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India plugs capital gains exemption loophole under tax treaty with Mauritius

On 10 May 2016, India and Mauritius signed a protocol to amend the existing tax treaty which has been in force since 1982. The most significant change made by the protocol is a phased-in elimination of the residence-based taxation of certain capital gains, which will close off what commonly is known as the "Mauritius route" for investment into India. Specifically, the protocol will allow source-state taxation of capital gains from the sale of shares, which effectively will grant India taxing rights over gains derived by a Mauritius company from the sale of shares in an Indian company.

Under the current version of the India-Mauritius tax treaty, capital gains derived by an entity are taxable only in the state of residence of the seller; thus, gains derived by a Mauritius company from the sale of shares in an Indian company are not taxable in India. Such gains are not taxable in Mauritius either, because Mauritius does not tax capital gains under its domestic law. This feature has made the Mauritius treaty immensely popular among investors in the Indian stock market. The Indian tax authorities have made several attempts to deny treaty benefits on the grounds that the treaty is being abused by "shell" companies set up in Mauritius by Indian resident investors (and multinational companies) to route funds into India without having to pay Indian capital gains tax on their investments.

Over the past few years, the Indian and Mauritius governments maintained a dialogue to renegotiate the treaty, to end double nontaxation and address a perception that Mauritius was being used to "round trip" Indian money back into the country as foreign investment. The recent OECD BEPS project gave further impetus to this dialogue, which ultimately resulted in the signing of the protocol.

Capital gains on share sales

Under the protocol, India will have the right to tax capital gains derived by a Mauritius company from the sale of shares of an Indian company acquired on or after 1 April 2017. However, "grandfathering" rules will protect investments in shares acquired on or before 31 March 2017, i.e. gains from the sale of such shares will be exempt from Indian tax.

The protocol also provides for a transition period before India will have the right to fully tax gains–gains arising during the period from 1 April 2017 to 31 March 2019 (on shares acquired after 31 March 2017) will be taxed at 50% of the Indian domestic tax rate, subject to the fulfillment of conditions in the "limitation of benefits" (LOB) article (discussed below). As from 1 April 2019, capital gains from the sale of shares in an Indian company may be taxed in India at the full domestic tax rate.

The rules can be summarized as shown in the table below:

Particulars Taxable in India Rate
Shares acquired on or before 31 March 2017 and sold thereafter No N/A
Shares acquired on or after 1 April 2017 and sold on or before 31 March 2019 Yes 50% of domestic tax rate, subject to LOB conditions
Shares acquired after 1 April 2019 and sold thereafter Yes Domestic tax rate

LOB article

The protocol includes a new LOB article that will deny a resident of Mauritius (including a shell/conduit company) the benefit of the 50% reduction in the tax rate on gains from a sale of shares of an Indian company during the transition period if the seller's affairs are arranged with the primary purpose of taking advantage of the benefits of the reduced tax rate in the transition rules.

A shell/conduit company will include any legal entity that falls within the definition of a "resident" under the treaty, but that has negligible or nil business operations or that carries out no real and continuous business activities in the contracting state. However, a resident will not be deemed to be shell/conduit company if (a) the company is listed on a recognized stock exchange of Mauritius; or (b) its total expenditure on operations in Mauritius is at least INR 2.7 million or MUR 1.5 million in the 12 months immediately preceding the date the gains arise.

The protocol does not incorporate the "main purpose test" or "bona fide business test" mentioned in the 10 May 2016 press release issued by the Indian government regarding the protocol. The "primary purpose test" appears to be a subjective test, and no criteria to be fulfilled have been set forth.

Other changes under the protocol

  • Interest income earned by banks: The protocol will set a maximum source-country withholding tax rate of 7.5% on gross interest payments to a resident of the other contracting state. This will include interest payments that are derived and beneficially owned by a bank carrying on a bona fide banking business, which currently are exempt from tax in the source state. However, the protocol will "grandfather" (i.e. exempt from tax) interest payments to such a bank arising from loans or debt claims existing on or before 31 March 2017.
  • "Other income": Currently, "other income" derived by a resident of a contracting state is subject to tax only in the country of residence of the recipient. The protocol will amend the other income article to provide for source-based taxation.
  • Fees for technical services (FTS): A new FTS article will cover managerial, technical and consultancy services, which will be subject to a maximum withholding tax rate of 10% in the source state.
  • Scope of PE: A new clause on service PEs, which will include consultancy services, will broaden the scope of the PE article. A service PE will be deemed to be created for a foreign company where an employee carries on activities in India (for the same or a connected project) for more than 90 days in any 12-month period.
  • Exchange of information (EOI): Amendments to the existing EOI article will bring it in line with international standards and enhance the flow of information between the tax authorities of India and Mauritius.
  • Assistance in collection of taxes:Under a new article, the contracting states will lend assistance to each other in the collection of revenue claims.

Comments

The protocol to the India-Mauritius tax treaty aims to address long-standing issues of treaty abuse and the round tripping of funds. The changes to the capital gains article also will have ramifications for investments into India from Singapore, since the existing India-Singapore tax treaty links the benefits of residence-based taxation of capital gains on the sale of shares to the relevant article in the India-Mauritius treaty.

Overall, the amendments made in the protocol are in line with India's commitment to the BEPS initiative (specifically, action 6 (preventing treaty abuse)) and the government's commitment to curbing the potential for double nontaxation. The prospective applicability of the provisions and the grandfathering of past investments are welcome moves, and will provide certainty to investors with existing investments in India.

The protocol will enter into force once both governments notify each other that the relevant procedures required under their domestic laws have been completed.