The consequences of capital gains tax from the amended tax convention between Mauritius and India

The Convention between Mauritius and India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to taxes on income and capital gains which came into force in 1983 mandated under Article 13 that capital gains derived by a resident of a State from the disposal of any movable property shall be taxable only in that State. The outcome is that any capital gain derived from an investment other than immovable property in an Indian resident company by a Mauritius resident company is taxable only in Mauritius. The Convention, as is the case with other bilateral Conventions, applies only to persons, which include companies, who are residents of one or both States. Hence, on disposal of movable investments by Mauritius resident companies in India, any capital gain derived in India could only be taxed in Mauritius where there is no capital gains tax (as opposed to income tax) to levy. Hence, the capital gain sourced in India is neither taxed by India nor by Mauritius.

On 10 May 2016, a Protocol was signed by the two States where  Article 13 of the Convention was renegotiated, giving India taxation rights on a source basis on capital gains arising from the disposal of shares (not movable property) acquired on or after 1^st April 2017 in an Indian resident company. Shares acquired prior to 1^st April 2017 will be grandfathered, that is retaining the right to use the old Article 13. For capital gains realised on shares acquired during the transitional period from 1^st April 2017 to 31^st March 2019, the tax rate will be limited to 50% of the domestic tax rate in India, subject to ‘Limitation of Benefits’ (LOB) clause and thereafter, the full domestic tax rate in India will apply.

The LOB clause requires that a resident of Mauritius (including a shell/conduit company) will not be entitled to the 50% tax rate in India if it fails the ‘main purpose’ and ‘bona fide’ business test. A Mauritius resident is deemed to be a shell/conduit company if its total expenditure on operations in Mauritius is less than INR 2.7 million or MUR 1.5 million in the immediately preceding period of 12 months. The LOB does not apply to a company listed on a recognised stock exchange.

The question that arises with regard to the grandfathering is the retention of records in Mauritius for those investments. The Mauritius Income Tax Act requires every person carrying on business in Mauritius to keep books, records or documents for a period of at least 5 years after
the completion, act or operation to which it relates. It is vital that the Mauritius resident company which has invested in India keeps all its records to be able to prove to the Indian Tax Office whether the nil capital gains tax is applicable whenever shares prior to 1^st April 2017 are disposed of. Capital gain in respect of the disposal of an asset is equal to the amount by which the proceeds received or accrued in respect of the disposal exceed the base cost of that asset. The base cost of the asset includes in the case of an investment the cost of the asset, the registration dues, the broker’s char-ges and any other incidental cost of acquisition. The onus to prove the grand fathering lies with the Mauritius resident company.

Secondly, the convention, as is the case with other bilateral conventions and with domestic laws, is meant to eliminate taxing income and capital gain (elimination of double taxation) in both States. The preferred method for such elimination is the credit method where credit for foreign tax is provided for deduction against domestic tax in the country of residence of the investing entity. Applied to a Mauritius resident company investing in India, credit for taxes suffered in India is allowed as a deduction from the Mauritius resident company’s income tax liability in Mauritius. However, such credit can only be provided to taxes of similar character. As there is no capital gains tax in Mauritius, capital gains tax suffered in India cannot be relieved against income tax in Mauritius and shall be non-deductible tax expenditure for the Mauritius company. It appears that the Protocol will largely discourage ‘round tripping’ or ‘treaty shopping’.

Round tripping, in the case of Indian residents, refers to routing investments by a resident of India through Mauritius back to India. Money is siphoned out of India and transferred to Mauritius where the money is treated as capital of a Mauritius registered entity. The money is invested back in an Indian company as foreign direct investment from Mauritius by bu-ying stakes or investing in Indian equity markets. With the current treaty without the Protocol, the capital gain made in India is not subject to any capital gain tax, thus allowing the Indian resident to get non-taxable fund (capital and gain) which primarily was undeclared before the round tripping.

Treaty shopping is the practice of structuring business to take advantage of tax treaties available. A business that is resident in a home country that doesn’t have a tax treaty with the source country from which it receives income establishes an entity in a country that has a favourable tax treaty in order to have a tax advantage. With the current treaty without the Protocol, a resident of a third country who earns capital gains from India (the source country) is able to benefit from the Convention between Mauritius and India to structure a resident entity in Mauritius so that the capital gain arising is not taxed.

True substance backed by administrative proof will henceforth be the order of the day. Otherwise, no treaty relief can be expected.