[The following guest post is contributed by Aarush Bhatia, who is a 5th year B.A.LL.B (Hons.) student at CNLU, Patna]
The protocol[i]dated 10 May 2016 amending the Double Taxation Avoidance Agreement (DTAA) between India and Mauritius is arguably the most significant changerelating to direct taxes in India in recent years, considering that approximately a third of all foreign investments into India are structured through Mauritius. The shift to source based taxation of capital gains from the hitherto residency based taxation is its most important feature.
To summarize, capital gains arising on sale of shares of an Indian company by a Mauritian resident shall be taxable in India (where the source of income lies) as against the earlier position of taxability in Mauritius (based on the residency of the seller). Since the amended protocol refers to shares, both equity as well as preference should be covered. The government has however, mitigated the immediate impact of the protocol on investorsby grandfathering all investments made through Mauritius in shares of Indian companies until 31 March 2017. The protocol provides for a relaxation in respect of capital gains arising to Mauritius residents for shares acquired on or after 1 April 2017 and sold before 1 April 2019, i.e. the transition period. The tax rate on any such gains shall be limited to 50% of the domestic tax rate in India, subject to a limitation of benefits (LOB) clause. The LOB clause states that the benefit of the reduced tax rate shall only be available to such Mauritius resident who is:
(a) not a shell/conduit company; and
(b) satisfies the main purpose and bonafide business test.
It provides that a Mauritius resident shall be deemed to be a shell/conduit company if its total expenditure on operations in Mauritius is less than INR 2,700,000 (approximately 40,000 US Dollars) in the 12 months immediately preceding the alienation of shares. The capital gains tax shall be levied at its full rate only after 1 April 2019.
While the manner in which the protocol is sought to be brought into effect is venerable, a more detailed analysis is required in order to fully understand its ramifications on foreign investors. Some of the protocol’s latent ambiguities and wider impact have been scrutinized in this post.
1. Taxation of Hybrid Instruments
The press release is silent about hybrid instruments like compulsory convertible debentures and futures and options transactions. For instance, foreign investors invest into Indian companies through convertible instruments, with the most common being compulsorily convertible debentures. If such instruments are converted after 1 April 2017, can it be said that the shares are acquired after 1 April 2017 and accordingly taxed in India? It needs to be seen whether any benefit can be obtained from the recently introduced Rule 8AA of the Income-tax Rules, 1962 (which provides that the period of holding shall include, the period for which debenture is held prior to conversion) for determining the date of acquisition of shares.[ii] This issue needs to be clarified under the text of the protocol as and when it is released by the Central Board of Direct Taxes (CBDT).
2. Impact On Other Beneficial DTAAs
The protocol has a contagion effect on other DTAAs as well. The position on capital gains under Article 6 of the India-Singapore DTAA is co-terminus with the benefits available under erstwhile provisions on capital gains contained in the treaty with Mauritius. Consequently, with the amendment in India- Mauritius DTAA, alienation of shares of an Indian Company by a Singapore Resident after 1 April 2017 may not necessarily be entitled to obtain the benefits of the existing provision on capital gains as the beneficial provisions under the India-Mauritius DTAA would have terminated on such date. However, clarity is required with regard to grandfathering and transition period provisions.[iii]Further, India has asked the Netherlands to resume negotiations on amending their bilateral tax treaty as the government extends its efforts to plug loopholes in such accords to curb misuse. The Dutch tax treaty, which allows exemption from capital gains and a lower rate of tax on dividends, has led to the proliferation of holding company structures.[iv]While Cyprus is the only other nation whose treaty presently offers capital gains tax exemption to investors, it had been a notified non-cooperative jurisdiction since 2013 for failure to share adequate data on tax evaders. The government has now got Cyprus to similarly amend the India-Cyprus DTAA. According to the new agreement, Cyprus investors’ capital gains on investments made in Indian companies after March 31, 2017 can be taxed in India. These provisional agreements are awaiting Cabinet approval.
It is speculated that Cyprus has agreed to give India the right to tax capital gains similar to the provision in the revised India-Mauritius tax treaty subject to being removed from the blacklist.
3. Indirect Transfers
While the direct transfer of Indian company shares by a Mauritius resident after 1April 2017 shall be taxable in India, indirect transfers may still remain out of the Indian domestic tax net. To illustrate, in a structure where there are two Mauritius companies say M Co 1 and M Co 2 wherein M Co 1 holds shares of M Co 2 which in turn holds Indian company shares and derives substantial value from India. In such a situation transfer of shares of M Co 2 by M Co 1 leading to an indirect transfer of Indian company shares may still not be taxable in India.[v]
4. Group Reorganizations
A clarification would also be required regarding application of grandfathering in case of shares allotted to a Mauritius resident pursuant to a merger or demerger in lieu of shares held in the merging or the demerged entity which were acquired before 1 April 2017.[vi]
5. Most Favoured Nation (MFN) Clause
The lowering of withholding tax (WHT) on interest to 7.5% under the new protocol has provided succour in favour of debt securities like CCDs. While the WHT of 7.5% is lower than the one provided in other DTAAs like Netherlands (10%), Singapore (15%), UAE (12.5%), etc., most DTAAs entered into by India contain MFN clauses, pursuant to which if India enters into a Convention, Agreement or Protocol with another country which reduces the tax rate of items of income like interest income, then such reduced tax rate shall apply in case of their DTAA as well. It remains to be seen whether the rate of WHT under other DTAAs will automatically reduce as a consequence of the protocol.
6. Impact on Investment Through Participatory Notes (P-Notes)
P-Notes are derivatives issued by FIIs to investors for the underlying securities invested by the FIIs on the Indian stock markets. Mauritius was the most suitable jurisdiction to invest through P-Notes as several FIIs were setup in Mauritius to avail of the India-Mauritius tax treaty benefits. The P-Notes enjoyed the same capital gains benefit as the FIIs enjoyed at the time of transfer of shares by the FIIs on the Indian securities.This benefit would now cease to be available. While it can be argued that GAAR would have checked treaty abuse anyhow without amending the treaty, it is speculated that the real reason behind this amendment seems to be to restrict investments through P-Notes to prevent round-tripping of money. Withdrawal of the treaty benefits would make this route unattractive for such investors.
The protocol seems to be the final chapter in along drawn tussle between investorsand the revenue. The phased manner of withdrawal of benefits by the government is laudable, especially after its retrospective taxation misadventure post the Vodafone case. While the press release clears the air regarding treaty benefits in no uncertain terms, its collateral impact as analyzed would be clear only after the text of the protocol is releaased. The details of the ‘main purpose’ test and the ‘bona fide purpose’ test stated in the press release too are unclear. There is a possibility that these tests may be subjective and lead to some uncertainty regarding the taxability of investments made during the Interim Period.
[i]Protocol for amendment of the Convention for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income and capital gains between India and Mauritius available at http://incometaxindia.gov.in/Lists/Press%20Releases/Attachments/468/Press-release-Indo-Mauritius-10-05-2016.pdf
[ii]Sahil Aggarwal, Protocol to India-Mauritius DTAA: A move towards avoidance of double non-taxation, available at taxmann.com
[iv]DeepshikhaSikarwar, After Mauritius, now government wants to amend Dutch tax treaty; asks Netherlands to resume talks, (Economic Times, May 30th 2016) available at http://economictimes.indiatimes.com/news/economy/policy/after-mauritius-now-government-wants-to-amend-dutch-tax-treaty-asks-netherlands-to-resume-talks/articleshow/52495938.cms
[v] Amit Bahl, Harsh Biyani and SurbhiBagga, Protocol amending India-Mauritius DTAA: Key changes and their impact, available at taxmann.com