Significant concern has been expressed regarding shell companies taking shelter of the India-Mauritius tax treaty to avoid paying taxes in India. The Indian government has made several efforts to renegotiate its three-decade old tax treaty with Mauritius. In what can be termed as a “bold step,” India has redrawn its treaty with Mauritius by inking a protocol to the tax treaty.
Amongst other things, the key changes include: (1) source-based taxation of capital gains on shares; (2) insertion of the Limitation of Benefit clause; (3) source-based taxation of interest income of banks; and (4) source-based taxation of ‘other income’ which, as till date, is exempt in India.
India will assume the right to tax the capital gains arising from alienation of shares acquired on or after April 1, 2017, in a company resident in India with effect from financial year 2017-18. Protection has been granted to investments in shares acquired before April 1, 2017, as these investments have been grandfathered. In addition, the fact that the amendment will not take retroactive effect is a silver lining, in what otherwise appear to be dark clouds over the Mauritius tax treaty.
To soften the blow, capital gains tax is proposed to be applied in a phased manner, where the tax rate will be 50% of the normal rate for capital gains arising from April 1, 2017, to March 31, 2019, and thereafter tax would be levied at the full rate. The benefit of reduced tax rate of 50% is, however, subject to fulfilment of certain Limitation of Benefit conditions, which require a Mauritian resident not to be a shell/conduit company—i.e. have an operating expenditure in Mauritius in the last 12 months of at least R2.7 million—and satisfy the “main purpose” and “bona fide” business test. The benefit of the lower rate is available only for purchases and sales made from April 1, 2017, to March 31, 2019. Purchases made after April 1, 2017, but sold after March 31, 2019, will be subject to normal tax rates.
The efforts of the Indian government must be lauded for providing a clear roadmap and bracing investors for a benign and smooth transition from a zero tax regime to a full tax regime. However, there are certain issues that need to be ironed out.
For example, withdrawing the India-Mauritius capital gains tax exemption may have collateral impact on the India-Singapore tax treaty. Consequently, capital gains earned by a Singaporean resident from transfer of shares of an Indian company may be subject to tax in India at the full rate. Further clarification on the impact of this development on the India-Singapore tax treaty will be welcome—for example, if the Singapore protocol is no longer in force, does one automatically fall back on the provisions existing in the treaty prior to the protocol coming into force?
In addition, allocation of capital gains taxing rights to India is only in respect of shares. Therefore, capital gains arising to a Mauritian resident from transfer of other instruments such as derivatives, debt, etc, may continue to be exempt. Also, it appears that an indirect transfer of shares of a foreign company whose value is derived substantially from Indian assets may still not be taxable because the scope of protocol is limited to shares of an Indian company.
Another concern is what constitutes total operating expenditure in Mauritius. Typically, this should include amounts paid to non-Mauritius vendors as well. Foreign portfolio investors earning short-term capital gains tax are likely to be severely impacted and the cost of P-Note instruments will rise due to the tax cost.
These amendments will have a significant impact on inbound investment activity in India. It is imperative that investors in these jurisdictions analyse the potential impact of these changes. Only time will tell if the Indian investment structures will be plain vanilla going forward or become even more complex.
By renegotiating the Mauritius tax treaty, the government has moved an inch closer towards the implementation of the Base Erosion and Profit Shifting (BEPS) initiative targeting treaty abuse. In addition, by notifying the proposed changes one year in advance, the government has demonstrated its seriousness on tax reforms, providing certainty, clarity and addressing concerns on the ease of doing business in the country.
(Assisted by Siddharth Ajmera, manager, and Ketki Shah, associate, Tax, PwC) The author is tax partner, PwC