India and Mauritius have recently signed a Protocol revising the tax treaty between them to enable India to impose tax on capital gains derived by a Mauritius resident on transfer of shares of an Indian Company.
The curtain finally came down on the protracted negotiations between India and Mauritius as the two countries signed a Protocol on 10 May 2016 (Protocol) to amend various provisions of the Double Tax Avoidance Agreement (Tax Treaty) between them, most notably being the capital gains tax benefit to Mauritian investors on sale of shares of Indian companies.
The Tax Treaty entered into in the 1980s provided for such capital gains taxation only in Mauritius. In the absence of any capital gains tax in Mauritius, the gains were fully tax exempt. On account of this favourable tax treatment, Mauritius has over the years emerged as the largest source of FDI in India as investors have set up intermediate holding companies solely to obtain the capital gains tax exemption on exit. This kind of 'treaty shopping' has been the subject of much litigation which led no less than the Supreme Court of India to give an authoritative stamp of approval on the availability of this benefit merely on the possession of a Mauritius tax residency certificate despite not having any economic substance or fulfilling the main purpose test. The government of India, has over the years, struggled to plug this source of tax leakage which was also turning out to be a potent source of money laundering by way of 'round-tripping' of funds.
The Protocol provides for taxation of capital gains in India arising from the transfer of shares of an Indian company by a tax resident of Mauritius for shares acquired on or after 1 April 2017 in a phased manner leading to an eventual phase-out of the benefit. On the other hand, the Protocol limits the tax on income from debt investment in India to 7.5%, a rate which is most favourable as compared to any of the other tax treaties.
KEY AMENDMENTS AND THEIR IMPACT
1. Capital Gains
(a) Shares acquired prior to 1 April 2017
Capital gains arising from transfer of shares of an Indian company acquired before 1 April 2017 would not be taxable in India. The existing beneficial provision has not been altered by the Protocol. However, since the phase-out of the beneficial tax treatment has been brought in by the Protocol by way of carve-outs to the main beneficial provision, the position regarding availability of tax exemption for the shares acquired prior to 1 April 2017 stands fully clarified.
Further, though it is settled law that a Mauritian resident having a valid tax residency certificate is entitled to the benefits under the India-Mauritius Tax Treaty, tax authorities have not shied away from challenging such claims. Accordingly, now that all investments made up to 31 March 2017 have been grand-fathered under the Protocol, they would be immune from any challenge.
(b) Shares acquired on or after 1 April 2017
The Protocol which amends the current provisions of capital gains is applicable with effect from 1 April 2017.
Transition period- LoB clause protection:
Capital gains tax on transfer of shares of an Indian company acquired on or after 1 April 2017 and sold before 1 April 2019 will be half of the domestic tax rate, subject to the fulfilment of the conditions in the Limitation of Benefits (LoB) clause.
According to the LoB clause, a shell / conduit company in Mauritius will not be entitled to claim benefit of reduced tax of half the applicable rate during the period April 2017 to March 2019. A bright-line test which prescribes the threshold to claim this benefit has been provided i.e. the total expenditure on operations in Mauritius should not be less than INR 2,700,000 (US $40,000) in the immediately preceding 12 months.
Accordingly, the short term capital gains tax rate for unlisted equity shares in India would be 21.63% (maximum marginal tax rate for shares would be held for up to two years). For listed shares held for a period more than one year there would be no tax as the domestic law itself treats such gain as tax exempt. Such securities if sold after being held for one or less years would be liable to a beneficial rate of 7.5% (plus additional surcharge and cess, as applicable).
It may be noted that General Anti-Avoidance Rules (GAAR) will be applicable in India effective 1 April 2017. These rules specify the 'principal purpose' test of an investment and empower the tax officer to deny treaty benefits if the predominant purpose of the transaction is avoidance of tax. Since the LoB clause clearly intends to provide a benefit that can be undone by GAAR, the Central Board of Direct Taxes (CBDT) would need to issue necessary circulars or instructions to its officers in this respect to prevent denial of treaty benefits despite having fulfilled the LoB clause requirements.
After transition period-complete removal of capital gains tax benefit:
The most significant amendment of the Protocol is the removal of capital gains tax benefit for sale of shares of an Indian company which are acquired on or after 1 April 2017 and sold on or after 1 April 2019. Capital gains arising from such sale will be fully taxable as per the Indian Income Tax Act, 1961.
The current capital gains tax rates (post enactment of the Finance Act of 2016) for sale of investments made on or after 1 April 2019 and where the acquisition was done on or after 1 April 2017 are as below:
Click here to view the table
(c) Gains from residual category of assets
The final amendment in respect of capital gains taxation brought in by the Protocol relates to gains arising from residual category of assets. The Protocol provides that the capital gains which do not fall under any of the specified clauses will be taxable in the country of residence of the seller.
This clause would be applicable to sale of debt instruments like debentures, hybrid instruments like compulsorily convertible debentures and shares of a foreign company that has underlying Indian assets. Accordingly, in case of indirect transfer of Indian assets by way of a sale of shares of a foreign company or sale of debentures by a Mauritius resident, it may still be possible to claim tax exemption in India under the residual clause. Of course, the tax officer can always invoke GAAR after 1 April 2017 to determine if the transaction is primarily driven by the motive of avoidance of tax. The government has made a promise that investments made before 1 April 2017 would be grandfathered and would not be subject to the rigours of GAAR (though no statutory changes have been brought).
(d) Impact on the India Singapore tax treaty
The India Singapore tax treaty provides for capital gains tax benefit similar to the India Mauritius Tax Treaty. This benefit is subject to a LoB clause specified in the India Singapore tax treaty.
The protocol to the Indian Singapore tax treaty (Article 6) which provides capital gains benefits specifies that the benefit will remain in force so long as the India Mauritius Tax Treaty provides that any gains from the alienation of shares in any Indian company will be taxable only in Mauritius. Accordingly, the capital gains tax exemption in India on sale of shares of an Indian company by a Singapore resident entity would end on 31 March 2017. The limited benefits of reduced tax rate of 50% of the specified rates for two years provided in the Protocol would not be available under the India Singapore Tax Treaty. More significantly, the grand-fathering benefit available under the Mauritius treaty would not apply to the Singapore treaty unless the treaty is specifically amended to this effect.
It may be noted that the Indian government is in the process of renegotiating the India Singapore Tax Treaty as well, and additional benefits and conditions may possibly be agreed upon by the two governments.
(e) Other beneficial tax treaties
The capital gains provisions in other beneficial tax treaties of the Netherlands and Cyprus are independent of the India Mauritius Tax Treaty, unlike the India Singapore Tax Treaty.
The India Netherlands tax treaty provides for capital gains exemption to a Dutch resident on sale of shares of an Indian company. The benefit is not available if the Dutch resident holds more than 10% shares and the transferee is an Indian resident. However, if the sale is made in the course of a group restructuring, then even if the sale is made to an Indian resident and the seller holds more than 10% of the shares in the company, there would be no capital gains taxation under the India Netherlands tax treaty. Of course, post 1 April 2017, GAAR would allow tax authorities to apply the 'main purpose' and 'bonafide business' tests to allow or deny the treaty benefits. The Indian government is engaged in re-negotiating the India Netherlands tax treaty so as to end the capital gains tax benefit and it would not be surprising to expect an outcome similar to the Tax Treaty.
Similarly, the India Cyprus tax treaty provides for an exemption from tax on capital gains on sale of shares of an Indian company. However, Cyprus has been notified by the Indian government as a non-cooperative jurisdiction on account of non-exchange of information under section 94A of the Income Tax Act, 1961. Though, such notification allows for punitive tax treatment of payments and transactions made with Cyprus residents, it does not allow the Indian tax authorities to deny the treaty benefits in respect of capital gains. Despite this legal position, tax authorities in India have taken a view that post the black-listing of Cyprus, capital gains arising to a Cyprus resident on sale of shares of an Indian company are liable to capital gains tax in India. A constitutional challenge to section 94A of the Income Tax Act, 1961 has failed before one of the High Courts. Accordingly, the Indian tax authorities will continue to challenge any exemptions claimed under this treaty till the time there is a Supreme Court decision or the government issues a clarification. The governments of India and Cyprus are engaged in negotiations regarding the treaty and the notification issued under section 94A.
2. Interest Income
For a debt investment made by a Mauritian resident in an Indian entity, India can tax the interest income but at a concessional tax rate of 7.5% of the gross amount of interest. Interest income of Mauritian banks from debt investment up to 31 March 2017 in India will be exempt from income tax in India. On or after 1 April 2017, the interest income of Mauritian banks would also be taxable at 7.5%.
Prior to this amendment, a debt investor from Mauritius was not granted any relief in the Tax Treaty. Accordingly, the tax rate under the domestic law was applicable (maximum marginal rate being 43.26%). The concessional tax rate of 7.5% on interest introduced by the Protocol is the most beneficial rate as compared to any of the other tax treaties entered by India. Other tax treaties prescribe a tax rate of 10% to 20% on interest income.
It is worthwhile to note that the press release of the Indian government had stated that this amendment would apply to Mauritius banks only. However, the text of the Protocol provides for the applicability of the concessional tax rate to all beneficial owners of interest. However, entities set up in Mauritius solely to obtain the benefit of concessional tax rate on interest could be challenged under the 'beneficial ownership' test and under Indian GAAR provisions.
3. Fees for Technical Services (FTS)
The concept of fees for technical service has been introduced in the Tax Treaty. As per the amendment, any FTS (for services rendered by a Mauritian resident) arising in India, will be taxable in India at 10% of the gross consideration. For this purpose, FTS has been defined to mean any payment for managerial, technical or consultancy services, including the provision of services of technical or other personnel. This provision is applicable for income arising on or after 1 April 2017.
The Indian courts have in the past held that in the absence of an FTS article in the Tax Treaty, FTS income of a Mauritian resident is not taxable in India. This amendment seeks to tax such services.
The definition of FTS, which is the same as the definition provided in the Income Tax Act, 1961, is widely defined unlike some tax treaties which provide for a restrictive definition by way of a 'make available clause'. However, FTS provided by a permanent establishment (PE) will be taxable as business income of the PE (and not at the tax rates provided for FTS).
4. Concept of Service Permanent Establishment (PE) Introduced
The Protocol has introduced the concept of a service PE in the Tax Treaty. As per the service PE clause, services of any kind which are rendered by a Mauritian resident (in India) for a period aggregating more than 90 days, within any 12-month period, will constitute a PE in India. This provision will impose tax on income derived by a Mauritian resident in India on or after 1 April 2017.
This concept of a service PE is akin to what is provided in the India USA tax treaty, and in the UN Model convention. The India USA tax treaty and the UN Model convention specify that for a service PE to be formed, the service provider must render the service in the source country. However, curiously enough, the India Mauritius Tax Treaty does not provide for this condition. Consequently, a literal reading of the amendment may lead to an awkward result as a service provider who is providing services from and at Mauritius to India for a period of over 90 days or more may constitute a taxable PE in India. Further, it is important to note that any service, whether or not it qualifies as a fee for technical service / royalties, may lead to a formation of a PE, if the time test is satisfied.
5. Other Income
From 1 April 2017, 'Other Income' (i.e. income that has not been specifically addressed in the Tax Treaty) which falls in the residuary category will be taxed as per the domestic law of each country.
Previously, the residuary category of income was taxable only in the country of residence of the recipient of such income. As a result, income in the nature of FTS, deemed income (arising on receipt of shares for less than adequate consideration under section 56 of the Income Tax Act, 1961) and certain other residuary categories of income, were not taxable in India under the Tax Treaty. The Protocol now provides taxing rights to both, the country of residence and the source country from where such other income is earned, thereby allowing India to exercise its taxing rights as a source country to tax such income in India.
6. Exchange of Information
As per the amendment, the Contracting States shall exchange information as may be relevant for implementing the purposes of the Tax Treaty and the domestic tax laws.
Further, the amendment mandates that any information exchanged by the Contracting States must be treated as confidential in the same manner as information obtained under the domestic laws of the concerned state and can be disclosed only to persons or certain specified persons / authorities concerned with the assessment or collection of taxes. The Protocol allows the disclosure of such information in public court proceedings or in judicial decisions. It is expected that this change will update the practice of exchange of information as per international standards.
While the loss of tax benefits currently available under the Tax Treaty and the India Singapore Tax Treaty will be lamented by foreign investors, the protection accorded to investments made prior to 1 April 2017 by way of grand-fathering, the phased manner of withdrawal of benefit and introduction of beneficial tax rates on interest, demonstrate the desire of the Indian government to make the transition as gradual as possible.
Further, re-negotiation of beneficial tax treaties and other concrete steps taken by the Indian government indicate its intention of achieving a stable tax regime. The stated tax policy of the government is to plug tax leakages while providing a certain and predictable tax landscape to investors.
In the long run, stability, predictability and fairness of the tax system can prove to be far more attractive and reassuring to a foreign investor than a tax sop grounded in interposing of shell entities. The consensus in the international tax community as reflected in the Base Erosion and Profit Shifting (BEPS) project recommendations of the OECD also point towards the same goal.