India and Mauritius have been engaged in protracted negotiations over the terms of the India-Mauritius tax treaty over the past few years. The negotiation effort culminated yesterday when the two countries signed a protocol amending the India-Mauritius tax treaty. While the actual text of the protocol hasn't been made public yet, the Government of India has issued a press release which highlights the key changes to that have been brought about by the protocol. The amendments include the phasing out of the capital gains tax exemption under the treaty. We have summarized herein below some of the key changes to tax treaty as a result of the protocol.
Phase out of capital gains tax exemption
The basis of taxation has moved from a residence based taxation to a source based taxation, thereby according India the right to tax capital gains earned in India from the transfer of shares of an Indian company as per its domestic tax laws. However, in order to smoothen the transition to the new regime, the right to tax capital gains will be implemented in a phased manner as follows:
Investment in shares prior to April 1, 2017: Capital gains tax exemption under the India-Mauritius tax treaty will continue to apply to investments in shares acquired before April 1, 2017, irrespective of their date of transfer.
Concessional tax rate from April 1, 2017 to March 31, 2019: Capital gains arising from the transfer of shares acquired by the investor after April 1, 2017 will be taxed at 50 per cent of the domestic tax rate of India during the transition period from April 1, 2017 to March 31, 2019. The concessional rate of tax will be contingent on the taxpayer fulfilling the conditions set out in the Limitation of Benefits ("LOB") clause.
Under such LOB clause, a resident of Mauritius (including a shell / conduit company) will not be entitled to benefits of concessional rate, if it fails the "main purpose" and "bona fide" business test. While the press release does not provide clarity on the ingredients of the "main purpose" and "bona fide business" test, one anticipates that requirements under these tests maybe along similar lines as the India-Singapore tax treaty, which 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 tax treaty.
The LOB clause further provides that a Mauritian resident will be deemed to be a shell/ 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.
Full taxation from April 1, 2019 onwards: Capital gains arising on alienation of shares acquired by the investor after April 1, 2017 will be taxed at the full domestic tax rate from April 1, 2019 onwards.
Withholding tax on interest income of Mauritian resident banks
Interest arising in India to Mauritian resident banks will be subject to withholding tax in India at the rate of 7.5 per cent in respect of debt claims or loans made after March 31, 2017. However, interest income of Mauritian resident banks in respect of debt-claims existing on or before March 31, 2017 will be tax exempt in India.
Update of exchange of information provisions
The protocol to the India-Mauritius tax treaty also updates the exchange of information article as per international standards.
The devil lies in the details, and therefore one must reserve judgement on the actual impact of the protocol till the text of the same is released by the Government of India. Encapsulated below are our initial thoughts on the matter:
Grandfathering of investments: Grandfathering of investments made prior to April 1, 2017, reflects the Indian government's commitment to provide certainty to taxpayers. Moreover, the phased withdrawal of capital gains tax exemption will give time to investors to reassess their investment structures in relation to India.
Impact on India-Singapore tax treaty: A key fallout of the withdrawal of the capital gains tax exemption under the India-Mauritius tax treaty will be its impact on the capital gains tax exemption accorded with respect to transfer of shares of an Indian company under the India-Singapore tax treaty. The exemption under the India-Singapore tax treaty is co-terminus with the exemption under the India- Mauritius tax treaty, and thus will remain in force only so long as India-Mauritius tax treaty exempts such capital gains.
Given the withdrawal of the capital gains exemption under the India-Mauritius tax treaty, the withdrawal of the exemption under the India-Singapore tax treaty seems a fait accompli. However, the timing of such withdrawal is unclear. This creates ambiguity as regards the benefits available under the India-Singapore tax treaty until the Indian Government issues clarification in this respect. To illustrate, one isn't certain if the benefit of the grandfathering provisions will be read into the India- Singapore tax treaty as well. Further, there is no clarity as regards the date from which the capital gains tax exemption under the India-Singapore tax treaty will cease to apply (i.e., May 10, 2016 or April 1, 2017 or any other date).
Preparatory steps for BEPS (Base Erosion and Profit Shifting) Initiative and General Anti Avoidance Rules ("GAAR"): The protocol to India-Mauritius tax treaty comes against the backdrop of the BEPS initiative, which is gaining increased momentum internationally, and GAAR that will come into force from 2017 onwards. All such measures, viewed cumulatively, signal India's serious resolve to curb tax avoidance. Foreign investors should re-look their investment structures in view of these developments.
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