India and Mauritius are likely to begin renegotiating the current India- Mauritius Double Taxation Avoidance Agreement (the “DTAA”) in the near future. The DTAA provides for the assessment of a capital gains tax on an investor only in the country of such investor’s residence. Mauritius-based companies that invest in India pay no capital gains because such income is tax exempt under the domestic laws of Mauritius. For this reason, many foreign investments in India are channeled through a Mauritius subsidiary.
The Indian government recognizes that an estimated US$600 million of untaxed money flows out of India to foreign investors annually as a consequence of the DTAA, and the ability to increase tax collections without directly burdening domestic taxpayers appears to be too tantalizing for the Indian government to ignore, regardless of the indirect consequences of such action. In particular, a portion of the Indian political establishment argues that businesses engage in impermissible tax avoidance by misusing the provisions of the treaty. The revision of the DTAA could have a significant impact on foreign investors’ returns on their Indian investments, which may in turn necessitate a reevaluation of foreign investors’ strategies for structuring investments in Indian businesses.
Current Benefits at Issue
The DTAA became effective on April 1, 1983 for the purpose of (1) avoiding the imposition of double taxation, (2) preventing fiscal evasion, and (3) encouraging mutual trade and investment. Article 7 of the DTAA stipulates that the profits of a company formed in India or Mauritius (each is a “Contracting State” or “State”) are to be taxed in such company’s State of formation unless that company (an “Enterprise”) conducts business in the other Contracting State through a permanent establishment situated in such other Contracting State.i
Article 13 of the DTAA limits the taxation of capital gains by the Contracting States. Article 13 provides that gains from the sale of:
- immovable property may be taxed in the Contracting State in which such immovable property is situated;
- movable property forming part of the business property of a permanent establishment that an Enterprise has in a Contracting State may be taxed by such Contracting State; and
- ships and aircraft operated in international traffic and movable property pertaining to the operation of such ships and aircraft may be taxed by such Contracting State in which the place of effective management of the Enterprise is situated.
All other gains derived by an Enterprise from the sale of property other than those specifically mentioned above are taxable by the Contracting State in which such Enterprise was formed and may not be taxed by the other Contracting State.
Capital assets can be short-term or long-term capital assets under India’s Income Tax Act (the “ITA”). Shares held as capital assets held for a period of less than 12 months are short-term capital assets, and shares held for longer than 12 months as capital assets are regarded as long-term. The tax rate on the gain from the sale of short-term capital assets recognized by foreign investors can be between 15% and 40%, while the tax rate for gains on long-term capital assets can be between zero and 20% for these investors. These rates my be reduced to zero when earned by an Enterprise holding a Category 1 Global Business License (a “GBL1”). Under Mauritius law, a GBL1 is able to benefit under the DTAA because Mauritius does not impose a tax on capital gains or levy any withholding tax on any gains, dividends, or interest derived by a GBL1. Accordingly, a GBL1 can claim benefits under the DTAA and pay no capital gains tax in either India or in Mauritius.
The Indian Argument
Indian companies have benefited, and continue to benefit, from the DTAA with respect to their investments in certain African countries by investing through Mauritius, because Mauritius has negotiated preferential trade agreements with many of these African countries. However, during the period in which the DTAA has been in force, Mauritius has transitioned from an offshore banking jurisdiction to an offshore holding-company jurisdiction often utilized by foreign investors making investments into India.
This change in purpose has generated some concern that the DTAA is now being used for unacceptable tax avoidance by foreign and, perhaps more importantly, Indian investors. Currently, an estimated US$600 million of profits flows out of India to foreign investors without taxation in India or Mauritius as a consequence of the DTAA each year. Some Indians argue that these foreign businesses are utilizing the DTAA in a manner that should be considered impermissible tax avoidance. Additionally, some Indians argue that some Indian residents may be abusing the DTAA by channeling their investments in Indian businesses through Mauritius. These types of investments have been dubbed “round-tripping transactions” because the money begins and ends in India.
India has petitioned Mauritius on multiple occasions to renegotiate the DTAA. It is widely reported that India and Mauritius have agreed to renegotiate the treaty in the second or third week of December 2011. India has reportedly finalized the agenda, but its precise posture on the capital gains elements of the DTAA is not publicly available.
It is possible that India may not ask for the complete elimination of the capital gains exception, but the revision of the capital gains exception is most likely the prime motivating factor behind India’s push to renegotiate the DTAA. It appears that fighting “round tripping” will likely be a key area of focus. Mauritius already uses its anti-money laundering process to attempt to minimize round-tripping, but India apparently believes this is no longer adequate to police perceived abuses. To the extent that India focuses more on such domestic tax abuses without pressuring Mauritius to revise the capital gains exception in such a way that would impact foreign investors may be a welcome outcome for foreign investors, but the scope of the revisions that India plans to pursue or that Mauritius might be willing to agree to are also not publicly available.
The DTAA may be revised to introduce provisions mandating the exchange of certain information on banking transactions and a limitation-on-benefits (“LOB”) clause to restrict the benefits of the treaty. The scope of a LOB clause will likely be one of the key elements of the negotiations. The LOB may be revised to require a foreign company to be listed on a recognized stock exchange in its state of residence (i.e., Mauritius) or that a foreign company must have total expenditures of at least US$200,000 in its state of residence (i.e., Mauritius) for at least two years before the date on which a capital gain arises in order to claim treaty benefits. Such residency requirements would mirror those set forth in the Double Taxation Avoidance Agreement between India and Singapore (the “India-Singapore Tax Treaty”). It is important to note, however, that the capital-gains tax benefits set forth in the India-Singapore Tax Treaty as amended in 2005 will remain in force only as long as the DTAA between India and Mauritius provides that any gains from the transfer of shares in a company that is a resident of either India or Mauritius shall be taxable only in the country in which the transferor is a resident.
Even if the elements of the DTAA that make Mauritius a preferred investment channel into India for foreign business remain untouched, certain provisions of the new Direct Tax Code (the “DTC”), which is slated for implementation from April 1, 2012 and will replace the ITA, are designed to addressed perceived abuses of the DTAA. General Anti- Avoidance Rules (“GAAR”) are included in the proposed DTC, which will subject investors claiming treaty benefits under the DTAA to a commercial substance and bona fide business purpose test. Under GAAR, Indian tax authorities will be empowered to declare any “arrangement” as an “impermissible avoidance arrangement” if a ownership or investment structure has been implemented that, in whole or in part, has the main purpose of obtaining a “tax benefit.” The burden of proof will be on the investor whenever an investment structure is challenged under GAAR, as an “arrangement” will be presumed to be for obtaining tax benefits unless the investor demonstrates that obtaining a “tax benefit” was not the main objective. Whether the DTC, a domestic Indian law, would override the DTAA, a treaty, is an issue that may not be settled until the middle of 2012. However, the resolution of any conflict may be that the DTC’s GAAR and the DTAA will be interpreted as complementary, and not conflicting, laws.
Current Regulatory Uncertainty
Today, Indian law regarding the application of the DTAA is clear, and the Indian Supreme Court has ruled that capital gains realized by foreign investors on their investments in India through Mauritius companies are exempt from Indian tax by virtue of the DTAA. Despite this clarity, significant tension exists between the law and its application by Indian tax authorities. The threat of disputes with Indian tax authorities regarding the applicability of the DTAA to foreign investments channeled through Mauritius is not insignificant. With the renegotiation of the DTAA looming and the imposition of GAAR on the horizon, certain Indian tax authorities feel empowered to question transactions that are clearly permitted by the DTAA and Indian law as judged by the Indian Supreme Court. Consequently, it appears that Indian taxation of capital gains realized by foreign investors through their Mauritius entities will remain uncertain in the near future, and the potential for related disputes with Indian tax authorities may increase until the renegotiation of the DTAA has been completed and the interpretation of GAAR is settled.
Once the DTAA discussions are completed and the DTC regulations become available, we will have a clearer picture of India’s revamped taxation system and related tax planning opportunities for foreign investors. In order to satisfy both substantive-activity and investment-threshold requirements, pooling investments in a Mauritius fund might ultimately prove to be a successful strategy for foreign investors seeking the benefits of the DTAA To do so, foreign investors seeking treaty benefits may wish to increase their substantive presence in Mauritius and grant more independence and control to their Mauritius operations. Additionally, in order to minimize the risk posed by India’s frequent regulatory changes, foreign investors might consider purchasing tax-insurance policies to safeguard the tax benefits of their Indian investment structures.