What is DTAA?
Double Taxation Avoidance Agreement (DTAA) also referred as Tax Treaty is a bilateral economic agreement between two nations that aims to avoid or eliminate double taxation of the same income in two countries.
Importance of this
- It is not unusual for a business or individual who is resident in one country to make a taxable gain (earnings, profits) in another. This person may find that he is obliged by domestic laws to pay tax on that gain locally and pay again in the country in which the gain was made. Since this is inequitable, many nations make bilateral double taxation agreements with each other. In some cases, this requires that tax be paid in the country of residence and be exempt in the country in which it arises.
- These treaties benefit institutions and individuals who earn in countries other than their country of residence, provided such an arrangement exists between their country of residence and the country/countries where their income sources are.
- India has DTAA with over 80 countries; it plans to sign such treaties with more countries. The major countries with which it has signed the DTAA are the US, the United Kingdom, the UAE, Canada, Australia, Saudi Arabia, Singapore and New Zealand.
What was the problem with Mauritius?
- Mauritius, and other tax havens, has almost negligible taxes. This was encouraging companies to route their investments in India through “shell” companies (those that exist only on paper) in Mauritius and avoid paying taxes.
How big was the problem?
- The DTAA was a major reason for a large number of foreign portfolio investors (FPI) and foreign entities to route their investments in India through Mauritius. At $94 billion, Mauritius has been the largest FDI source for India, accounting for 34% of total FDI in India between 2000 and 2015.
How do people use tax havens to avoid paying taxes?
- Through “round tripping” or “treaty shopping”
How does round tripping work?
- Round tripping refers to routing of investments by a resident of one country through another country back to his own country.
- You get money out of India and transmit it to a tax haven with whom India has a bilateral tax avoidance treaty such as the double-taxation avoidance agreement (DTAA). In the tax haven, this money is treated as capital of a registered corporate entity. You now invest this money back in an Indian company as foreign direct investment (FDI) by buying stakes or invest it in Indian equity markets.
How does this help in avoiding taxes?
- The entire purpose of this exercise is to window-dress as foreign capital your original money that you had taken out from India.
- In the entire process, you end up paying zero or negligible taxes. In India, you can claim tax exemption citing the DTAA arguing that you have paid taxes in the source country. In the source country, taxes are negligible since it is a tax haven.
Why has the treaty been amended?
- It is a move in line with the government’s initiatives to curb black money in the system, money laundering and tax avoidance.
- It is also expected to discourage speculators and non-serious investors, and thereby reduce volatility in the market.
What are the changes that will plug this gap?
- Under the original bilateral agreement between the two nations, capital gains from the sale of securities can only be taxed in Mauritius. However, the gains from the sale of shares held for less than 12 months are treated as short-term capital gains within India and attract a 15 per cent short-term capital gains tax. This has created an anomaly, thanks to a double taxation avoidance agreement with Mauritius, that meant business entities operating out of Mauritius escaped even paying short-term capital gains tax on share transfers. This has been exploited even by domestic Indian investors, who have resorted to routing their equity investments via Mauritius to avoid the tax liability at home.
- The changed DTAA will make it mandatory to pay capital gains tax on sale of shares in India by companies registered in Mauritius.
- While the protocol gives India the right to tax capital gains arising from sale or transfer of shares of an Indian company acquired by a Mauritian tax resident, it proposes to exempt investments made until March 31, 2017, from such taxation. The government also said that shares acquired between April 1, 2017 and March 31, 2019 will attract capital gains tax at a 50% discount on the domestic tax rate — i.e., at 7.5% for listed equities and 20% for unlisted ones.
- The full tax impact of the protocol will fall on investments beginning April 1, 2019, when capital gains will attract tax at the full domestic rates of 15% and 40%.
Why rules are not suddenly changed?
- Instead of a sudden and retrospective change, the government has chosen to give ample time for all investors to adjust.
- Thus the amended tax provisions will come into effect 11 months later and existing investors, who acquire shares before April 1 2017 will not be taxed.
- Further, firms will be taxed at a concessional rate for the first two years, until March 31 2019, to help them transition to the new regime.
What about previous investments?
- The new rules will not apply only to investments made before April 1, 2017, meaning share sale of investments made before this date will be exempt from capital gains tax.
Which companies will benefit from the reduced tax rates during the first two years?
- The benefit of 50% reduction in tax rate during the transition period from April 1, 2017 to March 31, 2019 shall be subject to a limitation of benefit (LOB) Article.
- A Mauritius-registered company (including a shell or conduit company) will not be entitled to lower tax rate, if it doesn’t spend at least Rs 27 lakh in Mauritius in the previous 12 months. This is called ‘purpose and bonafide business test’.
Are these rules related to the general anti-avoidance rules (GAAR)?
- GAAR are aimed at curbing tax avoidance and aim to give tax authorities the right to scrutinise transactions that they feel have been done to avoid taxes.
- Under GAAR corporations may be forced to restructure salaries of employees if taxmen conclude that these were structured only to avoid taxes. Similarly, if a foreign investment transaction from Mauritius has taken place with intent to exploit DTAA, it will come under GAAR.
- Implementation of GAAR will take place from April, 2017.
Impact and Analysis
(i) Impact on the India-Singapore DTAA: Article 6 of the protocol to the India-Singapore DTAA states that the benefits in respect of capital gains arising to Singapore residents from sale of shares of an Indian Company shall only remain in force so long as the analogous provisions under the India-Mauritius DTAA continue to provide the benefit.
Thus the amended tax regime will also apply to capital gains of Singapore-based companies, due to the direct linkage of the Singapore double taxation avoidance agreement (DTAA) clause with the Mauritius DTAA.
(ii) Impact on shares held by FPIs: Under the Indian income-tax law, shares of listed Indian companies held by FPIs are deemed to be capital assets irrespective of the holding period or the frequency of trading equity carried out by the concerned FPI. As such, income from sale of shares results in capital gains and at present, FPIs enjoy the benefits of the capital gains provisions under the India-Mauritius DTAA. Such investments will also be impacted by the amendment.
(iii) Foreign Investment might decline: Since investments until March 31, 2017 have been exempted from capital gains tax, there is no risk of an immediate outflow of funds. However, the protocol will impact all prospective investments with effect from April 1, 2017.
Experts feel that while some investors who are bullish on India may advance their plans and invest before April 1, 2017 in order to save tax, many others will raise their due diligence procedure on investments, factoring in the tax cost in the returns they generate i.e. it could hurt short-term foreign investor inflows into India, particularly from companies whose investment strategies are guided by minimising taxes. This could pull down markets initially.
Is any country likely to benefit as a result of the amendment?
Experts say the Netherlands may emerge as an attractive destination for FPIs following the changes to the Mauritius treaty. The India-Netherlands treaty is a smart treaty, and it can emerge as a preferred alternative for FIIs especially those in Europe. The treaty provides that if a company based in Netherlands holds less than 10% equity in an Indian entity, it would not attract capital gains on the sale of those shares to residents or non-residents. Even if it were to own more than 10% equity in an Indian company, the treaty allows it to sell the shares to a non-resident without attracting tax.