Should FPIs be worried about latest change to India-Mauritius tax treaty

Changes in tax treaties between India and Mauritius might have made Mauritius a less attractive route for foreign investments

Foreign portfolio investor (FPI) money channeled through Mauritius has historically played a role in the Indian market, but recent amendments to the tax treaty raise questions about its future significance. Last month, India and Mauritius amended their tax treaty to introduce the PPT. This means that simply having a Tax Residency Certificate (TRC) issued by Mauritius is no longer enough to claim tax benefits under the treaty.

Current Scenario:

1. Over 600 FPIs from Mauritius manage roughly $50 billion in assets under custody (AUC) in India. This translates to approximately 6% of the total FPI AUC in the country.
2. In March 2024, Mauritius funds held only 5.61% of the total FPI equity AUM in India.
3. Comparison: This is a sharp drop from 14.53% they held five years ago
4. Current Ranking: As a result, Mauritius-based funds are now the fourth largest investor by geography, following the US, Singapore, and Luxembourg.

" This change the in the treaty means that benefits of lower taxation as available under the treaty can be denied to investors investing via Mauritius if one of the primary purposes of investing via Mauritius was to obtain a tax Benefit. Investment via the Mauritius route were already on the decline and this step will further ensure that only those funds which can prove legitimate business reasons to be based out of Mauritius, will choose to invest through that jurisdiction," said Pallav Pradyumn Narang, Partner, CNK

Why the Change?

This amendment aims to prevent "treaty abuse," where investors exploit loopholes in tax treaties for tax advantages. This move aligns with global efforts to combat tax evasion. The PPT aims to prevent "treaty abuse," where investors use jurisdictions like Mauritius solely to benefit from lower tax rates, without having a genuine economic connection to the country.

Why is the government looking to plug loopholes in the  DTAA agreement between India and Mauritius?

Many companies and individuals set up investment vehicles in Mauritius and route investments through them just to save on tax. The DTAA is a bilateral agreement aimed at preventing double taxation of income earned in one country (India) by residents of the other country (Mauritius)

The Golden Age (Pre-2017):

Mauritius has historically been a popular tax haven due to its low or no capital gains tax rates. Since India's long-term capital gains tax was 10% (at that time) and Mauritius's was near zero, investors effectively paid close to no capital gains tax on their Indian investments by routing them through Mauritius.

In simpler terms, imagine you're an investor and want to invest in India. Normally, you'd pay a capital gains tax when you sell your investment for a profit. But by setting up a company in Mauritius (which has a very low capital gains tax), you could channel your investment through that company to India. This way, when you sell your Indian investment and make a profit, you'd pay taxes in Mauritius, which were much lower than those in India.

The Advantage:

1. Before 2016, the DTAA between India and Mauritius allowed investors based in Mauritius to be taxed on their Indian investments at the lower rate applicable in either country.
2. The India-Mauritius tax treaty exempted capital gains tax on both sides, leading to significant foreign investment inflows routed through Mauritius.
3. Many businesses and funds, despite having no real presence in Mauritius, set up shell companies there to channel investments into India tax-free.

The First Amendment (Post-2017):

1. Before 2017, investors could avoid Indian capital gains tax by routing investments through Mauritius. The amendment now taxes capital gains from post-2017 Mauritius investments in India, regardless of the investor's location.
2. Existing investments (pre-2017) remain protected under the grandfathering clause.
3. The LOB clause ensures the treaty benefits are only enjoyed by genuine Mauritian residents.
4. This significantly reduced the appeal of the Mauritius route for fresh investments.

The Latest Amendment: The Principal Purpose Test (PPT)

1. A new hurdle has been introduced - the PPT.
2. This test assesses the primary reason behind an investment structure.
3. If the sole purpose of using Mauritius is to gain tax benefits under the treaty (without a legitimate business connection), the treaty benefits will be denied.
4. This aims to curb "treaty shopping," where investors exploit loopholes for tax advantages.

"It is important to note that the plan is not only for Mauritius treaty. The primary objective here is a global effort to stop Base Erosion and Profit Shifting by Multinational Corporations. We can see the same clause being added in other treaties as well to stop MNCs from treaty shopping for their benefit. 

However, it is important to note that the old investments (made prior to 2017) which continued to be exempted from tax in the previous amendment have not been given any exemption this time. Hence, we may see challenges by the tax department for the those investments which were made prior to 2017 through the Mauritius route," said Ankit Jain, Partner, Ved Jain & Associates.

How Does the PPT Work?

"The proposed amendment to the India-Mauritius Double Taxation Avoidance Agreement (DTAA) introduces a Principal Purpose Test (PPT) requirement for Foreign Portfolio Investors (FPIs) and other investors seeking to avail themselves of capital gains benefits. What this essentially means is that if is found that the sole purpose of a transaction structured out of Mauritius by a third country resident is to gain the benefit of the favourable tax regime offered under the treaty, then in such cases India may opt to deny favourable treaty benefits concerning capital gains tax to such investors due to ‘treaty abuse’,"Keshav Singhania, Private Client Leader, Singhania & Co.

Since India introduced General Anti-Avoidance Rules (GAAR) in 2017, foreign funds have been prohibited from selecting jurisdictions solely for tax advantages. 

"The latest amendment further extends scrutiny to investors, requiring them to undergo comprehensive investigations and answer comprehensive questionnaires that help the Mauritius authorities to better understand the structures and understand whether there is sufficient commercial rationale for being based in Mauritius,, i.e., the investors will be required to prove that they have commercial reasons and an appropriate business structure for being based in Mauritius rather than simply availing the tax benefits" said Singhania.

Indian tax authorities will now have the power to look beyond the TRC and assess the entire structure of an investment. They will consider:

Commercial Rationale: Does the investment make business sense beyond just tax benefits?

Substance: Does the Mauritius-based entity have a real presence and activity, or is it just a shell company?

Overall Structure: Is the investment structure designed primarily to gain tax advantages?

The new treaty is expected to result in the denial of tax reliefs for assorted incomes – dividend, royalty, technical free etc. , to investors and traders from Mauritius. Indian HNIs who take the Mauritius route for tax avoidance will also be impacted.

What Does This Mean for Investors?

Existing investments from Mauritius will be subject to the PPT test as well. Investors need to demonstrate a legitimate business purpose for using Mauritius beyond tax benefits.

" CBDT Circular 789 had clarified that TRC by Mauritian authorities will constitute sufficient evidence of residence to claim benefits of tax treaty.  Later, the Supreme Court of India in the case of Azadi Bachao Andolan upheld the validity of Circular No. 789.  With PPT test now introduced in the India-Mauritius tax treaty, tax authorities in India are likely to look beyond TRC and will have the ability to deny the benefit of India-Mauritius tax treaty if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining the treaty benefits was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly such tax benefit.  The tax authorities will have the ability to take a closer look at the structure, and assess the intent and commercial rationale, before granting treaty benefits.  Existing structures / investments from Mauritius will now need to pass through the PPT test," said Lokesh Shah, Partner, INDUSLAW .

Impact on Investors:

1. This change might lead to increased scrutiny from Indian tax authorities.
2. Investors using Mauritius for legitimate business reasons should not be concerned.

"Although there has been an initial backlash due to this proposed change, causing FPIs withdrawing approximately Rs 8,000 crore from Dalal Street, causing an 800-point drop in the Sensex, the government has assured that the domestic liquidity is sufficient to absorb these outflows. 

Additionally, the Income Tax Department of India has reassured investors through a tweet that the change is pending ratification and notification under Section 90 of the Income Tax Act, alleviating immediate concerns over investment withdrawals," said Singhania.

While the full impact of the 2024 amendment remains to be seen, it signals a stricter approach to tax treaties. This could potentially lead to a shift in how foreign investments flow into India, with a greater emphasis on transparency and legitimate business purposes.