Anti-avoidance may be anti-Mauritius investment

India’s concerns about the basis of its tax treaties started with the landmark Supreme Court case of Union of India and Anr v Azadi Bachao Andolan and Anr in 2003. This case dealt with the question of whether investments from Mauritius were exempt from taxation in India. The court held that a tax residency certificate (TRC) was sufficient proof to claim the exemptions in a 1982 treaty. In 2008, a USD2 billion withholding tax levy imposed by the government on Vodafone took foreign investors by surprise. Some 15 years later, in October 2023, the same court delivered a highly anticipated and much-debated verdict on India’s tax treaty obligations in the case of Assessing Officer v M/S Nestle SA. A slew of media releases about tax notices received by foreign portfolio investors (FPI) have compounded investor concerns.

In ranking assets under the management of FPIs in 2023, the US had the largest share at INR25.7 trillion (USD3.08 billion), followed by Singapore and Luxembourg, both at INR4.5 trillion and then Mauritius at INR3.4 trillion. Similarly, analysing foreign direct investment trends in India, particularly in the past decade, Mauritius has been among the top five investors. This island nation with a population of 1.2 million and an area of 2,000 square kilometres, has been at the forefront of India’s strategic investment partnerships.

It is widely known that smaller island nations have opted to become offshore tax regimes because of the constraints on their natural resources and labour availability. These constraints preclude economies of scale for a wide range of products, leading to high unit costs of production. They have therefore implemented relaxed regimes for the taxation of offshore income.

The Mauritius treaty with India is a favourable tax agreement under which Indian-sourced capital gains of investors who were tax residents in Mauritius were exempt from paying tax in India. As dollar reserves stabilised and India’s foreign investment policy matured, the treaty was amended many times through its 2017 protocol.

At the same time, the government inserted the General Anti-Avoidance Rules (GAAR) into Indian domestic tax law in 2017. These codified the substance over form approach. The GAAR empowered the tax authorities to deny tax treaty benefits where the main purpose of an arrangement was to obtain a tax benefit.

In 2019, India ratified the Multilateral Instrument (MLI), a multilateral initiative spearheaded by the OECD to address concerns of base erosion and profit shifting. India has adopted the MLI, which includes the application of the principal purpose test (PPT), which aims to tackle instances of treaty shopping. Treaty amendments are undertaken through protocols. The 2024 protocol inserted a stringent anti-abuse test into the existing regime. It is clear that the protocol is aligned to the PPT language in the MLI. Accordingly, for the protocol to be effective, any treaty benefit, such as a concession dealing with the withholding tax rate on dividends, must pass the PPT. The protocol will enter into force from the date the two governments bring it into law.

In a fast-moving era where businesses are rapidly adopting ESG norms, and adherence to tax transparency and disclosure norms is emerging as a new normal, multinational companies should be allowed to demonstrate that their operations have commercial substance in a straightforward and flexible manner.

A retrospective application of such rigorous anti-abuse provisions will not only disturb the existing position on treaty eligibility but may also cause further uncertainty. While tax administrations are expected to increase anti-abuse actions in line with the global multilateral framework, economic interests must flag their concerns. With 2024 becoming the year when source jurisdictions come to the fore, perhaps in multilateral forums such as the UN or the OECD, India’s approach must include a more proportionate tax policy and an investor-friendly environment.

With TRCs no longer proof of treaty entitlement, India’s relationship with tax treaty law that began with the Supreme Court holding that such documents sufficed for Mauritius treaty entitlements has come full circle. To what extent this more robust tax approach casts doubt on repeated government promises relating to grandfathered investments remains to be seen.

Seema Kejriwal Jariwala is a partner, and Pranoy Goswami is a policy associate at BMR Legal.