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A letter of credit can be understood as a promise made by a bank to undertake a payment on behalf of the buyer, in case the buyer fails to make the payment. Therefore a letter of credit is a contract or a guarantee made by the bank on behalf of the buyer. A letter of credit is used in commercial contracts. Usually, a letter of credit is only drawn when there is an import-export transaction. Letter of Credit under FEMA governs import and export transactions in India. Usually, when an importer buys certain goods, the banks in India prefer using a letter of credit under FEMA rules.
The following services use Letter of Credit:
Out of all the above contracts, a letter of credit is frequently used in import and export contracts. Letter of Credit under FEMA rules requires the importer (buyer) and the exporter (seller) to comply with the rules related to foreign exchange. A letter of credit under FEMA would also depend on the terms of shipment, which is agreed between the buyer and the seller.
A letter of credit is used for the following purposes:
A letter of credit cannot be incorporated in a sales agreement between the buyer and the seller. An agreement between the buyer and the seller is the contract of sale. The bank issues the letter of credit under FEMA rules on behalf of the buyer. Therefore the letter of credit is a tripartite agreement between the buyer, seller, and the bank.
The importer (buyer) would contact the respective bank for issuing a letter of credit (LOC). The importer will approach a bank which he is familiar with. The buyer would give specific instructions to the bank for issuing a LOC. There are particular requirements that have to be satisfied with clearing a Letter of Credit under FEMA.
The following are the requirements which have to be fulfilled by the Buyer for Letter of Credit under FEMA:
The above details provided have to precise and correct. The bank issuing the letter of credit under FEMA has the authority to reject the specifications due to mistakes. Therefore, the parties have to make sure that no errors are present. The bank issuing the letter of credit on behalf of the buyer would be making a promise to the seller. The terms of the letter of credit must be decided by the buyer and seller. These terms have to be incorporated in the letter of credit. In certain circumstances, the buyer will be responsible for paying the deposit for the letter of credit. After deciding the terms, the buyer’s bank can issue a letter of credit.
The following process has to be used by the buyer’s bank in drawing a letter of credit:
The following requirements have to be met by the seller before the bank sends the money:
Goods sent by sea voyage are subjected to frustration. A contract is said to be frustrated, when the contract is affected by circumstances beyond the buyer’s and seller’s control. The buyer and the seller cannot be blamed for frustrated contracts. When it comes to the letter of credit under FEMA, the delivery of goods and frustration would not matter to the seller, as the seller would be paid by the bank in case the buyer does not carry out the payment. The documents have to confirm with the letter of credit.
The seller has to send the documents to the seller’s bank, which are forwarded to the buyer’s bank. The buyer’s bank conducts a review, and then documents are sent to the buyer. The buyer’s bank will have to make the payment to the seller’s bank. The payment made to the seller would depend on the type of letter of credit between the buyer and the seller. After the buyer verifies the documents, the seller would be paid within few business days.
Importing is the process where goods are received in the country. The central authority governing import trade in India is the Director-General of Foreign Trade (DGFT). Apart from this, the other bodies that govern the importing process are the Ministry of Commerce and Industry, Department of Commerce (DOC), and the Government of India.
The banks that regularly deal with foreign exchange transactions are the Authorised Dealers (Category –I) [AD]. All remittances related to import transactions have to be handled by Authorised dealers. The AD has to make sure that import transactions conform to the rules laid down by the Foreign Trade Policy (FTP) and the Foreign Exchange Management (Current Account Transactions) Rules, 2000. Apart from this, Authorised Banks have to go by regular banking procedures under the Uniforms Customs and Practice for Documentary Credit (UCPDC). Compliance with the Research and Development Cess Act, 1986 has to be followed for import transactions.
The Authorised dealer has to get requisite permission from the importer that the remittance is made for bona fide purposes and does not go against any foreign exchange provisions. For carrying out transactions related to import, banks can freely issue letters of credit under FEMA as per normal banking conditions. The documents which are received by the authorized dealer for carrying out the remittance must adhere to the guidelines issued by the RBI. These documents are stored for due diligence, which is conducted by auditors from time to time.
The importer must make sure to procure the necessary documentation. Apart from the above documentation, the license for import must be procured by the importer. Usually, the time for the settlement of imports would be six months. However, the time of settlement of imports can be extended to 3 years, due to causes such as financial hardships and suits against the parties. Under no circumstance will the period be extended beyond three years.
Importers are allowed to carry out remittances for the import of goods in advance. Such transactions are understood as advanced payment for the import of goods and services. For advance payment of import, a license must be procured by the importer. Categories of goods that come under the negative list do not require a license.
If the goods listed in the import do not come under the negative list of goods, then the concerned authorized bank can open a letter of credit for the importer. A letter of credit can be used in the following circumstances for advance payment. However, the import of goods must be under the rules of the authorized banks.
For advance payment using a letter of credit under FEMA, the following conditions have to be adhered to:
Authorized banks can make decisions on the import of diamonds. Apart from this, authorized dealers can provide a list of foreign mining companies to importers for making advance payments. This list would only be for specific importers and would not include government institutions/ government organizations and state-owned institutions. Advance payment for the import of rough diamonds in such instances can be made without any bank guarantee/letter of credit or some standby letter.
However, the following conditions must be adhered by the authorized bank:
Letter of Credit is a guarantee which is provided by a bank to the seller. It is understood as a promise made by the bank in case the buyer does not make the payment. In such a situation, the bank would make the payment. Letter of Credit under FEMA operates as a normal letter of credit between the importer and the exporter. However, the authorized bank has to make sure that import compliance is met as per the FTP and FEMA regulations requirements. The seller’s bank can draw a letter of credits for advance payment for the import of goods, services, and diamonds. A letter of credit under FEMA rules is a preferred mode of payment as per the seller’s requirement.