Tumble of a tax haven

India’s FDI landscape is shifting. The Reserve Bank of India has revealed a sombre tale. Foreign direct investment flows in India have plummeted by 62 per cent in the past fiscal year—a decline which can only be dubbed staggering. India’s net FDI flows now stand at USD 10.58 billion, the lowest since 2007. As a share of GDP, they stand at a mere 0.6 per cent, mirroring levels last witnessed in 2005-06.

“The whole," in the words of Aristotle, "is more than the sum of its parts”. Nevertheless, certain parts remain more important than others. In India’s FDI story, that more-important part is a small island nation located in the south-western Indian Ocean: Mauritius.

Mauritius, with a population of 1.3 million and a GDP of USD 14 billion, has injected over USD 170 billion into India between 2000 and 2024. Since India's economic liberalisation in 1991, it has been the largest source of foreign direct investment (FDI) for the country. From 2000 to 2017, Mauritius alone contributed 34 per cent of all foreign direct investment flowing into India.

The Mauritius allure, however, is now fraying at its seams. Once a cornerstone, prized for its dominance, its investments totalled just Rs 4.2 lakh crore by March 2024—merely 6 per cent of FPI assets. What might lie behind the zenith then and the nadir now? The same factor: a turbulent tax treaty (DTAA) with India.

The treaty

In 1982, India was a country wrestling with the disillusionment of socialism's unfulfilled promises—a nation where shortages were routine and deficits prevailed. Mauritius, known for its sugar plantations and rum distilleries, did not evoke much optimism either. India desperately needed foreign investments, while Mauritius, termed an economically fragile nation by Nobel laureate James Meade, sought economic diversification.

It was against this backdrop that they set the stage for signing a DTAA, which would ultimately reshape the economies of both countries. Under the DTAA signed by India and Mauritius in 1982, capital gains from the sale of shares in Indian companies by Mauritius residents were to be taxed exclusively in Mauritius.

The magic, however, was in the Mauritius tax regime, where these residents enjoyed a complete exemption from capital gains tax—a phenomenon infamously dubbed 'Double NonTaxation.'

Struggle and triumph

Disturbed by the loss of prospects, the Indian Income Tax authorities embarked on a crusade in 1994 to withhold treaty benefits. They contended that income from Mauritian companies should be attributed to their ultimate parent entities, effectively denying benefits under the Indo-Mauritius Tax Treaty. This situation created significant anxiety within the investor community.

In this swirl of uncertainty, the Central Board of Direct Taxes (CBDT) issued a circular in 1994. This circular aimed to clarify the tax treatment of capital gains arising from the sale of shares of Indian companies by Mauritian residents. The CBDT's stance reaffirmed in 2000, stated that such capital gains would not be subject to taxation in India, provided the Mauritian residents could present a valid Tax Residency Certificate (TRC) issued by the Mauritian authorities.

The Circulars, however, ignited a contentious legal battle, focusing on allegations of leveraging the Indo-Mauritius Tax Treaty via the utilisation of 'shell companies'. Initially dismissed by the Delhi High Court due to concerns over potential abuse and 'treaty shopping', the Circulars underwent a significant turnaround in the Supreme Court.

In a landmark ruling, the Supreme Court in UOI v. Azadi Bachao Andolan upheld the sovereign right in treaty negotiations, shielding them from judicial scrutiny against claims of misuse. Treaty shopping was termed a necessary evil for a developing economy underscoring the crucial role of the Indo-Mauritius treaty in India's investment framework.

It's fascinating to observe that back in the 1960s, Mauritius had a per capita income of just USD 260. By 2016, it exceeded USD 10,000. Contradicting Nobel Laureate James Meade, Mauritius evolved from a mere commodity exporter into a vibrant financial nucleus. Amidst a continent often marked by political turbulence, Mauritius stood as Africa's beacon of democratic progress, achieving the prestigious distinction of a high-income nation by the World Bank.

The beginning of the end

In 2016, amid the OECD's intensified push against tax havens, the Government of India decided to revoke the long-standing capital gains exemption enjoyed by entities based in Mauritius. At the same time, India introduced the General Anti-Avoidance Rules (GAAR) in its tax legislation, granting tax authorities the authority to disregard any arrangement as impermissible and aimed primarily at obtaining tax benefits. This was a kick in the powder keg. The Paradise Papers, a cache of leaked documents to the International Consortium of Investigative Journalists, that implicated Mauritius as a clandestine financial centre where businesses and affluent individuals could safeguard their assets and profits from taxation, marked the beginning of its end as a tax haven. By 2018, Singapore had overtaken Mauritius as India's top investor.

The final nail in the coffin, however, came with the introduction of the Principal Purpose Test (PPT) on March 7, 2024, as a protocol in the DTAA. This test allows for the rejection of DTAA benefits if obtaining them was considered one of the main purposes of the transaction. The debutant PPT managed to swiftly persuade foreign portfolio investors to withdraw nearly USD 1 billion from the Indian stock market.

Navigating the unknown

It is now undeniably apparent that Mauritius, as a tax haven, is on its last breath. The flow of investments from Mauritius will likely only surprise India on the downside. Therefore, India must now explore new avenues to attract foreign investments. It seems strange for a country with growth and prospects like India to be so unattractive to FDI flows. During its heyday, China was attracting nearly 5 percent of GDP as FDI, while the four Asian Tigers had even better numbers.

As for Mauritius, tough days lie ahead. For decades, the offshore sector fuelled its growth. However, now, as its tax haven life awaits its imminent demise, Mauritius needs to find new avenues for foreign exchange. The island gears up for elections by November 2024. Its people await to see if the new government will have the answer. So does the world.

The writer is a Chartered Accountant, law graduate, and an alumnus of IIM-Ahmedabad. Views expressed are personal