NATIONAL LAW SCHOOL OF INDIA UNIVERSITY, NAGARBHAVI, BANGALORE

PROJECT ASSIGNMENT ON
INVESTMENT LAW

TOPIC: DTAA IMPACT ON FDI INFLOW:- INDO MAURITIUS TREATY

COURSE TEACHER: PROF. N. L. MITRA SUBMITTED BY: - SACHIN MAURYA Ist YEAR LL.M. (BUSSINESS LAW) ID NO. 446

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ACKNOWLEDGEMENT
I would like to express my sincere gratitude to Prof .N. L. MITRA and owe my foremost regards to him for giving me an opportunity to carry out this project work under his guidance. This work would not have been possible without his invaluable support and thought provoking comments. It is due to his patient guidance that I have been able to complete the task. I also extend my gratitude to the Librarian and the Library staff who made available the required materials within time. I am indebted to all those who guided me while doing the research work. Their valuable contributions have played a vital role in the completion of this project. Though I have tried out best at the same time I know that there is nothing called perfection so I would like to have all valuable suggestion for future I dedicate this project to all the people who believe that hard work and creativity needs protection and encouragement.

SACHIN MAURYA LL.M. 1ST YEAR ID. NO. 446

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TABLE OF CONTENTS
ACKNOWLEDGEMENT. INTRODUCTION OBJECTIVE OF ENTERING INTO DTAA ... 2 4 5 6 6 8 8

MODELS OF DTAA .. DOUBLE TAXATION AVOIDANCE AGREEMENT WITH MAURITIUS.. TAXATION OF CAPITAL GAIN FROM ALIENATING SHARE TAXATION OF BORROWING FROM INTERNATIONAL INSTITUTIION

MISUSE OF DTAA..9 LANDMARK CASE AZADI BACHAO ANDOLAN 10 CONCLUSION 12 BIBLIOGRAPHY... .. 13

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INTRODUCTION Mauritius accounts for nearly half of all foreign direct investment (FDI) inflows to India. Indian tax officials said the treaty has been costing the exchequer over Rs 4,000 crore (Rs 40 billion) annually for some years in terms of revenue foregone on account of the capital gains exemption for investors routing their funds through Mauritius. Mauritius has remained the first major source for FIIs in the Indian stock market with the US being a distant second.To date, India has signed comprehensive double taxation avoidance agreements with approximately 75 countries1. This source-based taxation often gives rise to the problem of double taxation, where the same income could be taxed twice - in India, and also in the country of residence of the taxpayer2. India has entered into Double Tax Avoidance Agreements (DTAAs) with a large number of countries, to resolve this problem. Essentially, these DTAAs lay down the extent to which one country has a right to tax income of a resident of the other country that is sourced from the firstmentioned country. The Governments of the two countries, having regard to the source rules contained in their respective domestic laws, have negotiated this extent; The Income-tax Act provides that the provisions of such a DTAA, if they are more favourable to a taxpayer, will override the provisions of the domestic tax law3. Indian tax authorities have managed to tighten clauses in many of these treaties. Only 12 to 13 treaties have residence-based taxation, of which seven or eight have been revised. The others are in the process of being revised. The only ones left are Mauritius and Singapore, but the latter has safeguards4.

N.K.Bhat, Overview of International Taxation, International Taxation A Compendium, The Chamber of Income Tax Consultants, fifth edition, 2005 2 Ibid. 3 Ibid. 4 Ibid.

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OBJECTIVES OF ENTERING INTO DTAA The object of a Double Taxation Avoidance Agreement is to provide for the tax claims of two governments both legitimately interested in taxing a particular source of income either by assigning to one of the two the whole claim or else by prescribing the basis on which tax claims is to be shared between them.5 The need and purpose of tax treaties has been summarized by the OEC D in the Model Tax Convention on Income and on Capital in the following words6: It is desirable to clarify, standardize, and confirm the fiscal situation of taxpayers who are engaged, industrial, financial, or any other activities in other countries through the application by all countries of common solutions to identical cases of double taxation. The objectives of double taxation avoidance agreements can be enumerated in the following words7: First, they help in avoiding and alleviating the adverse burden of international double taxation, by a) laying down rules for division of revenue between two countries; b) exempting certain incomes from tax in either country ; c) reducing the applicable rates of tax on certain incomes taxable in either countries Secondly, and equally importantly tax treaties help a taxpayer of one country to know with greater certainty the potential limits of his tax liabilities in the other country. Still another benefit from the tax-payers point of view is that, to a substantial extent, a tax treaty provides against non-discrimination of foreign tax payers or the permanent establishments in the source countries vis--vis domestic tax payers
5

Ostime (Inspector of taxes) v. Australian Mutual Provident Society (1960) 39 ITR 210 (HL) http://siadipp.nic.in/publicat/invpub/taxation.htm Ibid.

6 7

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MODELS OF DTAA OECD Model, UN Model, the US Model and the Andean Model are few of such models. Of these the first three are the most prominent and often used models. However, a final agreement could be combination of different models. 1. Organization of Economic Co-operation and Development (OECD) :OECD Model is essentially a model treaty between two developed nations. This model advocates residence principle, that is to say, it lays emphasis on the right of state of residence to tax. 2. United Nations Model Double Taxation(UN Model) :This model is essentially a model treaty between Developed and Developing Countries. The UN Model gives more weight to the source principle as against the residence principle of the OECD model. Most of Indias treaties are based on the UN Model.

DOUBLE TAXATION AVOIDANCE AGREEMENT WITH MAURITIUS Mauritius accounts for nearly half of all FDI inflows to India. Mauritius is first major source for FIIs in the Indian stock market with the US being a distant second. Treaty with Mauritius was signed in august 1982. Treaty specified that capital gains made on the sale of shares of Indian companies by investors resident in Mauritius would be taxed only in Mauritius and not in India , since this treaty follows concept of residence for the purpose of taxation.

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WHY INVESTMENT THROUGH MAURITIUS?8 Investment coming into India from Mauritius is peculiar for a special reason which in international tax terms is known as the Residence/Source principle. Under residence approach:a country taxes all the income of the persons resident in the country. For Indian context ,

residence is defined under section 6 of income tax act 1961. Under source rule:- the country taxes only that portion of income which arises or relates in part to the country in question. For example for a person Resident in South Africa giving management advice to an Indian company and getting paid management fees for such advice would only be liable to pay tax on that potion of Management fees received in India and not on anything more. This residence principle has been the major driver for investment. In Mauritius , there is no charge of capital gains while in India capital gains are chargeable to income tax at two rates ; 10% and 30%+ on short term and long term capital gains respectively. This has following outcome9: For a person resident in India , capital gains are chargeable to tax at the given rates(because of the residence principle). For a person not resident in India, capital gains are again chargeable to tax at the given rates [because of the Source principle]. For a person who is resident in Mauritius, capital gains sourced in India are taxable in Mauritius because of the Indo-Mauritius DTC. Under Mauritius domestic laws no capital gains tax is chargeable. Therefore one can see that there is a lot of advantage for the tax payer if the Residence is located in Mauritius. This also means there is an added reason to opt for bringing your investments into India (if you are not an Indian tax Resident) and this is why Mauritius route becomes interesting.

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Investing into India through Mauritius by conyers &pearman

Ibid.

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TAXATION OF CAPITAL GAIN FROM ALIENATING SHARES Article 13 of treaty talks about capital gains. In case of immovable property may be taxed in the contracting state in which such property is situated. Gains from alienation of movable property forming part of the business property which a enterprise of a contracting country state has in the other contracting state, may be taxed in that other state10. For instance :- Applicant is a partnership firm and is a resident of Mauritius. In 2006 ,it acquired 1 million shares of A an Indian company amounting to Rs. 10 million. This company demerged into company B and C in 2009. the applicant got shares according to scheme of demerger and amalgamation in the companies referred to above. Now in 2011 applicant wants to sell the shares at the consideration which resulted in capital gains to the applicant. Issue:- Where the gains from alienation of shares in an Indian company held by resident of Mauritius will be taxed? Answer :- Being a resident of Mauritius such capital gain will be taxed in Mauritius and not in India according to DTAA. (article 13) .Under IT act it cannot be disputed the capital gains arising to a non resident in India are taxable in India. Having regard to section 90(2) of the act, the terms of the treaty have overriding effect over the provision of the act in the event of there being conflict between the treaty and the act. (Uoi Vs Azadi Bachao Andolan (sc) -263 ITR 706) TAXATION OF BORROWING FROM INTERNATIONAL INSTITUTION ARTICLE 11 - Interest :- Interest arising in a Contracting State and paid to a resident of the other Contracting State may be taxed in that other State. Such interest may also be taxed in the Contracting State in which it arises and according to the laws of that State provided that such person should have permanent establishment 11.

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Indo-Mauritius treaty DTAA

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Indo- Mauritius treaty DTAA 8|Page

For instance :- A a company in India takes external borrowing from B a bank in Mauritius. Issue :- how to tax interest arising from such lending of money. Answer :- Prima facie, Interest arising from a company A in India which is payable to bank resident of the Mauritius will be taxed be taxed in Mauritius. But where B a bank in Mauritius has Permanent Establishment in India , such interest arising from a company A in India shall be treated as arising in India and will be taxed according to the domestic law of India. Another situation is that , where an assessee becomes taxable in view of residential status in one country and permanent establishment in the other , tax sharing MISUSE OF DTAA Treaty shopping :- Where a national or resident of a third country seeks to obtain the benefit of a double tax agreement between two other countries by interposing a company or other entity in one or the other of them. 12 For instance:- a company from the UK may desire to invest in India. It may initiate, conduct and conclude all negotiations and agreements from the UK. But before the actual investment, it may purchase a shell company in a tax haven, say, Mauritius, and route its investment through that Mauritian company. Since technically or artificially the investment is made from out of a Mauritian company, it may seek to claim the Indo-Mauritian DTAA rather than the Indo-UK DTAA and, as such, would capitalize on the tax-effectiveness of the former treaty. This way, either India or the UK may be deprived of their share of higher revenue available to them under the Indo-UK DTAA. Since such investing company `shop around treaties artificially (rather than DTAA to which they are naturally subject), it is graphically described `treaty shopping.

12

India's DTAA with Mauritius has gaps, says OECD study, by Sidhartha,2008

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Shell company13:- A shell corporation is defined in Barrons Finance And Investment Handbook as a company that is incorporated, but has no significant assets or operations. LANDMARK CASES UOI V AZADI BACHAO ANDOLAN14 Issue:-. Indian revenue authorities had questioned the eligibility of these FIIs to claim the benefit under DTAA since, in their view, these FIIs were shell companies incorporated in Mauritius, which were controlled and managed from other countries and were basically using Mauritius as a conduit to claim concessional tax rates under DTAA. Subsequently, the Indian government issued a circular (Circular 789 dated April 13 2000) through Central Board of Direct Taxes (CBDT) clarifying that a Certificate of Residence issued by the Mauritian authorities would constitute sufficient evidence for accepting the status of residence for claiming benefits under Indo-Mauritian DTAA Supreme courts decision15: Regarding circular:- set aside the ruling of the High Court and restored the validity of the circular. Regarding override of treaty:-Under section 90 of the Income Tax Act 1961, the Central Government is empowered to issue notifications for implementation of terms of tax treaties and such tax treaties would override the provisions of the Income Tax Law as held by various Indian High Courts. Regarding treaty shopping:- If the residents of a third contracting state

qualify for a benefit under a Treaty they cannot be denied the benefit on a theoretical ground that Treaty shopping is unethical and illegal

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14
15

http://en.wikipedia.org/wiki/Shell_corporation [2003] 263 ITR 706 (SC) Ibid.

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IN RE ETRADE MAURITIUS LTD(AAR)16 Ruling:- India-Mauritius treaty benefits cannot be denied on the ground that assessee is a subsidiary of a USA Corp 17. Facts:- The applicant, a resident of Mauritius, was a subsidiary of a USA company. It received capital contribution and loans from the USA parent which were used to purchase shares in ILFS, an Indian company. On sale of the shares, the applicant earned capital gains which were chargeable to tax under the Act. However, under Article 13 (4) of the India-Mauritius tax treaty, such gains were not chargeable to tax in India18. Question:- whether in view of the Article 13 (4), the gains were chargeable to tax in India. (i) The effect of Azadi Bachao Andolan 263 ITR 706 (SC) is that there is no legal taboo against treaty shopping. Treaty shopping and the underlying objective of tax avoidance/mitigation are not equated to a colourable device. If a resident of a third country, in order to take advantage of a tax treaty sets up a conduit entity, the legal transactions entered into by that conduit entity cannot be declared invalid. The motive behind setting up such conduit companies is not material to judge the legality or validity of the transactions. Tax avoidance is not objectionable if it is within the framework of law and not prohibited by law. On facts, as all legal formalities for purchase of the shares and their subsequent transfer had been gone through and the consideration had been received by the applicant, it was difficult to assume that the capital gain has not arisen in the hands of the applicant but had arisen in the hands of the USA parent;
16 17

(2010) 324 ITR 1 / 190 Taxman 232 (AAR). Ibid. 18 Ibid.

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The fact that the USA parent provided the funds and played a role in negotiating the transaction of sale does not lead to the legal inference that the shares were in reality owned by the USA parent.The fact that the subsidiary has its own corporate personality and is a separate legal entity cannot be overlooked.It is unrealistic to expect that a subsidiary should keep off the clutches of the holding company and conduct its business independent of any control and assistance by the parent company; Consequently, the gains made by the Applicant were not chargeable to tax in India. Obiter: It looks odd that the Indian tax authorities are not in a position to levy capital gains tax on the transfer of shares in an Indian company. Whether the policy considerations underlying Article 13 (4) of the treaty and the spirit of the CBDT Circular would still be relevant in the present day fiscal scenario is a debatable point.

CONCLUSION Does DTAA has really helped India? Prima facie we can say that DTAA has helped in increasing the inflow of foreign investment from the tax haven countries. Analysis the facts it can be proved that India is receiving the majority of foreign investment from Mauritius because being a tax haven country. Because of lack of limitation clause in the DTAA with Mauritius, India is losing a huge amount of revenue every year and the reason is treaty shopping. At present efforts are going on to revise the treaty and introduce the limitation clause so that the evil of treaty shopping can be mitigated. This limitation clause is like the third party cannot get the benefit of the DTAA unless that party is the resident of one of the two countries. Also there is problem of round tripping for that purpose the negotiations are being going on to revise the treaty so that the principle of residence taxation can be changed into source .

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REFERENCE Books:1. Ostime (Inspector of taxes) v. Australian Mutual Provident Society (1960) 39 ITR 210 (HL) 2. N.K.Bhat, Overview of International Taxation, International Taxation A Compendium, The Chamber of Income Tax Consultants, fifth edition, 2005

Articles:1. India's DTAA with Mauritius has gaps, says OECD study, by Sidhartha,2008 Websites: http://in.rediff.com/money/2008/mar/13mauri.htm http://law.incometaxindia.gov.in/TaxmannDit/IntTax/mainInttax.aspx http://en.wikipedia.org/wiki/Double_taxation http://en.wikipedia.org/wiki/Capital_gains http://www.globalpolicy.org/nations/corrupt/2002/1205mauritius.htm http://www.globalpolicy.org/nations/corrupt/2002/1205mauritius.htm http://www.thehindubusinessline.com/2003/11/29/stories/2003112900080900.htm http://en.wikipedia.org/wiki/Shell_company

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