'New tax treaty has plugged the loophole of double non-taxation'

'New tax treaty has plugged the loophole of double non-taxation'

'New tax treaty has plugged the loophole  of double non-taxation'

Tax Treaty between India and Mauritius for avoidance of double taxation had become a double non-taxation treaty. Under this treaty, India could not tax the gains from sale of shares in Indian companies by a Mauritius resident, who is also not subject to any tax in Mauritius as such gains are tax exempt there. It was an open secret but not an easy one to deal with as Mauritius accounted for nearly one-third of total Foreign Direct Investment (FDI) during 2000-2015. Hence the revision of treaty needed careful consideration and input from the industry as well.

The government has done a carefully orchestrated balancing act. To protect current investment from Mauritius, it has included a security net called Grandfathering of investments which provides continuation of tax exemption for investments made up to end of fiscal year 2016-17. To further even out any shocks, capital gains tax will kick in at reduced rates, at 50% of the domestic rate for the first two years and take full effect from April 1, 2019.

Impact on investment
Once the revised tax treaty takes full effect on April 1, 2019, Maurtius residents dealing with shares of Indian companies will have to pay the same capital gains tax as Indian residents. For the transitional period of two years from April 1, 2017, they will be taxed at 50% of domestic rates provided they meet a set of conditions to ensure that this benefit is not available to shell companies. Mauritius investor must be either listed on the stock exchange or it must have incurred operational expenses of Rs 27 lakh during previous 12 months.

Impact on next treaty
This revised tax treaty has a huge impact on investments sourced through Singapore. Capital gains tax exemption under current tax treaty with Singapore is fully dependent on corresponding exemption in tax treaty with Mauritius. It is only logical to conclude that with this revised tax treaty with Mauritius, the tax exemption under Singapore treaty will also come to an end. 

However, what is not clenotes whether the provisions relating to ‘grandfathering of investments’ aimed at protecting current investments will be extended to Singapore as well. Considering the significance of Singapore sourced portion (of over 15%) in the FDI pie, common sense will dictate that the Singapore treaty needs to be re-negotiated on the same basis as the Mauritius one.

Impact on future fund flows
It is clear that Mauritius will no longer have the benefit of double non-taxation of income from Indian investments. Hence tax savvy free floating investor will explore other options. 

There are some bright spots in some other tax treaties. For example, tax treaty with the Netherlands exempts capital gains tax on sale of shares in Indian company by a Netherlands company provided it holds less than 10% equity of the Indian company. Even if it owns more than 10% equity, it will still enjoy the exemption, provided such shares are sold only to non- residents. So it is quite plausible that future flows from Mauritius and Singapore will significantly reduce and some of this drop may come back from other comparatively more tax efficient sources like the Netherlands.

Impact on overall fund flow
The government and some experts believe that this change will not have any adverse impact on overall fund flow. They argue that it provides a more stable and transparent regulatory framework, which should help investor confidence in the long run. However, it is clear that it does impact the returns on funds invested through Mauritius. 

Future investors will definitely take this into account and look for the next best investment option which may or may not be India. So it is reasonable to expect that there may be some drop in FDI  flows from April 1, 2017. There may be a windfall window for the next 10 months, as some future investors could advance their investment to take benefit of continued tax exemption under grandfathering of investments. This, though may sting immediately thereafter, as flow from April 2017 onwards may be lower to that extent.

Round Tripping issue
The government’s stated key objectives for this revised treaty was to prevent treaty abuse and to tackle the menace of round tripping — notorious practice of a company selling and buying its own assets to manipulate market which could assist money laundering and tax evasion.

New tax treaty has certainly plugged the loophole of double non-taxation, and thus addressed the government’s primary concern of treaty abuse. However, one can’t say the same about tackling the round tripping issue. This issue cannot be addressed without changing operative guidelines for participatory notes (PNs) — derivative instruments issued by registered foreign institutional investors to foreign investors who are not required to register with SEBI and hence remain anonymous. This is a haven for black money. 

Past attempts to tame the elephant of PNs have miserably failed. In 2007, SEBI’s proposal to introduce some curbs lead to an instant stock market crash and eventually forced SEBI and the government to abandon the exercise. The Special Investigation team formed by the Supreme Court to address black money has recommended that SEBI should do more to find real identity of owners of PNs. It suspected black money being rerouted through these PNs. A mere mention of this recommendation sends the market into a downward slide and hence prevents any action.

Keeping in view of this past experience, the government has quickly clarified that withdrawal of capital gains tax exemption does not apply to PNs. While this is good news for the market, it certainly does not help in the fight against money laundering and black money. If anything, with closure of double non-taxation loophole, PNs may become more popular, particularly so with habitual big tax evaders. In conclusion, the new treaty is a step in the right direction and may need to be quickly followed up with the revision of tax treaty with Singapore to calm the nerves and to provide a level playing field. As regards the black money and tax evaders, they still have plenty of routes to roam.

(The author is a Delhi-based management consultant and chartered accountant)

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