International Business Taxation
The taxation of international business is a vital political and social issue, as well as raising many fascinating legal, political and economic questions. Taxation is the point of most direct interaction between government and citizens, the state and the economy. Yet the technical complexities of taxation often make informed debate difficult.
The international interaction of tax systems has been recognized since at least the First World War as an important element in international finance and investment. With the growth of state taxation of income, including business income or profits, each state had to adapt its tax measures to its international payments and investment flows. Conflicts and differential treatment between states led to pressures from business for the elimination of international double taxation. Although early hopes of a comprehensive multilateral agreement allocating jurisdiction to tax were soon dashed, a loose system for the co-ordination of tax jurisdiction was laboriously constructed.
These international tax arrangements were an important feature of the liberalized international system which stimulated the growth of international investment after the Second World War. This growth of international business, and especially of the largely internationally integrated corporate groups, or Transnational Corporations (TNCs), led to increasing pressures on the processes of international business regulation.
Tax Treaty System
The key legal mechanism for the coordination of states’ jurisdiction to tax international business has been the bilateral tax treaty, a foundation was established for a highly flexible system. The basic text of the model could be adapted to the particular circumstances of each pair of partner states, while in turn the adaptations made in bilateral negotiations could progress into future, multilaterally agreed models.
Many countries have entered into tax treaties (also called double tax agreements, or DTAs) with other countries to avoid or mitigate double taxation. Such treaties may cover a range of taxes including income taxes, inheritance taxes, value added taxes, or other taxes. Besides bilateral treaties, multilateral treaties are also in place. For example, European Union (EU) countries are parties to a multilateral agreement with respect to value added taxes under auspices of the EU, while a joint treaty on mutual administrative assistance of the Council of Europe and the Organisation for Economic Co-operation and Development (OECD) is open to all countries. Tax treaties tend to reduce taxes of one treaty country for residents of the other treaty country to reduce double taxation of the same income.
The provisions and goals vary significantly, with very few tax treaties being alike. Most treaties:
- define which taxes are covered and who is a resident and eligible for benefits,
- reduce the amounts of tax withheld from interest, dividends, and royalties paid by a resident of one country to residents of the other country,
- limit tax of one country on business income of a resident of the other country to that income from a permanent establishment in the first country,
- define circumstances in which income of individuals resident in one country will be taxed in the other country, including salary, self-employment, pension, and other income,
- provide for exemption of certain types of organizations or individuals, and
- provide procedural frameworks for enforcement and dispute resolution.
The stated goals for entering into a treaty often include reduction of double taxation, eliminating tax evasion, and encouraging cross-border trade efficiency. It is generally accepted that tax treaties improve certainty for taxpayers and tax authorities in their international dealings. Several governments and organizations use model treaties as starting points. Double taxation treaties generally follow the OECD Model Convention and the official commentary and member comments thereon serve as a guidance as to interpretation by each member country. Other relevant models are the UN Model Convention, in the case of treaties with developing countries and the US Model Convention, in the case of treaties negotiated by the United States.
International Tax Avoidance
Multinational companies have emerged from international investment and trade as capital can be used more efficiently on a worldwide scale. However, for international investment to be more efficient than domestic the investor needs a double taxation treaty that ensures that income generated by the foreign investment is not double taxed by both the country of residence of the investor and the country the income is sourced from.
In order to prevent double taxation the international taxing rights are currently allocated as follows: Active or business income is taxable in the country where the activity takes place, that is, where the income is sourced from. Passive or capital income is taxable in the country where the owner of the capital is resident. Company residence is based upon the place of management or the place of incorporation of the enterprise.
Types of passive income:
- Interest: income from capital loaned
- Royalty: income from intellectual property (patent, design, know-how, franchise, etc.)
Double taxation treaties reinforce the residence-source allocation of international taxing rights. However, the source country can also be allowed to tax passive income even if there is a treaty in force. The actual allocation of taxing rights depends on the power relations of the particular treaty partners. Capital-exporting developed countries prefer the OECD model treaty, which is more favorable to residence, while capital-importing developing countries prefer the UN model treaty, which is more favorable to source.
The multinational corporation can shift its profit by transferring equity capital and ownership of intellectual property to its subsidiary that is resident in a tax haven. As a result its passive income is shifted to the tax haven.
In addition, the multinational corporation can shift its profit by transferring business risks to its subsidiary that is resident in a tax haven.
The active income of a subsidiary that is resident in a non tax haven state can be shifted by transfer pricing, when the subsidiary sells products or services to another subsidiary that is resident in a tax haven below market price or purchases products or services from it over market price.
To sum up the above, the multinational corporation is able to allocate its income by transferring capital, intellectual properties and risks and in addition by transfer pricing the products and services that are produced by the group. This means that the value of the income allocated to a particular nation state is the sovereign decision of the multinational enterprise.
The Defense against Profit Shifting
The non-tax haven state can levy a withholding tax on the interest and royalty paid out by the local subsidiary to another subsidiary that is resident in a tax haven. If however the high tax jurisdiction has a double taxation treaty with the tax haven state then passive income is taxable at residence.
In the absence of a double taxation treaty or directive the multinational corporation can channel passive income through a so-called conduit company which is resident in a country which have a double taxation treaty with the high tax country. The income is directed via the conduit company to the so-called beneficial owner company which is resident in a tax haven free of withholding tax. This structure is known as treaty shopping, as the beneficial owner of the income uses the intermediary state only to benefit from its double taxation treaty.
One of the main attacks launched by multinational corporations against domestic income comprises interest charged by a subsidiary that is resident in a tax haven to another subsidiary resident in a high tax jurisdiction. The multinational group puts its equity capital into its subsidiary located in a tax haven, whereas it finances its other subsidiary located in a high tax country by debt borrowed from its low taxed subsidiary. In this way, the income of the thin-capitalized subsidiary is shifted to the thick-capitalized subsidiary resident in a tax haven.
Against thin-capitalization the high tax state can defend itself by applying the so-called thin-capitalization rule, when it does not allow interest to be deducted above a certain limit if the subsidiary located in its jurisdiction is financed excessively by debt.
Against transfer pricing developed OECD countries fight by applying the so-called arm’s length principle, when the high tax state compares the prices of intercompany sales and purchases to the prices that have evolved between independent companies, i.e. the market prices. After establishing the arms’ length or market price, the state adds the difference to the income of the resident company. However, the establishment of the arm’s length price is practically impossible due to the following main causes.
The first problem is that the bulk of world trade takes place among multinational corporations, so there is practically no arm’s length price which could be applied between related companies. The markets typically dominated by multinationals (e.g. banking-, pharmaceutical-, automotive-, telecommunication-, computer industry, etc.) do not have a large number of independent participants.
The second problem is that one of the main goals of market competition is the establishment of prices, so the correct arm’s length price cannot be established cost effectively by way of calculation. The result of calculation, therefore, will be a broad range of prices which is more than sufficient for the multinational corporation to locate its income where it is optimal.
The third problem is that if the market profit is attributed to all related companies, a residual profit will arise in consequence of the fact that the aggregated income of the multinational corporation exceeds that of a group of independent companies (cet. par.), which is mainly due to centralized management and economies of scale.
The multinational enterprise which has succeeded in shifting its profit to tax havens is at the same time faced with a problem. The multinational corporation is structured hierarchically, that is a listed parent company, which is usually located in a high tax jurisdiction, owns all the subsidiaries resident in various states. The multinational corporation needs to report profit on the stock exchange, but at the same time wants to declare loss to the tax authority. The profit, however, which is shifted to tax havens generates a loss for the parent company listed on the stock exchange.
The solution to this contradiction is called a consolidated financial statement following the accounting standards of US GAAP or IFRS (EU). In a consolidated financial statement the income of the non-tax haven parent company and that of the tax haven subsidiaries are published together.
Nation states have responded to this attack by inventing the so-called controlled foreign corporation rule. In applying this legislation, the high tax jurisdiction adds the retained earnings of the subsidiary resident in a tax haven to the income of the parent company. In this way the shifted profit becomes taxable by the non-tax haven country.
However, the controlled foreign corporation rule can be avoided as well:
The European Court of Justice has declared in a court ruling that within the European Union the subsidiary resident in a low tax jurisdiction cannot be taxed by the state of residence of the parent company if the subsidiary performs a genuine economic activity.
The residence of the listed parent company can be relocated to a state where there is no controlled foreign corporation rule.
In the USA, the so-called check-the-box rule is used to circumvent the controlled foreign corporation rule.
The proposed solution against profit shifting of multinational corporations is the application of the so-called formulary apportionment method or unitary taxation, where the aggregated income of the multinational corporation is distributed among the countries where it performs its activities using arbitrary weighting of different factors, such as payroll, assets, or sales. However, this method does not differ substantially from the current system where multinationals allocate their own income arbitrarily, as we are faced with the same problem of how to allocate income truthfully among states.
The ideal method would allocate to every state the real value of the income locally generated, as the public services rendered have contributed to the generation of the income, and therefore the state is entitled to its fair share in order to be able to provide the services continuously. But the real value of the income is impossible to calculate in the absence of competition.
On the other hand, applying the formulary apportionment method does not in itself prevent the abuse. The value of income could also be manipulated in the formulary apportionment system, as multinationals could relocate those factors the formulary apportionment is based upon to where taxation is more favorable.
Tax Havens and International Finance
Tax havens are primarily the countries which have very low or no taxes levied on income. These countries are also supposed to have financial secrecy and thus enables individuals from other countries to hide their black money by opening another company in the tax heaven country and getting tax relief at home country. It is supposed that the Tax Havens are the main reason for the financial crisis.
Though tax havens did not “cause” the crisis, they contributed powerfully to it. This happened in various ways:
- The offshore system offered and offers an offshore “get out of regulation free” card to financial businesses.
- These escape routes helped U.S. and other financial firms grow much faster, achieving political and regulatory “capture” and contributing to the “too big to fail” and ‘too big to jail’ banking problems. This happened first in the offshore Euromarkets that originated in London in the 1950s, and then in the wider global offshore system.
- Unhealthy competition on tax and regulation between offshore financial centres, and between them and other jurisdictions, eviscerated and degraded regulations that may otherwise have staunched the crisis.
- Offshore centres played a demonstrable ‘conduit’ role in transmitting dangerous shocks quickly through the system.
- Tax incentives, typically through tax havens, played a major role in accelerating the build-up in debt and leverage across the global financial system.
- “Satellite” tax havens like some Caribbean islands or Britain’s Crown Dependencies are conduits for illicit and other financial flows, often from developing countries into financial centres like London, New York, and these contributed to large macroeconomic imbalances. The mainstream economics profession has not measured these vast flows, many of which (such as transfer and trade mispricing) do not show up in conventional national statistics.
- In the hottest phase of the crisis in 2008, the financial system gummed up under mutual mistrust and impenetrable complexity where actors could not understand the financial positions of their partners. The secrecy jurisdictions, inviting companies to festoon their financial affairs across multiple jurisdictions, and covering these affairs in a veil of secrecy, exacerbated the problems.
- Tax havens provided the cover for all manner of fraudulent business models – such as those offered by Bernie Madoff, Allen Stanford and others.
- Offshore centres helped corporations conceal serious losses, which contributed to the build-up.
- Offshore centres have played a powerful role in creating excess liquidity, which contributed to the crisis.
- Tax havens, by giving banks with global reach a “competitive” advantage over their more nationally-based rivals (by permitting evasion and avoidance of tax and regulatory obligations), contributed powerfully to the “too big to fail” problem.
Not only that, but by draining reputable jurisdictions of the tax dollars of their wealthiest citizens and corporations, and by fostering massive capital flight out of developing countries, they have made it so much harder for victims of the crisis to pay to clean up the mess.
Global Unitary Taxation Controversy
During the 1970s an increasingly publicised dispute developed over what has been referred to as Worldwide Unitary Taxation (WUT). The dispute arose over the application by a number of American state jurisdictions of their system of formulary apportionment of the taxable income of a unitary business to the combined worldwide activities of TNCs doing business within the state. Attempts to prevent the widening application of this approach developed into a worldwide campaign, led by nonW American, in particular British, TNCs doing business in the US. Although this campaign obtained support from the American Federal as well as most other national governments, and eventually succeeded in checking the application of unitary taxation to worldwide income, at the same time it focussed attention on the problem of allocation of the income of globally integrated businesses. This in turn led to increased scrutiny of the effectiveness of enforcement of the arm’s length pricing principles under the separate accounting approach, and stimulated renewed efforts by the US Internal Revenue Service to justify and develop its systems of audit of TNC accounts, as discussed in the previous chapter. It also encouraged the IRS to take the lead in pressing for further development of the international arrangements for coordination of the taxation of international business. Despite the widespread criticism of WUT, it became clear that a formula approach would be a necessary element of an improved system of international taxation.
In the uncoiling of India’s post reform stock market history, the small island of Mauritius always pops up. More often than not there is a lot of negativity attached to the island, typically considered an offshore tax haven. In the past, most Indian financial scams have tailed back to Mauritius. From Ketan Parekh’s K 10 to the 2G spectrum scam and even the more recent Agusta Westland chopper scam, there has always been a Mauritius link. A large dosage of portfolio investment comes in through Mauritius and hence the suspicion that Participatory Notes masking the identity of the actual investor have been using the tax dodge to round trip money into India always abounds.
At the same, what needs to be considered is that a lot of Foreign Direct Investment into India is also routed through Mauritius. From the time India unfettered its stock markets seeking foreign investment from institutional investors, the Double Taxation agreement between the two nations has been viewed with misgivings and scepticism. And every time when there has been a whiff of shenanigans, the first impression is that there is a Mauritius connection. More often than not, it is true. Hence the inherent distrust. Between April-December 2015-16, FDI of ₹39, 506 crore came through Mauritius, while ₹71,195 crore came from Singapore. However, in the previous full year, April-March 2014-15, Mauritius was in pole position with ₹55,172 crore, followed by Singapore with ₹41,350 crore.
Even the routing of FII money through Mauritius is overstated and overplayed. Of the top Mauritius based India dedicated funds, Copthall Mauritius Investment Fund has a $1.7 billion exposure to Indian equities followed by HSBC Global Investment Fund with a $1 billion and Citibank Global Markets Mauritius Fund with 4409.5 million. This pales into insignificance against Singapore FII investments where Temasek Holdings has a $99.1 billion exposure to Indian equities while GIC Pvt has a $44.2 billion exposure followed by Morgan Stanley Asia with a $1.2 billion. In any case, let me explain why FIIs using the Mauritius route are unlikely to abandon India and its great long-term buys just because of a new clause added to the DTAA. So, the worries on the same clause being added to the treaty with Singapore or other tax-havens are also not a big concern. It’s the pedigree of the company, rather than the tax structure of the home country, which makes a business a strong investment proposition. Obviously, it will be a deterrent to hot money and ‘fairweather friends’ which is a good thing for it will mean that ‘Treaty Abuse’ cases will lessen.
So, when India finally decided to amend a few key clauses in the nearly 30-year-old Double Taxation Avoidance Agreement (DTAA), there was no temblor whatsoever. Tax avoidance is something that most governments worry about. The amendments will now allow India to tax capital gains earned by Mauritius based entities. These entities will now have to pay capital gains tax for investments in India made from April 1, 2017. However, investments made before April 1, 2017 have been grand-fathered and will not be subject to taxation in India. This in a way is good news, for it means that prima facie all things being equal, till March 31, 2017, FIIs using the M route will continue to buy aggressively — something that has already begun to happen post the amendments.
From April 1, 2017 to March 31, 2019, these firms will have to pay capital gains tax at 50% of the tax rate that is paid by domestic entities. Currently, Indian investors are levied 15% tax on short-term capital gains (holding period less than 12 months) of listed companies on payment of security transaction tax (STT). According to Centrum Wealth Research, long-term capital gains are exempt from tax. According to the Limitation of Benefit (LoB) clause, the 50% concession rate can be availed by those entities which spend more than ₹27 lakh or Mauritian Rupees 15 lakh on operations in the African island nation in the 12 months immediately preceding the alienation of shares. After April 1, 2019, the full domestic tax rate will be applicable to all Mauritius based firms. The latest amendments does not change the life of long-term investors because long-term capital gains are exempt from tax. Again a huge plus.
While the move is aimed towards significantly reducing instances of treaty abuse, round tripping of funds and curb tax evasion, it could change investment flows between the two nations. Mauritius has been a source of one of the highest foreign inflows into India for a very long time now, because of its tax haven status. The earlier treaty allowed capital gains on Indian shares owned by a Mauritius company to be exempted from Indian tax. A Mauritius-based company was simply taxed as per Mauritius tax laws that are extremely favourable.
In the immediate term, India could see increase in FII investments as FIIs may want to take the tax advantage and invest in Indian securities before the sunset date of April 1, 2017. But, post that, can this taxation result in slowdown in foreign money flows into India? Theoretically, may be yes, but practically, looking at the potential of returns offered by the Indian market, this clarity on taxation is likely to lead to higher inflows of longer term money, thus bringing in stability in flows. The new India-Mauritius treaty is likely to impact hot money, which comes into India with an investment horizon of less than a year. Though these short-term FII flows add to the corpus of foreign money in the country, these come from investors who make a quick exit once their money is made. Hot money tends to increase volatility in equity markets, although it does inject liquidity into the market which leads to higher depth.
India’s capital market has some great stories playing out, which deserve attention and global investment. Global investors will not be deterred by a 7.5% or 15% tax (only on short-term capital gains) from investing into names which have the potential to offer great returns in the future. If we look at the companies with high FII holdings, most of them are names which have solid fundamentals and managements and have given fantastic returns in the past. HDFC, India Bulls Housing Finance, ICICI Bank, KPIT, Indus Ind Bank, Zee Telefilms, UPL, IDFC, Apollo Hospitals, HDIL, Hathaway Cable, Axis Bank, Mindtree, Yes Bank and Infosys already have FII holding in excess of 40 percent. Many of these scrips have seen a huge spurt in the last few days ever since the new amendments were listed out. Others where the FII holding is in the high 30s — Hero Moto Corp, M & M, City Union Bank, Tech Mahindra and Glenmark — there has been frenetic activity. It is clear that the long term investor has nothing to worry about as the changes will actually clean the system.
India-Mauritius Tax Treaty
Recent news of India and Mauritius signing a Protocol to amend their 33 year old tax treaty caused seismic changes in the tax world. Though not completely unanticipated, the change is significant for foreign investors to go back to the drawing board and reassess their structures.
The tax treaty between India and Mauritius was signed in 1982 in keeping with India’s strategic interests in the Indian Ocean and India’s close cultural links with Mauritius. The treaty provides for a capital gains tax exemption to a Mauritius resident on transfer of Indian securities.
As India opened the doors of its economy to foreign investment in 1991, Mauritius became a favourite jurisdiction for channelling investments into India. Soon enough, the Indian tax officers did not appreciate the prospect of perceived letter box companies in Mauritius claiming the tax exemptions and sent tax bills to them, alleging misuse of treaty. The Government of the day, concerned about the impact of these actions on stock markets, foreign inflows and the rupee, issued a circular in the year 2000 to halt the tax officers’ actions. The party continued and Mauritius emerged as the top destination for foreign investment into India (Mauritius ranks first in terms of FDI investment into India, with 33% of the total FDI coming from Mauritius; on portfolio investment, Mauritius ranks no. 2 after the US). While the golden tap kept flowing, apprehensions on round tripping of money by Indians via Mauritius continued even as successive Governments made efforts to renegotiate the treaty.
Timing of the change – Why now? The present Government came to power promising action on black money stashed abroad. Globally too there was widespread resentment against companies failing to pay their fair share of taxes. More notably, the OECD and G20 countries’ globally co-ordinated action plan on Base Erosion and Profit Shifting (BEPS) gave a shot in the arm to the Indian Government in the renegotiation process and virtually shut hopes of a possible continuation of the capital gains exemption with a limitation of benefits (LOB) clause in place, which was the hope and expectation of the investor community. Politically, this would be viewed as an achievement for the Government.
The Government’s press release issued after the signing of the Protocol states that “the protocol will tackle the long pending issues of treaty abuse and round tripping of funds attributed to the India-Mauritius treaty, curb revenue loss, prevent double non-taxation, streamline the flow of investment and stimulate the flow of exchange of information between India and Mauritius.” The stride taken by the Government perhaps also reflects their belief in the economy and the ability to attract foreign investment without tax incentives.
What does the Protocol say?
The protocol gives India the right to tax capital gains on transfer of Indian shares acquired on or after 1 April 2017. Existing investments will be grandfathered. Further, the Protocol provides for a two year transition period upto 31 March 2019 during which the tax rates will be 50% of the prevailing domestic tax rates, subject to a LOB clause. After 31 March 2019, tax will be charged at full domestic tax rates. Capital gains on derivatives and fixed income securities will continue to be exempt.
What is impact on foreign investors?
- A significant collateral damage of the Protocol is its impact on the India-Singapore treaty; capital gains tax exemption under the India-Singapore tax treaty is co-terminus with the capital gains tax exemption under the Mauritius treaty. Capital gains arising to a Singapore tax resident from transfer of Indian shares will therefore become taxable in India with from 1 April 2017.
- Long-only funds will not be impacted as the domestic tax law currently provides for 0% tax on listed shares held for more than a year.
- Hedge funds and other short-term investors will pay a 15% short-term capital gains tax on transfer of shares (7.5% in the two year transition period); listed F&O will attract a much higher tax rate of 30%
- Private equity funds will pay long-term capital gains tax of 10%.
- For P-Note investors, this will mean an increase in cost of taking exposure to Indian shares
- For P-Note issuers, this will translate into operational challenges of computing taxes and recovery from clients.
- Mauritius will continue to remain relevant for fixed income business with tax on interest being the lowest at 7.5% under the new treaty and capital gains continuing to be exempt (subject to overcoming the GAAR challenge – GAAR comes into force from April 2017.)
- India still has tax treaties with other jurisdictions (notably a few European jurisdictions) which provide for capital gains exemption on transfer of shares and one will need to see what India’s approach will be towards these treaties and whether the foreign investors will now consider these jurisdictions for Indian investments.
- Shares acquired on or before 31 March 2017 have been grandfathered which would mean a continuance of the Mauritius structures for few more years; we may also see a possible acceleration of transactions by 31 March.
||Total FDI Inflow
||Investment by FII
||FDI (Equity Component Inflow Only)
||Total FDI Inflow
||Investment by FII
|Total FDI Inflow
|Investment by FII
||Total FDI Inflow
||Investment by FII
|Total FDI Inflow
|Investment by FII
Table Regression with Total FDI on Y Axis & FII Investment on X Axis
|Adjusted R Square
Looking at both correlation and regression results it is very clear that there is not much relation between FII Investment and Total FDI investment in India. But there is a strong correlation between total FDI and its equity component.
SHARE OF TOP INVESTING COUNTRIES FDI EQUITY INFLOWS
Country 2012-13 % Age 2013-14 %Age 2014-15 %Age
MAURITIUS 9,497 42.35 4,859 20 9,030 29.19
SINGAPORE 2,308 10.29 5,985 24.63 6,742 21.8
U.K. 1,080 4.82 3,215 13.23 1,447 4.68
JAPAN 2,237 9.98 1,718 7.07 2,084 6.74
NETHERLANDS 1,856 8.28 2,270 9.34 3,436 11.11
U.S.A. 557 2.48 806 3.32 1,824 5.9
CYPRUS 490 2.19 557 2.29 598 1.93
GERMANY 860 3.84 1,038 4.27 1,125 3.64
FRANCE 646 2.88 305 1.26 635 2.05
UAE 180 0.8 255 1.05 367 1.19
Total 22,423 100 24,299 100 30,931 100
Foreign Direct Investment in India increased by 4876 USD Million in August of 2016. Foreign Direct Investment in India averaged 1190.70 USD Million from 1995 until 2016, reaching an all time high of 5670 USD Million in February of 2008 and a record low of -60 USD Million in February of 2014.
The “Mauritius route”, which has long bedevilled India’s attempts to chase down black money and to introduce greater transparency into its financial sector, is finally set to become history. Thanks to a three-decade-old favourable double tax avoidance agreement (DTAA) with the small Indian Ocean island, it had become the favoured source for capital inflows into India. It accounted for over a third of foreign direct investment flows into India between 2000 and 2015. Some of that must have been regular global capital taking advantage of favourable routes into the Indian markets. But the suspicion persisted that a great deal of it was “round-tripping”, or black money flowing back into India. But now the government has, after renegotiating the treaty, gained the ability to tax capital gains arising in Mauritius from the sale of shares bought after April of 2017. The benefits from the treaty were also limited by the amendment. A clause in the new protocol seeks to ensure that shell companies can no longer take advantage of the DTAA — only companies spending more than Rs 27 lakh in Mauritius itself in the preceding 12 months can take advantage of the DTAA.
The signing of the Protocol is certainly a decisive move by the Government of India which puts at rest more than a decade long controversy around the Mauritius treaty. It is also in line with the Government’s agenda of tax rationalisation and simplification and moderation of tax rates while phasing out tax exemptions. The Government also deserves to be applauded for giving sufficient notice of close to a year before the change takes effect as well as providing protection to existing investments.
Significantly, this development also blunts the impact of the much condemned GAAR, which would have conflicted with the capital gains exemptions under the Mauritius and Singapore treaties.
One will need to be cautious of the impact of this development on foreign flows, at least in the near term. Most comparable jurisdictions do not tax capital gains on portfolio investments and India is unique to that extent. Policy makers will therefore need to assess the competitiveness of India’s taxation system vis-à-vis other economies.
Key takeaways from shutting down of Mauritius route are:
- End of Exemption from Indian Capital Gains Tax. Prior to the amendment, a tax resident of Mauritius was eligible for an exemption from capital gains tax in India on a sale of shares of an Indian resident company. The Protocol amends the India-Mauritius tax treaty so that such a sale will be subject to tax in India at the applicable Indian tax rates on capital gains.
- Grandfathered Transactions. Shares acquired prior to April 1, 2017 are grandfathered and will not be affected by the Protocol. Accordingly, investors can continue to invest in shares of Indian resident companies through properly structured Mauritius holding companies until April 1, 2017 and be exempt from Indian capital gains tax. As long as the shares are acquired before April 1, 2017, the exemption from capital gains tax is available regardless of when such shares are disposed of.
- Two-Year Transition Period. The Protocol provides for limited relief from full Indian capital gains taxation for a two-year transition period. Investments by Mauritius tax residents that are made on or after April 1, 2017 and that are sold prior to April 1, 2019 will benefit from a 50% reduction in the applicable Indian tax rate if a so-called “limitation of benefits” (“LOB”) article, discussed below, is satisfied.
• Limitation of Benefits (LOB) Provision. The LOB provision will be met if a Mauritius resident (i) is not a shell or conduit company and (ii) satisfies the “main purpose” and “bona fide business” tests. A resident will be deemed to be a shell/conduit company if its total expenditure on operations in Mauritius is less than Rs. 2,700,000 (approximately 40,000 US dollars) in the immediately preceding 12 months. The press release does not provide details on what constitutes “main purpose” or “bona fide business.” The LOB provision apparently is not relevant to the sale of shares in a grandfathered investment.