By Ruma Dubey

The Mauritius ghost is back to haunt us. And it has a name too – GAAR, an acronym for General Anti-Avoidance Rules.  40% of the foreign investment into India comes from Mauritius thus any change in the rules is sure to have far reaching consequences. And that is also probably the reason why the Govt wants to tap this big source of revenue.

GAAR is an anti-avoidance measure. And what is anti-avoidance? As per the proposed provisions in the Direct Tax Code, a transaction shall be considered to be a tax avoidance transaction, if it is undertaken with the main purpose of obtaining a 'tax benefit'.

There is worry in the market, especially amongst the FIIs that GAAR could lead to many investments of the FIIs and P-Notes will now coming under the tax gambit. This means that money which is routed through Mauritius, which provides a tax benefit to the FIIs due to the tax treaty with Mauritius, will no longer be applicable. This means that FIIs will cease to enjoy any tax benefit.

The biggest issue more than GAAR itself is the uncertainty. The new rule is scheduled to come into effect from 1st April 2012 and till date, there is uncertainty in tax exemption for FIIs on sale of assets including equity investments is worrying. At this juncture the FIIs do not know whether the GAAR will come into place, overriding the Tax treaty with Mauritius or it will run alongside with some tweaking’s.

The Finance Ministry issued a clarification and that to some extent helped soothe some nerves, though it seems to have made the entire GAAR process too complex. The Ministry has stated that P-Notes are not being targeted; they will be differentiated as a separate class of investment. There will be no blanket application of GAAR on P-notes. But the way in which GAAR is designed, in all likelihood, P-Notes will attract tax.The Ministry has stated that GAAR will be invoked if set up for invoking tax benefit. There are a set of four tests – bona fide purpose test, commercial purpose test, abnormality test and misuse and abuse test.  First and foremost the FII has to prove a legitimate purpose and once he is able to do that, if P-Notes fail even one of these four tests, GAAR will be invoked.

But now the challenge is that all these four tests are very wide and it would be difficult to prove which transaction falls under which test. The entire test process has been made very complex and FIIs, with these set of clarifications, in all likelihood might shift to Singapore. For those wanting to set up new funds, yes, they will now head to Singapore but for existing ones,  already operating from Mauritius, there will be matter of concern.

Many a times, a P-Note holder’s main purpose of entering into a swap deal with the FII is with the purpose that the FII will pass on benefits like bonus, dividend and profits from sale of shares to the P-Note holder. And if that is the main purpose, clearly, it tantamounts to avoidance of tax and this is when GAAR will get invoked.

And why from Mauritius to Singapore? The Govt of India has a treaty with Singapore under which there will be waiver of capital gains tax for its residents on sale of equity in India. Since many FIIs are already head-quartered in Singapore, they can easily channel their funds from there. What is more important is that the DTAA with Singapore includes clauses that prevent misuse.

The GAAR will now wield tremendous power in the hands of the IT officers. They can determine the tax consequence for the assessee by disregarding any arrangement, even the DTAA, when he fails even one test.  Yes, the tax man, even for the FIIs is now a scary figure!

WHAT IS THE INDO-MAURITIUS TAX TREATY?

ü  Capital gains is exempted from tax in Mauritius - a Mauritian company cannot be taxed in India. That is why Mauritius is a tax-haven for foreign funds investing in India.

ü  The two countries had first started negotiations on revising the Double Taxation Avoidance Agreement (DTAA) in 2006, a joint working group was set up, but the talks were stalled in 2008 as Mauritius was not ready to allow India to tax capital gains at source.

ü  India wants DTAA with Mauritius at par with that of Singapore. The new proposal states that only companies listed on a recognised stock exchange be eligible for capital gains tax exemption under the treaty. The company should have a total expenditure of $200,000 or more on operations in Mauritius for at least two years prior to the date on which a capital gain arises.

ü  Cayman Islands is the other such similar tax haven. If 40% FDI comes from Mauritius, around 27% comes from Cayman.