India: India Mauritius Tax Treaty Renegotiated

India and Mauritius Sign Protocol to DTAA: Capital gains tax benefit falls away for Mauritius / Singapore structures

  • India and Mauritius sign protocol amending the agreement for avoidance of double taxation with Mauritius.
  • As per the protocol, India shall have the right to tax capital gains arising from alienation of shares acquired on or after April 01, 2017 in a company resident in India with effect of financial year 2017-18.
  • Protection has been granted to investments in shares acquired before April 01, 2017 as these investments have been grandfathered and will continue to enjoy the benefits of the erstwhile provisions of the India-Mauritius DTAA. Consequently, such investments will not be subject to capital gains tax in India on the basis of the protocol.
  • The protocol shall have a domino effect on India's agreement for avoidance of double taxation with Singapore ("India-Singapore DTAA") as the position on capital gains under the India-Singapore DTAA is co-terminus with the benefits available under erstwhile provisions on capital gains contained in the treaty with Mauritius.
  • The protocol is likely to have an adverse effect on various market participants and investors operating out of Mauritius such as P-Note issuers, FPIs, private equity funds and holding companies.

OVERVIEW OF THE PROTOCOL

India and Mauritius have signed a protocol ("Protocol") amending the double tax avoidance arrangement between the two countries ("India-Mauritius DTAA"). The Protocol is the outcome of an extensive and long drawn-out negotiation process that has been going for more than a year and a half. While the text of the Protocol is yet to be released, the Government of India has released a press note dated May 10, 2016 notifying the signing of the Protocol and highlighting the major amendments ("Press Note").

The Press Note states that the Protocol amends the prevailing residence based tax regime under the India-Mauritius DTAA and gives India a source based right to tax capital gains which arise from alienation of shares of an Indian resident company acquired by a Mauritian tax resident.

However, the Protocol provides for grandfathering of investments and the revised position shall only be applicable to investments made on or after April 1, 2017. In other words, all existing investments up to March 31, 2017 have been grand-fathered and exits/shares transfers beyond this date will not be subject to capital gains tax in India.

Additionally, the Protocol introduces a limitation of benefits provision which shall be a prerequisite for a reduced rate of tax (50% of domestic tax rate) on capital gains arising during a two year transitionary period from April 01, 2017 to March 31, 2019. Further, the Article on exchange of information has also been updated to match the prevailing international standards.

AMENDMENTS INTRODUCED UNDER THE PROTOCOL

(i) Taxation of capital gains on shares

Under Article 13 (4) of the India-Mauritius DTAA, capital gains derived by a Mauritius resident from alienation of shares of a company resident in India ("Indian Company") were taxable in Mauritius alone. However, the Protocol marks a shift from residence-based taxation to source-based taxation. Consequently, capital gains arising on or after April 01, 2017 from alienation of shares of a company resident in India shall be subject to tax in India.

The aforementioned change is subject to the following qualifications:-

(a) Grandfathering of investments made before April 01, 2017

The Protocol states that capital gains arising out of sale of shares of an Indian Company that have been acquired before April 01, 2017 shall not be affected by the Protocol. Such investments shall continue to enjoy the treatment available to them under the erstwhile Article 13(4) of the DTAA.

(b) Transition period

The Protocol provides for a relaxation in respect of capital gains arising to Mauritius residents from alienation of shares between April 01, 2017 and March 31, 2019 ("Transition Period"). The tax rate on any such gains shall not exceed 50% of the domestic tax rate in India ("Reduced Tax Rate"). However, this benefit has been made subject to a "limitation of benefits" article that is proposed to be introduced to the treaty (discussed below).

(c) Limitation of benefits

As per the Press Release, the benefit of the Reduced Tax Rate shall only be available to such Mauritius resident who is (a) not a shell/conduit company and (b) satisfies the main purpose and bonafide business test. Further, a Mauritius resident shall be deemed to be a shell/conduit company if its total expenditure on operations in Mauritius is less than INR 2,700,000 (approximately 40,000 US Dollars) in the 12 months immediately preceding the alienation of shares.

While the text of the Protocol is yet to be released, the Press Note does not provide any clarity on what constitutes "main purpose" or "bonafide business". Analogously, the protocol to the India-Singapore DTAA provides that benefits in respect of capital gains taxation are not available to a company whose affairs were "primarily arranged to take advantage of the benefits" available under the India-Singapore DTAA. The language in the Protocol is expected to be on similar lines.

Having said that, the Transition Period provides limited benefits as it applies to investments made after April 01, 2017 but are realized before March 31, 2019.

After the expiry of the Transition Period (from April 01, 2019), such gains shall be subject to taxation in India as per the prevailing tax rate.

(ii) Taxation of interest income of banks

The Protocol revises the tax rate on interest arising in India to Mauritius resident banks to state that such streams of income shall be subject to withholding tax in India at the rate of 7.5% in respect of debt claims and loans made after March 31, 2017. At present such streams of income are exempt from tax in India under the India-Mauritius DTAA.

(iii) Exchange of information

While the text of the Protocol is yet to be released, the Press Note states that the exchange of information article (Article 26) has been amended to bring it at par with the international standards. Provisions such as assistance in collection of taxes and assistance in source-based taxation of other income have been introduced.

IMPACT & ANALYSIS

(i) Impact on the India-Singapore DTAA

Article 6 of the protocol to the India-Singapore DTAA states that the benefits in respect of capital gains arising to Singapore residents from sale of shares of an Indian Company shall only remain in force so long as the analogous provisions under the India-Mauritius DTAA continue to provide the benefit.

Now that these provisions under the India-Mauritius DTAA have been amended, a concern that arises is that while the Protocol in the Mauritius DTAA contains a grandfathering provision which protects investments made before April 01, 2017, it may not be possible to extend such protection to investments made under the India-Singapore DTAA.

Consequently, alienation of shares of an Indian Company (that were acquired before April 01, 2017) by a Singapore Resident after April 01, 2017, may not necessarily be able to obtain the benefits of the existing provision on capital gains as the beneficial provisions under the India-Mauritius DTAA would have terminated on such date.

(ii) Impact on private equity funds and holding companies

As mentioned above, while investments in shares of an Indian Company made before April 01, 2017 shall receive the benefit of the erstwhile provisions of the India-Mauritius DTAA, such benefits shall be curtailed for investments made during the Transition Period. Such investments shall be subject to tax in India at the rate of 50% of the tax rate prevailing in India provided the investments are realized before March 31, 2019. All investments made after April 01, 2017 which are also realized after March 31, 2019 shall be subject to full taxation as per the domestic tax rate in India.

However, investments that are made through hybrid instruments such as compulsory convertible debentures may still be eligible to claim residence-based taxation as the Press Release only refers to allocation of taxation rights in respect of shares and the Protocol may restrict the shift to source based taxation only to such transactions. Having said that, clarity on this issue shall only be available once the text of the Protocol is released.

(iii) Impact on shares held by Foreign Portfolio Investors ("FPIs")

Under the Indian income tax law, shares of listed Indian companies held by FPIs are deemed to be capital assets irrespective of the holding period or the frequency of trading equity carried out by the concerned FPI. As such, income from sale of shares results in capital gains and at present, FPIs enjoy the benefits of the capital gains provisions under the India-Mauritius DTAA.

Such investments will also be impacted by the amendment and as per the Protocol such investments shall be subject to tax in India after April 01, 2017. While there is a zero percent rate applicable on gains arising out of shares that are listed and sold on a recognized stock exchange if such shares are held for more than 12 months, capital gains arising out of investments are subject to a tax rate of 15% (exclusive of applicable surcharge and cess) if such shares are held for less than 12 months i.e. short term capital gains. During the Transition Period, and subject to the satisfaction of the limitation of benefits clause, this rate may be reduced to 7.5%.

(iv) Impact on P-Note issuers

Issuers of promissory notes ("P-Notes") may be adversely affected by the Protocol as the cost of taxation arising out of the changed position on taxation would have to be built into such arrangements. This would make such arrangements not only costly but also less lucrative for investors who seek synthetic exposure to Indian securities. Considering that it is the FPI entity is issuing the P-Note which will be subject to tax in India, issues may arise with respect to the tax amounts that they will be able to pass on to the P-Note holders due to a timing mismatch on the taxability of the FPI entity (which is taxed on a FIFO basis and not on a one-to-one co-relation). It will have to be seen whether P-Notes can still prove to be attractive for investors, considering the incremental tax associated with the same.

(v) Impact on F&O transactions

Similar to the position in respect of compulsory convertible debentures, Mauritius based entities that enter futures and options contract in India, may still be able to claim the benefits of residence based taxation since such contracts relate to capital assets other than shares. However, complete clarity on this position shall only be available after the text of the Protocol is released.

CONCLUSION

The Protocol will have a significant impact on inbound investment activity into India as the benefits available under both, India-Mauritius DTAA and India-Singapore DTAA shall be adversely affected. Existing structures may have to be reexamined and, similarly, activities of P-Note providers may need extensive restructuring for the transactions to be cost efficient.

Join us for a webinar (click here) where we shall be discussing the various issues relating to the Protocol and impact on investment structures into India.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Authors
Ashish Sodhani
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