Clearing the way for oil refiners to pay Iran in Indian rupee, the Union Budget has exempted the payments made for crude oil purchased from the Persian Gulf nation, from any local tax.

Iran had in January agreed to accept 45% of the value of its oil exports to India in Indian rupees but the scheme could not be implemented due to taxation issues.

It was feared that the money paid to National Iranian Oil Co (NIOC) may be considered as income generated by Iranian firm in the country and liable to be taxed. The withholding tax was up to 40%, which neither NIOC or the Indian refiners wanted to pay.

As a way out, Finance Minister Pranab Mukherjee in his Budget for 2012-13 exempted payments to Iran from taxes in "national interest".

The exemptions would be effective from April 1, 2012.

Iran is India's second largest crude oil supplier accounting for for some 12 per cent of its total crude oil imports. Despite Western sanctions, New Delhi is keen to retain Tehran as its key supplier but has faced problems paying for oil imports.

India currently pays about USD 1 billion a month through a Turkish bank but there are fears that US and European sanctions against Iran may block even this route.

As a way out, rupee payments have been agreed to.

Under the mechanism agreed, NIOC will accept 45% of the payments in an account opened in Kolkata-based UCO Bank. UCO Bank has been chosen because it has no US or European exposure and its overseas presence is limited to Hong Kong, Singapore and China.

"In the national interest, a mechanism has been devised to make payment of certain foreign companies in India in Indian currency for import of crude oil," the Budget documents said.

"The curent provisions of the Income-tax Act would render such payment taxable in India because payment because payment is being received by these foreign companies in India in Indian currency. This would not be justified when such payment is based on national interest and particularly when no other activity is being carried out in India by these foreign companies expect receipt of payment in Indian currency," it said.

At present, the Iranian central bank, BMJI, holds an account with UCO Bank with a deposit limit set at USD 1 billion.

Indian refiners currently pay in euros through the Turkish bank, Turkiye Halk Bankasi, but there are apprehensions that Turkey may be forced to stop this after the move by US and the EU to ban any entity involved in Iranian oil and gas or petrochemical sectors.

Iran can use the money to buy machinery, metal products, iron, steel, minerals, clothes, fibre, sugar, tea, wood and automobiles from India.

As part of the January agreement, part of the rupee payments will also be deposited in two Iranian private banks, Bank Parsian and Karafarin Bank. These banks are still not under sanctions which have been imposed on all of Iran's state-owned banks.

The Budget document stated that a new clause would be inserted in Income-tax Act to provide for exemption in respect of any income of a foreign company received in INdia in Indian currency on account of sale of crude oil.