On 10 May 2016, the governments of India and Mauritius agreed to amend their more than two decade old tax treaty, allowing for the taxation of income and capital gains on investments channelled through Mauritius.
This is a historic event for both countries.
The tax treaty between the two nations was signed way back in 1983. The treaty came into force in both countries with effect from Assessment Year 1983-84. It was some time in the early 1990s that the advantage of Article 13 of the treaty really began to be exploited for inbound investments into India via Mauritius. What began as a trickle soon turned into a deluge. Over the past few decades, Mauritius became the largest source of FDI into India. It was only in the past few years that Singapore overtook Mauritius in this regard.
Tax Treaty Blamed for Black Money & Loss of Govt Revenue
As per Article 13 of the treaty, capital gains arising in India to a resident of Mauritius from the alienation of Indian securities is taxable in Mauritius. It has been at the centre of much debate in both countries for over a decade now. There has been massive pressure on the Indian government to amend this Article and equal pressure on the Mauritian government to preserve it.
The tax treaty was blamed for the various ills of black money in India. Every time a huge scam was unearthed, someone tried to find a link to Mauritius. There were also regular allegations of treaty abuse and round tripping which reportedly caused loss of revenue running into billions of rupees for the Indian government.
What Has Changed: Capital Gains is Now Taxable
10 May 2016 therefore will be a landmark day in the history of international taxation for India.
The Protocol provides for taxing rights on capital gains arising from alienation of shares in a company resident in India acquired on or after 1 April 2017. Thus, the new dispensation would come into force with effect from FY17-18 (which, in Indian tax terminology would refer to Assessment Year 2018-19).
Learning from the stinging criticism that the earlier Indian government faced over the disastrous experiment with GAAR, the present government seems to have covered all the angles well. There is very little scope for criticising the Protocol from an Indian perspective. I am confident, however, that this positivity would not be shared at the Mauritian end since it is bound to adversely affect the financial service sector there.
This is How the New Treaty Looks
- India gets the right to tax capital gains arising from transfer of shares of Indian resident companies.
- Companies based in Mauritius must spend at least Rs 27 lakh in the preceding one year to benefit from the tax treaty.
- All investments made before 1 April 2017 will not be liable to be taxed in India.
- For investments made after 1 April 2017, the new version of the treaty provides for a tax concession for two years in the transition phase.
Some significant reasons why I feel the Protocol has been carefully drafted are as under:
It’s Not Retrospective
It provides protection to investments in shares acquired before 1 April 2017 and won’t retrospectively impact investments already made on the basis of the present provisions of the treaty.
Some Comfort for FPIs
There is a transitional period of two years (1 April 2017 to 31 March 2019) in which there will be a concessional tax treatment for the gains that would come under the tax net because of the Protocol. For capital gains that arise during this period, the tax rate would be 50 percent of the normal rate as per Indian law.
This provision is would provide a little bit of soothing balm to the FPIs at least for two years. Of course, it has been further provided that this concession will be available only if the concerned taxpayer fulfils the conditions laid down in the Limitation of Benefits (LOB) Article.
Higher Expense Outgo vs Resultant Tax Benefit
The LOB clause is also liberally conceived (relatively speaking). It says that a Mauritian resident (including a shell / conduit company) will not be entitled to the concessional tax rate during the transition period if it fails the “main purpose test” and “bonafide business test”. “Shell company” and “conduit company” have been defined to be those whose total expenditure on operations in Mauritius is less than Rs 27 lakh (approximately 1.5 million Mauritian rupees) in the preceding 12 months.
Thus, any Mauritian resident with operational expenses of less than 1.5 million Mauritian rupees would automatically be considered as a shell/conduit company and would not be eligible for the concessional tax rate during the transition period.
Having said that, going by the amounts that GBC1 companies generally pay in Mauritius to the administrators for the various services, the amount of 1.5 million Mauritian rupees could probably keep a large number of smaller FPIs out of the benefit net and make them “shell/conduit” companies for the purposes of this Protocol.
One will need to wait and watch how the market reacts to this provision and whether the FPIs would weigh the cost benefit ratio of a higher expense outgo and resultant tax benefit during the transition period. The worrying part here is that any Mauritian resident that fails the “main purpose test” and “bonafide business test” will also lose the concessional tax rate during the transitional period. These tests are not defined yet. One would need to wait for the same to be notified.
Taxation of Interest Income of Mauritian Banks
The other important change that will affect investments into India via Mauritius is the one that impacts taxation of interest earned by Mauritian resident banks from Indian debt. The Protocol provides for source-based taxation of interest income of banks. Interest arising in India to Mauritian resident banks will be subject to withholding tax in India at 7.5 percent in respect of debt claims or loans made after 31 March 2017. Here too, a grand fathering provision has been made whereby interest income in respect of debt-claims existing on or before 31 March 2017 would continue to be exempt from tax in India. Readers may be aware that Article 11 of the treaty gives the taxing rights of interest income (in India) of a Mauritian bank to Mauritius. The Protocol reverses that position.
Consequences for Mauritius
Thus, what will be the consequences of the Protocol from a Mauritian perspective?
1. Post 31 March 2017, capital gains earned by Mauritian residents from alienation of Indian shares will no longer be exempt in India (subject to the grand fathering and transitional provisions).
2. Post 31 March 2017, interest earned by Mauritian resident banks from Indian debt will no longer be exempt in India. Even for Mauritian banks that have invested in Indian debt through the FPI route, they could opt for taxation under the domestic law of India since that rate of 5 percent would still be lower than the rate of 7.5 percent as per the Protocol.
3. What happens to the capital gains from the alienation of securities other than shares? There is no mention of this in the press release. It is common knowledge that several large FPIs are using the Mauritius route to invest in Indian F&O segment. And they have massive turnover. Since any Indian security held by an FPI is classified as a Capital Asset under the Indian Income-tax Act, naturally, any gain/loss from a derivative will also be classified as capital gains. This gain has also been exempt from tax in India because of the treaty. The question that arises is what happens to the exemption from tax in India in respect of this kind of a capital gain? Will it continue to be exempt? Will it get taxed? One will need to wait for further information on this front.
India-Singapore Tax Treaty Gets Impacted
This development will have another very significant repercussion - the India Singapore tax treaty will also get impacted!
In the Protocol dated 18 July 2005 signed between the Indian and Singapore governments, the tax treaty between the two countries was amended. The Protocol provided exemption from tax in India to capital gains earned by a Singapore tax resident subject to the LOB clause. Interestingly, Article 6 of the Protocol says that Articles 1, 2, 3 & 5 of the Protocol would “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 of which the alienator is a resident”.
Thus, the tax exemption from capital gains in India under the Singapore treaty is linked directly to the tax exemption under the Mauritian treaty. Once the exemption under the latter is taken away, automatically, the Singaporean tax residents too will lose the tax exemption in respect of capital gains from shares of Indian companies.
FPIs Not Running Away Anywhere
Indian tax professionals will wait and watch the developments with academic interest. But for custodians, brokers, bankers and fund managers, its certainly going to be an extremely nervous time ahead.
My personal view is that investors would continue to buy into the India story and therefore invest here if they see profits ahead. FPIs are here to make profits. In the bargain, if they have to pay some tax, they would surely not mind as long as the overall return on investment that they get from Indian stocks is higher than elsewhere.
I am keeping my fingers crossed!
(Ameet Patel is a tax expert and Partner at Manohar Chowdhry & Associates)