India: India-Mauritius Treaty: The Protocol-Through The Looking Glass

Key takeaways:

  • Shift to source based taxation restricted to capital gains accruing to Mauritius residents from sale of shares in Indian companies.
  • India shall have the right to tax capital gains arising from alienation of shares by a Mauritius investor acquired on or after April 01, 2017 in a company resident in India with effect of financial year 2017-18. However, share investments before April 01, 2017 shall be grandfathered and shall not be subject to the amended regime.
  • Capital gains arising out of convertible debentures should be entitled to benefits of taxation in Mauritius for Mauritius based residents. However, the aforementioned benefit shall not be available for compulsorily convertible preference shares.
  • The changes brought about by the protocol make debt structures based out Mauritius lucrative. Interest income earned by Mauritius residents from Indian debt holdings to be taxed at a lower rate of 7.5%.
  • As per the current state of affairs, the beneficial regime available in respect of capital gains on sale of shares under the India-Singapore tax treaty should fall away on March 31, 2017. However, media reports suggest that the Indian government has reached out to the Singapore government for renegotiation talks.
  • A specific fee for technical services article, and service permanent establishment concept has been introduced.

A. Overview:

The double tax avoidance arrangement between India and Mauritius ("India-Mauritius DTAA") was amended through the protocol ("Protocol") earlier this month. Our earlier hotline on the issue can be found here.

Before the text of the Protocol was released, speculation was rife in respect of the treatment that would be accorded to derivative instruments, convertibles and the like. Similarly, there was uncertainty surrounding whether the revised understanding on interest income would be extended to all recipients of such income or whether the revisions were related to banks alone.

Now that the text of the Protocol has been released, these concerns stand clarified for the most part, and investors can hope for tax certainty going forward.

Below are the key amendments and impact of the Protocol on foreign investments through Mauritius:

B. Amendments to the India-Mauritius DTAA:

The amendments have been geared towards resolving the issues of round tripping faced by the Indian revenue authorities while dealing with Mauritius based entities. While the limelight has been reserved for the reversal in capital gains taxation provisions , the Protocol also brings about significant changes to the status quo through:-

  1. The introduction of service permanent establishment
  2. Changes in allocation rights for "other income" to source country;
  3. Introduction of a provision covering taxation of Fee for Technical Services ("FTS")
  4. Introduction of stringent collection and recovery measures.

The table below provides a comparative analysis of the provisions of the DTAA before and after the Protocol:-

S.No.

Particulars

Treatment before the Protocol

Treatment after the Protocol

1.

Capital gains arising on alienation of equity shares/ preference shares

Taxed in the State where the alienator resides

Tax levied by the source rate as per the rates applicable under the domestic law

2.

Capital gains arising on alienation of convertible debentures

Taxed in the State where the alienator resides

Taxed in the State where the alienator resides

3.

Capital gains arising on alienation of derivative instruments

Taxed in the State where the alienator resides

Taxed in the State where the alienator resides

4.

Taxation of income categorized as "income from other sources" under the Income Tax Act, 1961, India

Taxable in the State of the resident i.e. Mauritius

Taxable in the source country i.e. India as well.

5.

Mauritian residents earning fee for technical services from Indian sources

Likely to be business income not taxable in India in the absence of a PE.

Taxed at the rate of 10%.

6.

Presence of employees constituting permanent establishment for an enterprise

No specific provision

Deemed to be a permanent establishment if the employees/other personnel spend more than 90 days in aggregate over a 2 month period in the other contracting state

7.

Cross collection of revenue claims

No provision for collection of revenue claims arising in the other contracting State

Revenue claims of the other contracting states may upon request, be collected by the other contracting states through mechanisms available under local law.

C. Impact on Transactions

  1. The verdict on taxing capital gains:-

    1. Equity Shares & Preference Shares:

      Capital gains derived by a Mauritius resident from alienation of shares of a company resident in India shall be taxable in India from April 01, 2017. Earlier, such gains were taxable only in the country of residence, resulting in no Indian capital gains taxes on sale of securities by Mauritius based investors.

      Grandfathering: As per the Protocol, shares of an Indian company that have been acquired before April 01, 2017 shall not be affected by the Protocol irrespective of the date of sale /alienation of these shares. Such investments shall continue to enjoy the treatment available to them under the erstwhile Article 13(4) of the DTAA. Importantly, grandfathering has only been offered to "shares" and not to a broader set of investments. Consequently, convertible debentures which post-conversion into equity shares, are sold after April 1, 2017 would not be grandfathered.

      Transition Period: The Protocol also 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. The tax rate on any such gains shall not exceed 50% of the domestic tax rate in India. This benefit 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.

      Limitation of Benefits: For the purpose of the above relaxations, 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 position in respect of taxation of capital gains marks a change that would lead to higher taxation on an absolute basis, the parallel rationalizations under Indian domestic law may ease the tax impact of such transactions and promote debt investments through Mauritius.

      For eg, the Finance Act, 2016 reduced the rate of tax on short term capital gains arising out sale of unlisted shares of an Indian private company to 10%, when indexation benefits are not availed. This will reduce the tax impact on the Mauritius based investors. Additionally, a lower holding period of two years has been prescribed to be classified as a long term capital asset in case of unlisted shares.

      Going forward, Indian taxes may just be factored as an incremental cost and may accordingly form a part of the valuation methodology for investments while determining the rate of return etc.

      As far as foreign portfolio investors ("FPIs") are concerned, the real challenge is the tax costs for short term investments, since sale of listed shares held for more than a year over the stock exchange are, in any event tax exempt under Indian domestic law. Alternatively, foreign investors may look at exploring other jurisdictions such as Netherlands, which provide exemption from Indian capital gains tax, albeit with certain conditions – a) If Dutch shareholder holds lesser than 10% in Indian company or b) in case of sale of shares to non-Indian resident purchasers.
    2. Other securities / capital assets:

      1. Convertible Debentures:

        Convertible debentures not being in the nature of 'shares' should continue to enjoy the benefits available to such instruments under the residual provision i.e. Article 13(4) of the India-Mauritius DTAA. Capital gains arising on alienation of such instruments shall only be taxable in the contracting state where the alienator is resident i.e. Mauritius.

        The use of such instruments could witness a surge as equity/ preference shares may longer represent a viable option to Mauritius based investors – especially for private equity players.

        Gains from other capital assets such as interest in Limited Liability Partnerships (LLPs) may also continue to be taxed only in Mauritius. Given the recent liberalization of foreign direct investment in LLPs, this is another tax efficient investment avenue that may be explored going forward.
      2. Derivatives:

        The Protocol should not adversely impact derivatives, which should also continue to enjoy exemptions from Indian capital gains taxes.

        The gap that is created between the tax treatment for equity shares vis-à-vis derivative instruments may lead to a shift in strategies that are dominated by exposure to derivative instruments as opposed to investments in equity shares.

        1. Debt investments

          As discussed above, sale of convertible and non-convertible debentures should continue to enjoy tax benefits under the India-Mauritius DTAA. That, coupled with the lower withholding tax rate of 7.5% for interest income earned by Mauritius investors from India, comes as big boost to debt investments from Mauritius.

          Prior to the Protocol, interest income arising to Mauritius investors from Indian securities / loans were taxable as per Indian domestic law. The rates of interest could go as high as 40% for rupee denominated loans to non-FPIs.

          The Protocol amends the DTAA to provide for a uniform rate of 7.5% on all interest income earned by a Mauritian resident from an Indian company. The withholding tax rate offered under the Mauritius DTAA is significantly lower than India's treaties with Singapore (15%) and Netherlands (10%). This should make Mauritius a preferred choice for debt investments into India, going forward.
        2. Other income:

          Earlier, the 'other income' provisions i.e. Article 22 of the India-Mauritius DTAA stated that other streams of income not provided in the above articles shall be taxable in the resident's state, and not in the source country.

          However, the Protocol amends this language to provide that 'other income' arising to a resident of one state shall be taxed in the source country i.e. other contracting state.

          A direct consequence of this amendment would be that shares sold at a price lower than fair value, shall be taxed at the hands of the purchaser to the extent of such difference between the sale price and fair value. This is by virtue of Indian domestic provisions on taxing "other income" (Section 56).

          This puts the India-Mauritius DTAA at par with the treaty with Singapore (in this respect) and other treaty jurisdictions as such incomes were already subject to tax under the DTAA between India and Singapore.

D. Impact on ODI issuers

The Protocol will have an adverse effect the offshore derivative instrument ("ODI") issuers that are based out of Mauritius. While most of the issuers have arrangements to pass off the tax cost to their subscribers, the arrangement may become less lucrative due to the tax incidence. However, this problem may be temporarily be a non-issue for ODI issuers who have existing losses that have been carried forward as any gains that arise can be set off against such losses.

Even in a scenario where the tax cost is being passed off the subscriber, complications shall arise due to a timing mismatch as the issuer shall be subject to tax on a FIFO basis (as opposed to a one-to-one co-relation).

E. Effect 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. Consequently, benefits available in respect of capital gains under the India-Singapore DTAA shall fall away after April 01, 2017. Further, it is not clear whether the grandfathering of investments made before April 01, 2017 will be available to investments made by Singapore residents.

However, media reports suggest that the Indian government is actively interacting with Singapore to renegotiate the treaty. It is a likely scenario as Singapore has an interest in the renegotiation since at present due to the lack of grandfathering, there is no tax certainty for Singapore based investors on the way forward.

F. Conclusion

While the changes brought about through the Protocol may be significant, it would be unfair to consider its implementation to be the demise of Mauritius and Singapore as preferred routes of inbound activity. The modification on capital gains taxation is limited to gains arising on sale of shares. This ensures continuity of benefit to other instruments and also provides much needed certainty in respect of the position of the treaty. This is important as there was a marked hesitation among the investors to use such structures during the prolonged negotiation period. This certainty coupled with easing of tax rates in India and the added benefits available in respect of interest income due to the Protocol should ensure that Mauritius remains a jurisdiction of choice for investments into India.

The Protocol also seeks to promote debt investments from Mauritius, as it now emerges has the preferred jurisdiction for debt considering the lower withholding tax rates for interest income as well as the capital gains tax exemption.

On a final note, there no longer remains a strait-jacket formula for foreign investors to minimize Indian tax costs by investing through Mauritius entities. Depending on investment strategies, nature of investment – whether portfolio or direct, nature of instruments (debt of equity), different structuring options may be explored or Indian taxes would need to be factored in by investors as a cost of doing business in 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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