The amendments may cause some uncertainty and anxiety for U.S. investors as they consider how these changes will impact business, income, profitability and the benefits or drawbacks of investing in India through Mauritius.
For many years, a useful route to invest into India was to go through Mauritius. A U.S. investor, for example, would hold an interest in a Mauritian tax resident company, and that company would hold the investment in shares of an Indian company. Until very recently, the expectation was that, on the sale of the shares in the Indian company, there would be no Indian capital gains tax imposed on the seller because of Article 13(4) of the Double Taxation Avoidance Agreement between India and Mauritius (the Treaty). On May 10, 2016, the Indian Ministry of Finance issued a press release announcing that Mauritius and India have executed a protocol that significantly amends the Treaty.1 Most notably, the protocol amends the Treaty to eliminate the capital gains tax exemption for Mauritian tax residents that own shares in Indian companies, and it introduces the limitation of benefits article, which limits the scope of Mauritian entities that may utilize the Treaty. The protocol was notified by the Indian government in the official Gazette of India on August 11, 2016 and entered into force in India on July 19, 2016.2 The key aspects of the protocol are summarized below.
Elimination of the Capital Gains Tax Exemption for Shares Held in Indian Companies
Acquisitions on or after April 1, 2017: The elimination of the capital gains tax exemption is centered around a cut-off date of April 1, 2017. Mauritian investors who acquire shares in Indian companies on or after April 1, 2017 are subject to a capital gains tax payable to the Indian government on any income received from the disposal of such shares.3 The rate of tax may vary, depending on when the shares are sold, as described in the next paragraph.
Acquisitions on or after April 1, 2017 and disposed of by March 31, 2019: Mauritian investors who acquire their shares on or after April 1, 2017, but who dispose of the shares prior to or on March 31, 2019 will pay capital gains tax at a discounted tax rate of 50 percent of the domestic rate in India, subject to a "limitations of benefits" clause (summarized next) in the Treaty. This two-year transitory period will expire on April 1, 2019; thus, investors who acquire their shares on or after April 1, 2017, but who dispose of the shares on or after April 1, 2019, will be taxed at the full capital gains domestic tax rate.
Acquisitions prior to April 1, 2017: Mauritian investors who acquire shares in Indian companies before April 1, 2017 will be grandfathered under the protocol. Thus, these investors will continue to profit from the current capital gains tax exemption set forth in Article 13(4) of the Treaty.
The new limitation of benefits (LOB) clause: The LOB clause is a new provision that sets forth the requirements for a Mauritian tax resident to avail itself of the 50 percent discounted tax rate explained above. A Mauritian tax resident cannot benefit from the discounted tax rate unless it passes the "main purpose test" and the "bona fide business test" under the LOB clause. Furthermore, a shell or a conduit company is not entitled to the 50 percent discounted tax rate. A Mauritian resident company is deemed to be a shell or a conduit company if its total expenditure on operations in Mauritius is less than 2.7 million INR and 1.5 million MUR (approximately 40,000 USD), in the 12 months prior to the disposal of the shares.
Interest Income Arising in India Earned by Mauritian Residents
Under the prior provisions of the Treaty, there were no concessional provisions with respect to interest income. As a result, a Mauritian resident was potentially liable for Indian withholding tax rates on interest income earned from debt claims issued by Indian borrowers for up to 40 percent. Under the protocol, for extensions of credit made after March 31, 2017, the withholding tax rate will be capped at 7.5 percent.
Mauritius as a Source of Foreign Direct Investment into India and Indian Tax Law
Over the last few decades, Mauritius has been a tremendous source of foreign direct investment (FDI) into India, owing in large part to the capital gains tax exemption. Mauritius has been the source of around 34 percent of all FDI inflows into India between 2000 and 2015. Additionally, approximately 20 percent of foreign portfolio assets in India come through Mauritius. Eliminating the capital gains tax exemption may drastically hinder the flow of FDI streaming into India through Mauritius.
Recently, there have been a number of developments in Indian domestic tax law. On May 14, 2016, the Finance Act 2016 was passed by the Indian Parliament.4 Additionally, the Indian Central Board of Direct Taxes (CBDT) also issued circular no. 6/2016, dated February 29, 2016 (the Circular),5 and follow-up letter no. F.No.225/12/2016/ITA.II, dated May 2, 2016 (the CBDT Letter).6 Under the Circular, with respect to listed shares and securities held for a period of more than 12 months, if the taxpayer wishes to treat the income from the transfer as a capital gain, he may do so, and this election will be binding for subsequent assessment years.7 There is currently no tax on capital gains for the sale of listed shares and securities after a holding period of 12 months on a recognized stock exchange, but, listed shares and securities sold before a 12-month holding period are subject to a short-term capital gains tax rate of 15 percent.
Under the Finance Act, unlisted shares held for 24 months or less will be treated as a short-term capital asset, to take effect from April 1, 2017 onwards; thus, any income on the sale of unlisted shares held for more than 24 months will be taxed at the long-term capital gains tax rate. The current long-term capital gains tax rate on sales of unlisted shares is 20 percent, while the short-term capital gains tax rate on sales of unlisted shares is 15 percent.
What Are the Implications for U.S. FDI into India?
Elimination of the capital gains tax exemption in the Treaty will primarily affect listed shares that are held for a short-term period (i.e., less than 12 months) and any unlisted shares, such as investments in subsidiaries of U.S. operating companies. Although the short-term gain on listed securities owned through Mauritius that are acquired between April 1, 2017 through March 31, 2019 will be taxed at the maximum rate of 7.5 percent, by April 2019, investors such as hedge funds and other short-term portfolio investors that commonly use Mauritius as a gateway to invest into listed securities in India will be subject to the short-term capital gains tax rate of 15 percent.
U.S. investors who seek to invest in listed securities in India and use the "Mauritius route" may want to consider making very short-term capital inflows into India in order to take advantage of the remaining time for the capital gains tax exemption, which ends effectively April 1, 2017.
Additionally, the 7.5 percent withholding tax rate on interest income under the Treaty is much lower than the rates set forth in India’s counterpart treaties with countries such as Singapore and the Netherlands, which may incentivize U.S. investors to consider creating Mauritian holding companies that fund their Indian subsidiary companies through debt securities.
A question arises as to which investments are encompassed within the definition of "shares," thereby determining the extent of India’s tax rights with respect to the disposition of such investments. Certain experts and commentators have posited that securities such as convertible and nonconvertible debentures and other debt instruments do not fall within the definition of "shares" and thus should continue to enjoy the capital gains tax exemption. However, there continue to remain some open issues with respect to the foregoing. For instance, what is the tax treatment in a situation where a Mauritian resident acquires a convertible debenture in an Indian company prior to April 1, 2017, but converts the debt into equity shares after April 1, 2017 and subsequently sells the converted shares? Are the converted equity shares exempt from capital gains tax and covered under the Treaty’s grandfathering clause, or will they be subject to capital gains tax in India? The answer to this question is somewhat ambiguous, and it depends on how such a situation is analyzed in the released protocol, as well as the effect of Rule 8AA of the Income-Tax Rules 1962, which explains what the holding periods should be for unconverted debenture instruments and the related converted shares.
Ambiguity also arises in a situation where shares transferred after April 1, 2017 are directly connected to shares that were acquired prior to April 1, 2017. A special panel composed of different officials from agencies such as the Securities and Exchange Board of India and the CBDT has identified a few such situations where open questions still remain:
Merger: An investor buys shares in Company A before April 1, 2017. After April 1, 2017, Company A merges with Company B, and the investor receives shares of Company B as part of the merger transaction and a share-exchange scheme. The investor subsequently sells his Company B shares five years later. Although the investor acquired Company B’s shares after April 1, 2017, such shares were directly connected to the merger and the share exchange with Company A occurring prior to this cut-off date. Thus, is the investor exempt from capital gains tax on the sale of Company B’s shares?
Bonus Issuances: Bonus shares that were issued after April 1, 2017 are sold, but they are directly related to shares that were acquired or issued prior to the cut-off date. Is the transfer of the bonus shares subject to capital gains tax?8
The special committee is set to provide recommendations to the Finance Ministry by September 2016, so it remains to be seen how and to what extent these open issues will be further clarified.
The recent amendments to the Treaty may certainly cause some uncertainty and anxiety for U.S. investors as they consider how these changes will impact business, income, profitability and the benefits or drawbacks of investing in India through Mauritius. However, certain features of the amendments, such as the grandfathering provision embedded into the capital gains tax provision and the fixed withholding tax rate for interest income provide U.S. investors with some added time to reconsider their investment vehicles and adapt their investment strategies to make these strategies tax efficient and profitable for the Indian financial climate.
3 Note that long-term capital gains realized from the disposition of shares in listed companies are exempt from the capital gains tax under Indian domestic law.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship. Internal Revenue Service rules require that we advise you that the tax advice, if any, contained in this publication was not intended or written to be used by you, and cannot be used by you, for the purposes of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.