Limitation of benefits clause: Indo-Mauritius tax treaty

In December, Mauritius agreed to include a ‘limitation of benefits’ (LoB) clause in its revised tax agreement with India. For the uninitiated, LoB is an anti-abuse provision that restricts eligibility criteria for third country (other than the contracting States) residents to obtain benefits under a Double Taxation Avoidance Agreement (DTAA).

India has been insisting upon an LoB clause with all the concerned nations. The introduction of LoB provisions in recent Indian treaties, as in India’s treaty with Singapore recently, demonstrates a policy to discourage treaty shopping — where a multinational business takes advantage of favourable tax treaties in certain jurisdictions.

In this context, it would be interesting to take a look at similar clauses/criteria in India’s treaties with various nations.

What they mean
Subjective arrangement: This is entered into to obtain tax benefits in countries such as Malaysia, Ethiopia, Estonia and Finland.

Objective treaty: The benefits of this treaty are extended only if the claimant is a qualified person, generally a government entity, listed company, and so on. It is with countries such as Iceland, Tajikistan, Tanzania and the US.

Beneficial ownership: This ensures that the benefit of lower withholding tax rate is given to genuine tax residents of a contracting state. This is with the US, UK, Singapore and Finland.

Substance treaty: Entered into with Singapore, the benefits are given considering the substance of the entity (not merely a conduit/shell company).

The India-Singapore treaty provides for an expenditure test as proxy for demonstrating commercial substance to restrict benefits only to genuine resident investors who fulfil certain conditions. The LoB clause of this treaty restricts eligibility for capital gains tax exemption either to companies listed on the stock exchange or to those who expend a minimum of $200,000 on operations in Singapore for a tleast two years prior to the date of such gain.

After numerous efforts and failed discussions, Mauritius has finally agreed to include an LoB clause. While the exact modalities are yet to be finalised, it is likely to be similar to the India-Singapore treaty.

Why they matter
Historically, almost 40 per cent of foreign investments in India flows through Mauritius. In view of the friendly local legislation, low cost of doing business, robustness of regulatory framework and quality of supervision, Mauritius enjoys a prominent place in the tax planning of private equity players, MNCs and global fund houses investing in India.

The India-Mauritius DTAA (made way back in 1983) provides for taxability of capital gains from sale of securities in India only in Mauritius. However, the local laws of Mauritius offering minimal tax rate make such transactions practically tax-free. This attracted global investors to Mauritius but with the consequence of treaty shopping.

India has been increasingly concerned about routing third country investment through Mauritius and round-tripping of funds resulting in the loss of huge tax revenues. Its continuing efforts to re-negotiate the DTAA with Mauritius are no secret. In addition, and though it is not only targeted for Mauritius, the Finance Ministry had introduced provisions of general anti-avoidance rules (GAAR) under Indian regulations. GAAR, a powerful and anti-tax evasion provision, seeks to empower the Indian tax authorities with a mechanism to deny tax benefits if the transaction/arrangement is without commercial substance or only with tax benefit motive.

Though it is deferred till April 2015, it would impact investments made post August 2010. The urgency for this rule is perceived to be a fallout of the Vodafone controversy.

Apparently Mauritius too wants to restrict the benefit of tax treaty only to genuine investors. It has tightened the local substance requirements to combat Indian GAAR provisions by proposing amendments to ‘Guide to Global Business’. This move may improve the image of the country as a clean and well regulated international financial centre.

Serious intent
With the introduction of GAAR and insistence on re-negotiation of the treaty with various nations, India is showing its seriousness to deal with treaty shopping, a major tax leakage source.

India is keen to receive its share of the tax revenues available in cross-border transactions and is heading on a policy path to allow only a clearly identified group of persons access to its tax treaties/benefits.

India’s share in the total number of investments made by global companies through Mauritius has almost halved in the past two years. The LoB clause coupled with GAAR are feared to be a dampener to inbound investments flow.

But in the long run, such policy decisions will not affect true long-term investors who will continue to invest in India.

However, it is becoming imperative for investors to embed substance and solid business rationale in the tax-planning of the holding/group structure.

By Anshu Khanna, a chartered accountant.

The article was published in The Hindu Business Line on 06 January 2013.