India Needs To Unscramble Mauritius Tax Treaty Imbroglio

by Lorys Charalambous, Tax-News.com, Cyprus

16 October 2002

The recent release of figures showing that Mauritius is the single largest source of foreign investment in India, accounting for almost 40% of the total in the last 10 years, has thrown the current squabble over the Mauritius double tax treaty (DTAA) between the Indian government and its tax collectors into sharp relief.

Until 2000, nothing prevented an Indian company (or individual) setting up a Mauritian company and using it to make tax-exempt investments in India; under the DTAA, capital gains tax is payable in only one country. If the Mauritian company is not 'effectively managed' from India, then Mauritian taxes apply, and CGT is nil in Mauritius. But in 2000, when it became popular to use this structure to escape capital gains tax on stock exchange investments in India, tax inspectors started issuing assessments on Indian companies they said were abusing the Treaty.

In response to complaints from genuine investors, the Central Board of Direct Taxes (CBDT), a part of the Finance Ministry, issued a Circular (circular number 789 dated 13 April 2000) requiring tax inspectors to accept a Mauritian residence document (freely issued in Mauritius, it is said) as evidence that the Treaty should be applied. Circulars issued by the CBDT are enforceable regulations under the Income Tax Act, 1961.

It is this Circular that the High Court famously 'quashed' last May, saying that the CBDT had acted ultra vires: 'Avoidance of double taxation would mean that a person has to pay tax at least in one country. Avoidance of double taxation would not mean that a person does not have to pay tax in any country whatsoever. In Mauritius, in terms of the statute a foreign company is not entitled to own any property, open any bank account, do any business. Several restrictions have been imposed in that country; as a result thereof no income may be generated in Mauritius and no income tax may be payable therein. Double taxation treaty clearly is not envisaged in such situation.'

The Delhi High Court judgement has created extreme unease amongst the international community investing in India through Mauritius, which the Government fears could have a major effect on the flow of foreign investments into India, hampering the overall globalisation of the Indian economy.

Ironically enough, the original purpose of the DTAA had much more to do with encouraging Indian investment in Mauritius than the other way around, not least in order to create a channel through which Indians could invest in South Africa, something they weren't allowed to do directly, under the apartheid system.

Later, after liberalisation of the Indian economy, and with the Indian government’ s commitment to encourage foreign investments, Mauritius became the desired platform for foreign investors investing in India.

During its 20 or more years of operation, this is by no means the first time that the DTAA has come under fire, and it is noticeable that every time, the Indian government has leapt to its defence. For instance, in 1994 the Ministry of Finance issued a circular clarifying that capital gains derived by a resident of Mauritius by alienating shares of Indian companies shall be taxable only in Mauritius according to Mauritius tax law. There have also been a number of Indian court rulings over the years which have tended to support the DTAA against attempts to weaken the benefits it offers foreign investors.

The current spat mostly revolves around the Indian revenue authorities can question the “tax residency certificate” issued by the Mauritian government. It is a well-recognised principle of international law that the determination of residency is a State subject and each country has the exclusive sovereignty to establish the criteria for residency for entities operating in its territory, so it's likely that the Indian government will win the appeal process it has begun before the Supreme Court against the High Court's ruling.

Longer term, however, there may be some changes to the DTAA agreed between the Indian and Mauritian authorities. After the High Court's decision, the Indian Ministry of Finance and Company Affairs set up a working group to examine the functioning of the DTAA, and the group has suggested various modifications to the DTAA, including the introduction of a clause which would prevent India entities calling themselves residents of Mauritius, and a requirement that an Overseas Corporate Body (the name given to a company eligible for exemption under the DTAA) should have at least 60% ownership by Non-Resident Investors (NRI).

Given that the DTAA is likely to be changed, and the pending Government appeal, it seems likely that companies benefiting from the DTAA will be left alone for now by the tax inspectors, who will be reluctant to chase after possibly illusory tax payments in such a legal minefield. The Indian Government must be hoping that international fund managers, who have been standing on the sidelines while the affair plays itself out, will now feel confident enough to re-enter the Indian investment sector.

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