What is the recent amendment to the Indo-Mauritius tax treaty and its impact on foreign capital flows?

India and Mauritius signed a protocol to amend the DTAA between them on March 7

India and Mauritius recently closed another lacuna in their Double Taxation Avoidance Agreement (DTAA), tightening the scrutiny on tax avoidance on investments coming into India. The latest amendment includes a Principal Purpose Test (PPT) to decide whether a foreign investor is actually eligible for treaty benefits, or was the tax benefit the primary reason to route investments via Mauritius. Through this explainer, we look at the amendment and the implications

For starters, what is the DTAA agreement between India and Mauritius?

It is a bilateral agreement aimed at preventing double taxation of income earned in one country (India) by residents of the other country (Mauritius)

Why is the government looking to plug loopholes in the DTAA?

Because many companies and individuals set up investment vehicles in Mauritius and route investments through them just to save on tax.

How do they benefit?

Till 2016, investments coming through Mauritius-based structures paid near-zero capital gains tax. That is because one of the clauses in the DTAA was that investors based out of Mauritius putting money in India would be taxed at the lower of the rates in the two countries. Long term capital gains in India was 10 percent while that in Mauritius was near zero.

Was this loophole plugged?

Yes. India and Mauritius renegotiated the DTAA to sign a revised treaty signed in 2016. Key changes included:

Source-based taxation of capital gains: With the amendment, capital gains from the sale of shares acquired in a Mauritius-based company after April 1, 2017, would be taxed in India.

Grandfathering provisions: Investments made before April 1, 2017, were not affected by the changes, thereby protecting existing investments from any sudden tax implications.

Limitation of benefits (LOB) clause: The revised DTAA included provisions to ensure that the treaty benefits would only be available to genuine residents of Mauritius, thereby preventing its abuse through shell or conduit companies.

What is the latest amendment to the DTAA?

Investment vehicles based out of Mauritius will now have to pass the principal purpose test (PPT). Meaning, they will indeed have to show proof that the Mauritian entity is not merely a shell company, but that it is a well-staffed properly functioning unit.

Is this something new?

While the requirement for substance has always existed, the inclusion of the PPT will necessitate the FPIs to demonstrate compliance with relevant provisions, including maintaining physical presence, employing local staff, appointing local directors, and conducting all operations in Mauritius, says Vivek Singhania, co-founder of Dovetail Group

How significant is the foreign portfolio investor money coming in through Mauritius?

At present, there are over 600 category I and category II FPIs contributing approximately $50 billion in assets under custody. This is roughly 6% of the overall FPI AUC in India.

But if FPIs are anyway paying capital gains tax at Indian rates, why is the market worried?

Following the 2016 amendment, all investments coming into India from Mauritius up until 31st March 2017 were grandfathered and investments made after April 1, 2017, were subject to capital gains tax in India as per Indian tax laws.

The latest 2024 amendment which incorporates the Principal Purpose Test in the DTAA can potentially undo the ‘grand-fathering’ by throwing open even investments made before 2017 to fresh scrutiny. The amendment states that the new protocol “shall have effect without regard to the date on which taxes were levied or the taxable years to which the taxes relate.”

Will this impact FPI money flowing into India through Mauritius?

It may not. That is because the 2016 amendment forced a lot of changes and weeded out many structures created solely for the purpose of tax avoidance, say market players. But foreign direct investments (FDI) through Mauritius-based vehicles could be impacted.

Why so?

That is because there is a lower withholding tax rate on incomes like interest, dividends, and royalties received from Indian companies. This led to many corporations routing FDI money through Mauritius-based structures. That may no longer be possible