Mauritius pact: A laudable reform

Last month the government announced an amendment to the Double Tax Avoidance Agreement between India and Mauritius. The DTAA was signed between the two countries in August 1982 and notified in December 1983. For the past thirty-three years it has been a key factor affecting foreign investment flows into India. If a company was resident in Mauritius and made an investment in India, then its capital gains were exempt from taxes in India, under this DTAA. Its gains would be taxed only in Mauritius, which had zero tax on capital gains.  Under most bilateral DTAA’s, an entity is taxed in the country of its operation, and gets tax credit in its home country. The Indo-Mauritius treaty gave complete exemption.

The distinction between legitimate tax avoidance, and illegitimate tax evasion was becoming blurred.  It was also suspected that black money in India was being routed through Mauritius to become “white” and making tax free profits. The prevalence of the Participatory Notes which hide the identity of ultimate beneficiaries, added to the suspicion.

As India opened up to foreign investors, no wonder most companies preferred to come via Mauritius. An investor in a third country had an incentive to set up a shell company in Mauritius to take advantage of this tax exemption. In the early days, as India sought to attract capital flows, the tax shield seemed like a reasonable incentive. But over the years this led to a massive distortion. In the next two decades, more than one third of all cumulative foreign direct investment was coming from Mauritius. One estimate is that approximately 4.5 lakh crores of investment came through this route. Clearly this shows that companies were doing “treaty shopping”. Also this led to several “postbox companies” being set up in Mauritius, which were mere shell companies for the sake of residency. The distinction between legitimate tax avoidance, and illegitimate tax evasion was becoming blurred.  It was also suspected that black money in India was being routed through Mauritius to become “white” and making tax free profits. The prevalence of the Participatory Notes which hide the identity of ultimate beneficiaries, added to the suspicion.

The Mauritius treaty came under intense scrutiny at the height of the stock market scam of 2001, and the governments made a determined effort to plug the loophole. But all such attempts proved futile, and the Indo-Mauritius treaty remained immune from amendments.  Mauritius continued to be a tax haven. Despite their best attempts the tax authorities in India were unable to pry open the secure capital gains of entities resident in Mauritius, but with operations in India. The Vodafone case is the most well known tax dispute that has this Mauritius connection.

But times have changed since 2008.  The world is much more wary of illicit flows of shady capital through opaque tax havens. The G20 is concerned about tax dodging and has posited the Base Erosion and Profit Shifting. It has also made anti-money laundering a global priority.

The BJP’s manifesto promised stern action on black money. In that context, the amendment to the Indo-Mauritius DTAA is a highly commendable breakthrough.  This government through an executive action has accomplished what others could not do in the past thirty odd years. This will count as one the most important reforms of the BJP government. Not merely because of its impact on curbing suspected round tripping of black money, or ending useless tax disputes. This reform is vital because it ends a huge distortion in domestic tax system, caused by the Mauritius treaty. That tax exemption has cast a long shadow, and is indeed the tail that has wagged domestic taxation.

Since STT was much higher on shares than derivatives, all the trading shifted to the latter. The volume of derivative trading in India is 16 times that of shares, possibly the highest in the world. Not only is this a distortion, but it also causes higher volatility and ultimately leads to suspicion and distrust of stock markets by retail investors.

Here is how that distortion has worked. Since foreign investors enjoyed capital gains tax exemption, domestic investors asked for parity treatment. Hence long-term capital gains in the share market were made tax free in India in 2004.  Then what about capital gains in other asset markets? They too demanded parity, and level playing field.  For instance they asked, why should investors in unlisted companies pay capital gains tax? Hence in 2016 a similar tax exemption was given to investors in private (unlisted) companies too.

All these tax exemptions were leading to a shortfall in collections. One estimate is the loss of revenue was more than Rs 10,000 crore annually.  Hence back in 2004 itself, the government introduced an alternative called the securities transaction tax (STT) on all share transactions. Since STT was much higher on shares than derivatives, all the trading shifted to the latter. The volume of derivative trading in India is 16 times that of shares, possibly the highest in the world. Not only is this a distortion, but it also causes higher volatility and ultimately leads to suspicion and distrust of stock markets by retail investors. Moreover with erosion of direct tax revenue (i.e. capital gains), the government was quietly moving to indirect taxes (STT, or excise on petrol and diesel for instance). This has caused another distortion, which is the excessive burden of indirect taxes. This is borne disproportionately more by the poor, as compared to the rich. We need to have a greater share of direct taxes in our total tax kitty. Capital gains are an example of direct taxes.

As we can see the Indo-Mauritius tax treaty has indeed had far reaching and unanticipated consequences, such as unethical treaty shopping or illegal round tripping. But more seriously it also contributed to skewing the domestic tax system. Plugging that loophole will allow us to restore some balance. It will also serve as a precedent, and first step in plugging all such loopholes in other bilateral tax treaties. It is for this reason that this reform should count as one of the most important reforms made so far by the Modi government.

The author is a senior economist based in Mumbai.