Recent Indian Tax Treaty Changes Affecting Nonresident Investments into India - Termination of Capital Gains Exemption under the India-Mauritius Tax Treaty

India and Mauritius entered into a Protocol amending the double-tax treaty between India and Mauritius (the “2016 Protocol”) on May 10, 2016. Under the 2016 Protocol, following a grace period and subject to a grandfather rule, capital gains earned by a Mauritian resident attributable to shares in an Indian company will be subject to Indian capital gains tax. 

Background 

Foreign investment into private companies in India has frequently been structured through Mauritius entities, with Mauritian companies serving as both fund vehicles for investments into India and as special purpose vehicles for individual Indian investments. Structuring investments into India through Mauritius is typically intended to allow foreign investors to take advantage of the long-standing double-tax treaty between India and Mauritius (the “India-Mauritius Tax Treaty”), which provides an exemption from Indian capital gains tax for Mauritian residents selling shares of Indian companies. However, with the advent of the OECD’s Base Erosion and Profit Shifting (“BEPS”) project and increased scrutiny of offshore investment havens, there has been a growing debate over the appropriateness of the capital gains exemption under the India-Mauritius Tax Treaty. 

Partly due to doubts over the longevity of the capital gains exemption under the India-Mauritius Tax Treaty, foreign investors have increasingly invested into India through Singapore, which offers a similar exemption from Indian capital gains tax for residents of Singapore under the double-tax treaty between India and Singapore (the “India-Singapore Tax Treaty”). However, and quite unusual for treaties, the availability of the capital gains exemption under the India-Singapore Tax Treaty is expressly conditional on the availability of a similar benefit under the India-Mauritius Tax Treaty. 

Timing of Termination of Capital Gains Exemption 

Under the 2016 Protocol, shares in an Indian company acquired by a Mauritian resident prior to April 1, 2017 will be grandfathered and capital gains from those shares (regardless of when they arise) will generally not be subject to Indian capital gains tax under the India-Mauritius Tax Treaty. Subject to a new limitation of benefits provision (the “New LOB Provision”), shares in an Indian company acquired after April 1, 2017 and sold before April 1, 2019 will be subject to Indian capital gains tax at a rate of 50% of the then current Indian capital gains tax rate. Shares acquired by a Mauritian resident after April 1, 2017 and sold after April 1, 2019 will be subject to full Indian capital gains tax. 

The New LOB Provision will disallow the 50% reduction in the capital gains tax rate if the Mauritian resident fails a newly-imposed main purpose test and bona fide business test. The tests under the New LOB Provision have yet to be defined, but the Indian government has stated that a resident is presumed to fail the LOB Provision if its total expenditures in Mauritius fall below approximately US$41,000 in the previous 12-month period (based on current exchange rates). New 

Withholding Tax on Interest Paid to Mauritian Banks 

The 2016 Protocol also imposes a new withholding tax on interest paid by Indian resident companies to Mauritian banks, subject to a grandfather rule. Such interest will be subject to a 7.5% Indian withholding tax on debt issued after March 31, 2017. Debt issued to Mauritian banks on or before March 31, 2017 will generally qualify for an exemption from Indian withholding taxes under the India-Mauritius Tax Treaty. 

Impact on India-Singapore Tax Treaty 

The 2016 Protocol will also affect the India-Singapore Tax Treaty. Under the India-Singapore Tax Treaty, subject to an existing limitation of benefits provision, capital gains of a Singapore resident from the sale of shares of an Indian company are exempt from Indian capital gains tax. However, this exemption under the India-Singapore Tax Treaty is conditional on the availability of similar benefits to a resident of Mauritius under the India-Mauritius Tax Treaty. The Indian and Singapore governments have not issued any guidance on the impact of the 2016 Protocol on the India-Singapore Tax Treaty. Until further guidance is issued, under the India-Singapore Tax Treaty, Singapore residents appear not able to qualify for an exemption from Indian capital gains with respect to any shares of an Indian company acquired after April 1, 2017. 

* * * Dechert LLP does not practice law in India and Mauritius. This OnPoint is for information purposes only and investors are urged to consult with Indian counsel regarding the potential impact of the 2016 Protocol on their particular situation.