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Letter of credit

Steps:
After a contract is concluded between buyer and seller, buyer's bank supplies a
letter of credit to seller.

Seller consigns the goods to a carrier in exchange for a bill of lading.

Seller provides bill of lading to bank in exchange for payment. Seller's bank exchanges
bill of lading for payment from buyer's bank. Buyer's bank exchanges bill of lading for
payment from the buyer.

Buyer provides bill of lading to carrier and takes delivery of goods.

Definition: A standard, commercial letter of credit is a document issued mostly by a


financial institution, used primarily in trade finance, which usually provides an
irrevocable payment undertaking.

The letter of credit can also be source of payment for a transaction, meaning that
redeeming the letter of credit will pay an exporter. Letters of credit are used primarily in
international trade transactions of significant value, for deals between a supplier in one
country and a customer in another.

Parties to a letter of credit are

Beneficiary who is to receive the money,

Issuing bank of whom the applicant is a client

Advising bank of whom the beneficiary is a client.

Properties:

Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without
prior agreement of the beneficiary, the issuing bank and the confirming bank, if any.

In executing a transaction, letters of credit incorporate functions common to giros and


Traveler's cheques.

Documents a beneficiary has to present in order to receive payment include a commercial


invoice, bill of lading, and documents proving the shipment was insured against loss or
damage in transit. However, the list and form of documents is open to imagination and
negotiation and might contain requirements to present documents issued by a neutral
third party evidencing the quality of the goods shipped, or their place of origin.

How it works
A business called the InCosmetika from time to time imports goods from a business
called ACME, which banks with the ABC Bank. InCosmetika holds an account at the
Commonwealth Bank. InCosmetika wants to buy $500,000 worth of merchandise from
ACME, who agrees to sell the goods and give InCosmetika 60 days to pay for them, on
the condition that they are provided with a 90-day letter of credit for the full amount. The
steps to get the letter of credit would be as follows:

• InCosmetika goes to The Commonwealth Bank and requests a $500,000 letter of


credit, with ACME as the beneficiary.
• The Commonwealth Bank can issue a letter of credit either on approval of a
standard loan underwriting process or by InCosmetika funding it directly with a
deposit of $500,000 plus fees which are typically between 1% and 8% of the face
value of the letter of credit.
• The Commonwealth Bank sends a copy of the letter of credit to the ABC Bank,
which notifies ACME that payment is available and they can ship the
merchandise InCosmetika has ordered with the full assurance of payment to them.
• On presentation of the stipulated documents in the letter of credit and compliance
with the terms and conditions of the letter of credit, the Commonwealth Bank
transfers the $500,000 to the ABC Bank, which then credits the account of ACME
for that amount.
• Note that banks deal only with documents required in the letter of credit and not
the underlying transaction.
• Many exporters have mistakenly assumed that the payment is guaranteed after
receiving the letter of credit. The issuing bank is obligated to pay under the letter
of credit only when the stipulated documents are presented and the terms and
conditions of the letter of credit have been met.

Availability
A letter of credit being an irrevocable undertaking of the issuing bank makes available
the Proceeds, to the Beneficiary of the Credit provided, stipulated documents strictly
complying with the provisions of the letter of credit, UCP 600 and other international
standard banking practices, are presented to the issuing bank, then:

• i.if the Credit provides for sight payment – by payment at sight against compliant
presentation
• ii.if the Credit provides for deferred payment – by payment on the maturity
date(s) determinable in accordance with the stipulations of the Credit; and of
course undertaking to pay on due date and confirming maturity date at the time of
compliant presentation
• iii.a.if the Credit provides for acceptance by the Issuing Bank – by acceptance
of Draft(s) drawn by the Beneficiary on the Issuing Bank and payment at maturity
of such tenor draft, or
• iii.b. if the Credit provides for acceptance by another drawee bank – by
acceptance and payment at maturity Draft(s)drawn by the Beneficiary on the
Issuing Bank in the event the drawee bank stipulated in the Credit does not accept
Draft(s) drawn on it,

or by payment of Draft(s) accepted but not paid by such drawee bank at maturity;

• iv. if the Credit provides for negotiation by another bank – by payment without
recourse to drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary
and/or document(s) presented under the Credit, (and so negotiated by the
nominated bank )

• Negotiation means the giving of value for Draft(s) and/or document(s) by the
bank authorized to negotiate, viz the nominated bank. Mere examination of the
documents and forwarding the same to the letter of credit issuing bank for
reimbursement, without giving of value / agreed to give, does not constitute a
negotiation.

[edit] Some of the Documents Called for under a Letter


of Credit
• Financial Documents

Bill of Exchange, Co-accepted Draft

• Commercial Documents

Invoice, Packing list

• Shipping Documents

Transport Document, Insurance Certificate, Commercial, Official or Legal


Documents

• Official Documents

License, Embassy legalization, Origin Certificate, Inspection Certificate,


Phytosanitary certificate

• Transport Documents
Bill of Lading (ocean or multi-modal or Charter party), Airway bill, Lorry/truck
receipt, railway receipt, CMC Other than Mate Receipt, Forwarder Cargo Receipt,
Deliver Challan...etc

• Insurance documents

Insurance policy, or Certificate but not a cover note.

Legal principles governing documentary credits


Primary peculiarities of the documentary credit

1) Payment obligation is abstract and independent from the underlying contract of sale or
any other contract in the transaction. Thus the bank’s obligation is defined by the terms of
the credit alone, and the sale contract is irrelevant. The defences of the buyer arising out
of the sale contract do not concern the bank and in no way affect its liability.[1] Article
4(a) UCP states this principle clearly. Article 5 the UCP further states that banks deal
with documents only, they are not concerned with the goods (facts). Accordingly, if the
documents tendered by the beneficiary, or his or her agent, appear to be in order, then in
general the bank is obliged to pay without further qualifications.

If the responsibility for the validity of documents was thrown onto banks, they would be
burdened with investigating the underlying facts of each transaction and would thus be
less inclined to issue documentary credits as the transaction would involve great risk and
inconvenience.

Secondly, documents required under the credit could in certain circumstances be different
from those required under the sale transaction; banks would then be placed in a dilemma
in deciding which terms to follow if required to look behind the credit agreement.

Thirdly, the fact that the basic function of the credit is to provide the seller with the
certainty of receiving payment, as long as he performs his documentary duties, suggests
that banks should honour their obligation notwithstanding allegations of misfeasance by
the buyer. [2]

Finally, courts have emphasised that buyers always have a remedy for an action upon the
contract of sale, and that it would be a calamity for the business world if, for every breach
of contract between the seller and buyer, a bank were required to investigate said breach.

The “principle of strict compliance” also aims to make the bank’s duty of effecting
payment against documents easy, efficient and quick. Hence, if the documents tendered
under the credit deviate from the language of the credit the bank is entitled to withhold
payment even if the deviation is purely terminological.[3] The general legal maxim de
minimis non curat lex has no place in the field of documentary credits.

The price of letters of credit


All the charges for issuance of Letter of Credit, negotiation of documents,
reimbursements and other charges like courier are to the account of applicant or as per
the terms and conditions of the Letter of credit. If the letter of credit is silent on charges,
then they are to the account of the Applicant. The description of charges and who would
be bearing them would be indicated in the field 71B in the Letter of Credit.

Legal Basis for Letters of Credit


Although documentary credits are enforceable once communicated to the beneficiary, it
is difficult to show any consideration given by the beneficiary to the banker prior to the
tender of documents. In such transactions the undertaking by the beneficiary to deliver
the goods to the applicant is not sufficient consideration for the bank’s promise because
the contract of sale is made before the issuance of the credit, thus consideration in these
circumstances is past. In addition, the performance of an existing duty under a contract
cannot be a valid consideration for a new promise made by the bank: the delivery of the
goods is consideration for enforcing the underlying contract of sale and cannot be used,
as it were, a second time to establish the enforceability of the bank-beneficiary relation.

Legal writers have failed to satisfactorily reconcile the bank’s undertaking with any
contractual analysis. The theories include: the implied promise, assignment theory, the
novation theory, reliance theory, agency theories, estoppels and trust theories,
anticipatory theory, and the guarantee theory. [4] Davis, Treitel, Goode, Finkelstein and
Ellinger have all accepted the view that documentary credits should be analyzed outside
the legal framework of contractual principles, which require the presence of
consideration. Accordingly, whether the documentary credit is referred to as a promise,
an undertaking, a chose in action, an engagement or a contract, it is acceptable in English
jurisprudence to treat it as contractual in nature, despite the fact that it possesses
distinctive features, which make it sui generis.

A few countries including the US (see Article 5 of the Uniform Commercial Code) have
created statutes in relation to the operation of letters of credit. These statutes are designed
to work with the rules of practice including the UCP and the ISP98. These rules of
practice are incorporated into the transaction by agreement of the parties. The latest
version of the UCP is the UCP600 effective July 1, 2007[5]. The previous revision was the
UCP500 and became effective on 1 January 1994. Since the UCP are not laws, parties
have to include them into their arrangements as normal contractual provisions.

International Trade Payment methods


• Advance payment (most secure for seller)

Where the buyer parts with money first and waits for the seller to forward the goods

• Documentary Credit (more secure for seller as well as buyer)


Subject to ICC's UCP 600, where the bank gives an undertaking (on behalf of buyer and
at the request of applicant ) to pay the shipper ( beneficiary ) the value of the goods
shipped if certain documents are submitted and if the stipulated terms and conditions are
strictly complied.

Here the buyer can be confident that the goods he is expecting only will be received since
it will be evidenced in the form of certain documents called for meeting the specified
terms and conditions while the supplier can be confident that if he meets the stipulations
his payment for the shipment is guaranteed by bank, who is independent of the parties to
the contract.

• Documentary collection (more secure for buyer and to a certain extent to seller)

Also called "Cash Against Documents". Subject to ICC's URC 525, sight and usance, for
delivery of shipping documents against payment or acceptances of draft, where shipment
happens first, then the title documents are sent to the [collecting bank] buyer's bank by
seller's bank [remitting bank], for delivering documents against collection of
payment/acceptance

• Direct payment (most secure for buyer)

Where the supplier ships the goods and waits for the buyer to remit the bill proceeds, on
open account terms.

Risk situations in letter-of-credit transactions


Fraud Risks

• The payment will be obtained for nonexistent or worthless merchandise against


presentation by the beneficiary of forged or falsified documents.
• Credit itself may be forged.

Sovereign and Regulatory Risks

• Performance of the Documentary Credit may be prevented by government action


outside the control of the parties.

Legal Risks

• Possibility that performance of a Documentary Credit may be disturbed by legal


action relating directly to the parties and their rights and obligations under the
Documentary Credit

Force Majeure and Frustration of Contract


• Performance of a contract – including an obligation under a Documentary Credit
relationship – is prevented by external factors such as natural disasters or armed
conflicts

Risks to the Applicant

• Non-delivery of Goods
• Short Shipment
• Inferior Quality
• Early /Late Shipment
• Damaged in transit
• Foreign exchange
• Failure of Bank viz Issuing bank / Collecting Bank

Risks to the Issuing Bank

• Insolvency of the Applicant


• Fraud Risk, Sovereign and Regulatory Risk and Legal Risks

Risks to the Reimbursing Bank

• no obligation to reimburse the Claiming Bank unless it has issued a


reimbursement undertaking.

Risks to the Beneficiary

• Failure to Comply with Credit Conditions


• Failure of, or Delays in Payment from, the Issuing Bank
• Credit Issued by Party other than Bank

Risks to the Advising Bank

• The Advising Bank’s only obligation – if it accepts the Issuing Bank’s


instructions – is to check the apparent authenticity of the Credit and advising it to
the Beneficiary

Risks to the Nominated Bank

• Nominated Bank has made a payment to the Beneficiary against documents that
comply with the terms and conditions of the Credit and is unable to obtain
reimbursement from the Issuing Bank

Risks to the Confirming Bank

• If Confirming Bank’s main risk is that, once having paid the Beneficiary, it may
not be able to obtain reimbursement from the Issuing Bank because of insolvency
of the Issuing Bank or refusal of the Issuing Bank to reimburse because of a
dispute as to whether or not payment should have been made under the Credit

Other Risks in International Trade

• A Credit risk risk from change in the credit of an opposing business.


• An Exchange risk is a risk from a change in the foreign exchange rate.
• A Force majeure risk is 1. a risk in trade incapability caused by a change in a
country's policy, and 2. a risk caused by a natural disaster.
• Other risks are mainly risks caused by a difference in law, language or culture. In
these cases, the cargo might be found late because of a dispute in import and
export dealings.

Incoterms or international commercial terms are a series of international sales terms,


published by International Chamber of Commerce (ICC) and widely used in international
commercial transactions. They are used to divide transaction costs and responsibilities
between buyer and seller and reflect state-of-the-art transportation practices. They closely
correspond to the U.N. Convention on Contracts for the International Sale of Goods. The
first version was introduced in 1936 and the present dates from 2000.

Contents
[hide]

• 1 Group F – Main carriage unpaid


• 2 Group C – Main carriage paid
• 3 Group D – Arrival
• 4 Summary of terms
• 5 See also

• 6 References

[edit] Group F – Main carriage unpaid


FCA – Free Carrier (named places)
The seller hands over the goods, cleared for export, into the custody of the first
carrier (named by the buyer) at the named place. This term is suitable for all
modes of transport, including carriage by air, rail, road, and containerised / multi-
modal transport.
FAS – Free Alongside Ship (named loading port)
The seller must place the goods alongside the ship at the named port. The seller
must clear the goods for export; this changed in the 2000 version of the
Incoterms. Suitable for maritime transport only.
FOB – Free on board (named loading port)
The seller must load the goods on board the ship nominated by the buyer, cost and
risk being divided at ship's rail. The seller must clear the goods for export.
Maritime transport only. It also includes Air transport when the seller is not able
to export the goods on the schedule time mentioned in the letter of credit. In this
case the seller allows a deduction of sum equivalent to the carriage by ship from
the air carriage.

[edit] Group C – Main carriage paid


CFR or CNF – Cost and Freight (named destination port)
Seller must pay the costs and freight to bring the goods to the port of destination.
However, risk is transferred to the buyer once the goods have crossed the ship's
rail. Maritime transport only.
CIF – Cost, Insurance and Freight (named destination port)
Exactly the same as CFR except that the seller must in addition procure and pay
for insurance for the buyer. Maritime transport only.
CPT – Carriage Paid To (named place of destination)
The general/containerised/multimodal equivalent of CFR. The seller pays for
carriage to the named point of destination, but risk passes when the goods are
handed over to the first carrier.
CIP – Carriage and Insurance Paid (To) (named place of destination)
The containerised transport/multimodal equivalent of CIF. Seller pays for carriage
and insurance to the named destination point, but risk passes when the goods are
handed over to the first carrier.

[edit] Group D – Arrival


DAF – Delivered At Frontier (named place)
This term can be used when the goods are transported by rail and road. The seller
pays for transportation to the named place of delivery at the frontier. The buyer
arranges for customs clearance and pays for transportation from the frontier to his
factory. The passing of risk occurs at the frontier.
DES – Delivered Ex Ship (named port)
Where goods are delivered ex ship, the passing of risk does not occur until the
ship has arrived at the named port of destination and the goods made available for
unloading to the buyer. The seller pays the same freight and insurance costs as he
would under a CIF arrangement. Unlike CFR and CIF terms, the seller has agreed
to bear not just cost, but also Risk and Title up to the arrival of the vessel at the
named port. Costs for unloading the goods and any duties, taxes, etc… are for the
Buyer. A commonly used term in shipping bulk commodities, such as coal, grain,
dry chemicals - - - and where the seller either owns or has chartered, their own
vessel.
DEQ – Delivered Ex Quay (named port)
This is similar to DES, but the passing of risk does not occur until the goods have
been unloaded at the port of destination.
DDU – Delivered Duty Unpaid (named destination place)
This term means that the seller delivers the goods to the buyer to the named place
of destination in the contract of sale. The goods are not cleared for import or
unloaded from any form of transport at the place of destination. The buyer is
responsible for the costs and risks for the unloading, duty and any subsequent
delivery beyond the place of destination. However, if the buyer wishes the seller
to bear cost and risks associated with the import clearance, duty, unloading and
subsequent delivery beyond the place of destination, then this all needs to be
explicitly agreed upon in the contract of sale.
DDP – Delivered Duty Paid (named destination place)
This term means that the seller pays for all transportation costs and bears all risk
until the goods have been delivered and pays the duty. Also used interchangeably
with the term "Free Domicile". The most comprehensive term for the buyer. In
most of the importing countries, taxes such as (but not limited to) VAT and
excises should not be considered prepaid being handled as a "refundable" tax.
Therefore VAT and excises usually are not representing a direct cost for the
importer since they will be recovered against the sales on the local (domestic)
market.

[edit] Summary of terms


For a given term, "Yes" indicates that the seller has the responsibility to provide the
service included in the price. "No" indicates it is the buyer's responsibility. If insurance
is not included in the term (for example, CFR) then insurance for transport is the
responsibility of the buyer or the seller depending on who owns the cargo at time of
transport. In the case of CFR terms, it would be the buyer while in the case of DDU or
DDP terms, it would be the seller.

Unlo Unload
Landin Entr
ad Landi onto
Expor Transp Transp g Entry - y -
Loa from ng trucks Transp
t- ort to ort to charge Custo Duti
Incoter d to truck charg from ort to Insura
duty export import s at ms es
ms truc at the es at the destinat nce
paym er's er's import cleara and
k origi origin import ion
ent port port er's nce Taxe
n's 's port ers'
port s
port port
EXW No No No No No No No No No No No No
FCA Yes Yes Yes No No No No No No No No No
FAS Yes Yes Yes Yes No No No No No No No No
FOB Yes Yes Yes Yes Yes No No No No No No No
CFR Yes Yes Yes Yes Yes Yes Yes No No No No No
CIF Yes Yes Yes Yes Yes Yes No No No Yes No No
CPT Yes Yes Yes Yes Yes Yes No No No No No No
CIP Yes Yes Yes Yes Yes Yes No No No Yes No No
DAF Yes Yes Yes Yes Yes Yes No No No No No No
DES Yes Yes Yes Yes Yes Yes No No No No No No
DEQ Yes Yes Yes Yes Yes Yes Yes No No No No No
DDU Yes Yes Yes Yes Yes Yes Yes Yes Yes No No No
DDP Yes Yes Yes Yes Yes Yes Yes Yes Yes No Yes Yes

MODVAT and CENVAT

Taxation of inputs, like raw materials, components and other intermediaries had a number of
limitations. In production process, raw material passes through various processes stages till a final
product emerges. Thus, output of the first manufacturer becomes input for second manufacturer
and so on. When the inputs are used in the manufacture of product `A', the cost of the final product
increases not only on account of the cost of the inputs, but also on account of the duty paid on such
inputs. As the duty on the final product is on ad valorem basis and the final cost of product `A'
includes the cost of inputs, inclusive of the duty paid, duty charged on product `A' meant doubly
taxing raw materials. In other words, the tax burden goes on increasing as raw material and final
product passes from one stage to other because, each subsequent purchaser has to pay tax again
and again on the material which has already suffered tax. This is called cascading effect or double
taxation.

This very often distorted the production structure and did not allow the correct assessment of the
tax incidence. Therefore, the Government tried to remove these defects of the Central Excise
System by progressively relieving inputs from excise and countervailing duties. An ideal system to
realize this objective would have been to adopt value added taxation (VAT). However, on account of
some practical difficulties it was not possible to fully adopt the value added taxation.

Hence, Government evolved a new scheme, `MODVAT' (Modified Value Added Tax). MODVAT
Scheme which essentially follows VAT Scheme of taxation. i.e. if a manufacturer A purchases certain
components(raw materials) from another manufacturer B for use in its product. B would have paid
excise duty on components manufactured by it and would have recovered that excise duty in its
sales price from A. Now, A has to pay excise duty on product manufactured by it as well as bear the
excise duty paid by the supplier of raw material B. Under the MODVAT scheme, a manufacturer can
take credit of excise duty paid on raw materials and components used by him in his manufacture. It
amounts to excise duty only on additions in value by each manufacturer at each stage.

The modvat scheme is regulated by Rules 57A to 57U of the Central Excise Rules and the
notifications issued there under (The Central Excise Rules, 2002 (Section 143 of the Finance
Act, 2002).

Modvat Scheme ensures the revenue of the same order and at same time the price of the final
product could be lower. Apart from reducing the costs through elimination of cascade effect, and
bringing in greater rationalization in tax structure and also bringing in certainty in the amount of tax
leviable on the final product, this scheme will help the consumer to understand precisely the impact
of taxation on the cost of any product and will, therefore, enable consumer resistance to unethical
attempts on the part of manufacturers to raise prices of final products, attributing the same to
higher taxes.

Subsequently, MODVAT scheme was restructured into CENVAT( Central Value Added Tax) scheme.
A new set of rules 57AA to 57AK , under The Cenvat Credit Rules, 2004, were framed and
whatever restrictions restrictions were there in MODVAT Scheme were put to an end and
comparatively, a free hand was given to the assesses.
Under the Cenvat Scheme, a manufacturer of final product or provider of taxable service shall be
allowed to take credit of duty of excise as well as of service tax paid on any input received in the
factory or any input service received by manufacturer of final product.

The term "Input" means: -

1. All goods, except light diesel oil, high speed diesel oil and motor spirit, commonly known as
petrol, used in or in relation to the manufacture of final products whether directly or
indirectly and whether contained in the final product or not and includes lubricating oils,
greases, cutting oils, coolants, accessories of the final products cleared along with the final
product, goods used as paint, or as packing material, or as fuel, or for generation of
electricity or steam used in or in relation to manufacture of final products or for any other
purpose, within the factory of production
2. All goods, except light diesel oil, high speed diesel oil, motor spirit, commonly known as
petrol and motor vehicles, used for providing any output service;

Explanation 1 : The light diesel oil, high-speed diesel oil or motor spirit, commonly known as
petrol, shall not be treated as an input for any purpose whatsoever.

Explanation 2 : Inputs include goods used in the manufacture of capital goods which are further
used in the factory of the manufacturer;"

The term "Input service" means any service: -

1. Used by a provider of taxable service for providing an output service; or


2. Used by the manufacturer, whether directly or indirectly, in or in relation to the
manufacture of final products and clearance of final products from the place of removal,

And includes services used in relation to setting up, modernization, renovation or repairs of a
factory, premises of provider of output service or an office relating to such factory or premises,
advertisement or sales promotion, market research, storage upto the place of removal,
procurement of inputs, activities relating to business, such as accounting, auditing, financing,
recruitment and quality control, coaching and training, computer networking, credit rating, share
registry and security, inward transportation of inputs or capital goods and outward transportation
upto the place of removal;"

Manufacturer and service providers can avail Cenvat credit of capital goods used by them. The plant
and machinery and allied items are purchased by a manufacturer. Such goods known as capital
goods may be duty paid. The capital goods shall be used in manufacture of final products or for
providing output service. The CENVAT credit in respect of duty paid on capital goods shall be taken
only for an amount not exceeding fifty percent of the duty paid in the same financial year and the
credit of balance amount can be take in any financial year subsequent to the financial year in which
the capital goods were received.

Duty Paying Documents against which CENVAT credit can be availed are:-

 Invoice issued by

• A manufacture of inputs or capital goods.


• An importer
• An importer from his depot or premises of consignment agent,
• Provided the depot/ premises is registered with central excise
• A first/second stage dealer.

 A supplementary invoice
 A bill of entry.
 A certificate issued by appraiser of customs
 An invoice/bill/challan issued by providers of input service.
 A challan evidencing payment of service tax.

Credit of duty is allowed only if all the conditions given below are met:-

 The basic criteria for availment of credit of duty paid on inputs or capital goods is that the
goods shall be used in manufacture of final products.
 The goods shall be accompanied with proper prescribed documents.

 The final products shall not be exempt from whole of duty or chargeable to nil rate of duty.