On Tuesday, the Indian government inked a pact with Mauritius that gave it the right to tax capital gains arising in Mauritius from sale of shares acquired on or after April 1, 2017, in Indian companies. The amendment of a three-decade-old double taxation avoidance agreement was signed in Port Louis. During a transition period of two years, the tax will be limited to half the Indian tax rate. The full tax rate will kick in from 2019-20. The treaty between India and Mauritius was inked in 1983, but assumed significance a decade later, when foreign institutional investors were allowed to invest in Indian shares.

The clause, which exempts capital gains, dividend on shares and interest from taxation in India became a key attraction of foreign investors coming into India. An entire industry with post box companies, which have very little real business, has cropped up in the island nation to route investments into India.

The white paper on black money submitted in 2012 made references to these Mauritius vehicles acting as conduits for round tripping unaccounted money from Indians back into India.

The white paper evoked a strong rebuttal from the Mauritius government. “We are deeply concerned by a statement contained in the Paper to the effect that investments into India are apparently routed through Mauritius for avoidance of taxes and/or for concealing the identities from the revenue authorities of the ultimate investors, many of whom could actually be Indian residents, who have invested in their own companies, through a process known as round tripping. No case involving Mauritius has been mentioned in the White Paper. This is a clear example of erroneous perception,” a Mauritius Ministry of Finance and Economic Development release of 2012 had said. It had expressed hope that the joint working group would come out with a structure, where mutual interests of both countries would be safeguarded.

Four years later, with the signing of the pact, investors would hope that such a structure is finally in place, ending the uncertainty and ambiguity that came with mention of the M-name, that often made the stock market go berserk.

In a note on the development, law firm Nishith Desai Associates analysed the impact of the move on various stakeholders in the market. Here are five key areas, which could see some action in the coming days:

Grandfathering of investments in Singapore route

Article 6 of the Protocol to the India-Singapore DTAA states that the benefits in respect of capital gains arising to Singapore residents from sale of shares of an Indian company shall only remain in force so long as the analogous provisions under the India-Mauritius DTAA continue to provide the benefit.

Now that these provisions under the India-Mauritius DTAA have been amended, a concern that arises is that while the Protocol in the Mauritius DTAA contains a grandfathering provision which protects investments made before April 01, 2017, it may not be possible to extend such protection to investments made under the India-Singapore DTAA.

Consequently, alienation of shares of an Indian company (that were acquired before April 01, 2017) by a Singapore Resident after April 1, 2017, may not necessarily be able to obtain the benefits of the existing provision on capital gains as the beneficial provisions under the India-Mauritius DTAA would have terminated on such date.

Private equity funds and holding companies

Investments that are made through hybrid instruments such as compulsory convertible debentures may still be eligible to claim residence-based taxation as the ministry press release only refers to allocation of taxation rights in respect of shares and the Protocol may restrict the shift to source based taxation only to such transactions. Having said that, clarity on this issue shall only be available once the text of the Protocol is released, the Nishith Desai note said.Private equity funds which are raising money now and would start deploying this in the new financial year would also be required to first decide on and then communicate to investors what will be the route they would take.

 Foreign Portfolio Investors (FPIs)

Under the Indian income tax law, shares of listed Indian companies held by FPIs are deemed to be capital assets irrespective of the holding period or the frequency of trading equity carried out by the concerned FPI. As such, income from sale of shares results in capital gains and at present FPIs enjoy the benefits of capital gains provisions under the India-Mauritius DTAA.

Such investments will also be impacted by the amendment and as per rotocol such investments shall be subject to tax in India after April 1, 2017. While there is a zero percent rate applicable on gains arising out of shares that are listed and sold on a recognized stock exchange, if such shares are held for more than 12 months, capital gains arising out of investments are subject to a tax rate of 15% (exclusive of applicable surcharge and cess) if such shares are held for less than 12 months i.e. short-term capital gains. During the transition period, and subject to the satisfaction of the limitation of benefits clause, this rate may be reduced to 7.5%.

P-Note issuers

Issuers of participatory notes (P-Notes) may be adversely affected by the Protocol as the cost of taxation arising out of the changed position on taxation would have to be built into such arrangements. This would make such arrangements not only costly but also less lucrative for investors who seek synthetic exposure to Indian securities. Considering that it is the FPI entity that is issuing the P-Note which will be subject to tax in India, issues may arise with respect to the tax amounts that they will be able to pass on to the P-Note holders due to a timing mismatch on the taxability of the FPI entity (which is taxed on a FIFO basis and not on a one-to-one co-relation). It will have to be seen whether P-Notes can still prove to be attractive for investors, considering the incremental tax associated with the same.

F&O transactions

Similar to the position in respect to compulsory convertible debentures, Mauritius-based entities that enter futures and options contract in India, may still be able to claim the benefits of residence-based taxation since such contracts relate to capital assets other than shares. However, complete clarity on this position shall only be available after the text of the Protocol is released.