Introduction

On 10 May 2016, the Indian and Mauritian governments signed a protocol amending the current India-Mauritius double tax treaty (the “Tax Treaty”), as disclosed in their press release (the “Press Release”).  The Press Release outlines a number of changes to the Tax Treaty, which are to be brought into effect by a protocol (the “Protocol”) which aims to reform the tax regime for transactions between India and Mauritius.  Whilst the Protocol makes a number of amendments to the Tax Treaty, the changes made to India’s right to tax capital gains have the greatest potential to impact FDI and so will be the focus of this article.  The policy objective of the changes to the Tax Treaty is to prevent companies from using the Tax Treaty to erode the tax base in India.  Whilst the reform is in line with a wider move to a more transparent system of taxation, it is unclear as yet what effect the Protocol will have on the Indian economy, which attributes a substantial proportion of its FDI inflow to companies based in Mauritius. Such companies were responsible for a reported $9.03bn of FDI into India in the 2015 financial year. 

The Agreement

The Tax Treaty has been in force since 1983.  Under its present terms, the Tax Treaty allows Mauritius tax resident companies, including companies whose ‘place of effective management’ is located in Mauritius, to dispose of their shares in Indian companies without any Indian (or indeed under Mauritius law, Mauritius) tax on capital gains.  As a result of these tax rules, a number of the largest companies investing in India do so through Mauritian based structures.

The Tax Treaty received criticism when, in 2013, the Supreme Court of India heard a petition filed by an Indian NGO, Azadi Bachao Andolan (the “Azadi Case”), alleging that the Indian government’s entry into the Tax Treaty contravened India’s sovereignty in relation to taxation.  The Supreme Court did not uphold the petition, reasoning that India had entered into the Tax Treaty knowingly and with the understanding that it would incentivise foreign investment in the Indian economy.  The Supreme Court in the Azadi Case found that the government was entitled to permit the avoidance of double taxation, even if no tax was levied in the other (investor) country.

Amendments

Policy

Attracting foreign investment remains a priority for India, with liberalised FDI policies being promoted by the government in initiatives such as ‘Make in India’.  However, there has been a move away from using tax treaties as a pull factor for investment, particularly given the concern that a number of companies were using a Mauritius base as a facade in order to benefit from more favourable taxation in India.  This is a significant step away from the ruling in the Azadi Case where the Supreme Court noted that there were a number of benefits for India from allowing companies to rely on treaty shopping.  The Supreme Court in the Azadi Case stated that the fact that investments may be routed through Mauritius by investors to take advantage of better treaty terms should not be a reason to inhibit the application of the Tax Treaty as long as the company was resident in Mauritius.  The move away from this position is in line with the wider global efforts to implement a framework against base erosion and profit sharing (“BEPS”), assisted by the OECD and launched by the G20.  In large terms BEPS seeks to ensure that profits are taxed where the activities generating those profits are taking place.  India, together with a number of other countries, has shown strong support for BEPS, as it seeks to deal with treaty shopping and treaty abuse.

Moving on from Azadi

The Press Release states that, under the Protocol, India will be able to levy Indian capital gains tax on Mauritius resident companies on a disposal of shares in an Indian company, thus taxing capital gains at source.  The measure specifically targets the situation where a company routes its investment in an Indian company through a company based in Mauritius purely to take advantage of the current favourable provisions of the Tax Treaty, with the effect that India is unable to tax the Mauritius resident company on any divestment gains. 

Phased movement

The Press Release discloses that source based taxation will be implemented prospectively, and in phases, as follows:  

Click here to view table.

The capital gains arising from a disposal of shares in an Indian company will not be subject to Indian capital gains tax, and will continue to fall within the protective remit of the Tax Treaty, to the extent those Indian shares are acquired by a company on or before 31 March 2017.  During the Transition Period, a disposal of Indian shares by a Mauritius company will be subject to Indian capital gains at 50% of the standard domestic Indian tax rate, if the seller satisfies the requirements of the new limitation of benefits (“LOB”) article of the Tax Treaty, discussed below.  From the beginning of the Implementation Period, the LOB provisions will no longer apply and Indian capital gains tax at 100% of the Indian domestic rate will apply to gains from the disposal of shares of Indian companies acquired by a Mauritian resident company on or after 1 April 2019. 

LOB article

During the Transition Period, in order for the rate of Indian capital gains tax to be reduced to 50% of the Indian domestic rate, Mauritian companies must meet a number of reasonably demanding requirements, which aim to prevent the use of holding companies in Mauritius for treaty shopping purposes.  Companies who are tax resident in Mauritius must meet (i) a main purpose test; and (ii) a bona fide business test in order to satisfy the requirements of the new LOB article.  The Press Release states that a company tax resident in Mauritius will not be considered to have satisfied the LOB article’s requirements if that company’s “total expenditure on operations in Mauritius is less than Rs. 2,700,000 [around £27,935]… in the immediately preceding 12 months”.

GAAR

In addition to the Protocol, as part of tax based measures to boost growth set out in India’s recently announced 2016-2017 budget, the government reiterated its commitment to implement general anti-avoidance rules (“GAAR”), which were introduced by the Indian Finance Act 2013 but have been deferred until 1 April 2017.  The policy incentive behind GAAR is similar to that behind the Protocol and is in line with the wider aims of BEPS to homogenise taxation policy and to ensure that companies are responsible for taxation generated by their activities where those activities are carried out.  With GAAR set to come into force at the same time as the Transition Period, companies structured in order to take advantage of the current Indian tax legislation should investigate how the reforms are likely to impact their business model.

India-Singapore Tax Treaty

A tax treaty was also entered into between India and Singapore in 1994 (the “India-Singapore Treaty”). The India-Singapore Treaty prevents India from taxing capital gains derived by residents of Singapore from the disposal of Indian shares.  Article 6 of the protocol to the India-Singapore Treaty states that exclusive residence country taxation in respect of such gains will apply while the Tax Treaty with Mauritius continues to provide for the same.  The amendments to the taxing rights regarding capital gains brought about by the Protocol to the Tax Treaty with Mauritius may therefore mean that the India-Singapore Treaty will also no longer provide for exclusive residence country taxation regarding capital gains on shares.  In response to queries over the status of the India-Singapore Treaty, Indian officials have stated that this treaty is being renegotiated, a process which can take a significant amount of time and may mean a period of uncertainty for investors.

Conclusion

The changes to the Tax Treaty through the Protocol form part of a wider tax reform effort to clamp down on tax avoidance in India.  With the forthcoming impact of GAAR already having an effect on FDI into India, it is likely that further movement will be seen as a result of the Protocol.  Whilst the long term impact of the Protocol and the enactment of GAAR on FDI into India is likely to bring the Indian economy further into line with other global economies and homogenise the environment for FDI, a period of uncertainty for companies investing in India and operating in Mauritius is likely, until the effects of GAAR and the Protocol are fully understood.

It is likely that a number of investors benefitting from the Tax Treaty and the India-Singapore Treaty will begin to look elsewhere for treaties which offer similar tax protections.  Very few treaties with India offer exemptions from Indian tax on capital gains in the same way as the Tax Treaty and the India-Singapore Treaty.  Investors may begin to consider the Netherlands as an alternative to Mauritius or Singapore as the tax treaty between India and the Netherlands contains provisions which allow companies resident in the Netherlands to avoid Indian capital gains tax on a disposal of Indian shares to non-residents and to residents and non-residents if the transferor holds a total of no more than 10% of the shares in the Indian company.