Stock markets fell as a proposal in the Finance Bill implied the govt could be cracking down on tax evasion, especially on concerns over Mauritius — the largest foreign direct investment source for India. HT looks at why.
Why did stock markets react adversely last week after the budget announcement?
The markets had fallen to a three-month low after a confusion with a proposal in the finance bill on Thurday stating a tax residency certificate “shall be necessary but not a sufficient condition” to take advantage of double taxation avoidance agreements (DTAAs).
What has the finance bill proposed?
The Finance Bill 2013, which Chidambaram tabled in Parliament on Thursday as part of the budget proposals for 2013-14, proposed to amend the law in order to provide that “submission of a tax residency certificate is a necessary but not a sufficient condition” for claiming benefits under double taxation avoidance agreements.
The proposal spooked markets as investors feared a clamp down by tax authorities on deals structured through investments from tax havens.
How do people use tax havens to avoid paying taxes?
The most obvious is to move to the tax haven country and become a resident for the purpose of paying taxes.
So what is the problem?
The problem has arisen because of ‘round tripping’ or ‘treaty shopping.’
What does it mean?
Round tripping refers to routing of investments by a resident of one country through another country back to his own country.
This is how it works: You get money out of India and transmit it to a tax haven with whom India has a bilateral tax avoidance treaty.
In the tax haven, this money is treated as capital of a registered corporate entity. You now invest this money back in an Indian company as foreign direct investment (FDI) by buying stakes or invest it in Indian equity markets.
The entire purpose of this exercise is to window-dress as foreign capital your original money which you had taken out from India.
In the entire process, you end up paying zero or negligible taxes. In India, you can claim tax exemption citing the double-taxation avoidance agreement arguing that you have paid taxes in the source country.
In the source country, taxes are negligible since it is a tax haven.
How does it work?
An Indian resident investing directly in shares of an Indian company would have to pay capital gains taxes. However, if the he routes his investments through an entity incorporated in Mauritius, the taxes can be avoided under a double taxation avoidance treaty (DTAA) between the two countries.
What is DTAA?
These are bilateral treaties signed between governments to prevent companies from paying taxes both in their country of origin as well as in the country where they are doing business.
So what is the problem with Mauritius?
The problem is that Mauritius and other tax havens have almost negligible taxes. This is encouraging resident Indian entities to route their investments back to India through Mauritius and avoid paying taxes.
Is this a rising trend?
Yes it is. At $64billion, it is the largest foreign direct investment source for India, accounting for 38% of total FDI.
Meanwhile, investments from Cyprus, another tax haven, are also on the rise with FDI from the country increasing 10 times in the last three years. At nearly $7 billion Cyprus is now the seventh largest FDI contributor to India ahead of Germany and France.
What did the government do to soothe the frayed nerves of investors?
A day after the budget, on Friday, markets shrugged off budget blues with the benchmark BSE Sensex bouncing after the finance ministry on Friday assured investors that it was not targetting investors from countries such as Mauritius by questioning the validity of tax residency certificates (TRCs) held by foreign investors.
What did the finance ministry say in its clarification?
The finance ministry sought to assure worried investors saying their concerns on TRCs for claiming treaty benefits will be ‘suitably’ addressed during discussion on Finance Bill in Parliament.
“Since a concern has been expressed about the language of sub-section (5) of Section 90 (of I-T Act), this concern will be addressed suitably when the Finance Bill is taken up for consideration,” the Ministry said in a statement on Friday.
Finance minister P Chidambaram also sought to soothe frayed nerves of investors stating that the language of the finance bill was “clumsily worded.”
“It has not become law yet. It’s a bill. When I read that clause again, I said it is clumsily worded,” Chidambaram said in an interview with ET Now TV.
“With respect to investments from Mauritius, the circular 789 (existing DTAA) “continues to be in force, pending ongoing discussions between India and Mauritius,” the finance ministry statement said.