Mauritius-based front companies of foreign speculators evade paying taxes in India amounting to thousands of crores of rupees with the help of loopholes in a bilateral agreement on double taxation, with the connivance of the Indian government.
THE logic of a liberal economic regime can result in apparent paradoxes. Mauritius, a tiny speck in the Indian Ocean, with a population of 1.2 million and an economy one-hundredth the size of the Indian economy, is the biggest exporter of capital to India.
The use of Mauritius as a gateway to funnel foreign investments into India has always been controversial. The island nation's financial regime, endowed with the key characteristics of a quasi tax haven, has facilitated this. Curiously, successive Indian governments, which have cried themselves hoarse about a runaway fiscal deficit and a resource crunch, have indulged in self-denial and have refused to tax the earnings of these foreign entities. But the issue is much more than lost revenues. The question is of equity. Can ordinary citizens be asked to pay taxes even as a small body of foreign-based entities are not even asked to pay a fraction of their earnings made through speculation on Indian soil? Although the Supreme Court on October 7 quelled the legal challenge to the government's refusal to clamp down on the Mauritius gateway, the controversy refuses to die.
The key to the apparent paradox lies in the provisions of a two-decade-old bilateral agreement, the Double Taxation Avoidance Convention (DTAC). Foreign entities have set up paper companies in Mauritius, claiming to be Mauritian residents. These companies, masquerading as Mauritian companies, have invested in India. And, taking advantage of the DTAC they avoid paying any taxes in India. They pay no taxes in Mauritius too.
Mauritius is the single biggest source of foreign direct investment (FDI) in India - amounting to $534 million in 2002-03 (about one-third of all FDI). But that is not all. Mauritius-based foreign institutional investors (FII) are also believed to be major players in the Indian bourses. FII investment in Indian stock markets between April and October this year amounted to almost $5 billion - almost ten times what they invested in the whole of the last financial year. Indeed, they are believed to be the ones leading the current boom in the stock markets. But the Mauritius angle does not end there. Reports in the financial media indicate that a substantial part of FII investment is believed to be coming from Non-resident Indians (NRIs) bringing back funds to participate in the ongoing speculative orgy in the Indian stock markets, much of which is said to be routed through Mauritius-based paper companies.
Mauritius is also reportedly the base of much of the hedge funds that are reported to be active in the current boom. Hedge funds, which deploy large volumes of funds in thin arbitrage deals made for very short-term gains, account for at least 30 per cent of the FII activity in the ongoing boom in the bourses. These entities, using the device of Participatory Notes, and dealing through the sub-accounts of the FIIs, which need not be registered with regulatory agencies such as the Securities and Exchange Board of India (SEBI) or the Reserve Bank of India (RBI), constitute the core of the speculative excess that is currently on.
This bout of speculation is not confined to the stock markets. In fact, from an economic perspective, this boom is far more dangerous than previous episodes because these players are betting simultaneously in several markets. While bringing in dollar denominated funds and thereby adding to the burgeoning foreign exchange reserves, currently amounting to over $90 billion, they are betting in stocks, the Indian currency and also speculating on the interest rates, all at the same time. That Mauritius is a home base for all this is common knowledge. The lack of regulatory oversight means that one is unable to quantify the funds coming in from the tax haven.
Although the losses to the government are difficult to estimate, primarily because it is difficult to ascertain how much comes through the Mauritius route, it is reckoned that the potential losses because of the loophole could run into several thousand crores since 1991, when India opened the floodgates to foreign investment. The government has repeatedly fought shy of taking on foreign investors. Instead, it has restrained its own arm, the Income Tax (I.T.) Department, from investigating the misuse of the bilateral agreement by foreign investors.
ALTHOUGH successive governments have refused to plug the loopholes in the DTAC, Indian regulators have always viewed them with suspicion. In late March 2000, officials in the I.T. Department in Mumbai investigated 24 Mauritius-based entities and issued "assessment orders" on them. The officers, racing against time to file their orders before the March 31 deadline, were basically engaged in lifting the corporate veil covering these entities. For instance, the I.T. Department's assessment of Cox and Kings Overseas Funds (Mauritius), made on March 29, 2000 for the company's assessment year 1997-98, showed that the company was in fact a subsidiary of Cox and Kings Overseas Fund Incorporated in Luxembourg. The assessment order revealed that the company routed its investment through Mauritius because "it realised that if it directly made investments in India, it will be liable to pay Indian income tax on investment including capital gains". Aware that if investments were made through a Mauritius-based company it would not have to pay taxes in India, it floated a fully owned subsidiary in the island nation. In 1994, Cox and Kings incorporated the subsidiary in Mauritius. It hired professional consultants, who were readily available for hire in Mauritius, to serve on the subsidiary's board. The subsidiary's business of investing funds in India was handled entirely by J. Henry Schroeder Bank AG, based in Switzerland.
The sole business of the subsidiary in Mauritius was to undertake investments outside Mauritius. In fact, Mauritius laws proscribed it from acquiring property or raising funds in the country. In fact it was not allowed to engage in any kind of business activity in Mauritius. Thus, the I.T. Department found that the company's sole motive for existence as an entity in Mauritius was to enable it to funnel investments overseas, particularly India. On the basis of its investigation, the I.T. Department's assessment order observed that "the real control of affairs of the Mauritian company is in the hands of the holding company incorporated outside Mauritius". It also noted that "the Mauritian subsidiary has been created with the main purpose to avoid tax". On the basis of its investigation of 24 cases, including Cox and Kings, the I.T. Department thus issued show-cause notices to them. It pointed out that they were not eligible for benefits of the DTAC since they were "not bona fide and genuine residents of Mauritius". The department also alleged that the abuse of the DTAC by entities from third countries amounted to "treaty shopping".
Soon after the orders were served on the FIIs, all hell broke loose. Amidst the controversy there were also allegations that the then Union Minister for Finance Yashwant Sinha's daughter-in-law was working for a Mauritius-based FII investing in India. The lobbies went into overdrive and there were dark hints that the stock market would collapse because FIIs would pull out of the Indian markets. On April 13, 2000, the Central Board of Direct Taxes, the apex body governing the Income Tax Department, issued Circular Number 789, which has since then been a subject of fierce litigation. The circular "clarified" that the production of a "certificate of residence" issued by the Mauritius authorities would "constitute sufficient evidence for accepting the status of residence as well as beneficial ownership for applying the DTAC accordingly". It also clarified that FIIs and other entities based in Mauritius "should not be taxable in India on income from capital gains arising in India".
The Joint Parliamentary Committee (JPC) probe into the 2001 stock market scam, in which the broker Ketan Parekh was the kingpin, revealed large-scale abuse of Mauritius-based entities. It revealed that Overseas Corporate Bodies (OCB), which are primarily vehicles floated by NRIs but which can act as fronts for other foreign investors, acted in concert with Ketan Parekh to siphon funds out of the country. In fact, there were allegations that Yashwant Sinha kept the Mauritius gate wide open so that speculators could avoid paying taxes in India. In fact, in his written submission to the JPC, after he was no longer Finance Minister, Sinha said that the revenue losses on account of the abuse of the Mauritius route were only "notional". In fact, he admitted that although he was aware of the abuse of the route, he did not plug the holes in the DTAC because the inflow of foreign investments was considered more important than raising revenue.
THE CBDT circular was challenged in the Delhi High Court by public interest petitions filed by the Azadi Bachao Andolan (represented by Prashanth Bhushan) and a former Chief Commissioner of Income Tax, Shiva Kant Jha. The latter, who is also an advocate with the Supreme Court Bar, argued that the Government of Mauritius, through "reforms" undertaken in the early 1990s, had transformed its legal and financial system into a veritable tax haven (see interview). He said that third-country entities were using the provisions of the DTAC to establish "conduit companies" in Mauritius and using them as vehicles to invest in India with the sole objective of dodging tax in India. Shiva Kant Jha pointed out that the CBDT circular, by asking I.T. officers to accept at face value the "certificate of residence" provided by the Mauritian authorities, effectively curtailed their ability to investigate whether they were really residents of Mauritius. He pointed out that the circular prevented officers from discharging their duties by "investigating the matrix of facts to determine whether a company seeking benefits under the convention was really a Mauritian resident". Shiva Kant Jha pointed out that the Mauritius-based entities were not paying any capital gains tax either in India or in Mauritius. He said that although Section 90 of the Income Tax Act provided the government with the authority to enter into agreements with other countries, these powers were specifically for entering into agreements on double taxation, that is, the elimination of a similar tax on the same set of entities for identical transactions in two different locations. Jha pointed out that the DTAC was meant to prevent double taxation, not tax evasion or avoidance. He also said that the government had failed to discharge its duties by causing wrongful revenue losses.
In May 2002, the Delhi High Court struck down circular 789. It observed that it was the duty of the I.T. Department to find out whether an assessee was taking shelter under the DTAC to avoid tax. In this, it was well within its right to make every endeavour to lift the corporate veil to find the true intent of these entities. It also observed that the abuse of a treaty or "treaty shopping" to "be illegal and thus necessarily forbidden".
The government filed an appeal against the High Court order in the Supreme Court in October 2002. A consortium of international investors, represented by the Global Business Institute (GBI), joined the government in filing the appeal. Interestingly, in February 2003, Arun Jaitley, currently Union Minister for Law and Justice and Commerce and Industry, who at that time was not a member of the Cabinet, donned his lawyer's robes to appear on behalf of the GBI. In its judgment, the Supreme Court ruled that it was the sovereign right of the state to enter into treaties with other countries. By taking a technical approach, the court ruled that Mauritius-based companies were liable to pay tax in Mauritius; it just so happens that they are not levied taxes there. It also ruled that the certificate of residence could not be disputed because as a sovereign state Mauritius had the power to determine who ought to be a resident of that nation. However, the Supreme Court observed that the Indo-Mauritius DTAC was in marked contrast to the Indo-U.S. DTAC. Shiva Kant Jha had pointed out that the Indo-U.S. DTAC provided for credits for taxes paid in either country, but had a specific provision that barred third-country entities from taking advantage of the bilateral treaty.
HOW much has the Indian state lost in revenues? Data are hard to come by to make an accurate estimate. However, one can hazard a guess on the basis of the value of securities sold by FIIs. The long-term capital gains tax, applicable on investments sold after holding them for more than a year, is at the rate of 10 per cent. Short-term rates are applied at the rate of 30 per cent when investments are liquidated. It is well known that the bulk of the FII investments are routed through Mauritius. Applying a uniform rate of 10 per cent capital gains tax on the gross sales made by FIIs would give at the very least a ballpark figure. Although it can be argued that this would overestimate the extent of lost revenue because it would not account for losses that FIIs made when they made sales, the fact that short-term capital gains are not being factored into the estimate offsets this reasonably.
On the basis of the figures presented in the table the losses to the exchequer on account of lost capital gains tax in the last decade would amount to a whopping Rs.28,139 crores. Even if it is an admitted policy of the state to woo foreign capital at any cost, the question is whether losses of this kind are acceptable to the polity at large. The average annual loss to the exchequer amounts to over Rs.2,300 crores. To get some idea of the magnitude of these losses in relation to the Union Budget, these magnitudes amount to roughly 10 per cent of the gross tax revenues of the Union projected for 2003-04. To put it more provocatively, in the context of the ongoing controversy surrounding the privatisation programme, the extent of lost revenues could easily have saved companies such as Balco, VSNL, IPCL and several others from being sold off to private parties; indeed, privatisation as an option would appear irrational if the executive chose not to forgo these taxes.
Tax havens are an important feature of the globalised world of financial speculation. Shiva Kant Jha believes that there is tension between the needs of the globalised system and the sovereignty of nation states. While financial entities want to move funds across a seamless world at will, nation states are finding that their traditionally accepted sovereign right to tax any economic entities active within their frontiers is increasingly coming under pressure from powerful players in the financial world. The rise of Mauritius as a tax haven in the 1990s, specialising in funnelling investments into India, reflects this reality. It is obvious that successive Indian governments have chosen to let this happen while creating two sets of tax payers within India - a privileged set of foreign entities who pay no taxes even as they engage in speculative excesses and ordinary Indians who have to pay taxes. Some would even regard the "notional" tax losses as subsidies paid to the well-heeled.
