RECENT AMENDMENT TO INDIA - MAURITIUS TAX TREATY

Karthik Ranganathan, Advocate

www.karthikranganathan.com
____________________________________________________________
Mauritius tax treaty amendment takes away with it treaty shopping
while doing business with India!
Indias tax treaty with Mauritius was amended on May 10, 2016. Hitherto,
residence based taxation on capital gains was followed as per the tax treaty.
Much of the investments into India came via Mauritius as it was the first tax
treaty India entered into with a low tax jurisdiction (LTJ), in 1983. Majority of the
foreign investors into India, be it portfolio investment or direct investment, used
the Mauritius tax treaty to avoid capital gains tax in India which is typically at
20%. The tax treaty follows residence based taxation whereby the jurisdiction
where the alienator of the shares is resident will have the right to tax the capital
gains. India generally has 20% capital gains tax on long term investments
(shares held more than a year) and 30% on short term investments. Over the
years, in order to create more favorable investment climate even from nonMauritius jurisdictions, specific provisions were introduced in the Income-tax Act,
1961 (the Act) to limit the capital gains tax on long term holding at 10% and
short term at 30% for listed securities. This benefit was initially available to
Foreign Institutional Investors (FII) alone but was later extended to Foreign Direct
Investors (FDI) as the latter is the one which actually makes long term
investment providing the much needed capital to the Indian companies. Under
the Act itself, sale of shares by any foreign investor through the stock exchange
resulting in long term capital gains was exempt in India with a small fee to be
paid to the stock exchanges called the Securities Transaction Tax (STT). If it
results in short term capital gains the same is taxed at 15%. However, for FDIs
which usually invest in unlisted securities, the above tax exemption and lesser
tax rate was not available. The India-Mauritius tax treaty was a big relief for
them as such capital gains were liable to tax only in Mauritius which does not
impose any capital gains tax thereby resulting in double non-taxation.
Since much of the investments were flowing into India through Mauritius, the
Indian Governments, over the time, did not take real steps to prevent this double
non-taxation situation. Instead, they fought only a shadow-fighting with the
investors/ taxpayers in the courts that though treaty was available the taxpayers
were expected to ignore it and still pay tax in India. However, the courts in India
including the Supreme Court time and again blessed the Mauritius route stating
that there was nothing illegal in such treaty shopping.

Unlike the US tax treaties, India does not have Limitation of Benefit (LOB) Article
in all its tax treaties especially with the Mauritius treaty which was much needed
to prevent treaty shopping. This catch-22 situation of the Indian Tax Department
(ITD) i.e. the choice between the economic growth and tax base erosion was
evident from its aggressive and going overboard measures in denying tax treaty
benefits to the investors in the name of substance over form concept. Though
not directly related to India-Mauritius tax treaty, ITDs frustration was visible in
the (in)famous Vodafone indirect transfer transaction in which a Mauritian entity
was also involved. The rest are details with regard to the Vodafone transaction
which led to the retroactive amendment to the Act and the introduction of the
draconian General Anti Avoidance Rule (GAAR) in the Act which will come into
force from April 01, 2017. GAAR has provisions which will override tax treaties
thereby disregarding tax treaty benefits like that of Mauritius.
Under these circumstances, the breaking news that Indias tax treaty with
Mauritius has been amended whereby source based taxation will be followed
post April 01, 2017 is certainly one more weapon in the ITDs artillery. This
simply means the capital gains benefit in the India-Mauritius tax treaty has been
officially sealed off.
The key amendments to the tax treaty which took place through a Protocol are
as follows:
1. Source based taxation of capital gains on shares: With this Protocol, India gets
taxation rights on capital gains arising from alienation of shares acquired on
or after 1st April, 2017 in a company resident in India with effect from
financial year 2017-18, while simultaneously protection to investments in
shares acquired before 1st April, 2017 has also been provided. Further, in
respect of such capital gains arising during the transition period from 1st
April, 2017 to 31st March, 2019, the tax rate will be limited to 50% of the
domestic tax rate of India, subject to the fulfillment of the conditions in the
Limitation of Benefits Article. Taxation in India at full domestic tax rate will
take place from financial year 2019-20 onwards.
The implication of the above is that the taxing right to India is only prospective
and not retroactive. In the sense, only those shares acquired on or after April 01,
2017 and transferred thereafter will be liable to tax in India. Further, with regard
to shares acquired after April 01, 2017 but transferred before March 31, 2019 will
be taxed only at 50% of the applicable capital gains tax subject to fulfilling the
LOB requirements introduced in the protocol.
The tax implication for FIIs on the transfer of shares acquired and transferred
during this interregnum (April 01, 2017 to March 31, 2019) is as follows:
-

Short term capital gains tax on sale of shares on-the-floor of the stock
exchanges will be only 7.5% (50% of current 15%). Long term capital gains
are already exempt from tax.
Short term capital gains tax on sale of shares off-the-floor of the stock
exchanges will be only 15% (50% of current 30%). Long term capital gains
will be taxed at 5% (50% of current 10%).
FIIs (now FPIs) are not allowed to invest in the shares of the private limited
companies (unlisted) post introduction of the new SEBI Foreign Portfolio
Investment Regulations, 2014.

The tax implication for FDIs on the transfer of shares acquired and transferred
during this interregnum (April 01, 2017 to March 31, 2019) is as follows:
-

Short term capital gains tax on sale of shares on-the-floor of the stock
exchanges will be only 7.5% (50% of current 15%). Long term capital gains
are already exempt from tax.
Short term capital gains tax on sale of shares off-the-floor of the stock
exchanges will be only 15% (50% of current 30%). Long term capital gains
will be taxed at 5% (50% of current 10%).
Short term capital gains tax on sale of shares of unlisted companies (like
private limited companies) will be only 20% (50% of current 40%). Long term
capital gains will be taxed at 5% (50% of current 10%).

To summarize, the above part of the protocol lays down four situations:
1. Shares acquired prior to April 01, 2017 and transferred before or after April
01, 2017 will not be subject to tax in India and will be governed by the law
prevalent at the time of investment i.e. only Mauritius will have a right to tax
based on residence test.
2. Shares acquired after April 01, 2017 but transferred before March 31, 2019
will be taxed at 50% of the applicable capital gains tax.
3. Shares acquired on or after April 01, 2017 but transferred after April 01, 2019
will be taxed at full rate as per the Act.
This appears to be a very sensible way to introduce this sudden change in the
Mauritius route. This means that investors who have already made the
investments need not worry about the change in the treaty as they will continue
to avail the benefit of capital gains exemption from both countries. With regard
to investors making investments post April 01, 2017, it depends on their nature
of investment i.e. whether FII or FDI. FIIs usually tend to exit in few years time
and if it is less than two years then they will be taxed only at 50% tax as
explained above. However, FDIs invest for a longer period to do business in India
and may more likely end up paying full capital gains tax (10% for LTCG and 40%
for STCG). Further, it should be noted that this years Indian Union Budget has
set the holding period (tacking) of unlisted securities at two years (instead of
previous one year) to be treated as long term capital assets. (Analysis of the
Union Budget can be found here at
www.karthikranganathan.com/sharing_read.php?_knowledge_id=NjQ).
Therefore, FDIs who invest in unlisted securities after April 01, 2017 will end up
paying 50% on short term capital gains of 40% (i.e. 20% tax) if they wish to exit
before March 31, 2019. Any transfer post April 01, 2019 will be treated as long
term capital gains taxable at full rate of 10%. However, on strict reading of the
amendment, only shares are liable to capital gains tax and other securities
appear to be out of it.
To enjoy the 50% tax on capital gains tax, an LOB clause has been introduced
which tries to achieve some commercial substance for a Mauritian entity
investing in India. This type of LOB is similar to the one prevalent in the tax
treaty between India and Singapore. The Mauritius treaty LOB requires the
Mauritian entity, in order not to be treated as shell/ conduit company, has to
incur operating expenses of Indian Rupees 2,700,000 or Mauritian Rupees
1,500,000 in Mauritius in the immediate preceding 12 months. In case of IndiaSingapore tax treaty the amount is Indian Rupees 2,400,000 in the immediate

preceding 24 months. This appears to be kind of proxy LOB clause given the
paltry sum that has to be incurred to create commercial/ economic substance in
Mauritius. In effect, the LOB clause is relevant only for two financial years (FY) to
enjoy the beneficial 50% tax on the capital gains tax.
Impact on Participatory Notes (P Notes) by the recent amendment
Post the OECDs BEPS Action Plans, several countries are taking effective steps to
crackdown tax evasion. India is not a member of OCED but is a member of G20
countries which is also part of the BEPS Action Plans. India has been a big victim
of these P Notes. P Notes have significantly contributed to money laundering in
India to the tune of approximately INR 3 Trillion (USD 45 Billion). P Notes are the
derivatives issued by the FIIs to its investors for the underlying securities
invested by the FIIs on the Indian stock markets. P Notes have several benefits
including free from compliance of Indian regulations, converting unaccounted
money into accounted money through round tripping. The real beneficial owners
of P Notes are usually untraceable thereby encouraging investments in the FIIs.
P Notes investors are referred to ghost investors due to their anonymity.
Mauritius was the most suitable jurisdiction to invest this unaccounted money
through P Notes as several FIIs were set up in Mauritius to avail India-Mauritius
tax treaty benefits. The P Notes enjoyed the same capital gains benefit as the
FIIs enjoyed at the time of transfer of shares by the FIIs on the Indian securities.
It appears that there were two compelling requirements for this recent tax treaty
amendment. One is the clarity in capital gains taxation as the ITD continued to
deny tax treaty benefits despite certain Supreme Court rulings. Second, the
Indian Government wants to have a crackdown on these P Notes investments.
Since collating information about the P Note holders could not be achieved,
shutting this investment route may be a solution to prevent this menace.
However, Indian unaccounted money took a round trip i.e. went out of India and
came back through P Note investments. Now, there may be only half of round
trip where the unaccounted money may go out of the country and may never
come back or the unaccounted money may never come out.
Recent amendment to affect India-Singapore tax treaty as well
The most convenient jurisdiction for money laundering and enjoying capital gains
tax benefits since 1983 was the Mauritius. However, Singapore also acted as an
alternative to Mauritius due to its banking secrecy laws and limited Know Your
Client (KYC) norms followed by its Regulators. To add to this, similar amendment
vide a Protocol was introduced in the India-Singapore tax treaty in 2005 which
shifted the capital gains taxing rights to residence country which was hitherto
with the source country i.e. typically India. However, an interesting article was
introduced in the Protocol that this residence based capital gains benefit in the
Singapore treaty will only be available as long as the Mauritius treaty with India
continued with similar benefits. Now that Mauritius treaty has been amended,
the Singapore treaty with India will also automatically lose its benefits. The
relevant portion of the Protocol read as Articles 1, 2, 3 and 5 of this Protocol
shall remain in force so long as any Convention or Agreement for the Avoidance
of Double Taxation between the Government of the Republic of India and the
Government of Mauritius provides that any gains from the alienation of shares in
any company which is a resident of a Contracting State shall be taxable only in
the Contracting State in which the alienator is a resident.

Since, post April 01, 2017, India will start to tax at 50% on the capital gains tax
by which the residence based taxation will be shifted to source based taxation,
the benefit between India and Singapore will also terminated.
Does India have any other treaty which can substitute Mauritius treaty?
Mauritius was the only tax haven/ LTJ since 1983 which the foreign investors
could use to invest in India for capital gains tax benefit. Singapore turned out to
be an alternative since 2005 with the introduction of the said Protocol. No other
LTJ with which India has comprehensive tax treaty has residence based taxation
with similar benefits that of Mauritius and Singapore. The other LTJs with which
India had entered into comprehensive tax treaties are Luxembourg, Netherlands,
Malta, Cyprus, New Zealand and UAE. Cyprus which has residence based
taxation like Mauritius and Singapore has been blacklisted by the Indian
Government since 2011 for noncooperation in exchange of information. It
appears that the Indian Government is negotiating with the Cypriot Government
to amend their tax treaty in line with the Mauritius tax treaty amendment so that
India will have source based taxation and further, the blacklisting of Cyprus
under section 94A may be abrogated retrospectively.
Barring Netherlands all other countries mentioned above have source based
taxation where India will have a right to tax. Netherlands has tricky residence
based taxation with Participation Exemption rules. However, from a closer
reading of this capital gains article it appears that FIIs can use this route as upto
10% of the investment in India and disposal will be liable to tax only in
Netherlands. Interestingly, under foreign exchange laws in India (FEMA), an FII
can invest only upto 10% in a particular company. However, all FIIs together can
invest upto 24% in a company. So, individual FIIs may still stand to benefit
through Netherlands route.
It, therefore, appears that the end of Mauritius tax treaty benefits puts an end to
any treaty shopping with India vis--vis capital gains benefit is concerned.
GAAR impact post this amendment
GAAR has treaty override provisions. GAAR is expected to come into force from
April 01, 2017 (FY 2017-18). GAAR emphasizes on substance over form theory.
Therefore, in effect, even if the tax treaty with Mauritius would not have been
amended, GAAR would have taken care of it! In fact, GAAR may disregard
Mauritius tax treaty benefit even for shares acquired prior to April 01, 2017
thereby making the prospective amendment to the tax treaty ineffective.
However, it appears from the Governments intention that such treaty
amendments in good faith may not be affected by GAAR provisions.
The question whether the provisions of the Act can override the tax treaty has
been held in favor of the tax department by the Madras High Court in a recent
case holding that the Act of Parliament prevails over Executive action of entering
into tax treaties applying dualistic approach theory. Therefore GAAR, if
challenged, may be held to be constitutionally valid.
What is the impact of this treaty amendment?
It was feared that the Indian bourses will tank significantly due to this
amendment. Rather the stock market surged after this amendment at least for
the time being. The reason appears to be that this amendment has created

much certainty in capital gains taxation while making investments via Mauritius.
Till now though the treaty gave Mauritius the right to tax, the ITD was denying
this benefit stating it was a tax driven structure. Now this uncertainty has been
put to rest though it may incur 20% tax cost to the investors which is worth
incurring given the fundamental economic stability in India. However, the
investors from US and UK still have to rely on Mauritius or Singapore tax treaty
as Indian tax treaties with US and UK do not give any capital benefit and leaves
the right to tax on capital gains to both countries thereby resulting in double
taxation. Foreign tax credit (FTC) will not be available in both jurisdictions as
both India and US will treat the capital gains as their source income applying
their domestic laws and thereby, pushing the FTC ball into the others court.
The amendment to the treaty has also introduced source based taxation on fees
for technical services (FTS) and has introduced service permanent establishment
(PE) which was hitherto not present in the tax treaty.
Much thought has to go, hereafter, before investing or transacting with India
keeping in mind the treaty amendments and GAAR implications.
With the recent amendment to the Mauritius tax treaty, Benjamin Franklins old
taxing quote has been buttressed again! Death & Taxes..