Global Policy Forum

By Jayanthi Iyengar

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.

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