The protocol to amend the India-Mauritius double taxation avoidance agreement has reduced the attractiveness of one of the top FDI routes into India, writes Chaitanya Verma
Foreign direct investment (FDI) has catalysed the growth of the Indian startup ecosystem, and Mauritius has been one of the most preferred jurisdictions for investors to route their investments in India. According to data published by the Department for Promotion of Industry and Internal Trade, India’s cumulative FDI inflow stood at USD666.5 billion between April 2000 and December 2023. Of this, Mauritius accounted for 25.6% (USD170.9 billion) of the total FDI India received. A key factor behind this substantial flow was the exemption from capital gains tax offered to investors by the India-Mauritius tax treaty.
The settled principle of law and favourable tax treaties have been the secret sauce for the inflow of funds in any jurisdiction. India and Mauritius have understood this and entered into a treaty almost four decades ago to provide a favourable tax environment to investors and promote mutual trade. Since then, the treaty has undergone a lot of changes, encapsulating the needs of an ever-changing Indian economy, and it has withstood the test of time.
However, on 7 March 2024, India and Mauritius signed a protocol amending the treaty, significantly altering the tax benefits available to investors based in Mauritius for their investments in India.
The constant tussle between the authorities and taxpayers to ensure that both are operating within the four corners of the law has never been easy, and at times it does more damage than good to the whole ecosystem. This article explores the challenges and changes for investors.
US Supreme Court Justice Potter Stewart famously said: “Ethics is knowing the difference between what you have a right to do and what is right to do.” The ethical implications of tax optimisation strategies have long been a subject of scrutiny by tax authorities. Taxpayers can demonstrate good faith by ensuring any benefits arising from their arrangements are incidental and not the primary purpose.
The tax trio: avoidance, evasion and mitigation
Tax avoidance is the art of the permissible, where the taxpayer carefully manoeuvres within the realm of the law to optimise their tax position. Taxpayers leverage the code, regulations and exemptions to their advantage. These methods are not illegal but are considered undesirable and unequitable as they impede tax authorities’ ability to effectively collect taxes.
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Tax evasion is a deliberate and deceitful act to evade paying taxes to the authorities. It involves deliberately obfuscating income, inflating deductions or using other deceitful practices to circumvent tax obligations.
Tax mitigation is a proactive approach by the taxpayer to employ the permissible tools to structure investments and business activities in a tax-efficient manner. It is leveraging the fiscal incentives provided to the taxpayer by virtue of being a resident of a particular jurisdiction or due to the very nature of the entity.
There is a subtle difference between tax avoidance and tax evasion – much depends on the intent and the specific strategy deployed to design a transaction. Taxpayers need to be careful about aggressive tax planning and illegal activity.
The subtle differences between tax avoidance, tax mitigation and tax evasion became instrumental in light of the recently amended India-Mauritius tax treaty. This is because the treaty now denies tax benefits if one of the primary purposes of an arrangement is to avoid or reduce taxes through evasion or avoidance strategies. Any tax benefit gained out of an arrangement must be incidental, not the main reason for the arrangement.
Changes, challenges through the protocol
Changes in the object clause. The object clause of the treaty has been revised. Its previous aim to promote mutual trade and investment stands deleted now. The revised object clause focuses on eliminating double taxation without creating opportunities for non-taxation and reduced taxation through tax evasion or avoidance.
The changes will lead to rigorous scrutiny of the investments made by corporate entities headquartered in Mauritius. They also create uncertainty regarding the interpretation of provisions of the treaty as the purpose of the treaty is amended.
Impact of the Principal Purpose Test (PPT). The amending protocol has introduced the concept of the PPT, aimed at determining whether one of the primary reasons for undertaking a transaction through a Mauritius entity is to enjoy tax benefits. In such a case, India can deny the benefit with respect to the specified transaction.
Investors now face the herculean task of proving to the taxman that the tax benefits accrued on a transaction are incidental, and the jurisdiction has been used for various other reasons such as better administration and convenience in pooling money in a fund.
The PPT also introduces a subjective element of “principal purpose”, which may be interpreted in different ways, leading to uncertainty and potential disputes.
The ghost of retrospective application is back. Uncertainty looms over whether the protocol will apply prospectively or retrospectively. This is a matter of great concern for all investors who have so far relied on the amendment introduced in 2016, which provided grandfathering benefits of exemption on capital gains tax on the sale of shares in an Indian company acquired on or after 1 April 2017.
The ambiguity may lead to disputes between investors and the tax authority, increasing costs and uncertainty for investors.
Dual guardians: GAAR and PPT
The introduction of the General Anti-Avoidance Rule (GAAR) marked a paradigm shift in the country’s approach to tackling tax abuse and tax avoidance. It empowers the tax authorities to review any transaction, whether domestic or international, to ascertain whether the transaction was entered into with the sole intention of tax abuse and/or tax avoidance. If the transaction is deemed an Impermissible Avoidance Agreement (IAA), the tax authorities have the power to deny benefits.
For years, the tax treaty between India and Mauritius offered significant benefits to investors. This included an exemption from any capital gains tax that may arise on the sale of shares in an Indian company. However, this landscape shifted dramatically when an amendment was introduced in 2016, allowing Indian tax authorities to tax capital gains on shares acquired on or after 1 April 2017. The recent amendment in 2024 has further tightened the screws by introducing the PPT.
The PPT expands the scope of scrutiny by tax authorities. Under the PPT, if the main reason or one of the principal reasons for structuring a transaction is to enjoy the tax treaty benefits, the tax authority can deny those benefits. However, this is not an automatic disqualification. The investors can still retain the tax benefits if they can demonstrate to the tax authorities that the benefits claimed align with the object and purpose of the relevant provisions of the treaty. In contrast, the GAAR focuses more on the taxpayer’s intent. The GAAR is invoked when the main purpose of the transaction is to avoid taxes or obtain undue tax benefits.
The PPT grants the tax authorities significant power to scrutinise tax arrangements. Unlike the GAAR, the PPT lacks an independent review panel to assess the tax officer’s determination of whether an arrangement is primarily aimed at achieving tax benefits. This absence of a check on the initial decision raises concerns about potential subjectivity in its application.
In contrast, the GAAR incorporates safeguards to ensure a more balanced approach. A dedicated approving panel evaluates transactions to determine if they constitute IAAs. Additionally, an appellate body exists to review the tax authorities’ decisions, offering taxpayers the opportunity to contest unfavourable rulings. Ultimately, the GAAR is only invoked if the appellate body upholds the tax authorities’ assessment.
The co-existence and related applicability of the PPT and the GAAR add to the layers of uncertainty for taxpayers. It also remains unclear whether the GAAR will take precedence over the PPT, or vice versa, if both apply. The lack of an independent panel to assess the tax officer’s decision could further lead to a surge in disputes and extended litigation as taxpayers may resort to challenging the approach chosen by tax authorities.
However, it is a settled precedent that domestic law is the prime source on the charging of tax as well as the characterisation of transactions or arrangements. This principle serves as a foundation for navigating the complexities introduced by the PPT and the GAAR.
Implications, considerations for stakeholders
While these amendments aim to prevent tax abuse and align with global efforts to combat base erosion and profit shifting, they also present a notable challenge for investors and raise important considerations for stakeholders.
It is important to consider that the protocol has not yet been notified by the government of India. This pending notification adds another layer of uncertainty to the situation, leaving investors and their advisers thinking about and anticipating the timelines and the manner of implementation.
This change highlights the unwavering commitment of the Indian government towards the prevention of base erosion and ensuring treaty benefits are not misused. The government must also balance the need to maintain India’s attractiveness as an investment destination. The country’s startup ecosystem is developing with unprecedented growth, fuelled by encouraging policies and incentives by the government and inflows of foreign capital into the economy. An open dialogue among all the investors is essential to keep the ecosystem conducive and facilitate growth.
As the dust settles and the protocol is notified by the government, a new equilibrium should emerge, balancing the legitimate interests of both investors and tax authorities in an interconnected global economy.
EVENTS IN INDIA-MAURITIUS TREATY RELATIONSHIP
In 1983, India and Mauritius entered into a tax treaty with the aim of avoiding double taxation, preventing tax evasion and, most importantly, promoting mutual trade and investment. Although Indian regulation did not permit free trade at the time, Indian companies that had operations in Mauritius benefited from the treaty.
In 1991, India decided to open its economy and liberalise trade. The balance of payments crisis in the same year made it difficult for the Indian economy to survive without foreign investment. The process of liberalisation resulted in a major jump in the foreign exchange reserves and an improved balance of payments position. Some credit for this turnaround goes to the India-Mauritius treaty for providing an investor-friendly tax regime to encourage mutual trade and investment. Over time, Mauritius has become a preferred jurisdiction for routing investments in India.
In 1994, India’s Central Board of Direct Taxes introduced a circular clarifying that capital gains tax would not be levied on the sale of shares in an Indian company by a Mauritius resident. Instead, the gains would be taxed according to Mauritian tax law.
In 2000, to allay the fears of foreign investors and address allegations of misuse of the India-Mauritius tax treaty, the board introduced the Tax Residency Certificate issued by the Mauritius Tax Office. The certificate served as sufficient evidence to claim tax benefits under the treaty and essentially stopped authorities denying tax claims to Mauritius certificate holders.
In 2016, the treaty was amended to allow the Indian government to tax capital gains derived from the sale of shares in an Indian company acquired on or after 1 April 2017.
CHAITANYA VERMA is a legal manager at venture capital firm Guild Capital.
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