o n Monday, the 20th June the stock market witnessed a sudden panic as the benchmark SENSEX suffered an intra-day loss of 550 points, finally recovering and closing at 17,507 down 364 points - a loss of 2% in a single day. Stocks in real estate, oil, and gas sectors suffered the most. Realty sector index lost as much as 4.2%. The market had a buzz that the sudden selling spree was triggered by a news the previous day ascribed to an unnamed official of Central Board of Direct Taxes that the Government intends to renegotiate the Indo - Mauritius Double Tax Avoidance Agreement (Tax treaty, for short).
The problem centres around a clause in the Tax treaty entered in 1983 as per which residents of Mauritius are not liable to pay tax capital gains arising on sale of shares in India. Remember the domestic investors pay tax @ 15% on short term capital gains and zero per cent on long term capital gains on sale of shares (where security transaction tax has been paid). The downslide in the market was such that the Finance Secretary had to come on TV to calm the markets. He said that though Mauritius has agreed to participate in the joint working group to rework the Tax treaty in 2006 but there is no agreement yet. "We have sent our agenda for discussion and suggested a few dates in July and August."
Veteran watchers of Indian stock market recall that this was not the first time that a vague rumour about possible review of the Indo- Mauritius Tax treaty has sent markets into a tizzy. Similar steep falls occurred at least thrice in the past when some rumour or the other regarding the impending renegotiation of this treaty led to panic selling and steep slide in the stock market indicators.
India has entered into Tax treaties with over 70 countries to ensure that the income taxed in one country is not taxed again in the other. Many of these have been renegotiated over the years in the routine course to provide for changed circumstances. In recent past itself treaties with 20 odd countries have been revised. What is so special about Indo-Mauritius Tax treaty or for that matter about Mauritius, the tiny island nation off the south east coast of African continent, that even a whiff of an indication about its revision sends the Indian stock markets into a tizzy?
Well, contrary to popular notion Mauritius is no ordinary country as far as foreign investments coming to India are concerned. Data from Department of Industrial Policy & Promotion shows that more than 42% of the Foreign Direct Investment (FDI) or a whopping 55 billion US Dollar has come to India from Mauritius in the last 10 years. Private estimates put portfolio investments by Foreign Institutional Investors (FII) at more than 50% of the total of 102 billion USD since1992.
If residents of Mauritius can invest such staggering amounts in India then one would think it to be a very rich country. Actually it is a small island nation with a nominal GDP of 9.279 billion USD (in 2010), a mere 2040 sq kilometres in area, and population of 13 lakh. Its economy is predominantly agricultural - sugar cane being grown on 90% of the cultivated land area and generating 25% of export earnings. In other words, the FDI coming to India in the name of residents of Mauritius is more than the GDP of the entire country!!
This wonderful development has happened because Mauritius took advantage of the Tax treaty with India and followed a development strategy which enabled investments originating in various foreign countries to be routed through it. On a conservative estimate it has attracted more than 15,000 offshore entities routing their investment in India and South Africa.
It’s so easy!
Under the Mauritius Companies Act, 2001, companies with Global Business License (GBL-I) can be set up as "residents" in Mauritius with paid-up capital of just one USD and with a single shareholder and Director. Though these have to maintain a registered office in Mauritius but this can be the address of a management company or law firm. Again, these have to disclose their beneficial ownership to authorities but these particulars are not publicly accessible. These have also to hold their general body meetings in Mauritius but this can be done entirely through proxies. These companies are entitled to hold property and to trade in Mauritius. They have also to maintain accounts and get these audited but again these are not accessible to public. They have to pay an annual licence fee of USD 1500 and a one-off licence application fee of USD 500 to the Financial Services Commission. Foreign exchange regulations have been liberalized and capital profits and dividends can be freely repatriated. Professional service firms operating in Mauritius abound to handle all the paper work to get such companies incorporated and then administer these, arrange for their accounting and audit requirements and mange other compliances etc for a fee of the order of 5000 USD. Advertisements are available on internet soliciting clients to set up a company in Mauritius complete with offshore corporate bank account within two working days. In other words it is perfectly possible, in fact common place, to have a company set up in Mauritius and run it from there without the physical presence of its beneficial owners in Mauritius.
No tax, karo relax
As per Mauritius tax laws companies 'resident" in Mauritius are not subject to capital gains tax in Mauritius. There are also no withholding taxes on payment of dividends, interest or royalties. There are no stamp duties or capital taxes either. Though nominal corporate tax rate is 15%, Mauritius allows these companies the benefit of "tax sparing". Tax sparing refers to granting a resident company credit for specific foreign taxes that it would have paid in a foreign country but for tax exemption enjoyed by it in that foreign country. Under Mauritius tax laws GBL-I companies can avail foreign tax credit of up to 80% of the normal tax rate of 15%, (i.e. 12%) without providing evidence of payment of foreign tax. Thus, by using this provision companies "resident" in Mauritius and earning income, say from India, can reduce the effective rate of taxation in Mauritius from 15% to a mere 3%. Consequently, Mauritius GBL-I companies are extremely popular to structure investments into Mauritius' Tax treaty partners, which include India.
Win here, win there
Thus, under the corporate laws of Mauritius a company can be structured to be nominally a "resident" in Mauritius without having any real activity there. And under the tax laws of Mauritius and the provisions of the Tax treaty with India it can invest in Indian share market but avoid tax on capital gains both in India and in Mauritius and pay Mauritius corporate tax @3% on its other incomes.
Treaty shopping at its peak
Is it then any surprise that Mauritius has become the most favourable destination for investing in India even for groups rom Europe, North America and South East Asia by creating holding or conduit companies in Mauritius? This is "treaty shopping" at its worst. The main problem with treaty shopping is that it breaches the reciprocity of a Tax treaty entered into between two sovereign nations and instead extends Treaty benefits meant for residents of Treaty partner countries to those of a third country which is not signatory to the Treaty and may not reciprocate corresponding benefits. In effect India's Tax treaty with Mauritius has become a treaty with the world at large without the consequent treaty benefits flowing to us.
Who will answer these?
The question is whether the Tax treaty negotiated between India and Mauritius in 1983 was to confer some tax benefit to the genuine / actual residents of Mauritius or to entities faking presence in Mauritius through subterfuge.
There have been persistent information in business circles that Mauritius is the preferred destination for round-tripping and that substantial sums of black money generated in India, including slush funds are being routed back to India through shell companies in Mauritius. In the JPC investigations of 2001 relating to Ketan Parekh, SEBI had brought out how certain Mauritius-based FIIs were issuing Participatory Notes (PN) to anonymous entities for large transactions in Indian stock market. The Government is already under attack in Supreme Court and from civil society on the issue of its tackling of black money.By some estimates India is losing more than 600 million USD every year on account of abuse of the Tax treaty with Mauritius. This is a large and recur ring hole in India's tax revenues. It makes little sense in today's economic environment to lose this kind of revenue as Indian market can no longer be ignored by global investors.
Odd statements coming out of Finance Ministry indicate that India would like to re-negotiate Indo- Mauritius treaty on the lines of our treaties with other countries. This means that capital gains should be taxed in the country in which they arise. This is easier said than done considering the implications for rest of the economy and the clout that the investments routed through Mauritius have acquired over the years. The shivers that the stock market felt on last Monday have to be understood in this light. It is the FII's way of telling us what they can do if the Government even thinks of upsetting their applecart. India has the economic muscle to persuade Mauritius for re-negotiation and if necessary to compensate it for the loss in its earnings from the financial sector. The question is does it have the muscle to counter the power of the global investors who have come via the Mauritius route?
The next best option available to Government is to curb the rampant "treaty shopping" via Mauritius is to negotiate "limitation of benefit" (LOB) clauses in the treaty so as to restrict its benefits to genuine residents of Mauritius. These typically are meant to exclude third country residents from obtaining treaty benefits. For example, a foreign company may be made ineligible for treaty benefits unless a minimum percentage of its owners are citizens or residents of the treaty country. India's Tax treaty with Singapore carries such LOB clauses. It excludes shell companies with no real or continuous business activities in one of the contracting States from the benefits of the treaty. Therefore only companies which have a proper establishment in Singapore and spend a minimum amount in Singapore are eligible to enjoy the treaty benefits.
(The writer has served as Member, Central Board of Direct Taxes, Government of India. He is winner of PM’s Award for Excellence in Public administration.)