Domestic or Inland Letter of Credit – Meaning and Purpose
Unpredictable situations such as delayed payments, or non-payment for delivery of goods could cause financial woes for any business. Thus, a domestic or inland letter of credit is a financial arrangement which helps to alleviate concerns by guaranteeing payments to the beneficiary within a certain date by a financial institution to minimise credit related risks for the sellers. While Letters of Credit are applied for import and export businesses for global transactions, they are equally preferred for domestic transactions.
Accordingly, a domestic or inland letter of credit is a document assuring payment to the beneficiary by a financial institution (also referred as issuer bank) on behalf of the debtor upon meeting the conditions stipulated in the contract entered into between the parties. As the name domestic or inland suggests, a domestic or inland letter of credit is not applicable for parties engaged in cross-border transactions.
Features of a domestic or inland letter of credit
- A domestic or inland letter of credit could be only used for domestic business transactions.
- Banks issue a domestic or inland letter of credit for collateral which is to be pledged by the buyer’s business.
- A domestic or inland letter of credit could be customized to meet individual business requirements.
- A domestic or inland letter of credit could be used to discount inland bills for immediate release of funds by the beneficiary.
- A domestic or inland letter of credit could also be applied for negotiating bills and avail finance before the due date.
Process of Issuance of a Domestic or Inland Letter of Credit
Enlisted below are the major steps involved in the life cycle of a domestic or inland letter of credit. Starting from the buyer and seller agreement to the use of letter of credit (LC) as a medium of payment, to the final closure of the deal/LC.
- Contract / Agreement – The parties agree to enter into a business transaction where the buyer either purchases goods or procures services in the course of business. They decide upon all the terms and conditions of the contract and decide the domestic or inland letter of credit as mode of payment.
- Request /Application to bank – Buyer ‘s bank (Issuer bank) starts the process by making a thorough verification of the financial health of the buyer business. Issuer banks may also seek security (i.e. cash, bank deposits, securities or business assets).
- Verification and Negotiations – Lending policies of the issuer bank, financial soundness of the applicant business and their credit history substantially impact the security requirement for issue of domestic or inland letter of credit. Thus, while certain financial institutions may need pledging 100% invoice value as security for risky businesses, businesses with better credit history may be required only 1% of the amount involved.
- Advisory Bank – In case more banks are involved the issuing bank may send the details and seek advice from the advising Bank. This generally happens when the amount or risk involved is high.
- Issuance – Once the process of verification and collateral is completed, the issuer bank may issue a domestic or inland letter of credit specifying terms related to payment to the seller, time duration within which it is to be presented, documents to be presented, etc. advance it to the seller’s bank.
- Seller’s Bank – Upon receipt of a domestic or inland letter of credit, the seller may present the required documents to his bank which will be again forwarded to the issuer bank for verification.
- Shipping or Order Completion – The seller will ship his goods and present the domestic or inland letter of credit to the issuing bank for payment along with the requisite set of documents as required by the terms in the domestic or inland letter of credit. Like insurance, Bill of landing etc.
- Release of Payment – Once the documents are verified, the issuer bank may release payments to the seller and initiate the process of collection from the concerned buyer.
- Bank initiates payment collection from the Buyer – Once the transaction is completed the domestic or inland letter of credit will cease to exist. The buyer, upon payments to the bank can obtain the requisite documents from the banks so as to release/obtain the goods shipped to him.
Inland LC – Its Purpose, Process, Benefits and Limitations
Benefits of a Domestic or Inland Letter of Credit
Being a non fund based financial instrument, the domestic or inland letter of credit has numerous benefits to both the seller and the buyer. It eliminates the waiting time for the payments to be released for the seller giving access to immediate cash flows, and reduces the pressure on the buyer for immediate payments. Banks involved earn their fees. Hence the arrangement of domestic or inland letters of credit is beneficial in several ways as listed below.
Eliminates payment-related risks-
A domestic or inland letter of credit eliminates the risk of non-payment or delayed payments for the seller, assuring fulfillment of payments upon presentation of documents.
Measure for Creditworthiness of a Business-
A domestic or inland letter of credit acts as a true measure for the creditworthiness of businesses and the business owners. The issuer bank validates the credibility of the business through business documents before the issue of negotiable instruments like Letter of Credit.
Acts as a proof for claim against disputes-
A domestic or inland letter of credit serves as a guarantee of payment on behalf of the buyer, which helps the seller to claim payments in the event of a dispute between the parties, and the buyer cannot refuse payments as the letter of credit positions the obligation upon the bank, which is later to be fulfilled by the buyer.
Flexible in Nature-
A domestic or inland letter of credit comes in various types that could be tailored in accordance with the requirements of the parties involved. Such varied instruments could be chosen on the basis of the specific considerations such as costs involved, level of risk and convenience. For instance, parties could use an irrevocable letter of credit due to the higher security for the sellers, whereas revocable letters of credit afford flexibility in the transaction. Likewise, if there are more than two parties involved, the parties may choose transferable domestic or inland letters of credit.
Efficient cash flow management-
Apart from all other advantages, a domestic or inland letter of credit ensures payments are made within timeframes, which further helps businesses to manage their cash inflows. Furthermore, the seller could also seek financing between the period of shipment of goods and receiving payment, which could get them access to immediate liquidity in the short term.
Encourages Mutual trust and Cooperation-
The mutual set of clauses agreed between the parties enables trust and confidence and encourages them to take more business endeavours in the future.
Limitations of Domestic or Inland Letter of Credit
Like two sides of a coin, a domestic or inland letter of credit has its own sets of disadvantages as well. Here’s a quick look at what can go wrong while dealing with letters of credit.
Ignore the standard of goods delivered-
While issuing and processing a domestic or inland letter of credit, the responsibility of the issuer bank is only restricted to validate the documents and fulfil the contract terms between the parties. However, the issuer bank gives no consideration as to whether or not goods meet the expected standards or not. Therefore, there is assurance of payment for the seller but the buyer has to suffer having limited recourse to stop payment.
Higher costs involved-
Banks/Financial Institutions levy a higher sum of fees for issuing and processing of a domestic or inland letter of credit which makes it challenging to consider compared to alternative means of financing. Businesses involving small business or transactions with limited tight profit margins may lead to further financial burden for the parties involved.
Time Consuming process-
Issuer bank for a domestic or inland letter of credit undertakes in-depth verification which may include complex paperwork which might discourage businesses expecting a quick turnaround time leading to more administrative drain for both parties. Furthermore, if the seller fails to present requisite documents within stipulated period causing parties leading to further costs and paperwork for parties.
Risk of Default for Issuer Bank-
Since a domestic or inland letter of credit transfers the burden from the buyer to the issuer bank there is considerable risk in the event of default by the bank. For instance, if the bank undergoes financial troubles or becomes insolvent, the buyer may not get his payments.
Prone to fraud in the transaction-
The role of issuer’s bank of a domestic or inland letter of credit is limited to transfer payments upon the satisfaction of all the stipulated conditions as per the contract between the parties but ignores the fact whether or not the seller meets required standards. Any failure to deliver goods within reasonable standards increases the risk of higher business costs and losses for the buyer business. Furthermore, there are high chances that the seller might attempt to sell low quality goods, present fake documents for payments, etc.
Given the limitation of a domestic or inland letter of credit, the smaller businesses may find it difficult to avail this type of funding from the banks. They may wish to avail other types of business loans and funding. To be sure they are not being overcharged or ensure proper credit against collateral, you may take the help of experts like BankKeeping. We help businesses handle their banking needs by negotiating better terms and ensuring timely submissions of important documents to avoid unnecessary bank charges or penalties.
Types of Domestic or Inland Letter of Credit (ILCs)
A domestic or inland letter of credit is available in different types with specific benefits and degree of risk which could be chosen by parties on the basis of their comfort and convenience. Some of which have been provided below-
Sight Inland Letter of Credit-
Sight Letter of Credit enables faster payment towards the seller when he submits requisite documents to the issuer bank. Unlike other types of a domestic or inland letter of credit, this enables immediate liquidity for the seller if he meets all terms and conditions agreed initially by the parties.
Standby Inland Letter of Credit-
A standby letter of credit is a type of a domestic or inland letter of credit that enables payment of compensation to the party who has suffered losses owing to actions or inaction of the other parties within a transaction. Hence, they indemnify the parties against any business losses apart from facilitating the transaction.
Confirmed Inland Letter of Credit-
Confirmed domestic or inland letter of credit enables confirmation of payment upon documents received from the beneficiary apart from the issuer bank which adds up the layer of protection in the transaction. Businesses new to a transaction or who lack mutual trust may prefer a Confirmed letter of credit.
Unconfirmed Inland Letter of Credit-
Contrary to Confirmed Letter of credit this type of a domestic or inland letter of credit includes guarantee of payment to the seller only by the issuer bank without any secondary bank for confirmation. Though having a single bank for payment security purposes simplifies the transaction but it also means higher degree of risk for the seller. Unlike confirmed domestic or inland letter of credit, this causes the seller to rely only on the assurance by the issuer bank which may be inadequate for parties entering into a contract for the first time.
Transferable Inland Letter of Credit-
Transferable Letter of Credit enables smooth transfer of payments to be received by the seller to any other party he wishes to transfer either partially or fully. This helps to release the burden off the seller party in situations where he is not able to fulfil orders solely and desires to subcontract the order partially. From a small supply business to a building subcontractor, transferable domestic or inland letter of credit helps businesses to optimize payment processes in complex transactions among parties.
Revolving Inland Letter of Credit-
A revolving domestic or inland letter of credit allows the buyer to enter multiple draws over a certain limit for numerous shipments over a specified period. Where the business relationship between parties is of continual nature, revolving letter of credit allows simplification of payment processes and eliminates the need for a new credit facility for each and every shipment.
Red Clause Inland Letter of Credit-
Red clause letters of credit involve a special clause which allows the seller to receive part of the payment in advance often stated to be a ‘red clause advance’ which could be applied for purchase of goods or production of goods. This type of domestic or inland letter of credit is especially relevant where the seller needs financial assistance for there is upfront payment required to complete the order. For instance, the seller may be in need of funds to purchase rare or expensive raw materials to fulfil the order.
Green Clause Inland Letter of Credit-
Also known as an extension of red clause Letter of Credit, the green clause domestic or inland letter of credit enables financial support for pre-shipment functions including storage for goods, meeting insurance costs, etc. allowing better flexibility in efficient management of business operations as well as logistics.
Revocable and Irrevocable Inland Letter of Credit –
As the name suggests, Revocable Letter of Credit are the financial instruments which could either be altered or withdrawn by the buyer or the issuer’s bank without intimating the beneficiary. However, Irrevocable Letter of Credit as a financial instrument that cannot be revised or cancelled without agreement of all the parties involved in the transaction. Irrevocable domestic or inland letter of credit are generally preferred by businesses owing to their safety feature and negligible risk involved.
Format for Domestic or Inland Letter of Credit
All types of letters of credit generally follow the same format. Hereunder we have demonstrated a sample format for the ease of understanding only.
DOMESTIC OR INLAND LETTER OF CREDIT
- FROM: ( NAME & ADDRESS OF OPENING BANK)
- TO: ( NAME & ADDRESS OF NEGOTIATING BANK)
- TYPE OF L/C- …………………………………………………
- L/C Number: ………………………………………….
- DATE OF ISSUE- ………………………………………….
- DATE & PLACE OF EXPIRY- …………………………………………
- NAME & ADDRESS OF THE- ………………………………………….
- APPLICANT DETAILS-………………………………………….
- NAME & ADDRESS OF THE BENEFICIARY- ………………………………
- AMOUNT OF CREDIT IN – …………. (IN FIGURES & WORDS)
- PERCENTAGE CREDIT AMOUNT TOLERANCE- …………………………
- CREDIT AVAILABLE WITH -……… (Name of Bank with branch address)
- CREDIT AVAILABLE BY-……………………………………….
- USANCE OF THE DRAFTS- ………………………………………………….
- DRAFTS TO BE DRAWN ON- ……………………………………………….
- PARTIAL SHIPMENT- …………………………………………………
- TRANSHIPMENT- ………………………………………………………….
- SHIPMENT FROM – ………………………………………………………..
- SHIPMENT TO- ……………………………………………….
- LATEST SHIPMENT DATE-………………………………………
- DESCRIPTION OF GOODS- ……………………………………
- DOCUMENTS REQUIRED………………………………..
- ANY ADDITIONAL CONDITION……………………………………………….
- CHARGES APPLICABLE- ………………………………………
- PERIOD FOR PRESENTATION- …………………………………….
- CONFIRMATION INSTRUCTIONS-…………………………………….
- REIMBURSEMENT INSTRUCTIONS-…………………………………
Documents required for Domestics or Inland Letter of Credit
- Passport-sized photos of the business owner and any co-loan applicant
- Copy of any documents such as Aadhaar card, PAN card, Driving License, Voter Id, etc. for buyer and directors of the buyer’s business as identification proof.
- Copies of Balance sheets, profit and loss statements, sales records, ITR documents, etc. for at least past 3 years of the buyer business.
- Transaction related documents such as invoice for the goods procured
- Shipping, packing and transport related documents
- Insurance documents
- Bill of Lading
- Copy of bill of exchange and certificate of origin.
- Any other document specified by the issuer’s bank.
Eligibility Criteria to Obtain Domestic or Inland letter of credit
Buyer shall meet the following eligibility criteria in order to seek issuance of domestic or inland letter of credit-
- The annual turnover of the buyer business shall be Rs. 500 crores or more;
- The buyer business shall have a positive credit rating and clear history of repayment;
- Board Resolution passed by the board of directors of the buyer business;
- The buyer business should have an established credit relationship with the issuer bank.
- The buyer business may have sufficient collateral in the form of cash, fixed assets, plant and machinery or fixed deposits.
Domestic or Inland Letter of Credit Costs Involved
The total cost of a Letter of Credit depends upon several factors such as category of letter of credit chosen, sum of the transaction, issuer bank lending terms, duration of the repayment, complexity of the transaction and degree of risk etc. Banks charge anywhere between 0.25% to 2% of the letter of credit amount involved. While the sum of fees charged might seem substantial, these ensure security while minimizing risks making it worth for high value investments.
Some of the fees and charges levied by the issuer bank includes-
- Issuance Fee for a domestic or inland letter of credit- Banks typically charge issue fees for domestic or inland letter of credit calculated as a certain proportion of the total value of the letter of credit.
- Confirmation Fee- Where the confirming bank undertakes payment guarantee it charges additional fee for added protection to the seller on the basis of degree of risk in the transaction and the buyer’s creditworthiness.
- Negotiation Fee- Incurred when the seller’s bank authenticates documents and forwards them to the issuer bank for payment.
- Amendment Charges- Charged for any alterations in the domestic or inland letter of credit document terms post its issue by the issuing bank upon request made by the parties.
- Discrepancy Fees- Levied where the documents submitted fail to adhere to the terms and conditions of the domestic or inland letter of credit, necessitating rectifications.
Conclusion
Therefore, despite certain drawbacks of the domestic or inland letter of credit, it acts as a crucial tool for businesses to afford protection and minimize risk in a transaction especially where the parties do not have a long business relationship history. Furthermore, it also comes in handy in circumstances where the buyer faces bankruptcy, or he refuses to make payment for goods or where the buyer changes or cancels the order enabling the seller to get payment for the goods shipped thereby reducing production risk. On the other hand, it helps buyers to demonstrate its intent to honor payment obligations to purchase raw materials or equipment and cannot afford to lose time.
Bank authorities issue letters of credit as a valuable asset which serves as a valuable instrument which encourages business partnerships, reducing scope for disputes among parties, managing cash inflows, growing their foothold within the concerned industry and markets while serving as the strongest back-up for businesses.