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Mauritius tax loophole under Indian
scrutiny
By Jayanthi Iyengar
NEW DELHI - Foreign investors, both
institutional and direct, many of them from the United
States, could be in for a shock if they base their
involvement in India on the assumption that the
government will continue to turn a blind eye to their
"treaty shopping" via Mauritius.
It is
estimated that India's revenue
department loses between US$100 million and $500
million annually through companies routing their investments
via Mauritius, a virtual tax haven, in what
is known as treaty shopping. Treaty shopping is when
companies from high tax countries scout the globe
looking for low tax havens to set up residency and claim
tax benefits available to the nationals of those
nations.
In 2001, out of total foreign direct
investment inflows into India worth $3.89 billion, 38
percent was from Mauritius, 7.54 percent from the US and
4.93 percent from Japan. Between 1991-2000, cumulative
FDI flows were $15.58 billion, with Mauritius
consistently topping the list as the leading source of
investment into India, followed by the US. In the case
of foreign institutional investors (FII), though
country-wise disaggregates are not available, as of
December 31, 2001, net foreign portfolio investments
stood at $2.79 billion. The bulk of these investments
are considered to really be US portfolio investments
being routed through Mauritius.
However, a case
currently before the Supreme Court of India, the
country's apex court, gives the first official inkling
of what could be on the anvil with regard to Mauritius
and treaty shopping.
Central to the issue, and
crucial for foreign investors in making decisions on
India, is tax liability that could shoot from virtually
zero for Mauritius-routed capital, to anything between
10 percent to 36.75 percent, depending on whether the
taxed income in question had been earned as capital
gains, interest earnings or corporation tax.
The
case is a complicated one, dating back to early April
2000, when tax officials from the Mumbai income tax
department, arguing their case on global developments
and a decision by the Indian Authority for Advance
Rulings in the case of Natwest Bank (Indo-UK treaty),
issued notices to 13 Mauritius-based foreign
institutional investors. Out of the 50-odd
Mauritius-based FIIs investing in India, the tax
department excluded FIIs with multiple shareholders.
Instead it selected 13 which had set up wholly-owned
subsidiaries in Mauritius, which in turn had invested in
India. The notices raised the question as to why these
FIIs should not be considered residents of India, and a
tax be levied on the capital gains booked by them.
The notices touched a sensitive nerve in the
Indo-Mauritius relationship. The loophole in the law,
and its exploitation, was known to both countries. As a
policy, both had intentionally chosen to ignore its
existence, though many tax experts have always believed
that the loophole could have been plugged any time that
the two countries mutually decided to do so. Fearing a
diplomatic backlash and the withdrawal of foreign
investment through the Mauritius route as a consequence
of the notice, the Indian government immediately forced
the officials to withdraw the notices through an
executive order. This order was in the form of a
circular from the Central Board of Direct Taxes (CBDT),
the revenue department arm of the Indian Ministry of
Finance responsible for administering the Indian income
tax law.
The CBDT circular made the point that
the responsibility for obtaining proof of residency in
Mauritius rested with the government of Mauritius. The
circular was issued when Yashwant Sinha was finance
minister (he is now foreign minister) and he was widely
accepted as being sympathetic towards catering to the
needs of foreign investors.
The issuance of the
circular created a public furor, resulting in a public
interest litigation being filed in the Delhi High Court,
amid intense debate in parliament. In early 2002, the
Delhi High Court found that the circular was invalid and
that the CBDT did not have the right to issue such
circulars.
This ruling in effect meant that
income tax officials could demand tax from the 13 FIIs,
and that their notices of early April 2000 were valid.
The Indian government then appealed against the High
Court's order in the Supreme Court, and its petition is
currently before that court, a process that could drag
on for at least another year.
This current
petition, though, was filed under the supervision of
Jaswant Singh, the new finance minister (former foreign
minister), who is perceived as being less receptive to
the particular needs of foreign investors. Also, the
political mood in India itself has changed over the past
two years, with parliamentarians coming down heavily on
foreigners benefiting from such loopholes as treaty
shopping, while Indians - read middle class, the vote
bank of the ruling Bharatiya Janata Party - reel under
high taxation and low returns on savings.
The
decision to appeal, therefore, came as something of a
surprise, as if the government wanted to clamp down on
investment through Mauritius, it simply had to accept
the lower court ruling. Many people, therefore, have
interpreted the fact that the government has filed an
appeal in the Supreme Court as an indication of its
desire to keep the Mauritius route open.
However, closer examination of the details of
the petition shows that this is not entirely the case,
and that the government is not necessarily prepared to
let investors get off scot free.
The
government's petition points out that the CBDT's
circular was only "clarificatory" and that "it would
nevertheless be open to the assessing authority to
determine whether the assessee was also a resident of
India under the Income Tax Act".
The wording of
this petition can be interpreted in several ways. The
worst-case scenario is that once the court case is over,
the government will resurrect the notices. That could
mean a tax demand being slapped on the FIIs with
retrospect effect, which would be most detrimental to
their interests. In the Indian context, a retrospect
demand could mean unpaid taxes being claimed not only
for the previous year, but also up to a 10-year period
in the past.
Alternatively, the petition could
also mean that the Indian government is planning to plug
the loophole with prospective effect. This could be
easily done by inserting a special anti-treaty shopping
clause in the Double Taxation Avoidance Agreement (DTAA)
between India and Mauritius. Such a clause exists in the
Indo-US DTAA under Article 24. It also exists in many of
the 38-odd tax treaties between India and other
countries.
However, it is conspicuous by its
absence in the tax treaty between India and Mauritius,
giving rise to what tax department officials call a tax
leakage. From the FII point of view, an anti-treaty
shopping insertion in the DTAA would be comparatively
less damaging. Though the latter would undoubtedly
result in India being rendered an unattractive foreign
investment decision, it would at least save the FIIs
from fresh tax demands, and the concomitant harassment.
It could even kick off another round of litigation,
which could be both time-consuming and troublesome.
India's DTAA with Mauritius lays down the rules
of the game when an entity has income arising both in
Mauritius and in India. If the entity is a resident of
India, it will be taxed under Indian tax laws. On the
other hand, if it is a resident of Mauritius, it will be
taxed under the tax laws of that country.
The
CBDT circular of 2000 merely made the point that the
responsibility for obtaining proof of residency in that
country rested with the government of Mauritius. Simply
explained, it means that if the government of Mauritius
were to certify that a company, domestic or domiciled,
belongs to that country, then India would not question
the antecedents of the claim.
This is a major
concession. Mauritius is a known tax haven. It attracts
investors with its zero to negligent rates of tax.
Hence, connivance between the certifying authority in
the national interest and a foreign company wanting to
take advantage of the country's concessional taxation
regime, cannot be ruled out. By foregoing the right to
question the certification of residency, India is
actually saying that it will turn a blind eye to treaty
shopping.
In this context, it is important to
understand how tax treaties are structured. One also
needs to understand the importance of the word
"residency" in these treaties. Presently, there are 41
tax havens across the world, including the Bahamas,
Bermuda, Barbados, Luxembourg, the Virgin Islands, the
Canary Islands, the Cayman Islands, the Isle of Man,
Ireland, Malta, Switzerland and Mauritius. Many foreign
investors set up post box addresses in these countries
to claim concessional tax treatment.
Countries
enter into bilateral tax treaties with each other to
decide on the manner in which they would like to tax
entities, which have incomes arising in both countries.
Central to the tax treaty is the philosophy of
orderliness in tax treatment, leading to minimum
hardships to transglobal companies with
operations/investments in multiple countries. It also
embodies the principle of taxing an income only once.
For instance, if an Indian company has
income-generating investments in India and the US, the
bilaterals between the two countries would ensure that
their income was either taxed in the US - where the
company is domiciled - or in India, where it is a
resident. So, also, is the case with incomes of
companies of Mauritius origin in India and of Indian
origin in Mauritius.
As already explained, to be
eligible for concessional tax treatment, a company has
to prove residency of that country, irrespective of
whether it is a foreign or a domestic company. Residency
is defined differently in different countries. In India,
an uninterrupted stay exceeding 180 days is necessary to
be considered a resident.
In the case of a
foreign company investing in India but claiming tax
treatment under Mauritius law, it would need to fulfill
two requirements. Such a company should have income
arising in both countries. It should also claim that the
company is managed from Mauritius.
Though there
are strictly no legal definitions for what connotes
"management from Mauritius", tax lawyers now advise
clients that a company would be considered a domicile of
Mauritius by the authorities there so long as it is
registered there, holds a substantial number of board
meetings either physically or through teleconferencing
in Mauritius, the annual general meeting and
extraordinary general meetings of the company are held
there, and major decisions are taken in that country.
What needs to be noted is that treaty shopping
is the fallout of globalization. Enhanced market access
permitting the free flow of goods, services and capital
across geographical borders has made it possible for
investors to claim residency of the country they chose.
Technological advancements have further made it possible
to move incomes from high tax countries to low tax
havens to claim lower rates of tax. Such creation and
rotation of income between geographical boundaries is
definitely in the self-interest of companies and
individuals, but not necessarily in the interests of
nations, particularly the high tax nations, whose
nationals may be responsible for this creation of
wealth. These nations view treaty shopping as a loss of
their legitimate revenues. It is they who have led the
move to plug treaty shopping.
At the helm of
this move is the Organization for Economic Cooperation
and Development (OECD). It comprises 29 industrial
nations, mostly in Western Europe, the Pacific Rim and
North America. The US is a part of this group, though it
is often considered to be a low tax country when viewed
from the European Union's perspective.
However,
it becomes a high tax country when seen from the angle
of treaty shopping by foreign investors routing
investments through the Cayman Islands, Malta, Mauritius
or Bermuda to the US. Normally, treaty shopping takes
place more in the case of investment companies rather
than manufacturing companies, but new tools such as
transfer pricing have made it possible for transglobal
companies to rotate and transfer profits generated
elsewhere to tax havens in a jiffy.
Interestingly, many tax havens like Mauritius
have fallen to pressure from the OECD - read developed
nations - and have agreed to adopt global tax
structures. For instance, Mauritius' budget for 1998 saw
it announcing several tax measures. However, when one
looks at the actual fiscal proposal, one can see why
these countries continue to be attractive to the global
investors.
Now take the instance of US investors
investing in India through Mauritius. While they enjoyed
a zero rate of tax prior to 1998 when they routed
investments through Mauritius, they still continue to
enjoy the best tax rates.
To illustrate, if a US
company were to invest directly in India, it would be
subject to a 42 percent corporate tax, inclusive of a 5
percent surcharge at current rates of tax. However, were
it to invest in India as a resident - foreign companies
incorporated in a country are considered residents of
that country for tax purposes - it would be taxed on a
par with a domestic company at 36.75 percent, inclusive
of surcharge. However, if the same investment were to be
brought in through Mauritius by a company incorporated
there after June 30, 1998, it would be subject to 15
percent tax.
Yet what needs to be pointed out is
that this handsome 15 percent corporate tax, as stated,
introduced on pressure from the OECD, is actually not
the effective rate of tax in that company. A 1996
regulation permits a company registered in Mauritius
with incomes in other countries to claim 100 percent
credit for tax paid on that income abroad. However, even
if the foreign investor cannot furnish "proof" of the
tax payment, the 1996 regulation also permits the
company to claim 90 percent credit against the sum it
claims it has paid as tax in another country on that
income. The net result is an effective rate of corporate
tax of just 1.5 percent, nowhere comparable with what
the company would have to pay were it to invest directly
in India or claim to be a resident of India.
The
same is the case with portfolio investments. Foreign
investments routed via Mauritius are tax exempt. If
invested directly in India as a US company, the transfer
of capital assets is subject to a 10-30 percent capital
gains tax, depending on the period of investment, and
how long the profits booked are retained in India.
Naturally, US companies prefer to route investments
through Mauritius. And it is for this reason that
Mauritius tops India's list of foreign direct and
portfolio investors.
Significantly, it is not as
if India is unaware of this loophole in the law, which
could be plugged with an anti-treaty shopping clause. In
1995, when Manmohan Singh was the finance minister, the
Indo-Mauritius DTAA was reviewed internally by the
Ministry of Finance, but the government took the
decision to turn a blind eye to treaty shopping via
Mauritius. The treaty was yet again reviewed internally
under P Chidmabaram and subsequently under Yashwant
Sinha as finance ministers. The Indian government
decided at both these points to let the situation
continue.
Whether this remains the case, though,
is now open to a considerable debate that investors will
be watching with keen interest.
(©2002 Asia
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