India-Mauritius Tax Treaty Amended-Capital Gains Tax Exemption Withdrawn - Capital Gains Tax

Background

It is the end of the road for the 'Mauritius route' followed by foreign enterprises for making investment in shares of Indian companies. In a historical development in the field of tax policy and legislation, India and Mauritius signed a Protocol to the Indo-Mauritius Double Tax Avoidance Treaty ('Tax Treaty') on 10.05.2016, to withdraw, in phases, the capital gains tax exemption on sale of shares in the source state available thereunder.

India signed the Tax Treaty with Mauritius in August, 1982. As per Article 13(4) of the India Mauritius Tax Treaty, capital gain arising in India to a Mauritian tax resident on sale of movable property (not forming part of PE, if any) situate in India is not taxable in India and vice-versa. Such capital gain is also exempt from tax under domestic tax laws of Mauritius. Accordingly, the India Mauritius Tax Treaty coupled with favourable Mauritian domestic tax legislation made the island nation an ideal jurisdiction for investing in India. The usefulness of the above Treaty was not felt until 1991, when India opened up its economy to the foreign investors and liberalized its economic regime.

The Mauritius Offshore Business Activities Act allowed foreign companies to register in the island nation for investing abroad. The said Act provided for quick incorporation, total business secrecy and full exemption from capital gains tax. Through this legislation, companies were enabled to setup enterprises in Mauritius for the purposes of investing in economies around the world. Many foreign investors invested in shares of Indian companies through Mauritius given the aforesaid tax benefit the Tax Treaty offered.

However, the investments in India through Mauritius had to face a lot of rough weather at the hands of the Indian Revenue, which time and again denied the Tax Treaty benefit on the alleged ground that the routing of investment through Mauritius was a device to evade tax, such transaction lacked commercial/business substance and were used for round tripping, etc. The first reported decision on this issue was that of the Authority for Advance Rulings in the case reported as P-9 of 1995, rendered on 22.12.1995, which is popularly known as the 'Nat West ruling'.

There was substantial also litigation as to whether Tax Treaty benefit could be provided to a Mauritius entity on the basis of Tax Residency Certificate (TRC) issued by the Mauritius Government. In April 2000, the Central Board of Direct Taxes (CBDT) issued Circular No. 789, which made it clear that the TRC issued by the Mauritian Government was to be accepted as evidence of residence and beneficial ownership of the investor, for purposes of the Indo-Mauritius Treaty.

The validity of the above Circular was upheld by the Supreme Court in the case of Azadi Bachao Andolan: 263 ITR 706. Based on this judgment, Treaty benefits were being availed by Mauritius investors by submitting TRC as sufficient evidence for substantiating tax residency.

The Indo-Mauritian Tax Treaty has constantly been under the limelight and has come in for criticism on the ground that it encourages treaty shopping and results in huge loss to the Indian exchequer. In fact, the Revenue was, notwithstanding the aforesaid judgment of the apex court, bitterly opposing the tax payers' claim for capital gains exemption under the Tax Treaty as evident from the scores of reported decisions on the issue delivered by various Courts, Tax Tribunals and AAR, post Azadi Bachao Andolan, which barring a few exceptions, were decided in favour of the tax payer.

In 2006, India and Mauritius agreed to establish Joint Working Group (JWG) to provide a platform to discuss concerns arising from the operation of the India-Mauritius Tax Treaty so that the same is not abused by parties from non-contracting States. However, there was no progress made.

The pressure on Mauritius to amend the Tax Treaty, however, increased with the unveiling of the OECD's Base Erosion and Profit Shifting project ('BEPS') which endorsed 15 Action Points. The Action Plan 6 - Preventing treaty abuse proposed countering treaty shopping through various measures such as Limitation of Benefits ('LOB') rules that limit the availability of treaty relief to entities that meet certain criteria based on their legal nature, ownership, business activities etc.

In addition, the General Anti Avoidance Rules (GAAR) rules to be implemented in India from April 1, 2017 which will override tax treaties in case of impermissible avoidance arrangements, created a greater need for establishing substance in countries like Mauritius.

The writing was there on the wall for Mauritius to see and to support India's efforts to curb tax treaty abuse, prevent revenue loss, minimise round tripping of funds and double non-taxation, stimulate the flow of exchange of information between India and Mauritius, a Protocol to amend the Tax Treaty between the two countries was signed on 10.05.2016.

Salient features of the protocol entered on 10.05.2016

The major amendments made to the Tax Treaty through the protocol entered into between India and Mauritius are as follows:

(i) Source-based taxation of capital gains on shares:

With effect from 01.04.2017, India will have the right to tax capital gains arising to a Mauritian resident from alienation of shares, acquired on or after 01.04.2017, in a company resident in India
Investments made prior to 01.04.2017 have been "grand-fathered" and will not be subject to capital gains taxation in India.
Capital gains arising to a Mauritian resident from sale of shares of a company resident in India (acquired after 01.04.2017),during 01.04.2017 to 31.03.2019, shall be taxable in India@ 50% of the rate prescribed in the Indian domestic tax law in respect of such income, provided the conditions stated in the Limitation of Benefits (LOB) Article (explained infra) inserted in the Protocol to the Tax Treaty are satisfied. In other words, in case the conditions stated in the LOB Article are not satisfied, then, capital gains shall be taxable in India at the rate prescribed in the Indian domestic tax law and the benefit of concessional rate of tax will not be available.
With effect from 01.04.2019, capital gains arising to a Mauritian resident from sale of shares of a company resident in India (acquired after 1.4.2017) shall be taxable in India at the rate prescribed in the Indian domestic tax law and no benefit/exemption would be available to Mauritian resident under the Indo-Mauritius Tax Treaty, whether conditions of LOB Article are satisfied or not and the said Article will cease to be of consequence w.e.f. 1.4.2019.

(ii) Limitation of benefits of the Tax Treaty

The benefit of 50% reduction in tax rate during the transition period i.e. from 01.04.2017 to 31.03.2019, shall only be available to a Mauritius resident entity, only if it is, (a) not a shell/conduit company, and (b) satisfies the primary purpose (i.e. the primary purpose of investment is not to take advantage of the capital gains tax exemption under the Treaty) and bonafide business test
A shell/ conduit company includes any legal entity with negligible or nil business operations or with no real and continuous business activities carried out in Mauritius
A Mauritian resident entity shall not be deemed to be a shell/ conduit company, if it is listed on a Stock Exchange in Mauritius or its total expenditure on operations in Mauritius is Indian Rupees 2.7 million (Mauritian Rupees 1.5 million) or more in the 12 months immediately preceding the date on which the gains arise.

(iii) Source-based taxation of interest income of banks:

Interest arising in India to Mauritian resident will be subject to TDS in India @ 7.5% in respect of debt claims or loans made after 31.03.2017. No rate of tax was otherwise provided in the Tax Treaty in relation to tax on interest income in the source state.
Exemption available in source State in respect of interest income derived from that State by resident of the other State carrying on bonafide banking business, has been withdrawn in respect of debit claims arising after 31.03.2017.

(iv) Fee for Technical services made taxable in source state:

The existing Tax Treaty does not contain any Article specifically dealing with taxation of fee for technical services, as is found in several Treaties that India has entered into with other countries.

The Protocol provides for insertion of new Article 12A in the Treaty, which gives right to the source State to tax 'fee for technical services' @ 10%. "Fee for technical services" has been defined to mean consideration for managerial or technical or consultancy services, including provisions of services of technical or other personnel.

Further, definition of 'Permanent Establishment' in Article 5 of the Treaty has been amended to provide that furnishing of services, including consultancy services, by an enterprise through employees or other personnel, shall result in 'permanent establishment' if such activities (for the same or connected project) continue for a period or periods aggregating more than 90 days within any 12 months period.

(v) Exchange of Information

The Protocol also provides for updation of Exchange of Information Article as per international standards, provision for assistance in collection of taxes, source-based taxation of other income.

Comments

The Protocol will have significant impact on inbound investments made through Mauritius. The impact of the amendment on various stakeholders/investors is discussed below:

(i) Impact on Private Equity Funds

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.

However, investments made in Mutual Funds and hybrid instruments such as Compulsory Convertible Debentures (CCDs) may still be taxable only in state of residence of the investor since the amendment distributes allocation of taxation rights only in respect of capital gains arising on sale of shares.

It is debatable whether gains arising to Mauritian tax resident from Futures and Options (F&O) contracts in India, where shares of Indian companies are the underlying asset, would be affected by the aforesaid amendment. It may be argued that derivatives and shares are distinct assets and that section 2(h) of the SCRA Act, 1956, recognises such distinction and that in terms of section 43(5) of the Income-tax Act, whereas screen based derivative trading is not considered speculative transaction, it is not so in case of non-delivery based trading in shares. However, it may be pointed out that the Delhi High Court in the case of CIT v. DLF Commercial Developers Ltd: 261 CTR 127, wherein it was held that Explanation to section 73 of the Income-tax Act, which deems loss arising from the business of purchase and sale of shares is speculative loss, would include loss arising from stock derivate transaction since the stock derivatives derive their value from stocks and shares. Clarification from the Government on this issue would be welcome

(ii) Impact on Foreign Portfolio Investors (FPIs)

FPIs (including P-note holders) who invest in securities listed on the Indian stock exchange but exit before 12 months from the date of purchase will be impacted since they will be required to pay short term capital gains tax in India @ 15%. During the transition period (i.e. during 01.04.2017 to 31.03.2019), and subject to the satisfaction of the limitation of benefits clause, this rate may be reduced to 7.5%.

However, gains accruing to the investors who invest in listed securities for more than 12 months will continue to remain exempt since long-term capital gains tax from sale of listed securities is not taxable in India, where the transaction is effected on Stock Exchange in India.

(iii) Impact on India-Singapore Tax Treaty

Article 6 of the Protocol to the India-Singapore Tax Treaty states that capital gains arising to Singapore resident from sale of shares of an Indian company shall be exempt from tax in India so long as the analogous provisions under the India-Mauritius Tax Treaty continue to remain in force. Since in terms of the Protocol signed between India and Mauritius, capital gains arising on sale of shares acquired on or after 1.4.2017 shall no longer be exempt from tax in India under the Tax Treaty, as a consequence the capital gains tax exemption under the India Singapore Tax Treaty would also not be available to a Singapore resident in respect of sale of shares of an Indian company after 31.03.2017.

While the Protocol to the India Mauritius Tax Treaty has "grand-fathered" investments made prior to 01.04.2017, it is not clear whether similar protection to investments made under the India-Singapore Tax Treaty would be available in absence of any amendment to this effect in the Indo-Singapore Treaty.

Further, the provision relating to application of tax rate of 50% of the domestic tax rate applicable to capital gains in India, during the transition period, i.e. 1.4.2017 to 1.4.2019, in terms of the Protocol to Indo-Mauritius Treaty, would not apply in respect of Indo-Singapore Tax Treaty. In other words, from 1.4.2017, capital gains arising to a Singapore resident from sale of shares of an Indian company will be subject to tax in India as per the applicable tax rates under the Income-tax Act.

The Protocol between India and Mauritius would, therefore, also affect inbound investment in India through Singapore from the next financial year.

Foreign investors would have to rethink their investment strategy to factor in the capital gains tax cost going forward.

The content of this article is intended to provide a general guide to the subject matter. Specialist professional advice should be sought about your specific circumstances. The views expressed in this article are solely of the authors of this article.

India: India-Mauritius Tax Treaty Amended-Capital Gains Tax Exemption Withdrawn