, whereas where there is any uncertainty in relation to these being paid, such as with doubtful accounts, disputed accounts, or accounts receivable with individuals or entities which are themselves insolvent or of poor financial standing, would not be.

In the real world, virtually all business accounts will contain accounts receivable (amounts due on outstanding, non-critically late invoices) and exclude all but the oldest accounts with questionable collectibility, due to their aged status indicating they are clearly uncollectible or otherwise unlikely to be paid. This description aligns with both the formal accounting definition of Accounts Receivable as well as the more practical business usage of this definition, while incorporating a slight modification for the purposes of ethical standards in accounting practices.

4. Prepayments and Deposits Paid

Payments that are made in advance in respect of current assets or transactions such as purchases on account (prepayments made to suppliers), advance sales of merchandise and advance payments for merchandise ordered but not yet received, come under the category of zakatable assets. In other words, such payments are in respect of current assets and transactions in respect of which the business has not yet parted with the asset or has not yet lost control of it.

What Gets Deducted: Business Liabilities

Just like personal zakat allows for deduction of current debts, business zakat allows for deduction of short term business debts and payables that will become due and payable in the near term. You are still dealing with net zakatable wealth, not total assets.

Deductible Payables

Trade payables, accounts payable to vendors, accounts payable to employees, accruals of taxes, instalments due for loans and other zakatable business expenses can be liabilities that are set-off against zakatable assets. The common phrase used to describe these liabilities is “due and payable”. So as long as these liabilities are genuinely “due and payable” on the date of the anniversary of the zakat applicable date, they will reduce the amount of the zakatable assets.

Long term business loans are treated in a similar way to a residential mortgage or long term debt and therefore only the part of the balance which has not been depreciated can be deducted. Only the annual repayments can be claimed as a deduction. So in this example an annual payment of £10,000 can be claimed as a deduction (although the business loan of £200,000 over ten years cannot).

What Is Not Deductible

Loans for the fixed assets like purchasing the machinery or the real estate or the business vehicles are not deductible from the zakatable trading assets because the fixed assets themselves are not considered as part of the zakatable wealth. Hence, the loan is not deductible as well because the fixed assets and the loan that is used to purchase these assets are not included in the zakatable wealth on both sides and thus they cancel each other.

What Is Excluded: Non-Zakatable Business Assets

First, let us define the items which are excluded from the business zakat calculation. These are called the assets of trade or business: plant and machinery, furniture, transport vehicles, land and buildings, or any software/intellectual properties. They are input to the business as such do not form part of the output.

Other investments in other companies or long term financial assets which are zakatable based on their terms and conditions (share zakat rules) will not be included in the general business inventory.

Worked Example: A Small Trading Business

Zakat on Clothing: Cases and Solutions Tariq is a wholesale clothing provider. His zakat anniversary date has arrived and he has calculated the following quantities of clothing:

Our Current Assets: Inventory: Current value of our finished garments $42,000 Fabric & Other Materials in Store $8,000 Cash in the Bank $11,500 Amounts Owed from Reliable Customers $9,000 Prepaid Order to the Supplier $3,500 $74,000

Business debt to suppliers amounts to £6,500 made up of fabric required for future orders, wages totalling £4,200 are also due at the end of the month, £2,800 of VAT has not yet been paid to HMRC and the next instalment of £1,500 on the loan is also due. Total deductible liabilities £15,000.

Net zakatable business wealth: $74,000 – $15,000 = $59,000 Zakat at 2.5%: $1,475.

Tariq has $18,000 in his personal savings account. When he combines this amount with his business wealth he has $77,000 in zakatable assets. He calculates his business and personal zakat and pays them in total on the anniversary of his business which is a valid opinion as this is a calculation of the total zakat due on his assets which he pays at the same time. His total zakat is $1,925.

Business Zakat Calculation Template

Use this calculator on your Zakat anniversary date each year with the most up to date numbers.

Zakat on Business (Trade) - Updated in line with SAMA If your net zakatable business wealth is less than the niṣāb amount for businesses, then no zakat will be payable. If you pay your business zakat and your personal zakat in the same year, then you should add your personal zakatable assets to the business wealth when applying the 2.5% rate.

Common Mistakes Business Owners Make

One of the common pitfalls is to include fixed assets in the assessment. So, if you are the owner of the warehouse where the merchandise is stored, the merchandise has to be valued, but not the warehouse. Similarly, if you are the owner of the van then you have to value the merchandise, and not the van. And all this should be done with caution, to avoid paying more tax than what is due.

Another common error is the neglect of accounts receivable or receivables. Most of us can be neglectful to record unbillled or unbilled accounts as assets. However for some companies they could amount to substantial amounts. Such companies include B2B businesses or professional services which carry large amounts of A/R as part of their normal business.

Challenge number 3 relates to the need to align the formula for business zakat with the accounting year (or fiscal year) as opposed to the Islamic zakat year which is based on the Hijri lunar calendar. Even though it may not be the same, it is highly unlikely that the accounts prepared by your accountant will fall on the zakat date. You therefore need to get a snapshot of the required data at the zakat date.

There are quite a few business owners that would like zakat to be an expense that they can utilise to pay down and reduce debt. So they may not always look at zakat in the way it should be looked at, other than a purely ethical or faith-based level. From an accounting perspective, the annual zakat calculation is often carried out on an ad-hoc basis. Therefore it may not be easily justified or even explained if the request is made. Doing the annual business zakat calculation on a ritual basis can actually make the task a lot easier. Hence it is advisable to carry out this calculation in the same manner each year by using the same template; and to do it at the same time of the year – perhaps even on the same date.

The Bottom Line

A straightforward rule sums it all up: Zakatable wealth is always circulating wealth and not operational wealth. So the operational expenditure and operational assets are excluded (by classifying them as fixed assets and their financing as debts that are not really due and payable, even if some accounting rules state so) and you apply a 2.5% on the remainder, starting after the niṣāb and paying the annual Zakat on the same date of the year.

This Form is for most businesses and investments. In rare cases you may need the advice of a scholar or the Islamic finance advisor at your bank: this might be the case if you have a variety of business operations or products, or have investments in joint ventures, real estate, stocks or bonds. But for virtually all cases, your affairs will fall into the four broad categories described in this Form. You can keep a copy of this application form on your computer to use each year as it will remain the same each year.

And Allah knows best.

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