On 30 December 2016, the governments of India and Singapore signed the Third Protocol to amend the Double Taxation Avoidance Agreement (“DTAA”) between the two countries. The amendment has been outlined in press releases made by the respective governments (“Press Releases”) and will come into effect from 1 April 2017.
The amendment of the DTAA is part of a recalibration of Indian fiscal policy, and follows a series of steps taken by the Indian Government to increase the country’s tax base. In June 2016 we reported on the amendment of the India-Mauritius double tax-treaty, and briefly set out the legal and economic context behind India’s tax policy towards foreign direct investment (“FDI”). This Law-Now article can be read here. Whilst the Third Protocol implements a number of changes to the DTAA, this article will focus on the changes made to India’s right to tax capital gains. These changes are the most significant for FDI between the two countries.
The DTAA came into force in 1994, and was modified by protocol in 2005 and 2011. Its current construction prevents India from taxing capital gains derived by residents of Singapore on the disposal of Indian shares. Until the 2017 changes come into effect, Singaporean resident companies disposing of shares in Indian companies would therefore pay capital gains tax only in Singapore. The DTAA was originally designed to increase FDI inflows into India, during a period of relatively low FDI in India. According to World Bank data, net FDI inflows to India did not exceed $1 billion in 1994 and rose to $7.3 billion by 2005. Both figures are significantly less than the $44 billion of net inflows in 2015. With such change in the investment landscape, the policy justification for amending the DTAA is clear.
The Press Releases set out the key changes to the DTAA. From 1 April 2017, India will levy capital gains tax on the sale of Indian company shares held by Singaporean resident companies. Accordingly, the taxation of such company shares is being moved from residence based criteria to taxation at source. Similarly to the recent changes to the India-Mauritius double tax-treaty, the changes will be implemented prospectively, and in stages:
1. Stage 1 – the amended DTAA preserves the current tax exemption on capital gains of shares held by Singaporean resident countries acquired before 1 April 2017. This is referred to as ‘grandfathering’ in the Indian Government press release.
2. Stage 2 – from 1 April 2017 to 31 March 2019, transition measures apply. The Press Releases state that capital gains on shares in Indian companies acquired by Singaporean resident countries will be taxed at 50% of India’s domestic capital gains tax rate, provided the gains arise between 1 April 2017 to 31 March 2019. To benefit from this reduced rate, the relevant shares must be bought on or after 1 April 2017 and be sold before 1 April 2019.
This 50% reduction in tax is conditional on the fulfilment of the Limitation of Benefits conditions provided for in the Third Protocol. This includes the requirement that expenditure on operations of the investor company in its residence state must be at least S$200,000 in the case of a Singaporean entity, in the preceding 12 month period from the date on which the gains arise. This condition is designed to limit any tax reduction for shell companies.
3. Stage 3 – from 1 April 2019, capital gains made will be taxable at the full Indian domestic rate, subject to the grandfathering protection described at stage 1.
Following the recent amendments to India’s tax treaties with both Mauritius and Cyprus, and the context of wider tax reform, change to the DTAA was expected. Investors expecting such change will welcome the Press Releases, for the certainty which has now been provided. Whilst increased certainty facilitates long term investment planning, it is unlikely that investors in India will benefit from such generous tax protections under treaties with other countries. The Netherlands is considered one alternative conduit for investment in India, as the tax treaty between India and the Netherlands offers some protection to companies resident in the Netherlands in relation to Indian capital gains tax on the disposal of Indian shares.