When the taxman comes calling, it’s rarely a pleasant experience. When they bring with them a tax notice demanding thousands of crores in unpaid dues dating back many years, it’s a rude shock.

That’s what happened back in February, when the service tax department served notices on almost all banks, demanding at least Rs.1.25 trillion cumulatively in dues dating back to 2008-09.

To put the number in perspective—the tax due is double the total net profit of Rs.68,829.20 crore earned by 40 listed banks in fiscal 2013-2014. Officials at the Indian Banks Association (IBA), an industry lobby, and the Mumbai service tax department both confirmed that such notices had been served.

The notices, served by the Directorate General of Central Excise Intelligence, are demanding that banks pay service tax on foreign exchange services provided to their retail clients and other banks in 2008-09, before an amendment exempted banks from service tax on interbank transactions, from 7 July 2009 onwards. Tax authorities argue that the amendment was not done with retrospective effect and hence dues of previous years must be cleared.

Banks, on their part, argue that the tax department does not understand the functioning of the foreign exchange market where transactions can add up to a staggering $40-50 billion a month. The issue has now landed at the government’s door with banks asking the government to allow for a write-off of the tax dues, perhaps as part of the Union budget on 10 July. If that doesn’t happen, a lengthy court battle between the tax department and the banks could follow.

When a retail customer goes to a bank branch to buy or sell foreign currency such as the dollar, the bank charges a premium. In case of retail customers buying dollars, the premium is typically a minimum of Rs.2 over the current market rate. If the customer is selling dollars, they will be offered Rs.2 below the market rate.

Today, this margin of Rs.2 is labelled as ‘handling charges’ or ‘service charges’ by the bank. On this amount, each bank pays a service tax of 12.5%. However, back in 2008, banks were not specifying this as a service charge. Fearing tax evasion, the service tax department at that time imposed an ad valorem tax of 0.25% on the whole amount. The ad valorem tax doesn’t apply where service charges are clearly mentioned.

The problem arose when the service tax department put this rule in writing. Suddenly, banks realised that all foreign exchange transactions, including interbank transactions where service charges are not mentioned, were subjected to a 0.25% ad valorem tax, which was to be imposed on the entire transacted amount.

Banks panicked because interbank foreign exchange transactions run into billions and the margin on these transactions is wafer-thin. As a way to circumvent the new law, banks started charging each other Rs.25-100 as interbank service charges, irrespective of the amount transacted. (LIVE MINT)