Should the Mauritian tax treaty be revoked?

As the ongoing wave of protest against corruption gets stronger, the call to bring back money stashed abroad is also getting louder. It is, therefore, not surprising that recent statement by a government official that the government will review the double-taxation avoidance agreement with Mauritius was taken very seriously by the stock market with stocks falling pell-mell on the news.

The tiny scenic island in the Indian Ocean, famous for white beaches and turquoise-coloured sea, has given Indian regulators nightmares over the last two decades. Mauritius is a leading offshore financial centre (OFC) with all the characteristics of a typical OFC such as very low taxes, relatively light financial regulation, banking secrecy and no requirement for a substantive local presence.

The Mauritian OFC became the popular route for FDI and FII money flowing into India from early 1990. The double-tax treaty between the Indian and Mauritian Government that allows capital gains tax (CGT) to be taxed in the country of residence, thus allowing residents of Mauritius to avoid this tax since CGT in that country is zero, is the genesis of this relationship.

Round-tripping

Of the $132 billion FDI flows received by India between April 2000 and 2011, $55 billion or 41 per cent was routed through Mauritius. A chunk of FII investment in equity is also from this country.

It is not surprising that this data has raised the hackles of the Indian government and the regulators, the RBI and the SEBI. Their concern centres around black money parked abroad, parading as FDI and FII flows, and coming back into the country. This concern is not baseless since most OFCs have a strengthened form of corporate veil. No public register of shareholders is maintained in these jurisdictions, so the constitution and shareholders of companies remain private.

There were a series of litigations in 2000 when the Income-Tax authority had filed cases against a number of FIIs on the ground that their sole purpose of existence was to evade tax. In the chaos that followed, CBDT issued a circular that a “certificate of residence” issued by the Mauritius should suffice to establish the residential status in Mauritius and the applicability of the double-tax agreement.

There have been other cases fought in courts since then and the war of nerves between the Indian and Mauritian government continues. The Mauritian government is reluctant to bring about changes in the treaty since it earns substantial sum from these offshore entities. But, at the same time, it is not entirely free of worries on this score since Indonesia has unilaterally ended the double-taxation agreement with Mauritius citing round-tripping and loss of revenue as the reason.

The Mauritian government had tried to placate India by tightening issuances of certificates of residence and issuing it one year at a time. It has also tightened the issuance of licence applications for collective investment schemes. But these measures are viewed as too little by the Indian Government.

Loss of revenue

Another concern expressed by critics of the double-tax avoidance treaty with Mauritius is that the Indian Government is losing revenue since users of this route are evading tax that should have flowed into the Government's coffers. This argument is, however, open to debate since, internationally, treaty shopping in which a third company uses DTAA between two other countries to avoid tax is a widely accepted form of tax planning.

Again, double-tax avoidance treaties are signed to avoid profits from the same source being taxed twice. Since the capital gains tax in Mauritius is zero, investors are evading tax. If it charged a low rate of CGT, India would still not have made any money since the revenue in that case would have gone to the Mauritian government.

The Supreme Court has addressed this issue in its ruling in the famous ‘‘Union of India vs Azadi Bachao Andolan'' case. The court had ruled that it was the sovereign right of countries to enter into DTAAs and if residents of a third contracting state qualify for a benefit under a Treaty, they cannot be denied the benefit on a theoretical ground that treaty shopping is unethical and illegal.

Need to scrap?

Although the DTAA is being misused by money launderers, there does not seem to be a need to revoke it since recent regulatory changes and other developments have mitigated this threat to a great extent.

SEBI has brought in various rules to tighten KYC norms for issuing P-notes, for registering sub-accounts and has improved disclosures made by FIIs. The move last year asking all FIIs to broad-base or have a minimum number of shareholders and disallowing multi-layered structures led to many FIIs and sub-accounts moving out of India altogether.

The noise being made by the Indian Government against money-laundering is not going unheeded and the threat of regulatory action seems to have made new investors wary of using the Mauritius route. Experts opine that incremental FII flows into equity markets are more from other jurisdictions such as Singapore, Dubai, Luxembourg and so on. FDI flows from Mauritius have also been declining of late. In April 2011, India received more FDI from Singapore (Rs 5,214 crore) than from Mauritius (Rs 4,332 crore).

The Singapore alternative that the Indian Government has provided to overseas investors by amending the DTAA with that country in 2005 could prove to be a serious competitor to Mauritius in the years ahead. Indian Government has made Singapore waive capital gains tax of its residents on sale of equity in India. Since many FIIs are already head-quartered in Singapore, they can easily channel their funds from there. What is more important is that the DTAA with Singapore includes clauses that prevent misuse.

The final reason why scrapping of Indo-Mauritius tax treaty is unnecessary is because the Direct Taxes Code that will come into effect from April 2012 has a modified GAAR (general anti-avoidance rule) that lays down that income-tax officers can determine the tax consequence for the assessee by disregarding any arrangement (such as DTAA) where the transaction lacks “commercial substance or is carried on in a manner not normally employed for bona fide business purpose.” This is a powerful tool which can be wielded wherever necessary.

It would be ideal if the Mauritian government could cede to India's demand to tweak the DTAA on the lines of the agreements with Singapore or the US, wherein investors from a third country cannot use the agreement (Limitation of Benefit clause). Other clauses such as looking at the source and not residence for judging eligibility and limiting the agreement to companies listed on a recognised stock exchange can also be considered.

Even if the Indian Government takes the unnecessary step of revoking the DTAA, investors in the stock markets need to understand that this is not a catastrophe. Such an event would effect only prospective FII flows and not money that is already invested. There could be a temporary outflow as FIIs book short-term capital gains before a given date, but this money will flow back, through other routes. Some FIIs might prefer to cut back on short-term trading and turn in to long-term investors and that would be good for our market.

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