Bad offshoot of Mauritius tax treaty

The amendment to the over three decade old Double Taxation Avoidance Treaty (DTAA) between India and Mauritius has been seen as a progressive and much overdue tax reform measure. In another two years, an entity which is a resident of Mauritius, cannot avoid paying income tax on capital gains arising in India. This is expected to plug a huge source of revenue leakage and capital flight.

But a more disturbing question has been overlooked: Does the new protocol discriminate between money meant for bona fide economic activity and that which originates from dubious sources — shell companies, foundations and NGOs — with security implications? This issue needs to be closely examined.

Background to the DTAA First, a resume of developments. Thirty three years back Government of India negotiated a Double Taxation Avoidance Agreement (DTAA) with Mauritius. Under this, tax payers who reside in one country and earn their income in another would not be taxed twice for the same income. However, this had, in effect, led to a situation where the entities concerned would avoid paying taxes in both countries.

This was because a Mauritian entity could avoid capital gains tax made in India, as India is not a ‘resident’ country, while not paying taxes in Mauritius as well, which does not levy the tax on its citizens.

India which levies capital gains tax on the sale of shares under the Income Tax Act, 1961, gave up this right under the DTAA.

This ushered in billions of investment into India in the last 15 years. Some reports indicate that investments in the last one and a half decades would be around ₹4.63 lakh crore. It also led to more and more investors holding shares of Indian entities through a holding structure in Mauritius. As a result, real value was created in India, but the asset value accrued to Mauritius.

It worked like this: if you were to sell shares of an Indian entity, capital gains tax was payable. On the contrary if the shares of the holding entity in Mauritius were to be sold, which has no independent economic value other than the underlying value of the Indian subsidiary, it is exempt from capital gains tax both in India and in Mauritius!

Mauritius became a "tax haven" for investments both “foreign” and “domestic” (routed through foreign jurisdiction) to flow freely into India. A 10 per cent margin or saving on the cost of money was a huge incentive for investments.

It also potentially became a route for bringing in black money and terror funds and ‘round tripped’ money — local funds being squirreled out of India and returning as foreign capital, thereby avoiding taxes.

Thus good and evil started to co-exist as inevitable sesame twins in the Indian investment market. The Mauritius route worked well for politicians, smugglers, anti-nationals and terrorists and their associates. It was exploited to win elections, smuggle drugs, foment terrorism and promote human trafficking.

Turning of the tide It slowly became evident that the incentive to recycle funds had assumed alarming proportions worldwide. The G20 realised that enough was enough. A series of measures were brought into place, the most critical being the BEPS (Basic Erosion and Profit Shifting), which was the trigger for the May 10 protocol between India and Mauritius.

Its key features are:

All investments up to March 31, 2017 will remain under the old regime i.e. ‘double non-taxation’. They will neither be taxed in India nor in Mauritius.

Between 2017 and 2019 capital gains would be taxed at 50 per cent of the domestic tax rate subject to the fulfilment of the Limitation of Benefits . The full rate would apply after 2019.

The interest arising in India to Mauritian resident banks will be subject to withholding tax in India at 7.5 per cent after March 31, 2017.

Vodafone case At first glance, the protocol appears to be a panacea for all evils. But, a closer look reveals that this attempt would only eliminate good investments in the next three years.

Why so? The Supreme Court while deciding on the Vodafone case, declared that in deciding on taxation, the basic parameter should be whether the investment is being used for generating wealth and employment in legitimate business activities.

Therefore, funds associated with shell/conduit companies, charities, foundations and NGOs were not to be spared. The judgement significantly declared that the source of investment was not important, so long as it created wealth and employment. On the contrary, if the investment was dubious, it should be hunted down and brought to tax.

But what does this protocol seek to achieve? Legitimate and illegitimate investments do not share common traits. A legitimate investment into a business helps the economy progress. An illegitimate hawala transaction hurts it. The protocol pursues a limited economic objective of taxing a transaction which otherwise remained outside India’s realm.

This protocol is now going to serve as a washing machine. Evil will now legally join the club of the good, so long as it chooses to pay capital gains tax. The only difference between the Vodafone judgement rendered by the Supreme Court and this protocol is that the former suggested exempting good money from taxation. Now, all that one has to factor in is a 10 per cent capital gains tax. Once that is paid, India can be flushed with illegitimate investments. This could lead to a legitimate investment with capital gains tax considering a different destination.

Better option The need of the hour is twofold. Without a doubt, share transfers which stood exempted from time immemorial need to be taxed. This protocol has rightly designed a progressive transformation.

But that is not sufficient. Coupled with this, the protocol should have added filters, check points and agencies and bodies to go into the very source and nature of investments. The idea cannot be to tax any investment, good or bad. A two-pronged attack could have been worked out: tax good money, which stood exempted till date, and prevent evil investments from entering India. A more likely consequence of this protocol is that good investment will start shrinking and illegitimate investments will thrive.

The writer is a senior advocate at Supreme Court

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