Protocol Amending India-Mauritius Tax Treaty

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 (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 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.

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.

(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 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 20%. 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:

Listed

Short Term: 15%
Long term: Exempt
Criteria for qualifying as long term: More than 1 year

Unlisted

Short term: 10%
Long Term: 40%
Criteria for qualifying as long term: More than 2 years

(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 only 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, shares of a foreign company that has underlying Indian assets and arguably derivate instruments. 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, it needs to be seen whether the grand-fathering benefit available under the Mauritius treaty would apply to the Singapore treaty.

(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.

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. A constitutional challenge to the government's notification is pending before the Supreme Court.

The Indian government is engaged in re-negotiating the tax treaties with Singapore, Netherlands and Cyprus and it would not be surprising to expect an outcome similar to the Mauritius Tax Treaty.

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. 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.

3. Concept of Fees for Technical Services (FTS) & Service Permanent Establishment (PE) introduced

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.

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.

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.

LOOKING FORWARD

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.

(Ayush Tandon, a Senior Associate at Trilegal, contributed to this article)