The Double Taxation Avoidance Agreement (‘DTAA’) entered into by India with Mauritius on 24th August, 1982 and made effective from 1st April, 1983 was the first of its kind wherein the right to tax the capital gains arising to a resident of Mauritius from transfer of shares of an Indian company was completely allocated to Mauritius. Tax on dividend received by a resident of Mauritius from an Indian company was also taxable only at 5% under the DTAA which was otherwise taxable at 25% under Section 115A of the Income-tax Act, 1961 (‘the Act’). These beneficial treaty clauses enabled the flow of more than USD 90 Billion (which accounted for one third of total investments in India) within a short span of 15 years, into India as Foreign Direct Investment (‘FDI’) from Mauritius.
Sensing the highly beneficial provisions of the Indo Mauritius DTAA, many entities which were actually being controlled and managed from countries other than Mauritius started setting up shell entities (what are called as ‘letter box’ companies) in Mauritius, and routed investments into India, though such shell entities. As queries were raised by Revenue Authorities on the eligibility of investment companies to the DTAA, the Central Board of Direct Taxes (‘CBDT’) vide Circular No 682 of 1994 [see end note1] clarified that production of Tax Residency Certificate (‘TRC’) from the Mauritian Revenue Authorities would suffice entitlement of a Mauritian entity to the DTAA. This Circular was quashed by the Delhi High Court in Shiva Kant Jha v. Union of India [see end note 2] as being ultra vires the Act, but was upheld by the Supreme Court in Union of India v. Azadi Bachao Andolan [see end note 3] as being issued well within the powers of CBDT and also binding on all Revenue Authorities.
The Supreme Court laid great emphasis on the need to follow the provisions of a DTAA especially when two governments have consciously agreed to certain terms and extended certain tax benefits keeping in mind the economic necessities prevailing at that time. Any attempt to ignore or override the provisions of a DTAA was held not to be permissible unless there was a bilateral agreement to modify the agreed terms. The Indo-Mauritius DTAA stands modified, with both the Government of India and the Government of Mauritius entering into a Protocol to this effect on 10th May, 2016. This article deals with a few practical implications of the protocol.
Gains from transfer of CCDs, options and other structured products would still be taxable in Mauritius only
The protocol, amends Article 13 of the DTAA dealing with ‘Capital Gains’. According to the amendment, gains from alienation of shares acquired on or after 1st April, 2017 in an Indian company in India is liable to tax in India from 1st April, 2017.
In order to provide a smooth transition, it has been provided that the rate of tax applicable to any gains from sale of shares from 1st April 2017 to 31st March 2019 shall not exceed 50% of the domestic tax rate prevailing in India.
This amendment however does not affect the ‘residuary clause’ of Article 13. The gains from alienation of movable assets ‘other than shares’ (and ships/ aircrafts), like compulsory convertible debentures CCDs), call and put options and other structured products qualifying as ‘securities’ under the Securities Contract (Regulations) Act, 1956, though deriving their value form the underlying shares of an Indian company, would also continue to be tax free in India.
It can be noted that the amendment to Section 9(1)(i) of the Act post the judgment of Supreme Court in Vodafone International Holdings BV v. Union of India [see end note 4] deems any asset in the form of ‘any interest’ in a foreign company to be regarded as located in India if interest derives, directly or indirectly, its value substantially from assets located in India. However, the Protocol to Mauritius DTAA in so far as providing taxing rights to India only covers gains from alienation of ‘shares’ in a ‘company resident of India’. Shares and other assets that derive their value from shares are clearly distinct assets. Hence, though the transfer of other assets that derive their value from shares located in India can be taxed in India under the Act, even under the amended Mauritius DTAA, such other assets would be taxable only in Mauritius.
This would evolve newer hybrid securities being introduced in the financial market to continue investments in Indian companies while not being hit by the amended provisions of DTAA.
Transfer of hybrid instruments converted into shares post 2017 liable to tax in India – earning stripping still an option
While transfer of a hybrid instrument per se would not be taxable in India, the transfer of shares allotted upon the instrument’s conversion (either compulsorily or voluntarily), would be subject to tax in India.
Section 49(2A) of the Income Tax Act clarifies that for computing capital gains on sale of shares received on conversion of debentures, cost of acquisition of shares shall be cost of convertible debentures. The Punjab and Haryana High Court in CIT v. Naveen Bhatia  62 taxmann.com 87 (P&H) has held that the period of holding of such converted shares for computing capital gain tax shall be reckoned from the date of acquisition of convertible instrument. A hybrid instrument would earn interest till the time it is treated as debt and would also reduce the tax liability on transfer of shares allotted on its conversion. A prudent investor can thus take a conscious call to be taxed under the DTAA so as to adopt an earning stripping to reduce his overall tax liability.
For example, 9% Optionally Convertible Debentures (OCD) of Rs. 100 Million is issued in 2010 for being converted into equity in 2020. In 2020, if the underlying value of shares as well as market value of OCD is Rs 225 Million, should the OCD be sold off as such or should they be converted into shares and then transferred? It would appear to an accountant that the OCD holder would be better off selling the OCD at Rs 225 Million instead of receiving shares in lieu of the OCD and then be subject to capital gain tax in India. However, a closer look at the mode of computation of capital gains would show that, if the OCD is converted into shares and then transferred, the transaction would result in a Capital loss of Rs 6.15 Million (as computed under Income tax Act) as the cost of acquisition would be computed at Rs 231.15 Million [see end note 5]. This tax loss can be used to set off tax liability that may arise from other transactions.
Singapore v Mauritius – Mauritius still wins
The DTAA between India and Singapore concluded on 24th January, 1994 provided that the gains derived by a resident of Singapore from alienation of shares of an Indian company would be taxable in India also. Subsequently, to attract more investments from Singapore, the DTAA with Singapore was amended vide protocol dated 29th June, 2005 to provide that the gains derived by a resident of Singapore from alienation of shares of an Indian company would be taxable only in Singapore. The protocol however provided that the benefit extended by India to investments from Singapore would be extended only till the time similar benefit is extended by India to Mauritius. The relevant provision of protocol reads as under;
Articles 1, 2, 3 and 5 of 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.
Now, with the DTAA with Mauritius being amended with effect from 1st April, 2017, there is possibility to contend that the Protocol between India and Singapore dated 29th June, 2005 would become inapplicable and the provisions of the DTAA signed on 24th January, 1994 would get revived. In any case, it is understood that India is re-negotiating its pact with Singapore to bring the taxing rights amongst the countries as originally agreed in 1994. Even assuming that the 1994 Singapore DTAA is retrieved, Mauritius would still stand a bar above Singapore for the following reasons
- The gains derived by a resident of Mauritius from the transfer of shares of an Indian company would be taxable in India only if the shares were acquired after 1st April, 2017. In other words, transfer of any shares of an Indian company acquired by a resident of Mauritius on or before 31st March, 2017 would not be subject to tax even if the transfer is executed after 1st April, 2017. On the other hand, transfer of shares of an Indian company by a resident of Singapore would be taxable in India if the transfer is executed on or after 1st April, 2017, irrespective of the date on which the shares were acquired.
- The Protocol to DTAA between India and Mauritius provides for a window between 2017 and 2019 for a concessional tax rate of 50% of the applicable tax rate. No such benefit is available under the Singapore DTAA.
- Further, capital gain from transfer of movable property other than shares (and ships and aircrafts) by a resident of Mauritius would be taxable only in Mauritius, while such transfer by a resident of Singapore would be taxable in India also.
- The Limitation of Benefit clause in the DTAA with Mauritius is less stringent than the DTAA with Singapore.
Amendments to other DTAAs in pipeline
Mauritius has been the source of more one third of all investments made in India. The tax exemption provided by India to the investors from Mauritius for over 30 years has been successfully been renegotiated. This would open the doors for renegotiation for withdrawal of capital gain tax exemption to investors from other countries like Cyprus, Netherland, etc. The relationship that India had developed with Mauritius for over 30 years has ensured that the investments made prior to 2017 are grandfathered with the benefits conferred on them when the investments were made. However, considering the unpleasant environment with other countries like Cyprus, it would be doubtful as to whether the investments made in the past would be protected if the DTAA is amended to tax the gains from such investments in India. Investors should be aware that DTAA with other countries like Cyprus can be amended to tax any gain on transfer of their investments, though such investments were made at a time when no tax was contemplated in India on the transfer of their investment.
Taxation of other income under Mauritius DTAA
Apart from the amendment to taxation of capital gains, the DTAA with Mauritius has also been amended to bring in provisions relation to Service Permanent Establishment and for taxation of income from rendering of managerial, technical or consultancy services.
In addition, the Article on ‘Other Income’ has also been amended to provide that the income arising in India of a nature not dealt with in the other articles would be taxable in India also. Such income was earlier taxable only in Mauritius.
Thus, income as specified in section 56(2)(viia) of the Act, like income in the nature of gifts etc. would become taxable in India.
Introduction of taxation of FTS and Service PE
The Mauritius DTAA was originally based on OECD Model, without providing for taxation of Fee for Technical Services (‘FTS’) or for Service Permanent Establishment (‘Service PE’). In line with international development post signing in 1983, the DTAA has been amended to allocate to India, taxing rights on FTS arising from India and rendition of services through a PE in India.
Every person resident of Mauritius and having any business transaction with India as well as every person resident of India transacting with a person resident of Mauritius should relook at the tax implications on all their transactions de-novo, in light of the new protocol between India and Mauritius as well as the recent amendment to the Act.
[The author is a Principal Associate, Direct Tax Practice, Lakshmikumaran & Sridharan, Mumbai]
- Circular 682/ 1994 dated 30th March, 1994
-  256 ITR 563 (Delhi)
-  263 ITR 706 (SC)
-  341 ITR 1 (SC)
- Considering Cost Inflation Index of 711 for 2010 and 1644 for 2020 (estimated based on the fluctuation between 2010 and 2015)