How amending the Mauritius tax treaty will boost India’s domestic tax reform agenda?

  • India signed a tax treaty with Mauritius in 1983 that gave Mauritius the sole right to tax investment gains made by investing in India. Mauritius’ tax rate on such gains was zero o Therefore, a large majority of investments into India chose this attractive route. This was perhaps necessary then for India’s foreign reserves-starved economy, but it led to several unintended consequences over the yrs o The high profile tax disputes are well known along with illegal round tripping of domestic money & other malfeasance. But this treaty also distorted India’s domestic tax reform agenda

How this treaty structurally damaged India’s economy & tax structure?

  • Cascading effect on India’s tax structure o Investments in publicly listed shares were granted exemption from long-term capital gains tax in 2004. The rationale was to provide a “level-playing field” to domestic investors vis-à-vis Mauritius’ investors o A new tax called the securities transaction tax was imposed on stock market transactions to offset any loss of revenues from the exemption of capital gains. This higher transaction tax on shares triggered a massive shift by investors to investing in risky derivatives vis-à-vis shares
  • The budget of 2016 increased transaction tax on derivatives to create a “level-playing field” with shares o Not to be left behind, investors in real estate through real estate investment trusts want a “level-playing field” with equity investments o This vicious cycle was started by the India-Mauritius tax treaty of 1983, the original culprit o This treaty has led to a long tail of arbitrages across various asset classes (private vs public shares), types of investors (Mauritius vs non-Mauritius), types of income (capital gains vs dividends) etc.
  • This treaty has hampered India’s ability to garner enough tax resources through progressive direct taxes
  • Capital gains almost always & totally accrue to the rich o To make up for the shortfall in tax revenues from such sources, all govts in the past have resorted to increasing indirect taxes, which are more insidious, economically inefficient & ultimately unfair o India’s direct-to-indirect tax ratio including state & central taxes is 35:65, making India’s tax system among the most regressive in the world. In most other similar economies, it is the exact opposite o The French economist Thomas Pikettv has pointed out that this skewed tax structure plays an important role in exacerbating India’s growing inequality
  • Thus, a series of policy measures over the last 3 decades to neutralise the impact of the Mauritius tax treaty, has led to a slew of inadvertent policy mishaps with unintended economic & social consequences

Conclusion

  • The govt’s move to amend the Mauritius tax treaty is not meant to merely curb offshore black money or curtail round tripping of domestic money
  • Judged in the larger context of India’s skewed tax structure & its adverse impact on income inequality, threats of foreign investor pullback from India due to the amendment of this treaty seem trivial. Long-term investment flows chase economic fundamentals, not tax arbitrage
  • This is a first step in eliminating a tall hurdle to change India’s skewed tax structure

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