Today I am writing on an issue over which a lot has been written, litigation culminated with a rhetoric decision of Supreme Court and lot of political hue and cry been witnessed by the Parliament and yet the matter is as it was earlier, yet unresolved and ailing for a cure. Yes, I am speaking of the contentious Double Tax Convention between India and Mauritius, which allegedly has led a lot of black money flowing in the Indian capital markets and has also allowed the flight of profits earned in India without the payment of tax thereon. However what I intend is to instill a new dimension to the debate, taking cue from the US model DTC's 'Limitation of Benefits' clause and aim to improve the situation in manner acceptable both politically and legally. So let us first begin with what the problem is, its magnitude, its causes, before discussing its cure.
Indo-Mauritius DTC: Tracing the timeline
India and Mauritius signed a Double Tax Avoidance Agreement on 24-08-1982. Formally titled the 'Convention between the Government of the Republic of India and the Government of Mauritius for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes of Income and Capital Gains', the Convention came into force on 06-12-1983 [vide Notification F. No. 501/20/73-FTD]. Under this Convention, taxing rights were allocated between the two countries and also various reliefs for the tax payers hit by the tax systems of both the countries were provided (in the form of 'double tax reliefs'). Thus crux of the issue was however the low tax rates and the absence of capital gains tax in Mauritius, as we shall see later.
The situation was normal for almost a decade and investment began to flow under the DTC until 2000 when the background for a raging debate was being built. In the year 2000, in the wake of heightened reports about evasion of tax and treaty shopping, few Income Tax Assessing Officers required the entities operating on India-Mauritius route to prove that their Residence was established in Mauritius in accordance with the principles for determination of Residence, as provided for under Section 6 of the Income Tax Act, 1961 and as developed and clarified by the courts. This was alleged by the affected entities as an indirect violation of the DTC as there was no such requirement in the DTC. To clarify (and seeming to settle the matter) the Central Board of Direct Taxes (CBDT) issued a Circular [No. 789 of 2000] clarifying that a certificate of residence issued by Mauritius would constitute sufficient evidence for accepting the status of residence as well as ownership for applying the provisions of the DTC. This implied that the Certificate would override the Income Tax Act, 1961 and therefore was challenged in a public interest litigation.
In the same Circular the CBDT had also clarified that the test of Residence would also apply to income from capital gains on sale of shares. Thus, FIIs Resident in Mauritius would not be taxable in India on income from capital gains arising in this country on sale of shares. This exemption from capital gains tax was also challenged as arbitrary, discriminatory and against the spirit of the Act.
Satisfied that it was beyond the powers of the CBDT and contrary to the Act, the Delhi High Court declared the Circular invalid and quashed it as inapplicable. [Shiv Kant Jha v. Union of India, (2002) 256 ITR 563]. However in another public interest litigation [Union of India v. Azadi Bachao Andolan, (2003) 263 ITR 706], which reached the Supreme Court, a three judge bench headed by Justice Ruma Pal took quiet a contrary view. Stating that in terms of Section 90 and 90A of the Income Tax Act, the Government of India was entitled to make provisions necessary to adopt/implement the DTC with a foreign country and since the CBDT Circular was only clarifying the provisions of the Indo-Mauritius DTC, they were within the legal ambit and thus valid.
The Supreme Court categorically held that the mere fact that the government was losing revenue payable to it on account of tax leviable but not charged because of the DTC, was not a valid reason for holding the provision ultravires for it was within the mandate of the Parliament as reflected from Section 90 which allowed the Government to enter into DTCs for promoting India’s trade etc. Thus the Supreme Court decided to play a deaf year to the administrative and fiscal concerns for the stance adopted by the Government was legally justified.
This authoritative and unambiguous decision of the Supreme Court did put an end to the litigation but did not reduce the criticism of the existing scenario in any manner. It was pointed out (and continues to be so) that huge amounts of revenue [Rs. 4000 crores according to last estimate] flow out of India without being subject to tax and that this has a number of demerits for India; (i) this promotes treaty shopping and consequently a lot of evasive structures come into being to operate in India, (ii) Indian government loses out on the revenue it is legitimately entitled to tax and collect, (iii) the burden of loss of revenue is to be shared and met by all those already paying the tax and complying with the system, (iv) the infrastructure provided for and used in India by these companies is not compensated for because of the foregone tax to be collected on these, and so on and so forth. For this reasons, there was hue-and-cry from almost everyone aware of the system to call for a revision of the DTC.
Consequently, after serious consideration to the matter, the Mauritius Government was requested by India to review the DTC in early 2007. However recently it has come out in news that the Mauritius government has refused to reconsider the treaty and therefore the situation would continue to be so for some more time.This is true despite the alleged offer on the part of the Government of India (though I do not know how such a thing in possible in India given the constitutional setup and control of the legislature over the executive) to compensate the Mauritius Government in terms of revenue on account of the proposed revision of the Treaty. Let us now see why this all has happened and then how to deal with it.
Why Mauritius route at all?
Investment coming into India from Mauritius is peculiar for a special reason which in international tax terms is known as the ‘Residence/Source’ principle. We have dealt with these in quiet some detail in one of our earlier posts but then we may need to look back at them for some understanding of this problem.
Under a ‘Residence’ approach, a country taxes all the income of the persons Resident in the country. For this purpose, ‘Residence’ is defined under the Income Tax laws of the country and is generally associated with the number of days stayed in the country in a particular year or in a number of preceding years or a combination of both. For example, for Indian context, ‘Residence’ is defined under Section 6 of the Income Tax Act, 1961 which states; An individual is said to be resident in India in any previous year, if he (i) is in India in that year for a period or periods amounting in all to one hundred and eighty-two days or more; or (ii) having within the four years preceding that year been in India for a period or periods amounting in all to three hundred and sixty-five days or more, is in India for a period or periods amounting in all to sixty days or more in that year.
Under the ‘Source’ rule context (which applies when the person in question is not a Resident of the country seeking to apply tax), the country taxes only that portion of income of the person which arises or relates in part to the country in question. For example for a person Resident in South Africa giving management advice to an Indian company and getting paid management fees for such advice would only be liable to pay tax on that potion of Management fees received in India and not on anything more.
This Residence/Source principle has been the major driver for the problem in India-Mauritius DTC. In Mauritius, there is no charge of capital gains while in India capital gains are chargeable to income tax at two rates; 10% and 30+% on short term and long term capital gains respectively. This has the following outcome;
- For a person resident in India, capital gains are chargeable to tax at the given rates [because of the ‘Residence principle’].
- For a person not resident in India, capital gains are again chargeable to tax at the given rates [because of the ‘Source principle’].
- For a person who is resident in Mauritius, no capital gains tax is chargeable because of the Indo-Mauritius DTC.
Therefore one can see that there is a lot of advantage for the tax payer if the Residence is located in Mauritius. This also means there is an added reason to opt for bringing your investments into India (if you are not an Indian tax Resident) and this is why Mauritius route becomes interesting. But then having looked through the implications, let us also see how this is done. Is it that easy to gain the residence status of Mauritius or is it just hype that has been created.
Under the Mauritius laws, for a company to derive the benefit under the Indo-Mauritius DTC, the Mauritius Offshore Business Activities Act 1992 (MOBAA) comes into play. Under this Act, in order to gain the benefits of the DTC, certain requirements must be met by the company whereupon it is granted a ‘Certificate of Residence’ in Mauritius. These conditions are;
- There must be two local (i.e. of Mauritius) directors in the company, who have been approved by the MOBAA authority,
- The company’s bank accounts must be in Mauritius, and
- The company is required to comply with the Mauritius corporate law formalities. Once these conditions are met and the Certificate granted, the company is deemed to be a Resident of Mauritius for the purposes of both Mauritius tax law and as well as under the Indian Income Tax Act, 1961.
Onces these conditions are satisfied, the company is granted as 'Certificate of Residence' for Mauritius, and as we saw above, this Certificate is sufficient under the Indian laws to let the income of the person tax free in India. This problem (for India) is particularly enhanced by the fact that Mauritius promotes itself as a off-shore activity business centre. This implies that the country offers significant advantages for companies based in Mauritius but engaged in activities outside Mauritius. [For a quick look, have a look here and here] Thus the Mauritius government itself advocates for companies from abroad to set their subsidiaries to get incorporated (or otherwise become Resident) in Mauritius and thereupon invest outside Mauritius (typically India because of the tax benefits which come into being) and thus the problem which we have been discussing for long, comes into being.
I have thought of a 'Limitation of Benefit' clause type solution for this problem. However given the lengthy post that this has already become, I will discuss it soon in a subsequent post.
Further readings;
1. Fenwick & West LLP's advice on investment in India through Mauritius
2. A nice background to the Azadi Baachao Case.
3. Hindu article on LOBs in Indo-Mauritius DTC
4. Recent update on Indo-Mauritius DTC.
5. List of India's Double Tax Avoidance Treaties
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