Implications of Mauritius tax treaty changes for markets

On May 10^th 2016, The Government of India amended the three-decade old treaty with Mauritius. Under an amended tax treaty, India would tax capital gains on investments channeled through Mauritius. This change will be implemented in three phases:

1. No change for investments made before April 2017: The investments made before 1 April 2017 will not be liable to be taxed in India. This means that even if investors who have brought shares in Indian companies before 1 April 2017 decide to sell these shares after this date, the accrued capital gains will not be taxed in India. This provides an incentive to buy Indian stocks (if that was on your radar) prior to this timeline!.

2. From April 2017 to April 2019, the tax applied will be 50% of the Indian domestic tax rate: From April 1, 2017 to March 31, 2019, firms based in Mauritius will have to pay capital gains tax at 50% of domestic tax rate (i.e. at 7.5%). Under the amended treaty, only those Mauritius-based companies that have a total expenditure of more than INR 2.7 million in the preceding twelve months will be able to benefit from the tax treaty.

3. After April 2019, the Indian domestic rate will be applied in full: The full tax rate (currently at 15%) is applicable on the capital gains on sale/transfer of Indian shares by Mauritius based firms.

But in this world nothing can be said to be certain, except death and taxes…Benjamin Franklin

As Benjamin Franklin quote summarizes, nothing can be certain, except death and taxes. Of course investors do not like to be taxed; however it is not a big deal as it is made to be! The Indian stock market also reacted negatively with a knee jerk reaction; however it recovered within hours as markets took a more balance view about this tax treaty. Here is our take on this:

No retrospective taxation and advance notice prior to implementation: What will come as a relief to foreign institutional investments (FIIs) is that there won't be any retrospective taxation on the capital gains made on shares of Indian companies. All shares purchased till March 31, 2017 will not be subject to short-term capital gains tax. India anyway does not have any capital gains tax on investment held for one year or more. Hence long term investors do not pay taxes anyway! Yes, this could affect ‘hot money’ flows, which is in fact will reduce unnecessary volatility in Indian equity markets. This move will result in a more stable and transparent regime and is a positive for long term investors. India is likely to see durable foreign investments from FIIs in the long-term as round-tripping of funds would be reduced.

Level-playing field for DIIs and FIIs: This move of the government was a long-awaited wish of the mutual fund industry in India as it is seen providing a level playing field to domestic and international mutual funds. Till now, short-term investment by FIIs were not taxable while those by mutual funds were.

Investors give more importance to the fundamentals of the market, rather than tax benefits: Participatory notes (P-notes) are the instruments issued by brokers to overseas investors, who invest in the Indian stock market without registering themselves. More than two-thirds of investments through P-notes or offshore derivative instruments (ODIs) come via Mauritius (30%) and Singapore (36.5%), which will now get taxed for short-term capital gains, starting 1 April 2017. The fund flows through P-notes will be impacted, however prior notice before implementation would mean that the impact will be negligible as these investors who accessed Indian markets through P-notes, can register directly with the capital markets regulator - Securities and Exchange Board of India (SEBI). Yes, this move will make P-notes less attractive as it is costlier than registering as an FPI. Yes, it could impact a few brokers who depend on this flow but it is not too bad for Indian markets in general. At the end of the day, Investors would base their investment decision in the Indian markets based on the FX adjusted net returns and not whether tax freebies are available or not. 

Changes applicable only for equity investments: Investors in mutual funds, derivatives and debt will not fall under ambit of the proposed tax changes as these instruments aren't mentioned in the reworked double taxation avoidance agreement. The provisions of the General Anti-Avoidance Rule (GAAR), which take effect from April 1, 2017, will override the tax treaty provisions in case the agreement is abused.

Reworking of Singaporean tax treaty on cards: The capital gains tax clause in the Indo-Mauritius treaty, becomes applicable to the Indo-Singapore tax treaty as well. This is because the agreement for avoidance of double taxation with Singapore ("India-Singapore DTAA") under the India-Singapore DTAA is co-terminus with the benefits available under erstwhile provisions on capital gains contained in the treaty with Mauritius. That means not only short-term capital gains tax will be imposed on FIIs purchases from Mauritius but from Singapore too. We expect the Government to move with this tax amendment in the next few days.

To conclude….As Indian markets, rightly so, have not reacted negatively to the Mauritius tax treaty changes. We opine that Investors do not need to be pampered and lured to invest in India; however prospects of stable FX adjusted sustainable long term returns will certainly draw investors to Indian markets.