Revised India-Mauritius treaty ends decade-long tax debate

The Indian and Mauritian governments signed a protocol on May 10 to modify their double tax agreement (DTA). The development will be a key tool in the Indian Government's efforts to tackle base erosion and profit shifting.

The protocol means that, with effect from 2017/2018 financial year, capital gains arising from the transferring of shares acquired from or after April 1 2017 will be taxed at the full domestic tax rate.

"The much talked about amendment to India–Mauritius tax treaty has seen the light of day. The talk about renegotiation of this tax treaty was going on for the last 8-10 years and has now finally happened"

"The change in the India-Mauritius treaty was inevitable. For two reasons: one, the BEPS recommendations from the OECD clearly provided that there cannot be a double non-taxation, which is what the India-Mauritius treaty ensured," says Dinesh Kanabar, CEO at Dhruva Advisors in India. "And two, India was introducing GAAR [general anti-avoidance rule] and therefore there was uncertainty that post-implementation of GAAR what would happen to the tax treaty."

During the transition period from April 1 2017 to March 31 2019, the tax rate will be limited to 50% of the Indian domestic rate, which will be subject to conditions under the limitation on benefits (LoB) clause.

The new LoB clause specifies that during the grandfathering period the reduced rate will not apply if a Mauritian resident fails to satisfy a "main purpose" and a "bona fide business" test.

"The changes in the interest and capital gains article of the India-Mauritius DTA will have a far-reaching effect on investments into India, as a majority of investors have been using Mauritius as a preferred destination to make investments into India," says Sagar Wagh, senior consultant at EY in New Delhi.

Government statistics indicate that, since 2000, as much as a third of total foreign direct investment (FDI) into India has been routed through Mauritius.

The revised DTA notes that a resident is deemed to be a shell or conduit company if its total expenditure on Mauritian-based operations is less than Rs2.7 million ($40.4 million) in the preceding 12 months.

The refreshed DTA also imposes a 7.5% withholding tax, "which is the lowest rate of tax India has ever agreed", says Kanabar, for interest arising in India to Mauritian resident banks for debt claims or loans made after March 31 2017.

However, interest from a Mauritian resident bank for debt claims existing on or before March 31 2017 will be exempt from tax in India.

The protocol also updates article 26 of the treaty, dealing with the exchange of information, which will assist in the collection of taxes, and audits.

"This approach is in line with the policy decision of the Government to promote a non-adversarial, certain and predictable tax regime in India," says Sanjay Sanghvi, partner at Khaitan & Co. "[It is] a well thought-out amendment to ensure that there is no scope for litigation going forward."

For trading and finance, the protocol may not have a big impact for long-term investors, but will affect short-term investors and have an effect on trading volumes.

"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," says Meenakshi Goswami, commissioner of income tax (official spokesperson) at the Central Board of Direct Taxes in India.

"Post-2017, the foreign institutional investors who are doing short-term trading will be impacted because their short-term gains will be taxable and they will have to adjust to take into account the tax cost implications," says Kanabar.

"The amendment will impact private equity and venture capital investors who invest in unlisted securities as they will now be liable to pay capital gains tax in India," says SK Attorneys in India. However, investments made in hybrid instruments such as compulsory convertible debentures may still be taxable only in the state of residence of the investor since the protocol refers to allocation of taxation rights only in respect of capital gains arising on sale of shares."

Foreign portfolio investors enjoy the benefits of the existing capital gains provision in the DTA. This will change under the modified DTA as they will be required to pay short-term capital gains tax of 15%, during the transition period.

From April 1 2017 to March 31 2019, and subject to the LoB clause, this rate may be reduced to 7.5%.

"Gains arising to the investors who invest in listed securities for more than 12 months will continue to remain exempt since long-term capital gains from the sale of listed securities are not taxable in India, where the transaction is effected on an Indian Stock Exchange," says SK Attorneys.

Other areas that have been left unclear include the taxation of indirect transfers.

"It will be debatable as to whether a transaction of indirect transfers prior to April 1 2017 will now be taxed under the Mauritian tax treaty based on the benefits secured to the Mauritian resident company, without seeking to look through the antecedent transaction of the indirect transfer," says ELP, a law firm, in a statement.

The DTA was first signed in 1983 and has since been known as the cornerstone for Mauritius's rise as an important financial centre in the Indian Ocean.

"The much talked about amendment to the India–Mauritius tax treaty has seen the light of day. The talk about renegotiation of this tax treaty was going on for the last 8-10 years and has now finally happened," says Sanghvi.

The Indian Government had been pressing the Mauritian Government for this change in the DTA since 2006.

The WTO trade policy review 2015 report on India points out that between the 2011 and 2014 financial years, Mauritius was the largest source of FDI into India, followed by Singapore.

The India and Mauritius DTA attracted investors to route their investment through Mauritius to take advantage of the capital gains tax exemption and a liberal tax regime.

"All in all, it is a welcome move amending the India – Mauritius tax treaty and thereby putting an end to the allegation of round-tripping and tax evasion by treaty abuse," says Sanghvi.

"Further, in the coming years, other favourable tax treaty countries like the Netherlands which have a capital gains clause in their tax treaty will gain prominence for making investment into India," says Wagh. "However, Cyprus – which has a similar capital gains exemption clause in its tax treaty with India – will not benefit from the amendment, as it is recognised as a notified jurisdictional area by India and subject to penalised tax provisions in India."

Between April 2000 and December 2015, Mauritius accounted for $93.66 billion of foreign direct investment into India, which totalled $278 billion

The protocol has triggered the Indian Government to initiate changes to the India-Singapore DTA, too.

"The Government has already announced that it is renegotiating the Singapore treaty, it is inevitable," says Kanabar. "I'm sure that Singapore will be comfortable because without the renegotiation, that treaty will be meaningless."

Revenue Secretary Hasmukh Adhia says, via Twitter: "2/3 capital gains on shares for Singapore can also now become source based due to direct linkage of Singapore DTA clause with Mauritius DTA."

Mauritius and Singapore accounted for $17 billion of the total $29.4 billion India received in FDI between April and December in 2015.

"The amendment to the India-Singapore tax treaty (protocol) is critical, since a 'black hole' has been created in the current protocol as a result of its co-terminus link to the capital gains article in the Mauritius- India treaty," says Vivek Kathpalia, partner at Nishith Desai Associates. "A similar two-year transition and grandfathering period should also be provided. The LoB limits are anyway higher in the current protocol."