Unclear terms in India-Mauritius tax treaty may stifle the FII

Unclear terms in India-Mauritius tax treaty may stifle the FII

Unclear terms in India-Mauritius tax treaty may stifle the FII romance with India, says Sudhir Kapadia.

Foreign investors have been using the Mauritius holding company structure to make investments in India right from the early 1990s. Following the liberalisation of the Indian economy, the Indo-Mauritius Double Tax Avoidance Agreement, or DTAA, was "discovered" as an effective mechanism to avoid capital gains tax on sale of shares in Indian companies. The first "attack" on the (mis)use of the Mauritius DTAA was launched by Indian revenue officials in 2003 against some foreign institutional investors, or FIIs. Following investigations into the investment pattern of these FIIs, the Bombay High Court ruled that the Mauritius entities floated by them were mere "shell" companies without any commercial or economic substance and, therefore, did not qualify for capital gains tax benefits under the Mauritius DTAA.

 Kapadia's take

  • FIIs have been using the Mauritius route to invest in India since the 1990s
  • They have been using the India-Mauritius taxation treaty for tax benefits
  • Recent court rulings on tax benefits and obligations have caused uncertainty
  • The treaty needs to clearly spell out the conditions for giving tax breaks

The ruling, however, created great uncertainty among FIIs in particular and foreign investors in general, leading to a free fall in the Indian capital markets. The Central Board of Direct Taxes promptly issued clarifications saying Mauritius entities would be eligible for benefits under the DTAA if they obtained a bona fide Tax Residency Certificate. The matter went right up to the Supreme Court (referred to as the Azadi Bachao Andolan case), which ruled that as long as legally tenable agreements had been entered into by the parties concerned those had to be respected and any consequential tax benefits could not be denied to them on the ground of "substance over form".

The Mauritius controversy resurfaced five years later, when the Bombay High Court upheld the action of the tax officer who denied a 'nil withholding tax certificate' to a Mauritius entity (E*Trade) for capital gains made on sale of shares in an Indian company. E*Trade then approached the Authority of Advance Rulings, or AAR, which upheld the treaty benefits based on the Supreme Court's decision in the Azadi Bachao Andolan case. However, the Supreme Court has admitted a special leave petition, or SLP, filed by the tax authorities against the AAR ruling in the E*Trade case.

We now have another Bombay High Court judgment in a case involving AB Nuvo and Tata Industries Limited, or TIL. The key issues before the court were whether the capital gains on transfer of shares of Idea Cellular Limited, or ICL, from AT&T Mauritius to AB Nuvo as well as transfer of AT&T Mauritius shares from AT&T US to TIL were taxable in India and whether AB Nuvo and TIL could be regarded as representative agents of AT&T US for recovery of Indian taxes.

The court noted the key facts under the original joint venture agreement in which the obligation to subscribe and own shares of ICL was on AT&T US, and all rights over the shares vested with AT&T US and payments made by AT&T Mauritius were on behalf of AT&T US. Accordingly, the court held that even though shares were registered in the name of AT&T Mauritius, it could not be treated as legal or beneficial owner. Moreover, the court held that the tax authorities were justified in proceeding against AB Nuvo and TIL and treating them as representative agents of AT&T US for recovery of Indian taxes, even though AB Nuvo had obtained the nil withholding tax certificate from the tax officer and TIL had paid withholding tax along with interest to the tax authorities.

Whilst the Bombay High Court judgment seems to be based on specific facts of the case, it has again created uncertainty over the use of Mauritius as a route for foreign investments in India. It also has grave implications for the buyers of shares in Indian companies. Here was a case where both the Indian parties involved had duly complied with the withholding tax process, but are now having to defend proceedings against them right through the Supreme Court when, in fact, the income obviously belongs to the foreign company. This creates a lot of uncertainty among purchasers over tax obligations.

These developments have cast fresh doubts over the use of Mauritius as an investment route. From an overall foreign investment climate perspective, India should seriously consider incorporating definitive conditions in the Mauritius treaty (like in the case of the treaty with Singapore) under which benefits will be available. This will spell out the circumstances under which treaty benefits will not be sought to be denied by the revenue authorities.

The author is National Tax Leader at Ernst & Young. Views expressed are personal