How the misuse of India’s treaty with Mauritius is leading to tax revenue loss

Thus, the effective tax rate on dividend income varies from a high of 42 percent to a low of 5 percent. This is a significant arbitrage to promote treaty shopping behaviour.

The ‘Mauritius route’ was famed as a channel used by foreign investments into India. Capital gains accruing to foreign investments coming through Mauritius were exempt in India due to the India-Mauritius DTAA. As a result, many foreign investors used to incorporate conduit companies in Mauritius and bring their money into India through the conduits. Between 2004 and 2014, about 39 percent of total Foreign Direct Investment into India was from Mauritius. Since Mauritius is a small island without the economic capacity to generate such huge capital, experts believed that these were ‘indirect’ investments through Mauritius.

The DTAA was speculated to have been widely misused by Indian residents to round-trip their investments in India through Mauritius.

India’s Mauritius DTAA was amended in 2016 to plug this loophole. Limitation of Benefits (LoB) clause was also inserted to limit benefits under the DTAA to shell companies or conduit companies that seek to abuse the treaty to save tax. However, a closer study of LoB rules reveals that the limitation of benefits is only for tax on capital gains. It is not applicable to dividend income.

A multilateral convention to prevent base erosion and profit shifting was convened by the Organisation for Economic Cooperation and Development (OECD) in 2016. This convention adopted a Multilateral Instrument (MLI) with an objective of introducing anti-abuse provisions in various DTAAs. MLI includes a provision to refuse the shelter of a DTAA (if the DTAA is covered by the MLI) if the principal purpose of a business arrangement is to save tax. It is gauged by using a Principal Purpose Test, which is a minimum standard under MLI.

While both India and Mauritius are signatories of MLI, Mauritius has not included its DTAA with India within the scope of its MLI compliance. As a result, anti-abuse provisions such as PPT are not applicable to India-Mauritius DTAA.

In the absence of any anti-abuse provision in DTAA, there is an apprehension that some investors from other countries may try to abuse the India-Mauritius DTAA to reduce their dividend tax liability. The possibility of Indian residents investing in India through Mauritius is an even greater concern.

However, the apprehensions are largely misplaced. Business arrangements with a principal purpose of reducing tax liability generally lack commercial rationale. Such arrangements use complex corporate structuring with the sole purpose of taking advantage of the DTAA. General Anti-Avoidance Rules, which is applicable from the financial year 2017-18, provides safeguards against this kind of treaty shopping. Thus, anyone who intends to abuse the India-Mauritius DTAA exposes themselves to significant litigation risk.

Secondly, investments yield dividends years after the investment is first made. Pillar 2 of OECD’s Inclusive Framework aims to introduce a global minimum tax rate by the end of 2020. Once Pillar 2 rules are introduced, Mauritius will be forced to tax its residents at a minimum rate. Thus, whatever arbitrage is available for abusing India-Mauritius DTAA is for a limited period, and open to significant litigation risk.