Treaty trick

The Vodafone case highlights yet again how foreign companies operating in India use tax havens to avoid paying taxes.

MAURITIUS is the biggest of an idyllic clutch of islands in the Indian Ocean off the south-eastern coast of Africa, roughly 870 kilometres east of Madagascar. Its sun-kissed beaches attract tourists in droves. Mauritius is also a preferred destination for another category of visitors who wear dark suits and carry briefcases when they are not sunbathing. They are rather adept at crunching numbers and reading the fine print of legal tomes. They represent foreign institutional investors (FIIs) and multinational corporations, especially those doing business with India.

Mauritius has for long had a special relationship with India. Its government is controlled by persons of Indian origin. The Indian Navy has an important presence in the island nation. More importantly, since August 1982 the governments of India and Mauritius have had a double taxation avoidance treaty (DTAT) that allows for treaty shopping or round tripping of investments phrases that imply that investors from third countries with relatively high rates of taxation on business profits and income earned from transactions in shares and other securities can get away without paying corporate income tax or capital gains tax by routing their funds through that country.

A large number of FIIs who trade on the Indian stock markets operate from Mauritius. According to the tax treaty between India and Mauritius, capital gains arising from the sale of shares are taxable in the country of residence of the shareholder and not in the country of residence of the company whose shares have been sold. Therefore, a company resident in Mauritius selling shares of an Indian company will not pay tax in India. Since there is no capital gains tax in Mauritius, the gain will escape tax altogether.

Thanks to the absence of capital gains tax and the low incidence of taxation on corporate profits, over 15,000 international companies have set up affiliate or associate firms in Mauritius. That is why we have a patently ridiculous situation in which the small island nation is the single largest source of foreign investment in India although its economy is a hundred times smaller. Mauritius ranks first among all countries in inflows of foreign direct investment (FDI) to India, with cumulative inflows amounting to roughly $11 billion (around Rs.55,000 crore at current exchange rates). In recent years, Mauritius has accounted for approximately half of the annual inflows of FDI to India and around 40 per cent of FII money that has come into the country's stock exchanges.

Definition of tax haven

Before continuing, it would be useful to explain what a tax haven is. Perhaps the oldest tax haven in the world is Jersey, which is part of the Channel Islands off the coast of Normandy in France. Geoffrey Colin Powell, former economic adviser to Jersey, candidly defined a tax haven: What... identifies an area as a tax haven is the existence of a composite tax structure established deliberately to take advantage of, and exploit, a worldwide demand for opportunities to engage in tax avoidance.

A December 2008 report of the U.S. government Accountability Office was unable to define categorically a tax haven but considered the following characteristics as indicative of a tax haven:

(a) nil or nominal taxes;

(b) lack of effective exchange of tax information with foreign tax authorities;

(d) no requirement for a substantive local presence; and

(e) self-promotion as an offshore financial centre.

While the Government of India has DTATs with 80-odd countries, the treaty with Mauritius is special because of particular clauses. Article 7 of the treaty stipulates that the profits of an enterprise of a contracting state are to be taxed only in that state, unless the enterprise carries on business in the other contracting state through a permanent establishment situated there. If a permanent establishment has been created, the profit may be taxed in the other state only to the extent that is attributable to that establishment. Article 5 defines permanent establishment as a fixed place of business through which the business is wholly or partly carried out.

Article 6 specifies that income from immovable property will be taxed in the contracting state in which the property is situated. Immovable property is defined according to the laws and usage of the contracting state. Article 13 (4) of the treaty states that gains derived by a resident of a contracting state from the alienation of any property will be taxed only in that state. Thus, if a Mauritius company earns capital gains in India, then such income is not eligible to be taxed in India. Moreover, capital gains arising from the sale of securities in India by a Mauritian resident are taxable only in Mauritius.

The problem arises from the fact that Mauritius is not just a place where over thousands of shelf or shell companies have been set up by smart lawyers and accountants to avoid taxes. The country has unfortunately become a convenient conduit for laundering illegal money. Not just drug pushers and arms merchants, unscrupulous promoters of Indian companies have been known to use firms located in Mauritius to ramp up the prices of their own shares through the use of participatory notes issued by international fund managers.

Participatory notes are financial instruments that help conceal the origin of funds invested in stocks and shares in India. The regulator of the country's capital markets, the Securities and Exchange Board of India (SEBI), had submitted a report to the Joint Parliamentary Committee that investigated the 2001 stock market scandal on how participatory notes are misused. Thereafter, the Reserve Bank of India opposed the use of such financial instruments, but the Finance Ministry has not heeded its objections.

Arun Kumar, Professor of Economics at Jawaharlal Nehru University, who is associated with Tax Justice Network, an organisation that tracks activities in 77 tax havens around the world, has estimated that the total amount of money (with interest) that has been taken out of India illegally over the five decades since 1950 would be in the region of $1.5 trillion, a figure, he says, is corroborated by a recent study done by an association of Swiss bankers. A portion of this money has returned to India after being laundered through Mauritius.

CBDT circular on FIIs

On April 13, 2000, the Central Board of Direct Taxes (CBDT) in the Union Ministry of Finance issued a circular placing an embargo on income tax officers conducting detailed investigations on the activities of Mauritius-based FIIs if such investors produced a certificate from the Mauritius government about their domicile or residential status in that country. This circular was challenged in court through two public interest litigation (PIL) petitions. A Bench of the Delhi High Court ruled that mere production of a certificate by a company that it was registered in Mauritius is not sufficient proof for claiming the (tax) benefit under (the) DTAT and added that the country had been losing millions of rupees by allowing the opaque system to operate.

The circular that had reportedly been issued at the behest of the then Finance Minister, Yashwant Sinha, elicited a lot of criticism at that time even from the government's supporters. Bharat Jhunjhunwala, who is close to the Rashtriya Swayamsewak Sangh (RSS), the ideological parent of the Bharatiya Janata Party (BJP), had this to state about the role of the then Finance Minister in Indian Express (August 1, 2001):

Any bureaucrat or Minister can subvert governance to favour his near and dear ones and yet claim that he is clean the Income Tax Department had issued notices to Mauritius-based FIIs seeking to deny them benefits of the Double Taxation Avoidance Treaty with that country because their head offices were located in USA or other countries. The Finance Minister intervened and instructed that a certificate of registration issued by the government of Mauritius was adequate and final proof of the FII's domicile and asked the Income Tax Department to withdraw their notices. The Finance Minister's bahu' (or daughter-in-law, Punita, who was working then for a leading international finance firm) was one beneficiary of the Minister's intervention. Yet, this was considered clean because the Finance Minister had disclosed his interest to the Prime Minister. Whether the decision was taken in the interests of the country or the bahu' can never be answered.

In his biography, Confessions of a Swadeshi Reformer, My Years as Finance Minister (Penguin Viking, New Delhi, 2007), Yashwant Sinha has recounted how greatly hurt he felt when it was alleged that the April 2000 CBDT circular on tax concessions for corporate bodies registered in Mauritius had been issued because he wanted to favour a firm that had employed his daughter-in-law.

The Union government appealed against the Delhi High Court judgment in the Supreme Court arguing that the CBDT circular was needed to attract foreign investment. In 2003, the apex court ruled that this device was an act of legitimate tax planning by stating that many developed countries tolerate or encourage treaty shopping even if it was unintended, improper and unjustified for non-tax reasons, unless it leads to a significant loss of revenue. The court added: The court cannot judge the legality of treaty shopping merely because one section of thought considers it improper, neither can it characterise the act of incorporation under the Mauritius law as a sham or a device actuated by improper motives.

On April 2, 2009, the heads of state of the Group of 20 issued a statement in London, a portion of which read: The era of banking secrecy is over. The statement called for blacklisting of those tax havens that did not adhere to the international standard for exchange of information. The then British Prime Minister, Gordon Brown, stated rather dramatically: This is the beginning of the end of tax havens. A day earlier, speaking at a dinner meeting, Prime Minister Manmohan Singh said: We should endorse sharing information and bringing tax havens and non-cooperating jurisdictions under closer scrutiny.

Should one take such pronouncements of political leaders seriously? There is a section within the government that wants to renegotiate certain controversial clauses in the India-Mauritius DTAT to check tax evasion despite the political and diplomatic implications of offending a friendly country. But there is a far more powerful section among promoters of corporate entities that wants the status quo to be maintained.

If India truly wishes to assist economically the people of Mauritius and not just its politicians, lawyers and accountants, it would probably make better sense for it to provide grants instead of allowing Mauritius to be used as a haven for a breed of money-launderers, financial sharpshooters and white-collar criminals.

Paranjoy Guha Thakurta is an independent journalist and educator.