Those expecting a large market sell-off due to the changes made in the double tax avoidance agreement between India and Mauritius on Tuesday would have been disappointed. The Sensex closed less than one per cent lower, though the trading day was quite volatile.
This muted reaction is a signal of the efficient way in which the Centre has managed to deal with a very contentious issue that was an embarrassment to the country over the last two decades – the loosely structured Indo-Mauritius double tax treaty that allowed investors to get away by paying no capital gains tax on their investments in to India. The misuse of this treaty for round-tripping money by establishing shell companies in Mauritius was also a major concern.
So what’s changed now? Earlier, the treaty provided for taxing capital gains tax in the country where the investor was resident. For instance, if a Mauritian company invested in an Indian company, it had to pay capital gains tax in Mauritius. Since Mauritius does not tax capital gains, the companies evaded this tax altogether.
The change to the protocol now says that capital gains tax arising from an investment into an Indian company will be taxed in India. Investments from Mauritius will therefore be brought into the capitals gains tax net.
Smooth transition
While that is a big blow to those using this conduit, full marks to the Centre for making the changeover to the new regime very smooth. One, the change is prospective. That is only capital gains on shares purchased after April 1, 2017 will be subject to Indian tax. So no CGT arises on shares already purchased or those purchased up to April 1, 2017. FPIs can hold the shares already purchased, for as long as they wish and sell them whenever they deem fit. Not CGT will arise on these share transactions.
Post April 1, 2017, they can look for an alternate channel to invest money in to India or decide to pay the capital gains tax and continue investing through Mauritius.
Two, companies that have operations in Mauritius and can show that they have spent Rs 27 lakh as operating expense in Mauritius can pay just 7.5 per cent as short-term capital gains tax on shares purchased from 1st April, 2017 to 31st March, 2019. Since long-term capital gains tax rate is nil, long-term investors, need have no concerns at all.
After March 2019, foreign investors need to decide, based on the tax rates in India at that point in time, whether they want to invest in to India or not. Given the relative attractiveness of Indian equity, that should not be a tough choice.
The Singapore treaty
The changes made to Mauritius treaty will affect the DTAA with Singapore too as the Singapore treaty is linked to the Mauritius treaty. India-Singapore treaty states that “this Protocol shall remain in force so long as any Convention or Agreement for the Avoidance of Double Taxation between the Government of the Republic of India and the Government of Mauritius provides that any gains from the alienation of shares in any company which is a resident of a Contracting State shall be taxable only in the Contracting State in which the alienator is a resident.” In other words, the CGT benefit that foreign investors from Singapore were deriving will also probably go now. Clarifications are awaited about this.
Participatory notes
There is also a question mark over participatory notes issued by foreign investors. Since the primary buyers – the foreign investors – will now be subject to tax, does that mean that the P-note holder will also have to shell out tax?
However, payment of capital gains tax might not be a deterrent to P-note holders since the users of these instruments mainly veer towards them due to the convenience and opacity offered by this route.
What next?
The move brings parity in the taxation of domestic and foreign investors, which is very welcome. This also signals that the Centre is serious about tackling black money and in plugging round-tripping.
While earlier there were fears that portfolio flows were necessary to bridge the current account deficit and hence, the Mauritius route should not be touched, this fear has been allayed to a large extent by the strong FDI flows received by the country over the last one year. Since these are more long-term funds, it is these that need to be encouraged.
Foreign investors who invest for long-term will anyway not be affected since there is no long-term capital gains tax. Even if some short-term hot money moves away from the country to other centres such as the Singapore stock exchange, that should not be a major cause for worry.