Foreign direct investment (FDI) in India has played an important role in the development of the Indian economy. FDI in India has in a lot of ways enabled India to achieve a certain degree of financial stability, growth and development. This money has allowed India to focus on the areas that needed a boost and economic attention, and address the various problems that continue to challenge the country.
India has continually sought to attract FDI from the world’s major investors. In 1998 and 1999, the Indian national government announced a number of reforms designed to encourage and promote a favorable business environment for investors.
FDIs are permitted through financial collaborations, through private equity or preferential allotments, by way of capital markets through euro issues, and in joint ventures. FDI is not permitted in the arms, nuclear, railway, coal or mining industries.A number of projects have been implemented in areas such as electricity generation, distribution and transmission, as well as the development of roads and highways, with opportunities for foreign investors.
Why does India, a country with resources and a skilled workforce, lag so far behind China in FDI amounts?
Physical infrastructure is the biggest hurdle that India currently faces, to the extent that regional differences in infrastructure concentrates FDI to only a few specific regions. While many of the issues that plague India in the aspects of telecommunications, highways and ports have been identified and remedied, the slow development and improvement of railways, water and sanitation continue to deter major investors.
Federal legislation is another perverse impediment for India. Local authorities in India are not part of the approval process and the large bureaucratic structure of the central government is often perceived as a breeding ground for corruption. Foreign investment is seen as a slow and inefficient way of doing business, especially in a paperwork system that is shrouded in red tape.
Click - FDI Policy of India
SOURCE OF FDI INTO INDIA BETWEEN APRIL 2000 AND MARCH 2011
A tiny speck of island on the Indian Ocean, Mauritius, for an average Indian, is largely a beach destination that beckons thousands of honeymooners to its coral reefs and picture-perfect underwater world every year. But for a little over a decade, it has also become a key component that oils the Indian capital market as a hub for routing financial investments into India.
Be it a multinational firm investing in its Indian subsidiary, a private equity firm looking to take advantage of tax loopholes or even an Indian promoter routing a part of his/her own holdings in a group company through a Mauritius arm, the island nation is easily the favourite tax haven for investors into India.
However, certain sections of the Indian government have raised concerns of ‘round tripping’ of funds which, in effect, leads to loss for the Indian exchequer. There have been talks of trying to plug the loopholes for quite some time. And there are rumours that this time around, it might just happen. Even as fresh reports suggest that there has been no decision regarding the same, for a stock market that is on the verge of sneezing at any whiff of trouble, it was enough to shave down almost 2 per cent value on Monday.
Mauritius has been the single largest source of FDI into the country in the first 10 years of the new millennium. As much as $55 billion worth of money has been invested in India after being routed through Mauritius. This is 42 per cent of the total FDI in the country in the past decade. For starters, bulk of this money originated not from the island nation itself whose GDP is 150th the size of India.
Over the past several years, Mauritius has been used as a platform by investors to invest into India. Over 40 per cent of total foreign direct investment in India comes from Mauritius, a low tax jurisdiction. The Mauritius structure has also been very common with private equity funds investing in India.
Reasons :
Under the India-Mauritius tax treaty (tax treaty), India does not have a right to tax gains derived by a resident of Mauritius from the sale or disposal of shares of an Indian company. In other words, a Mauritian resident selling shares of an Indian company can take the benefit of the India-Mauritius tax treaty and not be liable to Indian capital gains tax. To add more flesh to this, the Supreme Court of India has held that tax residency certificate issued by Mauritius tax authorities is sufficient evidence to prove tax residency in Mauritius for availing tax treaty benefits. This has lent a lot of credibility to the Mauritius route.
Now, let us look at the concern which India has. As per Press reports, India is estimated to lose over $600 million a year in revenue on account of this benefit under the tax treaty. Further, concerns have also been raised that Mauritius may have been used for illegitimate purposes by Indian tax residents for ‘round-tripping transactions.’
India-Mauritius Tax Treaty Being Re-negotiated
In the backdrop of these concerns, India and Mauritius had set up a Joint Working Group (JWG) way back in August, 2006, comprising of senior officials to work on important issues in the existing tax treaty. Press reports indicate that JWG had met on several occasions in the past to discuss issues relating to adequate safeguards to be put in place to prevent misuse of the tax treaty and strengthening of the mechanism for exchange of information. However, it is understood that there was no consensus reached.
It is learnt that both the countries have recently agreed in principal to recommence discussions in this regard. Press reports indicate that the tax treaty may be revised to introduce:
1. Exchange of information on banking transactions (in addition to the existing information exchange article).
2. Limitation on benefits (LOB) clause to restrict the benefits of the treaty – this should provide guidance on meeting the substance test to qualify for treaty benefits.
Thus, under the revised treaty, a mechanism can be put in place to prevent its abuse. It remains to be seen the conditions which will be prescribed under the LOB clause.
While the above hit the news a couple of days ago, as per a Press report of today, the government has strongly denied holding any talks on revising the double tax avoidance agreement with Mauritius. Indian equity market has been witnessing a volatile bout of sell-offs post news that India and Mauritius are in talks to revise the existing tax treaty.
Introduction Of General Anti-Avoidance Rules (GAAR) In The Indian Tax Legislation
Some believe that a revision of the Mauritius treaty to prevent abuse may not be necessary now, given that anti-avoidance provisions are already proposed under the new Direct tax Code (DTC), to be effective from April 1, 2012.
GAAR is proposed as an anti-avoidance measure under the DTC. Under GAAR, the Indian tax authorities will be empowered to declare any ‘arrangement’ as ‘impermissible avoidance arrangement’, if part or a whole of a structure has been set up with the main purpose of obtaining ‘tax benefit’. An ‘arrangement’ will be presumed to be for obtaining tax benefit, unless the taxpayer demonstrates that obtaining tax benefit was not the main objective of the arrangement.
Under the DTC, GAAR is a tool available with the tax authorities to question any such structure, including the Mauritius structure.In summary, under the DTC regime, commercial substance and bona fide business purpose test will be among the key requirements for availing treaty benefits.
Is Shifting To Any Other Favourable Jurisdiction A Solution?
Countries like Singapore and Cyprus also provide similar tax benefits as Mauritius. The India-Singapore tax treaty already has an LOB clause to prevent abuse. In any case, once GAAR is enacted under the DTC, substance requirements and bona fide business purpose test will have to be satisfied to claim treaty benefits, irrespective of whether the investor comes from Mauritius or any other jurisdiction. Once enacted, GAAR will not only impact the new structures but may also impact the existing structures, if there is a claim for capital gains exemption under the DTC regime.
The Way Forward
PE funds coming into India from Mauritius should take note of these developments, review its existing structure and perform an impact assessment. PE funds, which are likely to be impacted due to these proposals, should see if any corrective step can be taken, if necessary. Alteration of existing structure may, therefore, be on the cards for some of the PE funds. Based on the outcome of the impact assessment, some PE funds may also have to reconcile to the fact that tax cost may have to be factored in while making investment decisions going forward.
The government, of course, looks confident than ever and assumes that India’s strong economic fundamentals will continue to attract investments, notwithstanding the additional tax cost on investors.
