Double Taxation Avoidance Agreement (DTAA)

A major portion of international capital flows entering the Indian economy is aided by taxation laws and systems among countries like the Double Taxation Avoidance Agreement.

The phenomenal growth in international trade and commerce and increasing interaction among nations, citizens, residents and businesses of one country has extended their sphere of activity and business operations to other countries. A person earning any income has to pay tax in the country in which the income is earned (as Source Country) as well as in the country in which the person is resident. As such, the income is liable to be taxed in both the countries. To avoid this hardship to individuals and also with a view to ensure that national economic growth does not suffer, the Central government under Section 90 of the Income Tax Act has entered into Double Tax Avoidance Agreement (DTAA) with other countries.

Definition of Double Taxation: Double taxation can be defined as the levy of taxes on income or capital in the hands of the same tax payer in more than one country, in respect of the same income or capital for the same period. DTAAs provide for the following reduced rates of tax on dividend, interest, royalties, technical service fees, etc., received by residents of one country from those in the other. Where total exemption is not granted in the DTAAs and the income is taxed in both countries, the country in which the person is resident and is paying taxed, the credit for the tax paid by that person in the other country is allowed.

DTAT with Mauritius:

The Indo-Mauritius DTAT was first signed in 1983. The main provision of the agreement was that no resident of Mauritius would be taxed in India on capital gains arising out of sale of securities in India. The treaty gives capital gains exemption for investments if routed via Mauritius. The treaty remained on paper until 1992 when FIIs were allowed into India. The same year, Mauritius passed the Offshore Business Activities Act which allowed foreign companies to register in the island nation for investing abroad. Registering a company in Mauritius has obvious advantages such as, total exemption from capital gains tax, quick incorporation, total business secrecy and a completely convertible currency.

For foreign investors willing to invest in India, it made sense to set up a subsidiary in Mauritius and route their investments through that country. By doing so, they would avoid paying capital gains tax all together — India won’t tax because the company is based in Mauritius and Mauritius had anyway exempted investors from capital gains tax.

In the last few years Mauritius has emerged as the largest foreign investor [analysts estimate about 25% of all inbound FII money is routed thorough Mauritius] in India thus clearly indicating that it has become a tax haven for foreign investors. This indicates the route investors are taking into India to avoid otherwise due taxation.

There are allegations that foreign companies are using ‘notional residence’ in Mauritius to avoid paying taxes in India. It has even been claimed that tax losses to India are more than incoming investments. In spite of the controversies generated, it has been kept in its present form. As it was felt that changing its clauses would lead to flight of capital from the country, slowing down foreign investment inflows and may lead to a significant stock market crash. It is reported that Indians used Mauritius-registered companies and Mauritius offshore trusts to hold assets abroad beyond the reach of Indian tax laws. This is called ’round-tripping’, where Indians re-route their money stashed abroad through the Mauritius route.

It is now hoped that the Treaty, duly modified, will help encourage Indian investments in Mauritius, rather than the other way around. It is expected that Mauritius will agree to the changes as having signed similar DTATs with other ASEAN countries, it will be able to highlight its attraction as a tax haven and also plug gaps to stop both ‘round tripping’ and ‘treaty shopping’.

The list of FIIs that have preferred to invest in India via Mauritius includes Aberdeen Asset Management, Citi Group Global, CLSA Merchant Bankers, Deutsche Securities, Emerging Markets Management LLC, Fidelity Assets Management, Golden Sachs Investments, HSBC Global Investment, JP Morgan Fleming Asset Management, Merrill Lynch Investment Managers and UBS Securities Asia

DTAA with Singapore:

Under the India Singapore DTAA (2005), a Singapore tax resident is not subject to Indian taxes on capital gains derived from the sale of shares in an Indian company. The changes introduced in 2005 put the Singapore DTAA on par with the India-Mauritius DTAA with respect to tax exemption on capital gains but include two important limitations on beneficial treatment for capital gains:

First, investors from Singapore do not receive an exemption from Indian capital gains tax if the affairs of the company were arranged with the “primary purpose” of taking advantage of the capital gains exemption (the so-called “limitation on benefits”). Specifically, a “shell/conduit” company cannot avail itself of the capital gains exemption, but provides a safe harbour for companies listed in India or Singapore or a company with more than S$200,000 or Rs. 5 million of total annual expenditures on operations in Singapore in the preceding 24- month period.

A second important limitation ties the fate of the capital gains exemption under the Singapore DTAA to the India-Mauritius DTAA. Investors from Singapore will lose their capital gains exemption if India and Mauritius amend their DTAA to take away the corresponding exemption.

The Indian Government has entered into similar DTAAs with 79 countries including Cyprus (renegotiated now), UAE, Spain, Luxembourg etc. and other courtiers such as Saudi Arabia and Kuwait are eager to have such agreements with India in place.