The Indian Government on 10 May 2016 entered into a Protocol with the Mauritius government to amend the India-Mauritius double tax avoidance agreement (Mauritius DTAA)which was entered in 1983.Amid the changes in tax environment both in India with introduction of General Anti Avoidance Rules (GAAR) and globally with introduction of Base Erosion and Profit Shifting (BEPS), the amendments introduced by the protocol have far-reaching impact on taxation of income earned by Mauritius resident in India.
One of the key features of the protocol is the shift to source based taxation of capital gains from the hitherto residency based taxation i.e. as per the protocol, capital gains arising on sale of shares of an Indian company by a Mauritian resident shall be taxable in India (where the source of income lies) as against the earlier position of taxability in Mauritius (based on the residency of the seller). Since the amended protocol covers shares, both equity as well as preference should be covered.
Gains arising to a Mauritian resident on the transfer of an Indian company's shares acquired prior to 1 April 2017, will continue to be exempted from tax in India, regardless of when they are sold.
Transition period and Limitation of Benefit (LoB)
The protocol provides for a relaxation in respect of capital gains arising to Mauritius residents for shares acquired on or after 1 April, 2017 and sold before 1 April, 2019 i.e. transition period. The tax rate on any such gains shall not exceed 50% of the domestic tax rate in India. However, this benefit has been made subject to a limitation of benefits (LoB) article.
Such a lower tax rate would be available to Mauritius tax residents only on satisfaction twin conditions of (1) if its affairs are not arranged with the primary purpose to take advantage of lower tax rate or (2) the Mauritius company is not a shell of a conduit.
A Mauritius company shall be deemed not to be a shell/conduit company if:
(a) it is listed on a recognized stock exchange; or
(b) its expenditure on operations in Mauritius is equal to or more than Mauritian Rupees1.5 million or Indian Rupees2.7 million in the immediately preceding period of 12 months from the date the gains arise.
Capital gains on instruments other than shares
The amendment seeks to tax gains on sale of shares and thus gains arising on sale of instruments like compulsory convertible debentures (CCDs), derivatives, etc. will continue to be taxed in Mauritius only even after 1 April 2017.
Impact on convertible instruments and bonus shares
Acrucial cut-off date in the revised protocol is 1 April, 2017. Equity shares acquired before 1 April, 2017 are grandfathered. However there is ambiguity relating to taxability of instruments like convertible preference shares, convertible debentures acquired before 1 April, 2017 but converted into equity after 1 April, 2017.
A better view may be that unlike convertible debentures in the case of convertible preference shares, the shares already existed and conversion is merely a change in the terms, and thus grandfathering should apply.
Though the point of conversion is generally not dealt with in the DTAAs, the grandfathering provision being unique to Mauritius DTAA, the same could lead to potential litigation, unless a clarification is provided in this regard.
It may be reasonable to say that grandfathering may not be available to conversion of convertible debentures and bonus shares issued after 31 March, 2017 where the original debentures/shares were issued/ acquired prior to 31 March, 2017.
Shares allotted pursuant to group reorganization
Typically, group reorganizations such as merger, demerger in India are tax neutral (subject to fulfilment of certain conditions)and the shares received by the shareholder of merging or demerged company on such reorganization enjoy period of holding associated with the original shareholding in merging and demerged entity. However, clarity would be required regarding application of grandfathering in case of shares allotted to Mauritius resident pursuant to a merger or demerger in lieu of shares held in the merging or the demerged entity which were acquired before 1 April, 2017.
Post amendment, direct transfer of Indian company shares by a Mauritius resident after 1 April, 2017 shall be taxable in India. However, indirect transfer may still remain out of Indian domestic tax net. To illustrate in a structure where there are two Mauritius companies say M Co 1 and M Co 2 wherein M Co 1 holds shares of M Co 2 which in turn holds Indian company shares and derives substantial value from India. In such a situation transfer of shares of M Co 2 by M Co 1 leading to an indirect transfer of Indian company shares may still not be taxable in India. Further, in cases of such indirect transfers, the grandfathering available to M Co2 with respect to its holding in Indian Company may be available to the new buyer.
The purpose test and expenditure test in the LoB article are welcome introductions as they bring the DTAA in compliance with BEPS action Plan 6 - 'Preventing the granting of treaty benefits in inappropriate circumstances'.
It will be interesting to see whether the grandfathering provisions regarding shares acquired before 1 April, 2017 and conditions prescribed in the LOB clause will be sufficient under the GAAR provisions to prove the bona fide to claim the benefit of Mauritius DTAA.
Treaty benefit under India-Singapore DTAA
The India-Singapore DTAA ("Singapore DTAA") provides that capital gains arising to a Singapore resident on sale of Indian company shares shall not be taxed in India so long as the Mauritius DTAA continues to provide the benefit of residency based taxation.
Consequent to the changes in the Mauritius DTAA, the sale of Indian company shares by a Singapore resident will now be taxable in India. However, unlike the Mauritius DTAA, the absence of the grandfathering provision in the Singapore DTAA will lead to uncertainty regarding taxability of shares acquired before 1 April, 2017by Singapore resident and may also lead to litigation.
One possible view may be that since the Singapore DTAA provides capital gains tax benefit as long as the Mauritius DTAA provides the same and the capital gains benefit under the Mauritius DTAA is available on shares acquired before 1 April, 2017, the same will apply in case of the Singapore DTAA as well. However clarity in this regard is required considering Singapore accounts for a major chunk of foreign direct investment (FDI) in India.
It is pertinent to note that a Government official has said that the Singapore DTAA will be renegotiated to bring it in line with the Mauritius DTAA. It is expected that the government would provide a level playing field for investments and avoid arbitrage between jurisdictions. The grandfathering provisions should, therefore, be built into the Singapore DTAA as well.
With lowering of withholding tax (WHT) on interest to 7.5%, the new protocol has provided a sweetener in favour of debt securities like CCDs. The WHT of 7.5% is lower than the one provided in other DTAAs like Netherlands (10%), Singapore (15%), UAE (12.5%), etc. Further unlike dividend, the above interest paid by the Indian company and used for business purpose shall be tax deductible in India.
The combined benefits of lower WHT, tax deduction to the Indian company and tax exemption on the sale of CCDs may make it a preferred instrument going forward for investment in India.
Most favoured nation (MFN) clause
Various DTAAs entered by India provide for an MFN clause pursuant to which if India enters into a Convention, Agreement or Protocol with another country which reduces the tax rate of items of income like interest income, then such reduced tax rate shall apply in case of their DTAA as well.
Since India has entered into a protocol with Mauritius reducing the rate of tax to 7.5%, it will need to be seen how the same impacts India's DTAA with other countries wherein the MFN clause w.r.t. interest is provided.
Another important amendment is made in the "other income" article wherein like capital gains, source based taxation provision is introduced. This may have an impact on group restructuring like shareholding migration done by gifting/ contributing Indian company shares to a Mauritius company. Prior to this amendment, gift of shares was taxable in Mauritius and not in India. However such gift of Indian company shares will be taxable in India post the protocol coming into effect.
(a) Similar to other tax treaties, provision relating to taxation of fee for technical services (FTS) has been introduced in the protocol wherein FTS arising in India and paid to the Mauritius resident may be taxed in India at 10% of the gross amount of FTS if the beneficial owner of the FTS is a resident of Mauritius.
(b) The scope of the term permanent establishment has been widened by the protocol to include the activity of furnishing of services, including consultancy services.
(c) The WHT rate on interest arising in India to Mauritius resident banks have been increased to 7.5% in respect to debt claims and loan made after 31 March, 2017. At present such income is exempt in India.
(d) The existing provisions in the treaty relating to Exchange of Information and assistance in tax collection have been modified.
The Protocol is a welcome move and is likely to bring in more certainty and transparency on taxability under the Mauritius DTAA which has been a matter of litigation for a long time. This is also likely to reduce litigation. Credit must be given to the government for the phased manner in which the treaty is sought to be amended providing sufficient time to the investors to react and plan their affairs.
This step will also address the concern regarding ease of doing business in India.
Grandfathering of convertible instruments, impact on group reorganization, impact on the Singapore DTAA, etc. should also be clarified in order to avoid litigation. Further, it may be interesting to see whether Netherlands will now emerge as an attractive destination for FDIs in India following the changes to the Mauritius DTAA and its consequent impact on the Singapore DTAA as well.