India's cultural, political, diplomatic and economic relationship with Mauritius dates back to pre-Independence days. Besides being a favourite holiday destination, Mauritius also became an obvious choice for routing investments into India.
ver the past decade and a half, almost $93.65 billion, about 34 per cent of the total foreign direct investment (FDI) inflow into India, came from Mauritius. This preference is largely attributed to the favourable double tax avoidance agreement (tax treaty) between the two countries signed in 1983.
According to the tax treaty, Mauritius has the right to tax capital gains arising to its resident from sale of shares of an Indian company. While India had no right to tax such gains, Mauritius does not tax capital gains arising to its residents. This, according to the Indian government, gave rise to cases of treaty shopping, double non-taxation and round tripping of funds.
The Protocol that will change history
After over a decade and a half of discussions and hard negotiations, the two countries on May 10, 2016, signed a historic protocol that seeks to plug gaps in the tax treaty. With signing of this protocol, India will have right to tax gains from sale of shares of an Indian company acquired on or after April 1, 2017. Protection has been guaranteed to investments in shares made prior to such date, gains therefrom would not be taxable in India.
The protocol provides for a transition period for new investments. Capital gains arising on sale of shares acquired on or after April 1, 2017 but sold before March 31, 2019, shall be taxed at 50 per cent of applicable Indian tax rate on capital gains. However, such transitional treatment shall be subject to the inbuilt anti-abuse provision, the Limitation of Benefits (LoB) clause. According to the LoB clause, the investor claiming concessional treatment would need to satisfy the primary purpose test and bonafide business test. The former test acts as a check against entities who have arranged affairs with primary purpose to take advantages of the treaty benefits. The business test seeks to deny benefits to shell/conduit company with negligible/nil business operations or no real and continuous business activities carried out in Mauritius. Exception has been carved out to exclude listed companies or companies with total expenditure on operations in excess of Rs 27 lakh (Mauritian Rupees 15 lakh) in the immediately preceding 12 months from the date capital gain arises.
After the end of the transition period and with effect from April 1, 2019, any sale of shares of an Indian company by a resident of Mauritius shall be chargeable to the full Indian tax rate applicable to such capital gains.
The capital gains taxation at full rate (other than listed shares sold after 12 months) will bring tax treatment of investments from Mauritius on par with Indian investments.
Noticeably, the change in tax treatment applies only to shares. Therefore, right to tax capital gains on other instruments, namely debt securities, compulsorily convertible debentures, futures and options (derivatives), etc. may continue to be with Mauritius.
The Protocol is set to impact the co-terminus benefit under the India-Singapore tax treaty. As per the Protocol signed by India and Singapore in 2005, capital gains on sale of shares in an Indian Company shall be taxed only in Singapore (and not in India) till such time as the India-Mauritius treaty provided a similar treatment to investment from Mauritius. Unless specific amendments are effected in Singapore tax treaty, the Protocol with Mauritius may end the favourable tax regime under the Singapore tax treaty.
With domestic anti-avoidance provisions (GAAR) effective from April 1, 2017, whether concessional tax regime during the transition period is denied by invoking GAAR remains to be seen.
This initiative furthers the Indian government's commitment to the G20/OECD initiative on Base Erosion and Profit Shifting (BEPS) to address the issue of tax evasion by treaty shopping.
By this tax policy move, the investor community comprising of foreign institutional investors, private equity funds, holding companies will be affected. While, the signing of Protocol may not be pleasing to some, the announcement has brought clarity and ended a long-standing suspense over the fate of this tax treaty. With the effect being prospective from April 1, 2017, the investors have a short time window to plan their affairs.
While this may see a dip in investments routed from Mauritius and Singapore, it is not likely to impact plans of long term genuine investors seeing a stable economy with promising growth.