25 November 2021 - Article
Mauritius and India recently signed a protocol phasing out the Capital Gains Tax exemption available under their double-tax treaty with respect to the sale of Indian securities. This is a major development impacting both Mauritian and Singapore investment structures which currently contribute around 50% of the foreign direct investment into India.
India’s GDP is forecast to grow at around 7.5% this year, placing it well ahead of the other BRIC economies. Such a positive macro-economic trend, backed by its robust market and reform oriented Government, has made India a desirable destination for global investors.
Investments by Mauritian investors prior to April 1, 2017 are grandfathered and can continue to avail themselves of the Capital Gains Tax exemption. In the future, Dutch structures are likely to become more attractive for equity investments in India. However, with the lower 7.5% withholding tax on interest offered by the amended treaty, Mauritius may emerge as a preferred option for India-focused debt investments.
These structures will continue to be influenced by global developments, such as the BEPS initiative, and the growing consensus against aggressive tax-driven structures not justifiable by economic substance.
The amendment to the India-Mauritius treaty presents challenges as well as new opportunities − clearly a good reason to review and revisit structures and strategies for investing in India.
There are both commercial and tax-driven reasons for investing in India from Mauritius. Global investors consider Mauritius to be a stable and established holding company jurisdiction with advanced corporate laws and an efficient legal system. It offers unique hybrid vehicles such as the protected cell company, significant corporate flexibility and permits cross-border mergers.
The wide network of Bilateral Investment Protection Treaties (‘BIT’) signed by Mauritius is also an important benefit available to Mauritius based entities. The relevance of BITs, especially in the India-Mauritius context is discussed below.
Mauritian residents have benefited from the India-Mauritius tax treaty which exempts Indian Capital Gains Tax payable on the sale of Indian securities. In the absence of treaty relief, the tax liability ranges from 10% to 40%1 of the capital gains depending on the nature of the investment and the holding period.
To date, the Capital Gains Tax exemption has not been subject to any expenditure threshold, ‘substance’, limitation or relief criteria. Further, an Indian Revenue Authority circular2 states that the exemption is available to any entity that has received a tax residency certificate (‘TRC’) from the Mauritius Revenue Authorities. Over the years, there has been some debate and litigation on whether the TRC is sufficient to claim treaty relief. However, the Indian Courts have consistently affirmed the Capital Gains Tax exemption for Mauritian residents holding TRCs.3
In addition to the relief from Indian Capital Gains Tax available under the treaty, there is also no Capital Gains Tax in Mauritius and no withholding tax is imposed on dividends up-streamed by a Mauritian company to its shareholders.
As a result, Mauritius became a preferred route for investing in the shares of Indian companies. However, it was not popular for debt investments since the treaty did not reduce the Indian withholding tax rate on interest payments which could be as high as 40% for rupee denominated debt.
India-Mauritius treaty amendment
The recent amendment to the India-Mauritius tax treaty removes the Capital Gains Tax exemption with respect to all investments in the shares of Indian companies as from April 1, 2019.
A 50% reduction in Capital Gains Tax is available in relation to the sale of share investments after April 1, 2017 as long as the divestment occurs before April 1, 2019. This relief is subject to certain ‘substance’ criteria and is not available if the structure is not backed by business (i.e. non-tax) considerations or if the entity is a shell or a conduit. An entity is not considered to be a shell or a conduit if it incurs operational expenditure of around USD 40,0004 in Mauritius within a period of 12 months preceding a divestment.
Consequently, from April 1, 2017, a Mauritius holding structure may not be optimal for India-focused equity investments. However, it is likely to become a hub for debt investments into India. The amended treaty has reduced the Indian withholding tax rate on interest to 7.5% − lower than the 10% rate in India’s tax treaties with Netherlands, Luxembourg, and Cyprus and the 15% rate in the treaty with Singapore.
Impact on the Singapore route
Singapore is also a popular route for investment into India. It has emerged as a stable, respected and well regulated hub for investments across the whole Asia-Pacific region.
To date, entities resident in Singapore have been exempt from Capital Gains Tax on the sale of Indian securities, thanks to the relief available in terms of the India-Singapore tax treaty. This exemption is subject to a limitation of benefits criteria which requires that the structure is not primarily tax-motivated and that the entity is not a shell or a conduit. A Singapore resident entity is deemed not to be a shell or a conduit if it incurs annual operational expenditure of SGD 200,000 in Singapore for two years prior to any divestment. The exemption is also subject to the condition that a similar relief is available under the India-Mauritius tax treaty.
With the expiry of the full Capital Gains Tax exemption from April 1, 2017 under the India-Mauritius treaty, it will automatically result in the expiry of the similar benefit under the Singapore treaty. There is some ambiguity regarding whether any relief would be available to Singapore companies during the transition period between April 1, 2017 and April 1, 2019. These issues are likely to be taken up in the discussions to be held between the Indian and Singapore tax authorities which are expected soon.
Investment protection: It’s more than tax!
Although tax optimization is a key driver in investment structures, perhaps the most critical consideration is the safety and protection of investments. Effective use of Bilateral Investment Protection Treaties (‘BITs’) is a key risk management strategy, especially when investing into emerging economies such as India.
In addition to the tax treaty, Mauritius and India also have a BIT which provides various rights to Mauritius based entities, including fair & equitable treatment, non-discrimination, compensation for losses arising from expropriation, freedom to repatriate capital and income, settlement of disputes through international arbitration (as opposed to the Courts in India), as well as other reliefs.
There is no BIT between India and countries such as the US, Hong Kong, Luxembourg, Cayman Islands, BVI and various popular offshore jurisdictions. A sizeable proportion of investments into India originate or are pooled in such countries. In the absence of a BIT, such investments are exposed to the risks arising from arbitrary government policies or actions that may adversely impact the value of investments.
The Netherlands and Singapore5 also have agreements with India for the protection of investments. The objective of BITs is to promote bilateral trade and investments rather than tax collection. Therefore, most BITs are not subject to the ‘substance’, expenditure or limitation of benefits criteria common in tax treaties.
In the last few years, several global investors have made claims against the Indian Government under specific BITs. For instance, White Industries successfully sued the Indian Government under the India-Australia BIT for failure to provide effective means of enforcing its claims against Coal India (a Government entity). Around 17 BIT claims were made against the Indian Government when the 2g telecom licenses were cancelled. Even Vodafone invoked the India-Netherlands BIT after the retrospective tax amendment that resulted in a $2-3 billion tax liability even after the Indian Supreme Court had held that no tax was payable by Vodafone in relation to an overseas acquisition.
Irrespective of any relief available under the tax treaty, the benefits conferred by a BIT provide a compelling strategic reason for investing out of countries such as Mauritius, Singapore and the Netherlands.
Investing into India: Going forward
The amendment to the India-Mauritius tax treaty and the consequent impact on the Singapore route will have a major impact on MNCs, hedge funds, private equity, venture capital and other strategic investments focusing on India.
With the phasing out of the Capital Gains Tax exemption from April 1, 2017, neither the Mauritius nor the Singapore structures will be as attractive for India-bound equity investments as in the past.
Investors that have invested in convertible shares may face potential tax exposure if the instruments convert after April 1, 2017, since the equity shares issued by the Indian company on conversion cannot be grandfathered.
Dutch structures, however, still provide some advantage since a limited Capital Gains Tax exemption is available in relation to portfolio investments (less than 10%) and the sale of Indian securities by a Dutch investor to a non-resident.
While the amendment to the India-Mauritius treaty affects equity investments, it does not cover investments into Indian limited liability partnerships (‘LLPs’) which is now possible, without regulatory approval, in most sectors. The LLP structure is attractive since it eliminates the additional layer of dividend distribution tax of around 20% on profits up-streamed to investors.
The lower withholding tax on interest rate of around 7.5% makes Mauritius an attractive platform for investing in Indian debt securities. Structuring investments through convertible and non-convertible debentures can result in major tax efficiencies and is increasingly used in several sectors, especially thanks to regulatory reforms aimed at deepening India’s debt markets.
To secure this lower rate, it is important to demonstrate that the Mauritius entity is the ‘beneficial owner’ of the interest. Therefore, back-to-back debt structures may create risks if the Mauritius entity is required to pass on the interest to a third party. Similar risks may arise if a hedge fund (or a foreign portfolio investor) enters into certain derivative contracts such as total return swaps hedged by the underlying investments in Indian debt securities.
With the amendment, although the Mauritius or Singapore treaties may no longer exempt Capital Gains Tax on the direct sale of securities, they provide relief in situations involving the indirect transfer of Indian assets. Gains arising from the sale of foreign securities may be subject to tax in India if such securities derive more than 50% of their value from assets in India. This risk has to be constantly addressed in international mergers and acquisitions as well as in group restructures involving underlying subsidiaries and assets in India. Investors may therefore consider dual-tier structures providing the option to exit tax free at an offshore level by taking advantage of the relief available under the Mauritius, Netherlands or Singapore tax treaties.
In future, investors should also be cognisant of the onset of general anti-avoidance rules (‘GAAR’) in India from April 1, 2017. These rules override all tax treaties and target structures that are primarily tax driven and which lack commercial substance or are not bona fide or not arm’s length. It is therefore important to identify, demonstrate and document the business and strategic drivers behind each structure.
In most cases, the investment protection offered by an appropriate BIT is one reason important enough to justify using an intermediary jurisdiction like Mauritius, Netherlands or Singapore.