Background
In the last couple of weeks, the tax world has been abuzz with the historic news that 68 jurisdictions, including India, have signed the long-anticipated multilateral instrument (MLI) under the Organisation for Economic Co-operation and Development's (OECD) Base Erosion and Profit Shifting (BEPS) project. With the signing ceremony on June 7, 2017, these jurisdictions and the world at large have taken a conscious and landmark step forward in curbing the undesired practices of tax avoidance/evasion through the use of favourable tax treaties, ccommonly known as treaty shopping/abuse.
It a well-known fact that multinational companies (MNCs) have, over the years, developed investment holding structures and strategies which exploit favourable terms in certain bilateral tax treaties which result in the payment of zero/low tax in the country where the profit arises. Naturally, such structuring, which would not have been the intention of the tax treaties, has legally deprived many countries of their fair share of tax revenue.
History Of Foreign Portfolio Investors Claiming Tax Treaty Benefits In India
In the Indian context, Foreign Institutional Investors (FIIs), later categorised as Foreign Portfolio Investors (FPIs), have traditionally formulated their investment/pooling structures after factoring available tax treaty benefits in India. This can be observed from the fact that jurisdictions such as Mauritius, Singapore, Cyprus, which earlier provided for exemption from capital gains tax in India; and the Netherlands, which still continues to provide such exemption, have been popular jurisdictions for formation of entities investing as FPIs in India.
Especially, in absence of any Limitation of benefits (LoB) clause in the tax treaties, Indian courts, including the Supreme Court in the landmark decision of Azadi Bachao Andolan, have in the past held that mere furnishing of tax residency certificate (TRC) would be sufficient evidence to claim treaty benefits. Accordingly, proving substance and intention of using such jurisdictions was not required.
To overcome this, India renegotiated its tax treaties with Mauritius, Singapore, and Cyprus in 2016 which granted India the right to tax capital gains arising from the sale of shares of an Indian company acquired on or after April 1, 2017. While this change has definitely benefited India, even under the renegotiated tax treaties some benefits remain with these countries. These are:
- Capital gains arising to from the sale of shares of an Indian company acquired before April 1, 2017, as these are grandfathered); and
- Capital gains arising from the sale of any securities such as bonds, derivatives, etc. (i.e. other than shares) irrespective of the date of acquisition.
The renegotiated tax treaties continue to provide taxing rights to these categories of investments only to the country of residence and no tax in India.
In this context, India signing the MLI was viewed with eagerness and everyone was wondering about the fate of these renegotiated tax treaties. Singapore, Cyprus, and the Netherlands have all signed the MLI, and have surprisingly notified their favourable tax treaties with India under the MLI.
Mauritius has currently deferred its signing of MLI to June 30, 2017 – accordingly, Mauritius' position under the MLI on its tax treaty with India is currently unknown.
Once operational, the MLI provisions could potentially effect these renegotiated tax treaties and even deny tax treaty benefits.
Impact In The Context Of India's Tax Treaties With Singapore, Cyprus And The Netherlands
1. Introduction of preamble text:
Every covered tax treaty under the MLI will now include a preamble text which categorically states that the intention of the tax treaty is:
- to avoid creating opportunities for non-taxation or reduced taxation,
- through tax evasion or avoidance,
- including through treaty shopping arrangements aimed at obtaining reliefs for indirect benefit of residents of third jurisdictions.
This preamble text would assist courts and the authorities in the interpretation and application of the tax treaty provisions in the required spirit. Considering that countries such as Mauritius and Singapore do not tax foreign capital gains, these jurisdictions have effectively resulted in double non-taxation of capital gains. The preamble text, coupled with the fact that these jurisdictions are mostly used by residents of other countries to route investments into India, could have serious ramifications on FPIs seeking to avail exemption from taxation of capital gains in India.
2. Introduction of principal purpose test:
Unless there is a detailed LoB clause to be agreed under the BEPS measures, every covered tax treaty would have at least a principal purpose test (PPT) introduced in it. The PPT basically states that:
- having regard to all relevant facts and circumstances,
- if it is reasonable to conclude,
- that obtaining tax benefit was one of the principal purposes of any arrangement or transaction,
- the said benefit under a tax treaty shall not be granted.
Accordingly, PPT is a broad and subjective test under which tax treaty benefits can be denied if it is concluded that obtaining the tax benefit was one of the principal purposes of the arrangement/transaction.
In addition to the PPT, there was an option for the countries to also introduce Simplified Limitation of Benefits (SLoB) which specifically looks to deny the tax treaty benefits in case of holding companies, group financing entities (including cash pooling) and investment entities - unless the same is a bank, insurance company or registered securities dealer in the ordinary course of its business.
Interestingly, while India has chosen to supplement the PPT with an optional Simplified LoB clause, none of the corresponding treaty partners such as Singapore, Cyprus or the Netherlands have chosen to apply this SLoB clause.
Accordingly, such a clause cannot be read into India's tax treaties with these countries and therefore provides great relief for FPIs.
Possible Outcome Of Mauritius' Position On MLI
All eyes are now set on what position Mauritius will take on the MLI with regard to the tax treaty with India. Possible scenarios are as under:
- Scenario 1: Mauritius does not notify tax treaty with India under the MLI. In this case, the provisions of the existing renegotiated tax treaty will remain unchanged.
- Scenario 2: Mauritius notifies its tax treaty with India under the MLI. In this case, while the preamble text would stand inserted, it would be interesting to note that whether only the PPT will apply, or Mauritius also adopts Simplified LoB which is highly unlikely – considering Mauritius would want parity with Singapore and Cyprus.
We will only know once Mauritius notifies its position, hopefully by June 30, 2017.
The Way Forward
With the MLI now being signed by India as well as top destinations attracting FPI money, the investors would have to relook at their structures and strategies, especially if they are claiming any benefits under the treaty. The requirement of passing the PPT can be a challenge for FPIs if the favourable tax jurisdictions are used only for the purpose of obtaining tax treaty benefits with India, and has no substance. FPIs should now focus on building substance in their jurisdictions.
Also, it is worthwhile to note that invocation of the PPT may not require the tax officer to take any approvals unlike the ones required for invoking general anti-avoidance rules (GAAR). It would be advisable for the government to come out with a suitable guidance in this matter. It would also not be surprising if these foreign jurisdictions introduce token capital gains tax in their domestic legislation to overcome the double non-taxation aspect. Given the above issues, it would be interesting to watch out for Mauritius' approach on the MLI.
Maulik Doshi is a partner at SKP Business Consulting LLP and Abbas Jaorawala is a senior manager at Sudit K Parekh & Co.
The views expressed here are those of the authors' and do not necessarily represent the views of BloombergQuint or its editorial team.
