Merchanting Trade: Opportunities and Challenges
JUNE 28, 2016
By Ranjeet Mahtani, Rajat Chhabra & Ketan Tadsare, Economic Laws Practice
INCREASE in international trade has been a significant factor in the performance of many economies including India. For a variety of reasons including effective modes of communication, more efficient logistics, economic co-operation, etc., the last century has witnessed the fastest ever growth of international trade.
This growth also presents opportunities for businesses to participate in international trade and develop novel and newer ways of trading. An interesting phenomenon which has emerged in the international trade is ‘merchanting trade'. This article captures the conceptual and regulatory facets of the said phenomenon.
Concept and regulatory framework
In Indian context, merchanting trade signifies trading of goods in the international market whereby the subject goods are neither imported into nor exported out of India. In other words, for a trade to qualify as merchanting trade, two conditions are to be met: (i) goods acquired should not enter the domestic tariff area of a country; and (ii) the state of the goods should not undergo any transformation during their movement. Simply, there is inflow and outflow of foreign currency which requires monitoring and reporting.
Now, when there is no physical movement of goods in the country, it becomes a challenge to monitor and control the foreign exchange flow. Since foreign exchange is a precious reserve for a country such as India, the Reserve Bank of India (‘RBI') took upon itself the task of ensuring that the foreign exchange inflow/outflow is genuine and regulated.
Accordingly, the RBI has framed suitable guidelines (Ref: Circular No. 115 dated March 28, 2014) based on the recommendations made by the technical committee chaired by Mr. G. Padmanabhan appointed for evaluating the entire gamut of facilities/services provided by banks/financial institutions to the exporters. The significant ones are as under:
(a) Goods involved in merchanting trade should be the kind that are permitted for exports or imports, as the case may be, under the prevailing Foreign Trade Policy of India (‘FTP'), as on the date of shipment and all the rules and regulations applicable are to be complied with for the export leg and import leg respectively (except the requirement of filing of shipping bill/export declaration form in case of exports and filing of bill of entry in case of imports);
(b) The Authorized Dealer Bank of the trader (‘ADB') should be satisfied that the underlying transactions are bona fide;
(c) While handling such transactions, the ADB should observe the Know Your Customer and Anti-Money Laundering guidelines prescribed by the RBI;
(d) Both legs of a merchanting trade transaction should be routed through the same ADB. The ADB generally verifies documents such as invoice, packing list, transport documents and insurance documents and satisfies itself about the genuineness of the trade (if originals are not available, non-negotiable copies duly authenticated by the bank handling the documents may be provided);
(e) The commencement of merchanting trade would be the date of shipment or export leg receipt or import leg payment, whichever is earlier. The completion date would be the date of shipment or export leg receipt or import leg payment, whichever is later. The entire transaction is to be completed within an overall time limit of nine months and there should be no outlay of foreign exchange beyond four months;
(f) Merchanting traders may be allowed to make advance payment for the import leg on demand made by the overseas seller. In case where inward remittance from the overseas buyer is not received before the outward remittance to the overseas supplier, the ADB may facilitate such transactions by providing facility based on commercial judgment. However, if any such advance payment for the import leg beyond USD 200,000/- per transaction is to be made, the same ought to be paid against Bank Guarantee or Letter of Credit from an international bank of repute except in cases and to the extent where payment for export leg has already been received in advance;
(g) Letter of Credit to the supplier is permitted against confirmed export orders keeping in view the outlay and completion of the transaction within nine months; and
(h) Payment for import leg is also allowed to be made out of the balances in Exchange Earners Foreign Currency Account of the merchanting trader.
The RBI has clarified that merchanting traders have to be genuine traders of goods and not mere financial intermediaries. Further, the traders must receive confirmed orders from the overseas buyers prior to placing orders to its foreign suppliers. The ADB should satisfy themselves about the capabilities of the merchanting trader to perform the stated obligations. Even though there is no benchmarking prescribed with regard to the pricing pattern, it has been fairly indicated that the overall merchanting trade ought to result in reasonable profits to the trader.
The key documents in this arrangement are contract between Indian merchanting trader and the overseas supplier, contract between Indian merchanting trader and the overseas buyer, related purchase and sales orders, sale and purchase invoices, packing list, transport and insurance related documents in respect of both import and export leg.
Empirical studies reveal that the presence of merchanting activity in a country significantly increases its current account balance.
In terms of international precedents, there are several open economies, such as Finland, Ireland, Sweden, and Switzerland where merchanting trade has grown strongly in the last decade or so and thus, has become an important driver of these countries' current account balance.
Typically, in India an export transaction or a transaction which earns foreign exchange for the country is given a zero-rated treatment i.e. no tax burden is cast on the transaction (no tax on the output side and refunds/set-off of tax paid on the input side). Such transactions may additionally be incentivized (by granting ‘duty credit scrip') under the FTP.
Under laws governing levy and administration of Value Added Tax (‘VAT') as well as Central Sales Tax (‘CST') , exports are allowed as a deduction from the total taxable turnover for the purpose of discharging VAT/CST and are, thus, ‘tax free'.
However, practically, in more than one jurisdiction, there have been instances where the State VAT authorities have sought to levy VAT on the turnover of merchanting trade in the absence of evidence to support exportation of the subject goods, also for the reason that no shipping bills are filed.
In fact, the goods involved in merchanting trade ought not to be taxed in India in terms of Article 265 (taxes not to be imposed save by authority of law) and Article 286 (restrictions as to imposition of tax on the sale or purchase of goods) of the Constitution of India.
Therefore, departmental authorities attempt to bring such transactions within the tax net needs to be suitably defended by traders at the time of assessment in view of adequate documentation (as expounded above) exhibiting the true character and essence of subject transactions.
Going forward, such transactions are unlikely to be taxed under the imminent GST regime which rests on the principle of ‘destination based taxation'.
Other tax implications/considerations arising in respect to merchanting trade are (i) no customs duties incidence as no goods enter the domestic tariff area of India; (ii) reversal of CENVAT credit on common input services; and (iii) the profits arising out of merchanting trade is ‘income deemed to accrue or arise in India' and thus, liable to income tax in India.
The size of merchanting trade is growing and it is likely to change the dynamics of India's current account balance.
Nonetheless, the challenge for Indian traders in implementation of this phenomenon comes from VAT authorities who appear not to recognize and accept the concept. Given that in merchanting trade, goods are neither brought into nor leave India, any attempt on part of the VAT authorities to impose VAT on such transactions is not only onerous, but also violative of the mandate of Constitution of India.
This also brings on the back foot an advantageous framework implemented by the RBI and seeks to neutralize a crucial step taken to support Indian traders and help Indian economy grow. In this behalf, it becomes crucial for traders to maintain precise records and documents evidencing the merchanting trade in order to enjoy the ‘tax free' status accorded to such transactions.
(The authors are Partner, Associate Partner and Associate Manager respectively at ELP, Advocates & Solicitors.)
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