This article has been published by Taxmann at Impact of the proposed notification in the Protocol of the India-Mauritius DTAA to include Principal Purpose Test – Taxmann

Impact of the proposed notification in the Protocol of the India-Mauritius Double Taxation Avoidance Agreement to include Principal Purpose Test

A. Background

Foreign Direct Investments have been promoted^[1] by the current government by rationalising various policies around foreign exchange management regulations, simplifying taxation laws and promoting IFSC^[2] in GIFT^[3] city. These factors have also attracted foreign investors to make significant investments in India, mainly from the USA, the Netherlands, Singapore and Mauritius^[4]. Mauritius, in particular, has been an attractive business jurisdiction because of the various tax benefits. For example, income earned by way of capital gains is exempt from tax in Mauritius. Furthermore, historically, the India – Mauritius Double Taxation Avoidance Agreement (“DTAA”) has provided considerable benefits to Mauritian residents inter-alia in terms of exemption from taxation in India on capital gains, reduced rate of tax on dividends, etc.

On 7 March 2024, India and Mauritius signed a Protocol (“Protocol”) to incorporate the Base Erosion and Profit Shifting (“BEPS”) related anti-abuse provisions in the India-Mauritius DTAA. The Protocol proposes to incorporate the minimum standards of anti-abuse provisions in the Preamble^[5] and includes the Principal Purpose Test (“PPT”)^[6] in the DTAA.

While the primary purpose of a DTAA is to allocate taxing rights between countries, it was conceptualised for the avoidance of double taxation of the same income arising out of cross-border transactions. The amendment being proposed in the India – Mauritius DTAA now seeks to substitute the intent of the DTAA from mere avoidance of double taxation to something more. The proposed intent now also seeks the elimination/curtailment of events such as non-taxation or reduced taxation through tax evasion or avoidance (including treaty shopping).

Furthermore, as already stated above, the amendment seeks to bring in fold PPT in the India – Mauritius DTAA, which is an internationally acknowledged tax anti-avoidance principle that was introduced by the Organisation for Economic Development (“OECD”) as part of its BEPS project in 2017^[7]. PPT clause allows the denial of benefit under the DTAA in respect of any item of income if it can be reasonably concluded that obtaining such benefit was one of the principal purposes unless it is established that the benefit is in accordance with the object and purpose of the relevant provisions of the DTAA.

Although the executives of both countries have signed the Protocol, the Protocol is not yet in force due to the absence of notification under section 90 of the Income Tax Act, 1961 (“IT Act”). In this regard, reference may be drawn to the case of Assessing Officer (International Taxation) v. Nestle SA^[8], wherein the apex court held that a notification under section 90(1) of the IT Act is a mandatory condition to give effect to a DTAA, or any protocol changing its terms or conditions, which has the effect of altering existing provisions of law.

Accordingly, once the legislature notifies the same in both countries, the proposed amendment will come into force.

B. Prospective / Retrospective applicability

Article 3(1)^[9] of the Protocol states that the Protocol will come into force once the same is notified.  Article 3(2) of the Protocol 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”. While the language in the italicised portion does seem to indicate retrospective applicability, the provisions of the Protocol may not be capable of such retrospective application.

As discussed above, while Article 2 of the Protocol seeks to insert a general anti-avoidance rule in the India – Mauritius DTAA, Article 1 seeks to substitute the existing preamble, which contains the declaration of intent with which India and Mauritius entered into the DTAA. As per the existing preamble, the India – Mauritius DTAA is stated to have been entered into for the avoidance of double taxation and prevention of fiscal evasion and encouragement of mutual trade and investment. On the contrary, as per the amendments being proposed, the intent for entering into India – Mauritius DTAA is stated to be the elimination of double taxation “without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in the convention for the indirect benefit of residents of third jurisdictions)”.

On the first principle, it is unfathomable to imagine how the intent of the India – Mauritius DTAA can be altered with retrospective effect. Nevertheless, the use of the phrase “treaty-shopping” in the proposed amendment does ring a bell as far as the intent with which India – Mauritius DTAA was entered into. In this context, it is relevant to travel back in time to the celebrated decision of the Supreme Court in UOI v. Azadi Bachao Andolan^[10], which overturned the decision of the High Court of Delhi in Shiva Kant Jha v. UOI^[11]. Before the Delhi High Court, Circular No. 789 issued by the Central Board of Direct Taxes (“CBDT”) dated 13.04.2000 was challenged. By way of the said Circular, CBDT had declared that a validly issued tax residency certificate (“TRC”) by Mauritian authorities was sufficient evidence of residency and beneficial ownership in order to claim the benefits available under the India – Mauritius DTAA. Agreeing with the Petitioners and recognising that treaty shopping may amount to fraudulent practice, which cannot be encouraged, the High Court quashed Circular No. 789 issued by CBDT. However, while doing so, the High Court had recorded the defence of the Government of India that because of the India – Mauritius DTAA, political arrangement had been made and that Mauritius route could be taken recourse to for gaining benefits.

On the Government’s challenge, the Supreme Court overturned the decision of the Delhi High Court, wherein the following was observed as far as the intent with which India – Mauritius DTAA was entered into:

“103. ‘Treaty shopping’ is a graphic expression used to describe the act of a resident of a third country taking advantage of a fiscal treaty between two Contracting States……. 

104. ……It is urged by the learned counsel for the appellants, and rightly in our view, that if it was intended that a national of a third State should be precluded from the benefits of the DTAC, then a suitable term of limitation to that effect should have been incorporated therein…… The appellants rightly contend that in the absence of a limitation clause, such as the one contained in Article 24 of the Indo-U.S. Treaty, there are no disabling or disentitling conditions under the Indo-Mauritius Treaty prohibiting the resident of a third nation from deriving benefits thereunder……

…….

121. An important principle which needs to be kept in mind in the interpretation of the provisions of an international treaty, including one for double taxation relief, is that treaties are negotiated and entered into at a political level and have several considerations as their bases.…… Based on these observations, counsel for the appellants contended that the preamble of the Indo-Mauritius DTAC recites that it is for the “encouragement of mutual trade and investment” and this aspect of the matter cannot be lost sight of while interpreting the treaty.

……

123. Developing countries need foreign investments, and the treaty shopping opportunities can be an additional factor to attract them……. Mauritius today provides a suitable treaty conduit for South Asia and South Africa. In recent years, India has been the beneficiary of significant foreign funds through the “Mauritius conduit”. Although the Indian economic reforms since 1991 permitted such capital transfers, the amount would have been much lower without the India-Mauritius tax treaty.

……

125. There are many principles in fiscal economy which, though at first blush might appear to be evil, are tolerated in a developing economy, in the interest of long term development. Deficit financing, for example, is one; treaty shopping, in our view, is another. Despite the sound and fury of the respondents over the so called ‘abuse’ of ‘treaty shopping’, perhaps, it may have been intended at the time when Indo-Mauritius DTAC was entered into. Whether it should continue, and, if so, for how long, is a matter which is best left to the discretion of the executive as it is dependent upon several economic and political considerations.”

(emphasis supplied)

Therefore, based upon the submissions of the Government as well as the observations of the Supreme Court as extracted herein above, it is clear that the India – Mauritius DTAA was entered into with the intent of encouraging trade relations between the two countries and that treaty shopping was per se not considered prohibited but was instead intended to invite significant foreign funds into India through the Mauritius route.  Accordingly, there is no gainsaying that the Governments of both India and Mauritius have decided to change their intent going forward, and hence, the proposed amendment to the preamble of the India – Mauritius DTAA should not have a retrospective effect. Having said that, one may pause to ponder whether the decision of the Supreme Court in Azadi Bachao Andolan (supra) would cease to have any impact once the Protocol is notified.

Currently, no clarification has been provided on the applicability of the proposed change in the preamble. It would only be prudent that such amendment comes into effect prospectively (akin to India-Singapore DTAA wherein a similar language was incorporated) as retrospective amendment of the preamble would result in litigation.

On the other hand, if the preamble to the India – Mauritius DTAA cannot be amended with retrospective effect, it could be argued that even PPT cannot be applied retrospectively, despite the language of Article 3(2) of the Protocol suggesting otherwise. This is because Article 3(2) of the Protocol suggests retrospective applicability of both the amendments simultaneously. Therefore, a clarification to this effect by the Government or CBDT is much needed in order to avoid litigation on this score.

C. Broad Issues

Pursuant to the notification of the Protocol, there may be multiple issues that may arise such as:

a.) Tax Residency Certificate (TRC):

1. The issue of whether a TRC is sufficient to claim benefits under the DTAA is a never-ending issue as far as the Indian tax authorities are concerned. As already stated above, the CBDT clarified its stand as early as in the year 1994^[12], which was reiterated in 2000, that capital gains derived by a Mauritian resident on the sale of Indian company shares would not be taxable in India subject to production of a valid TRC issued by Mauritian authorities. As such, while doing so, the CBDT specifically relied upon the unambiguous language contained in Article 13(4) of the DTAA. However, in the past decade or so, the Indian tax authorities have been regularly questioning the sanctity of TRC in the case of interposed entities located in Mauritius, but in vain^[13]. Therefore, whether the PPT will now come to the rescue of Indian tax authorities to legitimately question TRC (with retrospective effect) needs to be seen. A view could be taken that PPT cannot be used to question residency in Mauritius since PPT itself would only come into operation where the non-resident is seeking and is entitled to the DTAA (which in turn contains PPT).
2. Currently, petition^[14], wherein the question of whether TRC is a sufficient document or not for availing benefits under the India-Singapore DTAA, is pending before the Supreme Court of India. The outcome of the said petition may not apply in the case of India-Mauritius DTAA, unless the decision of the supreme court in Azadi Bachao Andolan [supra] is overturned.

b) Grandfathering of shares:

i.) Prior to the amendment to India – Mauritius DTAA with effect from April 01, 2017, gains derived by a Mauritian resident from alienation of property, such as shares held in an Indian company, were taxable only in Mauritius. Post the amendment, gains derived by a Mauritian resident from alienation of Indian company shares (which are acquired after April 01, 2017), have become taxable in India. However, even after the amendment, gains derived by a Mauritian resident from the alienation of Indian company shares, which were acquired before April 01, 2017, would continue to remain taxable in Mauritius and have thus been grandfathered.

ii.) An issue may arise as to whether PPT can be invoked to disregard the grandfathering benefit. One may argue that PPT cannot be invoked to take away a benefit already bestowed since obtaining such benefit would be in line with the object and purpose of the afore-stated amendment. However, clarity on this score is also required to avoid proacted litigation.

D. Conclusion

While the finance minister has clarified via its Twitter^[15] handle on April 12, 2024, that the concerns/ queries are premature, and the Protocol is yet to be notified, however, where the amendment is notified retrospectively, it would stir a new wave leading to perhaps inter-alia re-assessments, questioning gains derived on alienation of investments, even post exit of non-resident investors. Here, a sensible way of implementing the proposed amendment would be rather prospectively than retrospectively.

These are only some of the issues that may arise once the Protocol is notified. The authors will endeavour to address those in the next article, which shall follow soon.

Footnotes:

[1]              https://dpiit.gov.in/publications/fdi-statistics

[2]              International Financial Service Center

[3]              Gujarat International Finance Tec-City

[4]              https://www.statista.com/statistics/1020989/india-fdi-equity-inflows-investing-countries/

[5]              The Government of the Republic of India and the Government of Mauritius intending to eliminate double taxation with respect to the taxes covered by this convention without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty shopping arrangements aimed at obtaining reliefs provided in this convention for the indirect benefit of residents of third jurisdiction, have agreed as follows

[6]              Notwithstanding the other provisions of this convention, a benefit under this convention shall not be granted in respect of an item of income if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of relevant provisions of this convention

[7]              As part of BEPS Action Plan 6 – “Prevention of Tax Treaty Abuse”

[8]              [2023] 458 ITR 756 (SC)

[9]              Each of the contracting state shall notify the other the completion of the procedures required by its law for bringing into force this protocol. This protocol shall enter into force on the date of the later of these notifications

[10]             [2003] 263 ITR 706 (SC)

[11]             [2002] 256 ITR 563 (Delhi High Court)

[12]             Circular No. 682 of 1994 dated March 30, 1994

[13]             Vodafone International Holdings B.V. v Union of India [2012] 247 CTR 1(SC), Indostar Capital v Assistant Commissioner of Income-tax, (International taxation) 2(2)(1) [2019] 415 ITR 513 (Bombay High Court), Sapein Funds Ltd v. Commissioner of Income-tax (International Taxation) [2023] 108 ITR(T)180 (Delhi trib.), Bid Services Division (Mauritius) Ltd. v Authority for Advance Ruling (Income-tax) 148 taxmann.com 215

[14]             Assistant Commissioner of Income-tax v Blackstone Capital Partners (Singapore) VI FDI Three Pte. Ltd 158 taxmann.com 261

[15]             https://x.com/IncomeTaxIndia/status/1778804751993618707