CAPITAL GAINS EXEMPTION TO BE PHASED OUT UNDER A PROTOCOL TO INDIA – MAURITIUS TAX TREATY
The Ministry of Finance, Government of India, has issued a Press Release1 on 10 May 2016 that marks a watershed moment in India's quest with tax avoidance and the 'substance over form' debate. While talk of the re-negotiation of the India – Mauritius Double Taxation Avoidance Agreement (Treaty) and curbing or withdrawing the beneficial capital gains tax provision2 has been on the table for years, the Press Release brings finality to the long-drawn debate and suspense.
While the public release of the formal Protocol amending the extant capital gains tax provision of the Treaty is awaited, we provide here an analysis of the change, based on the Press Release and the impact of the change on the international investor community in India.
India & Mauritius – Couple made in H(e)aven?
India and Mauritius have always shared close historical, geo-political, diplomatic and economic relations. The Treaty executed in 1983 bore testament to this fact. However, the application of the Treaty ran into rough weather when Indian tax authorities began to increasingly scrutinise the blanket capital gains tax exemption claimed by Mauritian residents.
Currently, the Treaty states that capital gains derived by a Mauritian resident from the alienation of securities of an Indian company shall be subject to tax in Mauritius alone3. Given that Mauritius does not impose tax on capital gains arising to its residents, taxpayers investing in India hugely benefited by routing their investments through Mauritius. The Supreme Court of India gave a stamp of legality to such treatment under the Treaty by upholding Circular 789 issued by the Central Board of Direct Taxes (Circular)4 in the famous Azadi case5. Having contributed over USD 6,000 million between April and December 2015 alone, Mauritius currently ranks the highest in terms of foreign direct investment inflows into the country with a share of 34% of the total inflow. The next biggest investor jurisdiction is Singapore with a share of merely 16% - less than half of Mauritius' contribution.6
The pressure on India to alter the Treaty stemmed from several quarters - concerns being raised to arrest the revenue loss to the public exchequer, India's commitment to implement the Base Erosion and Profit Shifting (BEPS), initiative to curb treaty shopping and implement the recommended 'nexus' approach, provide a level playing field to all investors and certainty in respect of capital gains tax to the entire investor community.
Decoding the Press Release
The Press Release indicates that the Protocol that seeks to amend the Treaty shall usher four key changes explained below.
- Capital Gains Tax
Exemption: With effect from the financial
year7 2017 – 18, shares of an Indian company
acquired on or after 1 April 2017 shall be subject to capital gains
taxation in India (source country). Investment in securities made
prior to the said date are protected. To cushion the blow, a
transition period commencing from 1 April 2017 through 31 March
2019 (Transition Period) has been provided during which time, only
50% of the applicable Indian capital gains tax rate shall apply to
gains, so long as the seller satisfies a Limitation of Benefits
(LOB) clause. Therefore, the full blown impact of applying (full)
capital gains tax rates as specified in the (Indian) Income Tax
Act, 1961 (Act)8 shall occur from 1 April 2019
A tabular summary of this change is included below with two key reference events viz. acquisition of shares and sale of shares.
Relevant Date Applicable Tax Rate on Capital Gains Shares acquired prior to 1 April 2017 Not taxable in India Shares acquired on 1 April 2017 and thereafter Taxable in India Capital gains arising during Transition Period if LOB provisions are satisfied Taxable in India at 50% of the applicable capital gains tax rate provided in the Act Capital gains arising after Transition Period (i.e., 1 April 2019 or thereafter) Taxable in India at full capital gains tax rate provided in the Act
- Limitation of Benefits (LOB): The Protocol shall introduce an LOB provision (currently included in some treaties such as the India – Singapore, India – Unites States (US) and India – Luxembourg). As stated above, the satisfaction of the LOB clause is a condition precedent for a Mauritius resident to qualify for the 50% capital gains tax rate during the Transition Period. The LOB clause provides that the Mauritian resident must pass the 'main purpose' and the 'bona fide business' tests. A Mauritian resident would be deemed to be a 'shell or conduit company', if its total expenditure on operations in Mauritius is less than INR 2,700,000 (Mauritian Rupees 1,500,000) in the immediately preceding 12 months.
- Withholding on Interest Income of Banks: Presently, interest arising in India is exempt from tax in India if it is derived and beneficially owned by any Mauritian resident bank carrying on a bona fide banking business. The Press Release states that interest arising in India to Mauritian resident banks will be subject to an Indian withholding tax at the rate of 7.5% in respect of debt claims or loans made after 31 March 2017.
- Enhancing Exchange of Information: The exchange of information provision and mechanism shall be updated as per the international standard.
What the Protocol Really Means...
Impact on Other Tax Treaties
This Protocol has killed more than one bird with a stone. It will also have the impact of sealing the fate of the capital gains tax exemption provided in the India – Singapore tax treaty. The protocol9 amending the India – Singapore tax treaty (effective 1 August 2005) specifically provides that the capital gains tax exemption shall remain in force so long as the Treaty provides for residence-based taxation vis-à-vis the alienation of shares in the source country. From which date would this benefit cease to accrue to Singapore residents needs to be determined - is it immediate or will the grandfathering provision be automatically extended to Singapore residents as well or is it with effect from 1 April 2017?
It would be interesting to see whether this Protocol would also pave the way to a change in the India – United States tax treaty, particularly with respect to the US sourcing rules for the purpose of granting foreign tax credit on capital gains. Investing through Mauritius allowed taxpayers to avoid double taxation on capital gains arising on the sale of securities of Indian companies. US has 'resourcing' provisions in several of its bilateral treaties, including, its treaty with China. Such a rule can give tax credit for Indian taxes in the US. Can such a provision be incorporated in the India-US tax treaty?
It seems that for phasing out the capital gains tax exemption, the Protocol has adopted the mechanism provided for in 'Termination' clause10 of the Treaty. In the context of termination of the Treaty, a transition period of two calendar years has been agreed upon to implement a notice of termination. The Protocol has followed this approach, perhaps to ease the pain.
The Protocol can be seen as India's leap in the direction of its huge-stated support to the Action 6 of OECD's Action Plan on BEPS to address treaty abuse and double non-taxation. The grandfathering provisions specified in the Press Release show India's commitment to provide certainty to investors and not take away retrospectively, what has been provided so far. The Transition Period provisions not only allay fears of unexpected disruptions in the investment climate in India but also afford the Mauritian economy time to assimilate the potential setback to its financial sector.
A key observation is that time is of the essence for investors, with the hanging sword of the General Anti-Avoidance Rules (GAAR) and now the application of the Protocol, there is a short window until 31 March 2017 before which investors may decide to make investments in India to continue enjoying the capital gains tax exemption. This could perhaps lead to a flurry of activities in the capital markets as well as mergers and acquisition activities as investors rush to strategically plan their investment structures in India. However, until 31 March 2017, the Circular and the Azadi ruling which upheld the validity of the said Circular, remain untouched.
Currently, based on the Press Release, there is little information provided on how the terms 'main purpose' and 'bona fide business' as provided in the LOB clause shall be interpreted. Would the level of subjectivity introduced be a buzzkill? Hopefully, the Protocol shall throw light on this.
The question one would like to have answer to is: would GAAR have similar grandfathering provisions and dates as the Protocol? That would provide significant certainty.
2. Article 13(4) of the Treaty
4. CBDT Circular No. 789 dated 13.4.2000
5. (2004) 10 SCC 1
7. The fiscal year commences from April 1 through March 31 each year.
9. Article 6 of the Protocol amending the India-Singapore Treaty.
10. Article 29 of the Treaty.
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