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The Mauritius Advantage—DTC

Posted By cmadevarajan On July 4, 2011 @ 8:11 am In Taxation | No Comments

 This is a post by Indraneel Sen Gupta. He is a financial, economic writer and research analyst.

The Mauritius Treaty controversy … debated, discussed and beaten to death, but still unresolved after more than a decade.  Though the controversy has meandered through many interesting events, it has been one step back for every step forward.  The Government’s position on this controversy is almost a barometer for the Indian economy.

1990’s …India was taking its first unsteady steps as a liberal capitalist state and keen to encourage foreign investment the Government issued a circular in 1994, stating that gains earned by Mauritian residents from sale of Indian shares would not be taxable in India.  2000 …steadily growing and still in need of foreign investment.

When a zealous Tax Office tried to raise the ‘conduit’ argument to deny the Treaty benefits, the Government in swift and decisive action issued the famous circular 789.  In 2004, SC in the AzadiBachaoAandolan, one hoped, firmly put the issue to bed.  Justice Ruma Pal observed that Treaties at times went beyond just tools for Revenue collection and sought to achieve other objectives such as encouragement of trade and commerce, foreign investment flows etc…

2004 onwards …the Government, probably buoyed by steady growth and a conviction that India was too important for any investor to ignore, changed sides.  The Tax Office in umpteen cases is making attempts to deny the Treaty benefits and litigations are proliferating.

A recent press report suggested that the Tax Office has collected a list of entities that are taking advantage of the Treaty, a list of potential ‘targets’.  The Government is gunning for an amendment in the Treaty citing massive ‘revenue loss’ due to the capital gains shelter.

The proposed GAAR in the Indian Direct Tax Code is the latest variable in a convoluted paradigm and threatens to completely derail the Mauritius band wagon.  GAAR will be invoked to re characterize/annul transactions which lack ‘commercial substance’ with almost unbridled discretion available to the Tax Office.

‘Commercial substance’ is a concept which is ambiguous and has led to a plethora of litigation even in highly developed tax regimes such as Canada and Australia.  One can imagine a tool like this, in the hands of an overtly zealous Tax Office, wont to litigation, which has been striving to scuttle the Treaty, will wreak havoc with investors.

Investors are getting nervous and the Advance Ruling Authority has become a favorite destination. Others are buying insurance against tax risk.  Is this behavior warranted?  India is still a far cry from its potential of being a global leader; we need billions of dollars to fund our infrastructure and social sectors, to fund employment opportunities and to tap the potential of our teeming billions, to trickle down the fruits of capitalism to the rural sector.

At this stage, undermining the importance of a robust investment holding structure is fraught with risk for India.  A 20% (capital gains rate) swing in return economics is a significant play and definitely a key factor in some of the investment decisions in India, at least in the FII and private equity space.  While growth rates in India are zooming, so are valuations (the Indian stock market today trades at 17-18 PE, one of the highest in the world) and hence the capital gains tax shelter provided by Mauritius cannot be undermined.

Investment flows create a big multiplier for the economy and that has to be weighed against any ostensible loss of revenues.  The Government cannot afford to take a myopic view; the numbers speak for themselves …almost 40% of India’s FDI and 50% of FII investment is from Mauritius.  One could argue that none of this will change even if the Treaty went …possibly, but why argue with success, with a winning formula?

India’s concerns around round tripping and money laundering are probably more justifiable and need remediation and should be reviewed in any Treaty re-negotiations. Though in this space, Mauritius, has certainly taken many steps over the years.  Mauritius casts onerous requirements on companies for the issue of Tax Residency Certificate, the banking system has strengthened KYC norms, it has made tax laws more robust and onerous and Mauritius was removed from the OECD watch-list of tax havens. It has co-operated with India on sharing information on fund flows in cases of suspected round tripping.

I also want to raise a debate on the notion that there is significant ‘revenue loss’ due to the capital gains shelter under the Mauritius Treaty.  Is a capital gains tax on shares, equitable?  As a tax policy matter, there is at least one school of thought that believes that taxing capital gains on equity tantamounts to double taxation.

The capital gain represents capitalization of future corporate earnings which will anyway be taxed as corporate profits (barring cases of tax holidays, which are anyway proposed to be done away under DTC) in future.  The Kelkar Committee (in 2002) had made a recommendation to do away with such a tax.

In summary, there is merit for the Government to seriously re-look at its strategy around the India Mauritius Treaty.  It has been a key enabler for fund flows in the past and will likely continue as such.  Even if revenue loss is a concern, there are several other adjacencies and ancillary benefits associated with higher investments which probably more than offset any perception of a revenue loss.  The current situation is really undesirable.  The investor today is confused and is running amok to review his options.

The need of the hour is (1) for the Tax Office to respect settled law and the Government’s own famous circular 789 (2) provide clarity on applicability of GAAR (under DTC) in the context of the Treaty, with a clear definition of ‘commercial substance’ in the context of a holding company and possibly only restrict it to cases of round-tripping (3) clarify that existing investments which were evaluated under extant law and hence already baked in the benefits of the Treaty would be grandfathered and not get impacted by GAAR.


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