The recent agreement signed between India and Mauritius to amend the double tax avoidance treaty is important in many ways. It signals that India is willing to let go of the round-tripping funds that is routed through the verdant island nation and that Mauritius is keen on rebuilding its image as a credible offshore financial centre. But more importantly, the change signals growing intolerance globally towards abuse of loopholes in bilateral tax agreements, which is resulting in a large loss of revenue for governments.

The original intent of the tax treaty with Mauritius, signed in 1982, was to promote investment flows between the two countries and to prevent the gains on investments from being taxed twice. But since the treaty provided for the capital gains to be taxed at the country of origination, and with capital gains tax rate in Mauritius being zero, entities from other jurisdictions began investing into India through Mauritius, to save on tax.

The other, and greater, concern was the Mauritian authorities allowing businesses without significant business presence to be incorporated in the country; called shell companies or brass-plate companies. The island nation had very lax rules, which allowed the ultimate owner of the companies to stay hidden. This allowed Indian entities to set up shell companies in Mauritius to round-trip money, much to the annoyance of the RBI and SEBI.

But winds of change are blowing, not just for Mauritius, but for all tax havens. It began with all the major countries coming together under OECD to sign the BEPS (Base Erosion and Profit Shifting) agreement in 2017. This required countries to close the gaps in bilateral treaties, improve information sharing and tighten domestic rules to check tax evasion. The results are already evident in changing pattern of global investment flows.

Global action

Global regulators had been confounded by the problem of corporates shifting their base to low tax jurisdictions to avoid tax. The US Congressional Research Service estimates that revenue loss to the country from such base shifting could range between $50 billion to $100 billion annually. The other issue was tax evasion and money laundering through gaps in bilateral treaties.

In 2016, more than 100 countries agreed to implement changes to tax treaties and update international tax rules to reduce the gaps available for MNCs to avoid paying taxes. The BEPS MLI came into force on July 1, 2018.

The signatories to the agreement include almost all the tax havens such as Mauritius, Luxembourg, the Netherlands and Hong Kong. It covers almost 1,900 bilateral tax treaties, making its enforcement quite effective.

Tighter treaty

India’s signing of the BEPS MLI in 2016 was followed by a significant amendment of the Indo-Mauritian double tax avoidance treaty that year. The amendment resulted in investments in Indian shares done after April 1, 2017, being liable for taxation in India, thus removing the tax benefit derived by investing in Indian equities from Mauritius. But the amendment left investments in equity made prior to April 1, 2017, out of its ambit. Fixed income and other non-equity investments were also not covered.

Last month, India and Mauritius agreed to amend the treaty further. A Principal Purpose Test will be included in the agreement, under which, the benefit of the treaty can be denied if it is established that the main objective of the arrangement or the transaction is to benefit from the treaty.

This implies that companies can no longer flash tax residency certificates (TRCs) issued by the Mauritian government to claim benefits under the treaty. The use of TRC to establish residency has been a bone of contention because earlier it could be obtained easily without the entity having a substantial presence in the country.

Through the recent amendments, both the governments seem to be signalling that they will not tolerate tax evasion or round-tripping using the treaty any longer.

Diminishing flows

The change in stance of the Indian and Mauritian government is in sync with other jurisdictions. The amendment to various bilateral treaties, along with greater scrutiny since 2017 is resulting in reduced investment flows out of low tax jurisdictions, which were earlier preferred by treaty shoppers.

From the graph of net FDI outflows based on data from World Bank, it can be seen that outflow from Luxembourg, which was one of the preferred tax havens, has declined from $176 billion in 2019 to $-265 billion in 2022. Outflows from Mauritius have declined from $58 million in 2019 to $19 million in 2022. Similarly, flows out of the Netherlands and Switzerland have also been erratic after 2017.

On the other hand, FDI investments from the US, the UK are increasing. A large proportion of global funds are based in the US and the UK and these funds appear to be investing directly from their home countries instead of taking a more circuitous route through tax havens. Outflows from more transparent offshore centres such as Singapore have been steady.

This trend is visible in the foreign flows into India as well. Foreign portfolio investors from Mauritius had the largest share of 26 per cent in FPI assets in Indian shares and debt, prior to 2013. But the share has now reduced to 6 per cent and the country relegated to the fourth position. FPIs from the US are now the largest holders of FPI assets with 39 per cent share. Similarly, in FDI inflows, Singapore has displaced Mauritius as the largest source.

Global tax havens seem to be at an inflexion point. The tighter laws are likely to reduce the income they derive from offshore services, forcing them to reinvent themselves and find other sources of revenue. Whether the tax planner fraternity admits defeat or manages to find other loopholes for ‘tax avoidance and management’, remains to be seen.