October 12, 2019
Actors Amitabh Bachchan and Aishwarya Rai, Industrialists Vinod Adani of the Adani Group and Shishir Bajoria of S.K. Bajoria Steels, Dawood Ibrahim’s right-hand man Iqbal Mirchi and part-time liquor baron and “full-time renegade” Vijay Mallya. All these names have one thing in common – being named in the 2016 ‘Panama papers’ scandal for their involvement with offshore companies as beneficiaries.
The International Consortium of Investigative Journalists’ (ICIJ) findings in 2016 had the ramifications of spurring Federal Governments worldwide to concentrate their efforts in curbing ‘tax avoidance’ and imposing stringent penalties against ‘tax evaders’ so as to set a detrimental example. This transpired into a 15-point action plan as the Base Erosion and Profit Shifting (hereinafter ‘BEPS’) policy was espoused by the G20 nations and OECD members. In consonance with the mounting resentment globally against corporations ‘evading’ and ‘circumventing’ tax, in the Indian context, the then newly elected Narendra Modi-led BJP Government’s vociferous campaign against ‘black money’ encompassed the promise of strict action against foreign investors unfairly operating through offshore bases that served as “safe havens” for ‘tax avoidance’.
‘The Mauritius Route’ was identified as one such channel that accounted for almost 34% of the total Foreign Direct Investment (hereinforth, ‘FDI’) to India, encompassing nine of the ten largest foreign businesses investing in India including the likes of Vodafone, Oracle Global, Cairn Holdings and Merrill Lynch – making Mauritius the top destination for FDI Investment in India with a staggering inflow of INR 465,163 Cr (from April 2000 to December 2015). Singapore who was second to Mauritius accounted only for 16% in the same period.
The rationale behind gargantuan multi-national companies such as Vodafone Inc. and Oracle Global investing in India through a minor island-nation such as Mauritius may almost be attributed solely to exemptions on ‘capital gains tax’ granted to all residents by virtue of the Indo-Mauritius Tax Treaty of 1982 – a Double Taxation Avoidance Agreement (hereinafter, DTAA) constituted under sections 90 and 91 of the Income Tax Act, 1961 between the two nations, in consonance with the two countries’ cultural ties and Indian strategic interests at the time. Thereby, Mauritius has the sole right to tax capital gains accruing from any shares or securities in India. However, Mauritian law does not tax capital gains which results in a double non-taxation of capital gains income for investments made in India. Therefore, subsequent to the liberalisation policies of the the P.V. Narasimha Rao-led Government in 1991, with the Indian economy open to foreign investment, Mauritius emerged as one of the favourable destinations for channelling investments to India ranking second only to the United States of America in terms of portfolio investment.
However, Indian tax agencies and officials soon alleged that these ‘letter box companies’ in claiming ‘tax exemptions’ under the Indo-Mauritius Tax Treaty were “misusing” the benefits accorded under the treaty and thereby defeating its purpose. Then again, following the 1999 Kargil War with Pakistan, the Vajpayee Administration citing an adverse effect to the stock market and the Rupee to an already weakened economy, issued a circular ordering tax officials to desist from causing anything to interfere with foreign inflow and investment which they deemed imperative at the time. Nonetheless, with the passage of time and the stabilisation of the Indian economy, notwithstanding the efforts of the Congress Government to renegotiate the terms of the treaty, the round tripping of money to India via Mauritius showed no sign of stopping.
In 2015, the cumulative efforts of the Governments of the past and the policies of the OECD members and G20 nations with regard to ‘tax avoidance’ and ‘Base Erosion and Profit Shifting’ following the Panama Papers scandal culminated in giving the Modi Administration an upper hand in the renegotiation process thereby, leading to the insertion of a limitation of benefits (hereinafter, LOB) clause and successfully concluding the negotiations with the signing of the Protocol.
One of the key loopholes prevalent earlier was that “residence-based taxation of capital gains arising from alienation of shares.” In essence, what that means is that if a Mauritius based company invested in shares of a company resident in India, and it sold those shares later and made a profit, then it would have to pay capital gains tax in Mauritius.
With the enforcement of the new amendments as part of the Protocol, Indian agencies are bestowed the right to tax capital gains with respect to the transfer of Indian shares acquired on or subsequent to 1st April, 2017. Subject to an LOB Clause, the Protocol permits for a two-year transition period (from 1st April, 2017 to 31st March, 2019 wherein the corporations shall be charged only 50% of the prevailing domestic tax rates, on termination of which they shall be liable to be charged full domestic tax rates. The LOB Clause mandates that Mauritian residents meet (i) the ‘Main purpose test’ and (ii) the Bonafide business test to avail the 50% reduction in taxable rates. Additionally, a Mauritius resident shall be deemed a shell/conduit company, if its total expenditure on operations in Mauritius is less than INR 2.7 million in the immediately preceding 12 months. A resident listed under a Mauritius stock exchange will also not qualify as shell/conduit company.
Notwithstanding such amendments, investments antecedent to such amendment shall be ‘grandfathered’ viz. the corporations or entities shall be permitted to continue with their operations and gains from the alienation of other popular instruments such as debentures, bonds, derivatives and interest in a limited liability partnership, continue to be exempt from tax in India even under the amended tax treaty.
The Government representative in a press release antecedent to the signing of the Protocol maintained that the “protocol will tackle the long pending issues of treaty abuse and round tripping of funds attributed to the India-Mauritius treaty, curb revenue loss, prevent double non-taxation, streamline the flow of investment and stimulate the flow of exchange of information between India and Mauritius.” The belief of the Modi Administration in the economy and to attract foreign investment albeit tax-based incentives is apparent from the measures taken with this treaty.
Additionally, with the implementation of the amendments under this Protocol, Singapore that accounted for 16% of all Foreign Direct Investment to India in the period between (from April 2000 to December 2015) is stands to lose as collateral damage of the Protocol. The ‘capital gains tax’ exemptions extended to Singaporean tax residents under the India-Singapore tax treaty also stands ‘null and void’– since such benefits were extended under the co-terminus caveat that they would apply only when a similar benefit was available under the India-Mauritius tax treaty. Capital gains accruing to a Singaporean tax resident on transfer of Indian shares will therefore become taxable in India with from 1 April 2017. Moreover, the 50% taxable rate during the transitionary period puts Singaporean residents at a more disadvantaged position as opposed to their Mauritian counterparts. It is, however, important to note that antecedent to the Protocol in 2015, Singapore’s FDI to India was Rs. 39,506 crores which is 80% higher than that of Mauritius’ Rs. 71,195 crores during the period April 2015 to December 2015.
The implications of the amendments of this Protocol shall extend to foreign investors in as much as hedge funds and other short-term investors will pay a 15% short-term capital gains tax on transfer of shares (7.5% in the two year transition period) however, listed F&O will attract a much higher tax rate of 30%. On the other hand, long-only funds will not be impacted as the domestic tax law currently provides for 0% tax on listed shares held for more than a year.
‘P-Note investors’ shall yield an increase in the cost of taking exposure to Indian shares and this shall translate into operational challenges of computing taxes and recovery from clients.[1]
The positives that might be accounted from the Protocol in 2015 are that a major loophole has been plugged, so the amount of tax revenue lost through the ‘Mauritius route’ should decrease and this subsequently shall contribute to more resources to the government to carry out developmental activities. In addition to this, India’s actions have set in motion a chain of events as other governments across the world have begun to take inspiration of the same, such as Kenya, where the government is being taken to court for its tax-abuse-enabling Double Taxation Avoidance Agreement with Mauritius. Most importantly, this may be construed as a victory for the ‘source-based’ principle of taxation, which states that tax should be levied where the money is made, as opposed to where the company is based (which is what the ‘residence-based’ principle states). The residence-based principle works to the advantage of rich countries, where most large corporations are headquartered, to deprive poor countries of their fair share of taxes.
However, on the other hand, the matter is far from resolved altogether, India still has tax treaties with other jurisdictions, such as the Netherlands and British Virgin Islands, which provide for capital gains exemption on the transfer of shares and it is yet to be seen if India’s aggressive approach with respect to Mauritius will be extended towards these jurisdictions and treaties and whether the foreign investors will now consider these jurisdictions for Indian investments.
‘Tax avoiders’ therefore will attempt to try setting-up shop in these jurisdictions until the gap is sealed there as well.
Furthermore, in 2017 The foreign inflow from Mauritius accounted for a staggering 44% of total Foreign Direct Investment equity inflows into India, a year later, this number plummeted to USD 3 billion, accounting for only 15% of inflows. In other words, inflows dropped by three times in a single year. On the other hand, other jurisdictions that also saw major increases in sending Foreign Direct Investment to India are Japan (whose share tripled from 3% in 2017 to 9% in 2018) and the UK (whose share quadrupled from 1% to 4%).
Interestingly, the Netherlands, which is another big source and a not-so-secret tax haven, saw its share decline from 8.6% to 7.7%. This is despite the Double Taxation Avoidance Agreement with Netherlands left untouched perhaps indicative of the fact that ‘tax evaders’ are now wary of the threat of the Dutch ‘safe haven’ now being the next on the list of the Indian Government.
The signing of the Protocol thereby amending the Indo-Mauritius Tax Treaty, 1982 is certainly a clear-sighted move by the Modi Administration which puts to bed the decades-long controversy around the Mauritius treaty. The move is also in consonance with the Government’s agenda of ‘tax rationalisation’ and simplification and moderation of tax rates whilst at the same time phasing out tax exemptions.
The Governmental effort in giving sufficient notice of close to a year before the change takes effect as well as providing protection to existing investments is also laudable (Almost seems like someone learnt from the debacle that was ‘demonetisation’). In doing so, the negative ramifications of the GAAR, which would have conflicted with the capital gains exemptions under the Mauritius and Singapore treaties, have also been diverted to an extent.
That being said, it is imperative to be wary of the impact of this development on foreign flows, at least in the near term, especially with sign of a global economic recession perhaps on the horizon. Most comparable jurisdictions do not tax capital gains on portfolio investments and India is unique to that extent and in doing so has set forth a precedent, which other developing nations have espoused. However, policy makers must with the passage of time see how well India copes up with other jurisdictions with regards to the same.
[1]https://www.taxsutra.com/experts/column?sid=627#targetText=Finally%2C%20after%20about%2033%20years,treaty%20has%20now%20been%20amended.&targetText=The%20amendment%20is%20also%20aimed,exchange%20between%20the%20two%20countries.
Bhrigu A. Pamidighantam 
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