In today’s Finshots, we tell you why a tax treaty amendment with Mauritius nudged foreign investors to withdraw their investments from the Indian stock market and why Mauritius let that happen.

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The Story

Sensex and Nifty, India’s benchmark equity indices fell by over 1% on Friday.

Sure, that’s not much and it’s something that can happen on any given day. But experts are pointing out that Foreign Portfolio Investors (FPIs) had dumped nearly $1 billion worth of stocks that day. And that these folks are feeling pretty nervous.

Why did they chicken out, you ask?

Well, it’s not because they’re worried about the economic prospects of India. Instead, it might just be that they’re worried about a big tax bill coming their way.

See, India and Mauritius have a deal. It’s called the Double Taxation Avoidance Agreement (DTAA), and it says that investors from one country can operate in another without being taxed twice on the same income. So, if you’re a Mauritian investor making money from Indian stocks, you can skip paying taxes in India and do it in Mauritius.

But here’s the thing. Mauritius has almost no or low taxes.  The country turned itself into a tax haven in the 1980s to diversify away from agriculture and attract foreign capital.

And here’s what happened as a result of the DTAA with India. People began to set up businesses in Mauritius to invest in Indian stocks. They would invest, make their profits and get away with a zero tax on the gains.

So by “treaty shopping” which is a term for when people set up shell companies or businesses just to exploit a favourable double taxation agreement, you could avoid paying taxes without breaking the law.

Meanwhile, India would’ve taxed the same kind of gains at 10%.

And the end result was that money poured into India via Mauritius. It was the country’s second largest source of FPI flows into India in 2017.

But the Indian government was watching. It realised that it was losing a lot of tax revenue due to this practice. Besides, even when Indian tax authorities initiated tax disputes, courts mostly never ruled in their favour because the DTAA protected investors.

So the government tweaked the rules. It said that if a Mauritian entity sold shares acquired in India, they wouldn’t get the tax exemptions anymore. They’d have to pay taxes in India for transactions starting from 1st April 2017.

Sure, entities selling shares acquired before this period were still protected by the DTAA as long as they had proof to show that they were genuine Mauritian resident entities. But even then, there was a huge drop in inflows from Mauritius after that. The country has fallen to become the fourth largest source of foreign direct investments (FDI) inflows into India today, from being at the top of the list in FY17.

Now you’d think that this was enough for the government. But, no.

Last week, a new amendment to the DTAA sort of erased this exemption too. It said “Hey, if you’re a Mauritian entity who’s invested in India before the cutoff date and want to enjoy paying lower taxes, you’ll have to pass a Principal Purpose Test (PPT).”

Wait… what’s that?

Well, it’s simply a test to understand an entity’s intention behind choosing Mauritius as its operational base. It’s also something the OECD (Organisation for Economic Co-operation and Development) framework calls for. This is an international framework that aims to have minimum tax standards for all the member countries. And since Mauritius is a member too it wants to make sure that it adheres to these guidelines.

So in effect, it must convince the Indian tax authorities that it isn’t a mere shell company that has been operating from Mauritius and routing its Indian investments from there just for the tax benefits. If they can win them over, then they can keep paying zero taxes on their past investments. If not, they may lose that privilege.

To make things worse, it could even mean a tax on past transactions too. And you can be sure that investors won't like that.

But things are still hazy and it’s hard to tell if that’s what the new amendment aims to do since it hasn’t become an enforceable Income Tax law yet.

But at the end of it all, you’re probably wondering ― Why would a country like Mauritius suddenly become so rigid with its tax treaties? Won’t foreign companies flee Mauritius then?

Well, the thing is that companies have been fleeing Mauritius for a while now. And that’s because it was getting a lot of global attention because of its ‘tax haven’ image.

The European Commission had added Mauritius to its list of countries that had to be closely watched for money laundering and terrorism financing. And the FATF (Financial Action Task Force), an inter-governmental body that sets anti-money laundering standards, placed the island under increased scrutiny because it felt that Mauritius had strategic deficiencies in its financial regulations.

All of that forced most US and European banks to leave the island country, simply because they didn’t want to attract scrutiny due to Mauritius’ shady image.

Ever since then, Mauritius has only wanted to prove the world wrong. It wants to wipe out the bad name associated with being a tax haven by overhauling its old tax laws. And let’s just say that the India-Mauritius tax treaty amendment could be part of the cleanup too.

But what will be the final outcome of this amendment, and will it spook the foreign investors even more?

Only time will tell.

Until then…

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