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Straight from the Specialists

Getting a handle on the Mauritius tax treaty

By Vishal Shah and Smit Sheth
July 11, 2011

(The views expressed in this column are the authors’ own and do not represent those of Reuters)

Mauritius has for long been the most prominent jurisdiction for investing into Indian markets, particularly under the Foreign Institutional Investor (FII) portfolio route.

One of the key reasons for investors preferring Mauritius has been the beneficial India-Mauritius Tax Treaty which exempts capital gains arising upon exit from Indian equities. Just to have a scale of reference, as much as 40 pct of the portfolio (FII) investments and more than 42 pct of strategic investments (FDI) come into India from Mauritius-based investors, beating larger peers like the U.S., UK, Singapore, Germany convincingly.

Treaty – bone of contention

As much as Mauritius has been the preferred base for India-bound investors, its tax treaty with India has been an equally prominent subject matter of tax debate and litigation in the country.

Undoubtedly, any whispers about the tax treaty evoke a chain of reactions starting from the tax office to investors, to stock markets and eventually the government. Simply given the amount of investments at stake, this is not surprising.

Recently, a similar rhetoric revolving around the renegotiation of the tax treaty (to eliminate the capital gains tax exemption for investors) evoked similar reactions and ultimately it needed the finance ministry to calm the nerves of jittery markets.

It was no different back in 1998 as well, when tax authorities sought to deny the Mauritius treaty and tax a bunch of Mauritius-based FIIs on capital gains on Indian equities. The reactions triggered a sharp 10-15 pct collapse in the Indian stock market in two days, with the finance ministry pushing the apex tax body — Central Board of Direct Taxes — to issue a circular granting treaty benefits to investors holding a valid Mauritius Tax Residency Certificate. It calmed the markets at that point but the matter did not end.

The circular was challenged under a public interest litigation before the courts and the drama carried on for 3-4 years before, finally, the Supreme Court upheld the tax circular in 2003.  One thought that would be the end of it.  As it turns out, that was not to be.

Repeatedly, the tax office seeks to debate the matter (various cases like E*Trade, etc.) and the uncertainty continues, despite consistent disposition of the issue in favour of investors by judicial authorities, including the Authority for Advance Ruling, as also the apex Supreme Court.

The intent of the Indian tax authorities to get a handle on the issue is not fully misplaced with governments globally seeking its due share of the pie (taxes). Investment jurisdictions with no or wafer-thin substance have been under the lens.  However, what foreign investors would look up to is a matured response in handling it as against sporadic events leading to a lot of uncertainty.

Here are the following options, which the government/tax authorities seem to be tapping into.

Renegotiate the treaty

This, by far, appears to be the most logical option. The issue really is the ability of the Indian government to have Mauritius agree to a treaty amendment, which either completely eliminates the capital gains tax benefit or restricts it to Mauritius resident investors (in the real sense, eliminate it). In either case, the impact for FIIs is the same i.e. no capital gains tax advantage under the treaty.

Incidentally, gains on long-term shares (held >1 year) from stock exchange sales (STT paid) are exempt from tax even under the domestic law.  Thus, in the listed equity sphere, the renegotiation should impact only short-term capital gains (shares held <1 year) and off-market deals (short term or long term). Currently these are being taxed at 15 pct and 10 pct/40 pct respectively.

One would possibly consider this as a long-term positive for Indian markets, given that this would be a deterrent only for the short-term investors, bringing in the so-called “hot money”. The long-only investment flows, in other words, should not be impacted.

It has been observed that even smaller countries do give a tough time when it comes to treaty re-negotiation. In the context of the UAE tax treaty, authorities were successful to amend a similar favourable capital gains clause. The political question of convincing Mauritius remains. And this has not proven to be an easy task in the past.

New Direct Taxes Code (DTC)

The government also seems to have made an attempt to unilaterally override Mauritius-like treaties under the proposed DTC, on the grounds of alleged misuse/treaty shopping. The much-talked about General Anti-Avoidance Rules (GAAR) under the DTC provides a handle to tax authorities to ignore the Treaty if tax avoidance is the prime objective. Obviously, the government is likely to come with a set of guidelines in applying the GAAR rules — whether impacts past investment or not, would a substance-test be applied, etc.  Obviously, with the future of DTC itself up for question (given the policy paralysis at the centre), this approach also lacks clarity and a concrete timeline.

Unilateral Termination

While this may seem an option, the possibility thereof looks very remote. A bilateral treaty between two countries (more for a preferred investor partner like Mauritius) is unlikely to meet this fate.

Conclusion

At this stage, legally speaking, a Mauritius investor holding a valid TRC is entitled to avail the capital gains tax benefit under the Treaty.  At the ground level, it is likely that the tax authorities will keep up its ante as it seems to be challenging the E*trade case before the apex court.

If one has to view the impact of re-negotiation (assuming it happens), the same should be for short-term “hot money” only, as long-term capital gains is anyways exempt. Also, probably, clearing the air one “final time”, even if it means a tax imposition, will only add to investors’ comfort on India’s tax policy and probably have a long-term positive impact for fund flows into India.  This seems some time away though.

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