Why text of amended tax treaty with Mauritius triggered stock sell-offs

Introduction of the Principal Purpose Test

India and Mauritius, on March 7, signed a protocol at Port Louis, amending the Double Taxation Avoidance Agreement (DTAA) between the two nations. The text of the amended treaty was made public Wednesday.

The amended pact includes the Principal Purpose Test (PPT), which is in line with the global efforts against treaty abuse, particularly under the BEPS (Base Erosion and Profit Shifting) framework. The PPT essentially implies that the tax benefits under the treaty will not be applicable if it is established that obtaining that duty benefit was the principal purpose of any transaction or arrangement.

The two nations have also amended the preamble of the treaty to incorporate the thrust on tax avoidance and evasion. The earlier objective of “mutual trade and investment” has now been replaced with an intent to “eliminate double taxation” without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance including through “treaty shopping arrangements” aimed at obtaining relief provided under this treaty for the indirect benefit of residents of third jurisdictions.

The recent amendment reflects India’s intent to align with global efforts against treaty abuse, under the BEPS framework — an international framework to combat tax avoidance by multinational enterprises using base erosion and profit shifting tools i.e “shifting” profits to higher tax to lower tax jurisdictions . Though India is yet to make any announcements regarding Pillar Two amendments (a minimum 15% corporate tax on income) in its domestic tax laws, experts said it is anticipated this may be announced in the July 2024 budget, after the general elections.

Impact of the amended treaty

While the Income Tax Department has stated that the amendments are yet to be notified and ratified, investors are awaiting clarity whether past investments, especially those made before March 2017, will be grandfathered or not.

The text of the protocol amending the treaty states that the “provisions of the protocol shall have effect from the date of entry into force of the protocol, without regard to the date on which the taxes are levied or the taxable years to which the taxes relate”. This suggests that the PPT will apply to all transactions after the treaty gets notified, irrespective of the date of the investment itself.
Investors are apprehensive that this will result in greater scrutiny of the capital gains tax levy and exemption, as the PPT will be applicable to past investments where investors have not made an exit yet.

The DTAA was a major reason for a large number of FPIs and foreign entities to route their investments in India through Mauritius, as there was no capital gains tax on sale/transfer of shares. The March 2017 timeline is significant in the context that the treaty was last amended in May 2016 allowing the right to tax capital gains arising from sale or transfer of shares of an Indian company acquired by a Mauritian tax resident. However, the government at that time had grandfathered, or in other words, exempted investments made until March 31, 2017 from such taxation.

Mauritius remains India’s fourth largest source of FPI investments, after the US, Singapore, and Luxembourg. FPI investment from Mauritius stood at Rs 4.19 lakh crore at the end of March 2024, which is 6 per cent of the total FPI investment of Rs 69.54 lakh crore in India. FPI investment from Mauritius had stood at Rs 3.25 lakh crore, out of total FPI investment of Rs 48.71 lakh crore at the end of March 2023.

What tax experts say

Experts said that after this amendment, any Indian inbound or outbound cross-border structuring of investment routed through Mauritius should factor in the BEPS MLI (Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting) impact, especially if the structuring involves availing of tax treaty benefits (in India or Mauritius).
“This amendment applies to all incomes such as capital gains, dividends, fee for technical services, etc,” Yeeshu Sehgal, Head of Tax Market, AKM Global said, adding that it may also result in a rise in litigation.

Lokesh Shah, Partner at Induslaw, said: “Introduction of PPT is a measure implemented to align the tax treaty with BEPS Action Plan 6, which was developed to combat tax evasion… with the newly introduced PPT test, tax authorities in India will have the ability to deny the benefit of India-Mauritius tax treaty if it is reasonable to conclude that obtaining the treaty benefits was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly such tax benefit.”

With regards to grandfathering of investments, Manoj Purohit, Partner & Leader – Financial Services, Tax & Regulatory Services, BDO India said that “a formal clarification from the authorities” will remove any ambiguity.

“The amendment does not clarify whether or not past investments will be grandfathered, albeit, the PPT provision has been introduced as a non-obstante clause of the treaty. It is possible to interpret that the Protocol shall prevail over other provisions of the treaty, including the grandfathering provision,” he said.