India cracks down on a major tax evasion route
A guest blog by Abdul Muheet Chowdhary
My award winning essay, written for a competition jointly held by the Tax Justice Network and Oxfam International, focused on how India is unable to meet its child rights obligations as it loses a huge amount of tax revenue because of some policy decisions taken by the government. These decisions enable tax abuse, and as is being increasingly understood, tax abuse is a human rights issue.
One of these decisions is the Double Taxation Avoidance Agreement (DTAA) with Mauritius, a favourite tax haven for Indians. Under this, Mauritius based companies selling shares of Indian companies are effectively exempt from capital gains tax. This encouraged tax evaders to route investments into India through Mauritius based shell companies, leading to lots of tax revenue foregone. Official data states that over the 15 year period from 2000-2015, the highest amount (34%) of total FDI into India was from Mauritius, valued at US$ 93.6 billion.
What Basically Happened
This treaty has now been amended after years of negotiations between the two countries. From 2017, Mauritian investors will be taxed on capital gains at half the Indian rate (meaning 7.5%) till 2019, after which the full rate will apply. This basically removes the incentive for tax evaders to route funds through Mauritius as they will be taxed anyway. In that sense it plugs a major loophole. It is also one of the remedies sought in my essay and it is a stroke of good fortune that action on the issue has been taken so quickly.
Shell companies are exempt from the half rate during the two year transition period. If a Mauritian resident company has spent less than 1.5 million Mauritian Rupees on operations in the preceding year, it will be deemed a shell company. This is a rigorous definition and will include almost all shell companies.
The government has announced that it will now rework (on similar lines) its DTAA with Singapore, another major tax haven and the second biggest source of FDI after Mauritius.
- A major loophole has been plugged, so the amount of tax revenue lost through the ‘Mauritius route’ should decrease.
- This will provide more resources to the government to carry out developmental activities such as building more schools.
- Other governments around the world can take inspiration/warning. A historic litigation is unfolding in Kenya, where the government is being taken to court for its tax-abuse-enabling DTAA with…Mauritius.
- It’s also a victory for the ‘source-based’ principle of taxation, which states that tax should be levied where the money is made, as opposed to where the company is based (which is what the ‘residence-based’ principle states). The residence-based principle works to the advantage of rich countries, where most large corporations are headquartered, to deprive poor countries of their fair share of taxes.
- It seems that other securities – mutual funds, exchange-traded derivatives and convertible or non-convertible debentures, to name a few – will be exempt. Thus other options for investing illicit cash remain. All eyes will now be on the contents of the long-pending General Anti-Avoidance Rules.
- Its application is prospective, not retrospective – meaning farewell to the money lost so far.
- Mauritius (and Singapore) are the biggies, but by no means the only ones. Evaders will likely shift to other havens, such as the Netherlands or British Virgin Islands.
Despite these drawbacks, this is a big step forward and certainly a boost to the global effort on tax havens. An intergovernmental tax commission in the UN is needed now more than ever to catalyse these individual efforts and enable globally coordinated and consistent action against tax havens.
Update from Abdul Muheet Chowdhary 3rd April 2019:
After India renegotiated its double tax avoidance agreement with Mauritius in 2016, there have been some positive developments. First, a quick recap: the essence of the 2016 renegotiation was to plug the key loophole that made Mauritius a preferred investment route into India. The loophole was “residence based taxation of capital gains arising from alienation of shares.” Shorn of jargon, what that means is that if a Mauritius based company invested in shares of a company resident in India, and it sold those shares later and made a profit, then it would have to pay capital gains tax in Mauritius. Conveniently enough, Mauritius doesn’t levy any capital gains tax! This loophole was plugged in 2016 and henceforth there would be source based taxation of capital gains. Meaning that if Mauritius based companies sold shares in a company resident in India, the capital gains tax would be collected by India.
Fast forward to today. The changes were to kick in fully from 1 April 2019. Hence, was there any change in the meantime? Was there a mad scramble by tax-avoiding investors to flee Mauritius in the face of impending doom? The answer, satisfyingly, is yes.
From 2017 to 2018, there was a precipitous drop in FDI equity inflows from Mauritius. In 2017, Mauritius accounted for a staggering 44% of total FDI equity inflows into India, valued at USD 9.8 billion. A year later, this number plummeted to USD 3 billion, accounting for only 15% of inflows. In other words, inflows dropped by three times in a single year.
This raises another question: where did these funds go? Some of these may have gone to Singapore. Inflows from Singapore during the same period doubled. In 2017, Singapore was the second biggest source of inflows, accounting for 20% valued at USD 4.5 billion. A year later this number doubled to USD 8 billion, which in 2018 was 40% of FDI equity inflows. In 2019, Singapore remains the largest source by far.
This is somewhat puzzling because in 2016, India also renegotiated its double tax avoidance agreement with Singapore to plug the exact some loopholes as existed with Mauritius, which was residence based taxation of capital gains arising from selling shares. Perhaps Singapore’s other strengths as a financial hub such as the ability for companies to raise funds at comparatively lower rates and an effective dispute resolution system continue to make it a preferred place for Indians to setup companies.
Other jurisdictions that also saw major increases in sending FDI to India are Japan (whose share tripled from 3% in 2017 to 9% in 2018) and the UK (whose share quadrupled from 1% to 4%). Interestingly, the Netherlands, which is another big source and a not-so-secret tax haven, saw its share decline from 8.6% to 7.7%. This is despite the DTAA with Netherlands left untouched.
Coming back to the main story – the tremendous shift of capital away from Mauritius definitively proves that the tax exemptions it offered, and the ease of establishing shell companies (the two key elements of the DTAA with India that were amended in 2016) were the main reasons why it was a capital exporter. With these benefits gone, Mauritius’ utility declined considerably. India’s effort in renegotiating the treaty to close off at least one route for tax avoidance, which was backed by political will at the highest levels, seem to have paid off.