The last few years have witnessed substantial buoyancy in economic growth in emerging countries such as India. Also, the government over the last many years has substantially liberalized foreign direct investment (FDI) regulations. Accordingly, a number of multinational companies eyeing a piece of the Indian growth story are establishing a business presence in India in terms of incorporating an Indian subsidiary or entering into joint ventures with Indian business groups.
Hence, currently, foreign investments in very few sectors/industries require government approval, that is, approval from the Foreign Investment Promotion Board.
The experience thus far has been that, by and large, foreign investments in India have been structured though intermediary holding companies located either in Mauritius or Cyprus. Recent media reports have suggested that certain foreign investments requiring government approvals structured through Mauritius/Cyprus are being examined by the authorities and such investments through an intermediary holding company may possibly not be considered favourably.
The reports indicate that such a position is possibly being adopted by the government since investments made through tax havens such as Mauritius or Cyprus may result in loss of tax revenues for India and could potentially be considered what is commonly termed as “treaty shopping”.
The concept of treaty shopping is commonly understood as routing or structuring investments in a country through an intermediary country to minimize or mitigate tax incidence in the investee country compared with a direct investment in the country through the home country of the investor.
The double tax avoidance agreements executed by India with Mauritius and Cyprus get favourable treatment on capital gains derived on disposal of shares of an Indian company, that is, such capital gains would be subject to tax in Mauritius or Cyprus only.
Illustration: Jayachandran / Mint
Hence, structuring Indian investments through intermediary holding companies in Mauritius/Cyprus enables minimization of the tax cost on exit/divesture of the Indian investment and consequently increases the return on investments. This is why traditionally, several foreign investments in India are structured/routed through Mauritius and recently, Cyprus.
It is important to put matters in perspective: Some time in 2000, there was an apprehension that the benefit of the India-Mauritius tax treaty would be denied to foreign institutional investors registered in Mauritius on grounds that they were not really residents of that country.
Later on, to clear that apprehension, the Central Board of Direct Taxes (CBDT) issued Circular No. 789 dated 13 April 2000 clarifying that a “Tax Residence Certificate” (TRC) issued by the tax authorities in Mauritius would be regarded as conclusive evidence regarding residential status and, accordingly, the India-Mauritius tax treaty would apply.
Supreme Court decision
The CBDT circular was challenged in a public interest litigation by the Azadi Bachao Andolan and the matter reached the Supreme Court. The court in a very detailed judgement dated 7 October 2003, examined various aspects and held that if it was intended that a national of a third state should be precluded from the benefits of the India-Mauritius Treaty, then a suitable limitation of benefit (LoB) clause would have been incorporated.
The court referred to Article 24 of the India–US tax treaty, which specifically provides limitations subject to which the benefits under that treaty can be availed of. One of the limitations is that more than 50% of the beneficial interest (or in the case of a company, more than 50% of the number of shares of each class of the company) should be owned directly or indirectly by one or more individual residents of one of the contracting states. The court observed that Article 24 is in marked contrast to the India-Mauritius tax treaty.
By implication, where a suitable limitation clause does not exist in a treaty, it cannot be read into it.
Further, the court observed that there are many principles in fiscal economy which, though at first glance, they may appear to be evil, are tolerated in a developing economy, in the interest of long-term development.
“Deficit financing, for example, is one; treaty shopping, in our view, is another,” the court said. “Despite the sound and fury of the respondents over the so-called ‘abuse’ of ‘treaty shopping’, perhaps, it may have been intended at the time when the India-Mauritius tax treaty was entered into.
Whether it should continue, and, if so, for how long, is a matter which is best left to the discretion of the executive as it is dependent upon several economic and political considerations. This court cannot judge the legality of treaty shopping merely because one section of thought considers it improper. A holistic view has to be taken to adjudge what is perhaps regarded in contemporary thinking as a necessary evil in a developing economy.”
India-Singapore tax treaty
India has signed a Comprehensive Economic Cooperation Agreement (Ceca) with Singapore. As a part of Ceca, the two countries have also signed a protocol that forms part of the India-Singapore tax treaty.
According to Article 1 of the protocol, capital gains arising on transfer of shares are taxable as per local laws of the country in which the seller/transferor is a tax resident.
So, gains on the sale of shares of an Indian company would be subject to tax only in Singapore. However, Article 3(1) of the protocol clearly states that the beneficial provisions in respect of taxation of capital gains shall not be applicable if the affairs of the company are arranged with the primary purpose of taking advantage of the benefits of the India-Singapore tax treaty. Thus, though the tax treaty provides treatment similar as the India-Mauritius/Cyprus tax treaties on taxation of capital gains in India, there is one major differentiating factor—the provision of the LoB clause. Hence, the India-US and India-Singapore tax treaties are clear examples of tax treaties containing the LoB clause, thus limiting the applicability of the treaty and possibly preventing treaty shopping.
Amended India-UAE tax treaty
Another example where the Indian government has plugged the beneficial provisions of taxation of capital gains is the India-UAE tax treaty.
The original treaty provided that the capital gains derived from alienation of shares of an Indian company would be subject to tax in UAE only. Further, the original treaty did not contain an LoB clause. However, recently, India and the UAE signed a protocol to amend the treaty.
The protocol provides that gains derived from the sale of shares of an Indian company would from 1 April be subject to tax in India. Further, the protocol has introduced an LoB clause whereby a resident of a contracting state shall not be entitled to take advantage of the India-UAE tax treaty if the main purpose of the creation of such an entity was to claim the benefit of the treaty, that otherwise is unavailable.
Tax treaties executed by India with countries such as the US, Singapore and UAE clearly have an LoB clause to prevent treaty shopping. Further, the Supreme Court has also mentioned that unless a tax treaty has a specific clause on to LoB, a national of a third nation should not be precluded from taking the benefit of a favourable tax treaty. Further, CBDT itself has issued a circular stating that TRCs issued by the Mauritius tax authorities should be conclusive evidence for claiming benefit of the India-Mauritius tax treaty.
In fact, for validity and the issuance of this very circular, the government and CBDT had filed a special leave petition in the Supreme Court, which was upheld by the court.
So, the position now being adopted by the government while approving FDI from countries such as Mauritius/Cyprus seems contradictory to its own earlier position. Further, FDI regulations themselves do not contain any provision whereby the investor is precluded from structuring its investments into India through a third country.
In summary, it is important for the government not to mix up approval of a regulatory body on the basis of tax benefits claimed and that too, tax benefits that are clearly envisaged by a treaty and blessed by the highest court of the land. The perception of India’s approach to FDI will take a significant hit should that distinction not be kept.
Ketan Dalal is executive director and Manish Desai is associate director, PricewaterhouseCoopers. Your comments and feedback are welcome at groundrules@livemint.