mauritius tax: Will the Mauritius route be blocked after India's new draft Direct Taxes Code?

The proposed revised Indian Direct Taxes Code contains a provision that could significantly impact India's existing tax treaties, including the treaty with Mauritius, a treaty frequently used for investment into India. The draft tax code bill was released by the Finance Minister on 12 August 2009, and, if the process moves as planned, the bill is likely to be presented to the Parliament in the Winter Session 2009. Once approved by Parliament and after receiving the President's assent, the Direct Taxes Code Bill, 2009 will become law and subsequently come into force on 1 April 2011.

To first briefly touch upon the historical importance of Mauritius in the context of total foreign direct investment in India, Mauritius tops the list with 44% of investment routed through the country during the period April 2000 to April 2009 (in contrast, Singapore stands at 9% and the U.S. at 7%). Mauritius has been used as a holding company jurisdiction for making investments in India, with the investors in the holding companies being tax residents of other countries.

The reasons for using Mauritius are simple: Indian domestic law taxes gains derived from the sale of shares in an Indian company regardless of whether the shareholder is a resident or nonresident. Under India's tax treaty with Mauritius, gains derived by a resident of Mauritius from the sale of shares in an Indian company are taxable only in Mauritius. Mauritius, however, does not tax capital gains. Therefore, any transaction involving a transfer of shares in an Indian company by a Mauritius company escapes tax in both India and Mauritius.

The India-Mauritius tax treaty, which dates back to 1983, was unsuccessfully challenged before the Indian Supreme Court in the 2003 case of Union of India v. Azadi Bachao Andolan and Anr. The Court enunciated the following principles in its decision:

- An important principle in the interpretation of international treaties, including double tax treaties, is that they are negotiated and entered into at the political level and have several considerations as their basis. The main function of a treaty is to promote and foster commercial relations between the treaty partners, and tax treaties essentially strike a bargain between the countries as to the allocation of tax revenue between them in respect of income "falling to be taxed" in both jurisdictions.

- The principles used to interpret treaties are not the same as those used to interpret statutory legislation.

- If the treaty partners intended to deny treaty benefits in specific cases, they could have included a limitation on benefits provision in the treaty. The India-Mauritius treaty does not contain any provision limiting benefits, and, in the absence of such a provision, treaty benefits cannot be denied to a person that otherwise qualifies as a resident.

- A country may tolerate certain behaviors, such as treaty shopping, in the interest of long-term development, and this may have been the intent at the time India and Mauritius concluded their treaty. Whether such activities should continue and, if so, for how long, is an issue that should be resolved by the executive, which is in a better position than the courts to understand the full extent of economic and political considerations. It is not for the courts to judge the legality of treaty shopping merely because it may be considered improper.

The principles laid down by the Supreme Court in Azadi Bachao Andolan were recently followed by the Delhi Tribunal in the case of DDIT v. M/s Saraswati Holding Corporation, Inc., wherein it was held that a taxpayer would be entitled to the benefits of the India-Mauritius treaty provided the taxpayer holds a valid tax residence certificate in Mauritius and the place of effective management is not in India (see article in this issue on the Saraswati Holding case).

With India losing significant tax revenue due to application of the Mauritius treaty, one option would be for the government to renegotiate the Mauritius treaty, in particular, the article on capital gains, or to insert a limitation on benefits article. The government apparently did try but without success. Meanwhile, Mauritius decided to more strictly enforce the substance requirements under its domestic law for companies to be considered tax resident in Mauritius and entitled to the benefits of the India-Mauritius treaty. To obtain treaty benefits, Mauritius requires, inter alia, that a company obtain a tax residence certificate issued by the commissioner of income tax.

A more controversial option for India would be to amend its domestic law to unilaterally nullify the effect of the treaty. The draft Direct Taxes Code Bill, 2009 appears to be just such an attempt. The following proposals in the draft code may potentially impact the operation of all of India's tax treaties:

1. Under current Indian tax law, where the central government has entered into an agreement with the government of another country for granting relief from tax or, as the case may be, for the avoidance of double taxation, a taxpayer entitled to the benefits of the treaty may apply the provisions of domestic tax law to the extent they are more beneficial to the taxpayer. As a result, a nonresident taxpayer that has India-source income has the option to be governed by either the provisions of domestic Indian tax law or an applicable tax treaty, whichever is more beneficial to the taxpayer.

The draft Direct Taxes Code Bill, 2009 also grants power to the central government to enter into an agreement with another government to provide relief from double taxation and for the purpose of exchanging information for the prevention of evasion or avoidance of income tax. The draft code, however, provides that neither a tax treaty nor the code will have preferential status by reason of its being a treaty or law and that, in the case of a conflict between the provisions of a treaty and the provisions of the code, the one later in time will prevail. This is a significant departure from current rules. India has tax treaties with about 75 countries. Given that the draft code is expected to be enacted sometime in 2010 and come into force on 1 April 2011, it would be later in time with respect to all of these tax treaties and thus may override them, including the treaty with Mauritius. Therefore, any transfer of an Indian company's shares by a Mauritius holding company could become liable to tax in India under the new Direct Taxes Code (once enacted) without relief from the treaty.

2. The other significant proposal in the draft code concerns the general anti- avoidance rule (GAAR). The GAAR would be triggered if a taxpayer has entered into an arrangement:
     . The main purpose of which is to obtain a tax benefit, and
     . Which has been entered into or carried out in a manner not normally employed for bona fide business
purposes, or has created rights and obligations that would not be normally created between persons dealing at arm's length, or results in the misuse or abuse of the provisions of the Code or lacks commercial substance.

"Arrangement" for these purposes has been given a sufficiently broad definition to encompass a wide array of transactions, including the interposition of an entity or a transaction where the substance of the entity or transaction differs from the form. A transaction that is conducted through one or more persons and disguises the nature, location, source, ownership or control of funds is also an indicator of a lack of commercial substance.

A designated officer in India's Department of Revenue would be empowered to declare an arrangement as an impermissible avoidance arrangement and, once so declared, the officer could ignore the tax treaty, disregard an intermediary holding company and tax the income in the hands of the parent company. An arrangement would be presumed to have been entered into for the main purpose of obtaining a tax benefit and the burden would be on the taxpayer to demonstrate that a tax benefit was not the main purpose of the arrangement. Significantly, under general principles of interpretation, the GAAR rule would not be affected by, and could override, the provisions of tax treaties.

Assuming the new Direct Taxes Code comes into effect, the use of Mauritius as a holding company jurisdiction for India appears fraught with controversy. Because provisions under the new code would be later in time, they may prevail over the India-Mauritius tax treaty (and other treaties), unless reaffirmed by protocols or renegotiated in toto. Even if new tax treaties are concluded or old treaties reaffirmed or renegotiated after the draft code comes into force, anti-avoidance provisions would come into play unless it is demonstrated to the satisfaction of the Indian revenue authorities that the holding arrangement is not in the nature of an impermissible avoidance arrangement.