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Varun Matlani is Managing Editor of GNLU Blog on Corporate Laws, penultimate year student of GNLU and CA (Intermediate), Institute of Chartered Accountants of India.
INTRODUCTION
The India-Mauritius Double Taxation Avoidance Agreement (“DTAA”) has historically been a significant treaty for foreign investors seeking to access the Indian market.[1] Over the years, Mauritius emerged as a popular investment route, ranking the country fourth highest contributor of FPI investments[2] due to the favourable tax treatment provided under the DTAA, particularly the exemption from capital gains tax on the sale of Indian securities.[3]
However, the landscape has recently changed with the signing of a protocol dated 7 March 2024 (the “Protocol“)[4] to amend the India-Mauritius DTAA. The amendments, which are yet to be formally notified, aim to address concerns surrounding “treaty shopping” by incorporating a “Principal Purpose Test” (“PPT”) into the DTAA.[5] This article analyses the key provisions of the amended DTAA and its potential implications for foreign investors, particularly foreign portfolio investors (“FPIs”) and alternative investment funds (“AIFs”) with investments routed through Mauritius. This article also reviews the impact on grandfathering of investments or whether such drafting could be interpretated as retrospective as well in nature.
KEY PROVISIONS OF AMENDED DTAA
Introduction of the Principal Purpose Test (PPT)
Explanation of the PPT and its purpose The Protocol incorporates a Principal Purpose Test (PPT) into the India-Mauritius Double Taxation Avoidance Agreement (DTAA). The PPT is a general anti-abuse rule that aims to address concerns surrounding “treaty shopping” by allowing tax authorities to deny treaty benefits if it is reasonable to conclude that one of the principal purposes of any arrangement or transaction was to obtain a tax benefit under the DTAA. By means of the principal purpose test, the tax administration can deny the tax treaty benefit if one of the principal purposes of the action undertaken by the taxpayer was to obtain a benefit. This principal purpose test has been developed by the OECD with the political support of the G20 as one of the actions to tackle Base Erosion and Profit Shifting by multinationals (BEPS Project).[6]
The introduction of the PPT marks a significant shift from the previous regime, which primarily relied on the Tax Residency Certificate (“TRC”) issued by the Mauritian authorities to establish treaty eligibility. Under the PPT, the tax authorities can look beyond the formal legal structure and examine the underlying commercial substance and intent of the arrangement to determine if the principal purpose was to obtain a tax advantage.[7]
The PPT is inspired by the OECD’s recommendations under the Multilateral Instrument (MLI) to tackle instances of treaty abuse. The language of the PPT in the India-Mauritius Protocol is similar to the PPT provision contained in the MLI, which has been adopted by several countries as part of their tax treaty network. The underlying rationale behind the PPT is to ensure that tax treaties are not used for purposes that are contrary to their object and purpose, such as treaty shopping arrangements aimed at obtaining treaty benefits indirectly.
Implication of PPT
Potential impact on tax benefits for investments routed through Mauritius with the introduction of the PPT, foreign investors seeking to avail of the tax benefits under the India-Mauritius DTAA will now need to demonstrate that the principal purpose of their investments was not to obtain a tax advantage. This could potentially impact the tax treatment of various types of income, including capital gains, dividends, and other payments, which were previously exempt or subject to concessional rates under the DTAA.
The application of the PPT could lead to increased scrutiny by the Indian tax authorities on the commercial substance and intent behind investment structures routed through Mauritius. Taxpayers may be required to provide detailed documentation and evidence to substantiate that the principal purpose of the arrangement was not to obtain a tax benefit under the DTAA.
The impact of the PPT is likely to be felt most acutely in the context of capital gains taxation. The India-Mauritius DTAA had previously provided an exemption from capital gains tax on the sale of Indian securities for Mauritius residents. However, with the introduction of the PPT, this exemption may now be denied if the authorities conclude that the principal purpose of the investment was to avail of the tax benefit. [This would imply if the draft is interpreted with retrospective application]
Grandfathering of Pre-2017 Investments
Clarification on the treatment of investments made before April 2017, the 2016 amendment to the India-Mauritius DTAA had grandfathered investments made prior to 1 April 2017[8], allowing the continued application of the capital gains tax exemption for such pre-2017 investments.[9] However, the language of the current Protocol raises uncertainty as to whether this grandfathering protection will be extended to the new PPT requirement.
The 2016 amendment was prospective in nature, applying the capital gains tax to shares acquired after 31 March 2017, while grandfathering pre-2017 investments. This approach was in line with the general principle of non-retroactivity of tax laws, as affirmed by the Supreme Court of India in several rulings.[10] However, the current Protocol does not explicitly address the treatment of pre-2017 investments under the PPT, leading to concerns about potential retrospective application.
If the PPT were to be applied retrospectively, it could unsettle the settled position on treaty eligibility for Mauritius-based investors, even for investments made prior to the introduction of the PPT. This could potentially lead to a substantial tax liability for investors who had structured their investments based on the existing DTAA provisions and judicial precedents upholding the treaty entitlement of Mauritius residents.
The uncertainty surrounding the grandfathering of pre-2017 investments is a crucial aspect that requires prompt clarification from the Indian tax authorities. Investors need a clear and unambiguous position on the application of the PPT to ensure stability and predictability in the tax treatment of their existing investments.
IMPLICATIONS FOR FOREIGN INVESTORS
Impact on Foreign Investors
Scenario 1: Retrospective application to realized gains
In this scenario, the tax authorities could potentially re-examine FPI investment structures and transactions that have already been completed and realized. This could lead to substantial tax liabilities for FPIs, as the authorities may deny treaty benefits and impose capital gains tax on past sale of Indian securities. The retrospective application would undermine the settled position that FPIs had relied upon while making their investments, based on the existing DTAA provisions and judicial precedents upholding the treaty eligibility of Mauritius residents. This could severely erode investor confidence and lead to protracted tax disputes.
Scenario 2: Retrospective application to unrealized gains
Even if the retrospective application of the PPT is limited to unrealized gains on investments, it would still create significant uncertainty and compliance challenges for FPIs. FPIs would need to revisit their existing investment structures and prepare documentation to substantiate the commercial substance and principal purpose of these structures, in order to avoid potential denial of treaty benefits in the future. The burden of proving the principal purpose of historical investments could be onerous, especially for long-held positions. This could prompt FPIs to consider restructuring their portfolios or exiting certain investments to mitigate the tax risks, potentially disrupting the smooth functioning of the Indian capital markets.
Scenario 3: Only prospective application
If the PPT is applied prospectively, it would still increase the tax compliance burden for FPIs with investments routed through Mauritius, but the impact may be more manageable. Under a prospective scenario, FPIs would need to focus on ensuring that the principal purpose of their future investments through Mauritius is well-documented and substantiated to meet the PPT requirements. This may involve strengthening the local substance and operations of their Mauritius-based entities, exploring alternative investment structures, or diversifying their investment channels to other jurisdictions.
Alternatively, the prospective application may see a potential decline in Mauritius funding route and a shift in routing through GIFT City.
CONCLUSION
The amendments to the India-Mauritius Double Taxation Avoidance Agreement (DTAA), particularly the introduction of the Principal Purpose Test (PPT), have created significant uncertainty for foreign investors, including foreign portfolio investors (FPIs) and alternative investment funds (AIFs), with investments routed through Mauritius.
The lack of clarity surrounding the retrospective application of the PPT and the scope of grandfathering for pre-2017 investments is a major concern for these investors. A retrospective application could unsettle the established tax treatment of historical investments, leading to substantial tax liabilities and potentially undermining investor confidence in the Indian market.
Even if the PPT is applied prospectively, it will increase the compliance burden for FPIs and AIFs, requiring them to carefully document the commercial substance and principal purpose of their Mauritius-based investment structures. This could prompt some investors to explore alternative investment channels or restructure their existing portfolios, potentially impacting the flow of foreign capital into India.
To maintain India’s attractiveness for foreign investment, it is crucial for the Indian tax authorities to provide prompt and clear guidance on the scope and application of the amended DTAA, particularly regarding the treatment of pre-existing investments. A collaborative approach between policymakers and the investment community will be essential in navigating this evolving tax landscape and ensuring a stable and predictable regulatory environment.
[1] https://www.taxsutra.com/sites/taxsutra.com/files/dtaa/MAURITIUS%20DTAA.pdf
[2] https://www.fpi.nsdl.co.in/web/Reports/ReportDetail.aspx?RepID=14
[3] Article 13 of India-Mauritius DTAA
[4] https://newsonair.gov.in/?p=171079#
[5] The Protocol expands the “objects and purposes” of the DTAA to include a commitment to ensure that no opportunities for non-taxation or reduced taxation arise through tax evasion or avoidance, specifically including treaty shopping arrangements.
[6] https://globtaxgov.weblog.leidenuniv.nl/files/2020/06/beps_principal_purpose_test_and_customary_international_law.pdf
[7] https://economictimes.indiatimes.com/news/india/concerns-raised-regarding-recent-amendment-to-india-mauritius-dtaa/articleshow/109253678.cms?from=mdr
[8] https://incometaxindia.gov.in/DTAA%20Articles/Mauritius/108020000000005679.htm
[9] The 2016 amendment to the India-Mauritius DTAA grandfathered investments made prior to 1 April 2017, allowing the continued application of the capital gains tax exemption for such pre-2017 investments.
[10] The Supreme Court of India has consistently upheld the principle of non-retroactivity of tax laws in several rulings, such as Circular No. 789 (1999) and Union of India v. Tata Tea Co. Ltd. (2017).