The India Tax Treaty Amendment

The signature of an amending protocol to the India-Mauritius tax treaty has brought to a close a long and arduous process of
negotiations between the countries, spanning over two decades.

Background

For the first decade, tax incentives in the Treaty were strongly recognized as necessary to attract foreign investments to India. The Indian Government extended support to the Treaty at critical junctures, by validating the tax residence certificate in the CBDT Circular of April 2000, and appealing successfully to the Supreme Court in the Azadi Bachao Andolan case in 2003.

The Treaty thus withstood several onslaughts, including the negative fallouts from a major stock market scam, investigation by a parliamentary committee, several financial scandals, and strong public and media criticism. In 2005, Singapore was also granted the same capital gains tax exemption benefit as Mauritius.

In the second decade, as from 2006, India’s stance began to shift. The Mauritius investment route grew substantially in size, but became less relevant in strategic terms, relative to the foregoing of tax revenue. The tax treaty served India well, providing close to USD 100 bn of FDI equity flows between 2000 and 2015, but now seemed to have outlived its purpose.

Moreover, domestic tax developments, coupled with the Vodafone case, led to the introduction of General Anti Avoidance Rules (GAAR) in 2012, which, after several postponements, was set to be effective as from April 2017. GAAR’s implementation date proved to be an effective deadline to push for treaty revision.

Treaty changes

Following the signing of a draft protocol in July last year, a final amendment protocol was concluded last week, with two main changes to comfort the Mauritian side, namely the provision of a transition period and a clear grandfathering of existing business.

The final protocol eliminates the tax exemption of capital gains on shares in a phased manner, starting from April 2017, by applying the capital gains tax at half rate for two years until April 2019, and at the full tax rate thereafter.

Instead of zero taxation, interest on bank credit is now taxed at 7.5%, with a widened scope of the interest tax clause to cover non-bank debt as well.

A Limitation of Benefits (LOB) clause is incorporated, almost identical, word for word, to the LOB clause in the India-Singapore tax treaty. In line with the Singapore treaty, the Protocol introduces taxation of fees for technical services as well as of other income, and updates the article on exchange of information.

It is clear that the aim is to achieve a close alignment of the Singapore and Mauritius treaties, except for the two-year partial reprieve on capital gains taxation.

Strategic Issues

The terms of the Treaty Protocol amendment are widely at variance with the official line taken by the Mauritian authorities in negotiations until last year. Mauritius was willing to make two concessions, namely (i) to adopt a LOB, provided that capital gains tax exemption, termed as “sacrosanct”, is maintained, and that GAAR does not override Treaty provisions, and (ii) to accept a main purpose test for the interest clause. Mauritius was also agreeable to the latest revised standard of an automatic exchange of information.

By playing the geopolitical card at the highest political levels in India, Mauritius invariably succeeded in prolonging the status quo. However, the coming of GAAR made the status quo increasingly counter-productive. The share of Mauritius in FDI equity flows into India halved from 42% in FY 2012 to 21% in FY 2015, while Singapore more than trebled its share from 10% to 34% over the same period. Mauritian policy makers held the responsibility to opt for a more flexible negotiating strategy in the face of a looming GAAR deadline, and in response to a gradual but inexorable hollowing out of the tax treaty.

With economic growth running high at 7% p.a., and FDI at record levels, India is naturally impelled to reassert its tax sovereignty, especially in view of the incoming OECD-driven BEPS agenda for improving global tax fairness. As may be surmised, the conclusion of any deal on the treaty would necessarily imply the taxation of capital gains and bank interest, while issues such as setting a cap on the tax rates, or the duration of the adjustment period, would be open to negotiation.

The one tangible gain for Mauritius in the treaty revision lies in the expanded scope of the interest clause to include non-bank debt. The Indian offer of USD350 million in project-tied grants must have also contributed to nudge Mauritius towards a final settlement. Whether Mauritius could have opted for alternative solutions, by standing up to GAAR with an unrevised treaty, or striking more favourable terms, with or without grants, are issues for continuing discussion.

Economic Impact

However, the more practical concern is the prospective impact of treaty change on FDI and portfolio flows. Overall, Indian stock markets have not reflected any undue concerns from investors. Some worries prevail about the treatment of derivative participatory notes issued by institutional investors, but adverse sentiment has been mostly muted in India. In Mauritius, on the other hand, global business operators are taking a pessimistic view, mostly in fear of a drying up of new investment flows.

Global business and related activities are estimated to account for up to 5% of GDP, of which Indian treaty business represents at least two thirds, or a value added of about Rs13 bn annually. To sustain global business sector growth in the event of declining share investments, it is hoped that Mauritius can transmute into a debt-based jurisdiction. A new avenue for debt-related investments into India could emerge on the strength of the broadened interest clause in the amended treaty, and of the continuing capital gains tax exemption on debt instruments.

But a remaining source of investor uncertainty could still arise from the application of GAAR, in the absence of any LOB protection in the treaty, except on share capital gains for two years. Investors hold legitimate apprehensions about GAAR, which Indian officials are trying hard to dissipate. It will even prove difficult in practice to take full advantage of the share capital gains window, which is limited to only two years.

While the adverse effects of treaty changes on GDP and employment in Mauritius should be manageable, the risks to the country’s external balance could be more severe. The IMF warned in its March 2016 report on Mauritius that “external balance and domestic financial stability conditions are crucially dependent on continued funding from the GBC sector, which could be affected by a revision of the DTAA with India”.

Net GBC inflows, representing about 15% of GDP, are vital to prop up the balance of payments surplus of about 5% of GDP. The latest Moody’s analysis, following treaty amendment, estimates that “a curtailment of new investment flows through Mauritius would cause a deterioration in the balance of payments equal to 1-2% of GDP annually, and consequently put pressure on Mauritian foreign exchange reserves, and that a sharper shift in investor sentiment would have more dire consequences”.

The Bank of Mauritius expects “a mitigated impact on our banking industry in the foreseeable future” after treaty amendment, but cautions that “our jurisdiction could suffer should there be a failure to take imaginative actions to review, alter and innovate the business model that the sector has embraced for years.” The assessment by the Bank of Mauritius of the balance of payments impact is still awaited.

Conclusion

It is indispensable that a thorough review of the strategy and prospects for the financial services industry be conducted. The succession of negative shocks, foundering institutions, and a widening gap in policy credibility, are undermining the stability of the financial sector, which could lead to a searing crisis of confidence in the absence of corrective action.

Sushil Khushiram is a former Minister of Financial Services. This article is a slightly edited version of his intervention at the 10th IFA-Mauritius Conference held on 19-20 May, 2016

* Published in print edition on 27 May 2016

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