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Overview of Letter of Credit under FEMA Rules

Varun Hariharan

| Updated: Jun 05, 2020 | Category: FEMA

Letter of Credit under FEMA

What is a Letter of Credit?

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.

Services which use Letter of Credit

The following services use Letter of Credit:

services use Letter of Credit: under FEMA

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.

Why is the Letter of Credit under FEMA used?

A letter of credit is used for the following purposes:

  • The parties involved in the letter of credit may be new, so more confidence is present with the seller while using a letter of credit.
  • The seller would require the buyer to use the letter of credit as per the terms of the contract.
  • If the parties are in any severe hardship, the letter of credit would be a saviour to the seller.

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.

Process in Obtaining the Letter of Credit

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:

Process in Obtaining the Letter of Credit

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 buyer’s bank should issue the letter of credit to the seller’s bank.
  • The seller’s bank will conduct a review of the letter of credit. After reviewing the letter of credit, it will be forwarded to the seller. On reviewing the letter of credit, the seller has to make sure that the letter of credit confirms with the requirement of the contract. Apart from this, the seller also has to verify that the letter of credit is as per the terms.
  • The seller would also decide whether they are comfortable at trusting the bank, which issues the letter of credit.

Requirements which have to be met by the Seller

The following requirements have to be met by the seller before the bank sends the money:

  • The seller must ship the goods to the location as discussed between the buyer and the seller;
  • Goods sent by the seller will be subjected to inspection by the buyer;
  • The method of shipment must be under the letter of credit;
  • The location (“To and from”) for the goods must conform to the contract; and
  • The letter of credit would be applicable irrespective of the solvency position of the banker.

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.

Letter of Credit under FEMA for import transactions

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[1] (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.

Remittance for payment- letter of credit under FEMA

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.

License for import- Letter of Credit under FEMA

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:

  • If the amount of payment exceeds USD 200000 or equivalent to another foreign currency, then an unconditional, standby letter of credit or guarantee is required from an international bank. The international bank has to be reputed and situated outside India. Apart from this, a guarantee is required from the Authorised bank in India. This guarantee would act as a counter-guarantee against the guarantee issued by the international bank.
  • Where the importer (except a Public Sector Undertaking/ bank or State Government or an institution under the government of India) cannot obtain the bank guarantee from the suppliers overseas, the authorized dealer would look at the import history of the importer. Apart from this, the track record and the transactions of the importer would be taken into consideration. If all the transactions conducted by the importer are bona fide, then the requirement of the bank guarantee or the letter of credit will not be required by the Authorised Dealer. This would be for advance remittances up to USD 5 million. Banks can frame their policies regarding the requirement of the amount of advance remittance.

Letter of Credit under FEMA can also be used for advance payment for Diamonds/ Cut Stones.

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:

  • The foreign mining company accredited with the Gem and Jewellery Export Promotion Council (GJEPC).
  • The importer must have a good record of dealing with diamond transactions and should be a recognized processor of rough diamonds.
  • The authorized dealer should take due diligence in conducting the transaction. The bank has to exercise commercial prudence in the transaction. Apart from this, the bank must consider the bona fide of the transaction.
  • Advance payment for the import of diamonds must be according to the stipulations of the contract. 
  • The advance payment for the import of diamonds must be according to the Kimberly Certification. The remittance must be allowed for the import of the diamonds. There must be no conflict when it comes to payment for diamonds.
  • Authorized dealers should ensure to check with the concerned authorities regarding the documents related to import/ bill of lading or documents evidencing such import.

Conclusion for Letter of Credit under FEMA

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.

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Varun Hariharan

Varun Hariharan has completed the Legal Practice Course from BPP Law School, Manchester. He has a Masters in Commercial and Corporate Law from the Queen Mary University of London and LLB Honours from Bangor University, UK. He specialises in law related to corporate, artificial intelligence and technology law.

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