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India Presses Mauritius To Renegotiate Treaty

Tuesday, May 25, 2010

The Indian government would like to see an end to the provision in the India-Mauritius tax treaty which provides that capital gains from sale of securities in India can only be taxed in Mauritius, especially with regard to "treaty shopping". In the absence of a capital gains tax in Mauritius, more than 40% of foreign investment inflows to India are routed through Mauritius, more than any other country.

“A team is going to Mauritius… we are on the job,” finance minister Pranab Mukherjee told reporters, "but the process could take as long as negotiating a new treaty."

Earlier in 2010, Milan Meetarbhan, the Chief Executive of Mauritius's Financial Services Commission (FSC), defended the tax treaty, arguing that Mauritius was not a tax haven. He denied that the treaty resulted in a high incidence of "round-tripping," whereby funds are transferred illegally out of India and then transferred back as foreign investment into the Mumbai stock market via participatory notes. However he did agree to address Indian concerns on the matter through tighter checks on treaty abuse by Indian entities.

There had been suggestions earlier this year that the Indian government might include a clause in the Direct Tax Code which would override India's tax treaties on the matter of treaty abuse, but the legal controversy this caused has meant that this proposal will probably be quietly dropped.

In its negotiations of other treaties after 2004, India has insisted on limiting the benefits clause with an anti-abuse provision. The limitation of benefit clause in the India-Singapore treaty provides for an expenditure test to demonstrate commercial substance, and a similar clause was included in the UAE treaty, whilst Cyprus is also reportedly under pressure to accept such an amendment.

A recent judgement in the Indian courts has highlighted that changes in the double taxation treaties are needed rather than relying on commercial substance arguments. A Mauritius resident company, also a subsidiary of a US company, used capital contributions and loans from the US parent to buy shares in ILFS, an Indian company. On sale of the shares, the Mauritian company succeeded in arguing that earned capital gains were not chargeable to tax in India through Article 13 (4) of the India-Mauritius tax treaty.

The Indian tax department objected unsuccessfully on the ground that the real and beneficial owner of the capital gains was the US company, and the Mauritius company "merely a façade" to avoid capital gains tax in India. According to the judgement, for the act to be a ‘sham’, the parties must have had a common intention not to create the legal rights and obligations which they gave the appearance of creating.