Indian tax officials are asking foreign banks to provide details of letters of credit (L/Cs) after a high court ruling determined that importers should pay tax on usance interest, the charge levied by a supplier for extending credit after the delivery of goods.

Usance interest is, according to the Gujarat High Court, different from the usual understanding of interest as a payment arising from a debt claim and is therefore not tax deductible.

Ship-breakers

The recent decision by the Gujarat High Court could impact on several sectors, but will apparently hit ship breakers particularly hard.

In their normal course of business, ship-breaking companies pay huge amounts of usance interest and according to T P Oswal, senior tax consultant, and member of India's first Transfer Pricing committee, the tax authorities are looking very carefully at the way ship-breakers' L/Cs are framed.

"The income-tax department has already started sending notices to foreign banks, asking for details of the L/Cs these banks are handling," he says.

Purchase price

A central issue is whether usance tax forms a part of a purchase price. Earlier, the Andhra Pradesh High Court held that usance interest is part of the purchasing price. The decision of the Gujarat High Court means that transactions in which usance interest is demarcated as a separate component will have tax deducted.

This latest decision reverses the decision taken by the Income-Tax Appellate Tribunal (ITAT), a quasi-judicial body dealing with tax matters, which had decided that tax need not be deducted at source from interest if the interest forms a part of the purchase consideration.

Vijay's dispute

The issue of taxation on usance interest has centred on a dispute between Vijay Shipbreaking Corporation and the tax authorities in which the ship breakers purchased two ships from UK and Singapore-based companies respectively.

As per the Memorandum of Agreement (MOA) between the company and the seller, the purchase consideration was to be paid by means of an irrevocable 180 days usance L/C acceptable to the sellers through any nationalised Indian opening bank for the net amount.

Invoice for interest

Once the L/C was released, on receipt of the Notice of Readiness (NOR) by the buyer or his authorised representative, the buyer would arrange for the opening bank to instruct the negotiating bank to release the full purchase price to the sellers.

After releasing the full purchase price, the negotiating bank would pass on the purchase invoice along with the invoice for interest amount for 180 days usance from date of the NOR to the opening bank for onward transmission to the buyer.

This article represents the views of the author and not necessarily those of the ICC or any of the other partners in DC-PRO.