EY Tax Alert. Executive summary. Protocol signed on 10 May 2016 to amend the 1982 India- Mauritius tax treaty. 12 May 2016

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1 12 May 2016 EY Tax Alert Protocol signed on 10 May 2016 to amend the 1982 India- Mauritius tax treaty Executive summary Tax Alerts cover significant tax news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest tax issues. For more information, please contact your EY advisor. This Tax Alert summarizes the key amendments proposed to the existing Double Taxation Avoidance Agreement (DTAA) entered into between India and Mauritius in 1982 (1982 DTAA). The Protocol to amend the 1982 DTAA was signed on 10 May 2016 (2016 Protocol). The 2016 Protocol is available on the official website of the Mauritius Government and was the subject matter of a Press Release by the Government of India on 10 May Amendments to the Capital Gains Article will be effective in India from tax year once the requisite procedures for ratification of the 2016 Protocol are completed in both the countries, while the other provisions will be effective subsequently. Significantly, the 2016 Protocol has included a number of provisions for enhancing source country taxation rights, such as inclusion of a service permanent establishment (Service PE) provision, fees for technical services (FTS), source country taxation rights on capital gains from shares, interest income of banks and other income. At the same time, a limitation on source country taxation rights in respect of interest income has been provided at the rate of 7.5%. Importantly, the 2016 Protocol also provides for carving out of shares acquired on or before 31 March 2017 from source country taxation rights. Transitory provisions for reduced taxation by the source country on capital gains from alienation of shares (taxation at 50% of domestic tax rates) has also been provided for a limited period from 1 April 2017 to 31 March However, a limitation of benefits (LOB) provision has also been included for availing transitory provisions. A carve-out has also been included for interest earned by banks from debt claims existing on or before 31 March Provisions relating to exchange of information (EOI) have been revamped in order to bring them in line with existing international standards. Additionally, an Article on Assistance in collection of taxes has been introduced.

2 Key amendments introduced by the 2016 Protocol Inclusion of a Service PE clause in the PE Article The 1982 DTAA contains only the Fixed PE Rule and Agency PE Rule. The 2016 Protocol introduces a Service PE Rule as part of Article 5(2). As a result of this inclusion, the term PE will include furnishing of services, including consultancy services, by an enterprise of one State through its employees or other personnel engaged by the enterprise for such purposes, where such activities continue for the same or a connected project for a period or periods aggregating more than 90 days within any 12 month period. Interestingly, this provision does not seem to contain a requirement that the service activities should be carried out within the Other Contracting State. The United Nations Model Convention (UN MC) includes this requirement in its Service PE provision contained in Article 5(3)(b) of the UN MC. Additionally, the threshold is much lower in the 2016 Protocol at 90 days, whereas it is 183 days in the UN MC. taxation rights on interest (including interest earned by banks) to a maximum of 7.5% on the gross amount of interest. This is the lowest tax rate cap agreed to by India on interest income for source country taxation rights amongst all its DTAAs. Insertion of FTS Article The 2016 Protocol introduces an FTS Article in the 1982 DTAA. As per this Article, both the Resident State as well as the Source State will have the right to tax FTS. However, the Source State taxation will be limited to 10% of the gross amount of FTS, where the FTS income is beneficially owned by a resident of the other State. For the purposes of this Article, FTS has been defined in a wide manner as any payment made as a consideration of managerial or technical or consultancy services. It also includes payments made for the provision of services of technical or other personnel. The OECD MC does not have an FTS Article. The FTS Article is in line with the FTS Article which is generally present in many of India s DTAAs. Capital gains taxation Source based taxation of interest income The 1982 DTAA exempts interest income beneficially owned by taxpayers engaged in a bona fide banking business of one State sourced from the other State. The 2016 Protocol removes this generic exemption. However, a carve-out has been included to continue to provide exemption from taxation in the Source State on interest income arising from debt claims existing on or before 31 March Additionally, the 1982 DTAA provided for unlimited taxation rights for source country on non-exempted interest income [1]. The 2016 Protocol restricts the source country [1] Interest earned by the Government or agency or entity organized by the Government is exempt Capital gains arising from the transfer of shares, until now, were subject only to residence based taxation under the 1982 DTAA. The 2016 Protocol now proposes to restrict this exemption for investments in shares acquired up to 31 March The exemption will apply irrespective of the date of subsequent transfer of such shares. Accordingly, taxation rights are now also provided to the State of residence of the company whose shares are alienated (Source State) on gains from alienation of shares acquired on or after 1 April The 2016 Protocol also provides for a transitory provision for gains arising during a window period of 1 April 2017 to 31 March 2019 in respect of shares acquired on or after 1 April Such gains arising during the transitory period will be subjected to tax at 50% of the domestic tax rates as applicable in the Source State.

3 LOB Article applies only for transitory period benefit on capital gains income The 2016 Protocol includes an LOB Article in the 1982 DTAA. The LOB Article denies the transitory provision benefit in respect of capital gains arising between 1 April 2017 and 31 March 2019, where the LOB conditions are not fulfilled. The following tests are provided in the LOB clause for a taxpayer to be eligible to claim the transitory period benefits: Primary purpose/motive test Under this test, transitory period benefit is not available where the affairs of the taxpayer are arranged with the primary purpose of taking advantage of the transitory period benefit accorded by the 2016 Protocol. It has also been clarified that legal entities not having bona fide business activities will be considered as having its affairs arranged with the primary purpose of availing the transitory period benefit. Activity test This test requires that the transitory period benefit will not be available to a shell or conduit company. For this purpose, a shell or conduit company means a company which is a resident of a Contracting State, but which has almost negligible or nil business operations or no real and continuous business activities in such Resident State. Expenditure test This test provides the circumstances in which a taxpayer would be deemed to be a shell or conduit company in its Resident State. As per the expenditure test, the taxpayer would be considered as a shell/conduit company if its expenditure on operations in the Resident State is less than Mauritian Rs. 1,500,000 or INR2,700,000, as the case may be, in the 12 months immediately preceding the date on which the capital gain arises. However, where the taxpayer is listed on a recognized stock exchange of the Resident State or where its expenditure on operations in the Resident State exceeds the above threshold in the 12 months immediately preceding the date on which capital gain arises, then such taxpayer will not be treated as a shell or conduit company. Source based taxation of other income Income from sources which is not expressly dealt with any of the Articles in the 1982 DTAA is presently subjected only to taxation in the resident country, except in cases where such income is effectively connected with the PE/fixed base of the recipient in the other State. The 2016 Protocol expands the source country taxation rights by providing that such income can also be taxed in the Source State if it arises in the Source State. Revamping of EOI Article in line with 2014 OECD MC The scope of the EOI Article in the 1982 DTAA has been enhanced to fall in line with international standards on transparency. The EOI Article is largely in line with the 2014 OECD MC and extends to information relating to taxes of every kind and description imposed by a State or its political subdivisions or local authorities, to the extent that the same is not contrary to the taxation as per the 1982 DTAA. EOI would also be possible in respect of persons who are not residents of the Contracting State, as long as the information requested is in possession of the concerned State. Specifically, information held by banks or financial institutions can be exchanged under the EOI Article. Article on Assistance in collection of taxes in line with 2014 OECD MC The 2016 Protocol includes an Article on Assistance in collection of taxes. This Article is largely in line with the one provided in the 2014 OECD MC. Broadly, this Article enables the revenue claims of one State to be collected through the assistance of the other Contracting State, subject to fulfilment of certain conditions and requirements.

4 Revenue claims for this purpose means the amount payable in respect of taxes of every kind and description and which is not contrary to the 1982 DTAA or any other instrument to which the States are a party. Assistance would also involve undertaking measures of conservancy by freezing assets located in the requested State, subject to the laws therein. Entry into force The 2016 Protocol will be effective in India and Mauritius only after completion of the procedures in both the countries for bringing it into force. Once the procedures are completed, the various clauses of the 2016 Protocol would apply in India as follows: Changes to the Capital Gains Article for assessment year and onwards. Article on EOI and inclusion of assistance in collection of taxes, from the date of entry into force of the 2016 Protocol. Other provisions for fiscal year beginning on or after the first day of the fiscal year (i.e., 1 April for India) following the year in which the 2016 Protocol enters into force.

5 Comments The past many years have witnessed various controversies involving the 1982 DTAA. It may be recalled that, in the year 2000, the Central Board of Direct Taxes (CBDT) had issued Circular No. 789 stating that the 1982 DTAA benefits would be available to a Mauritius company if it is able to obtain a tax residency certificate (TRC) from the Mauritius authority. On challenge, the validity of this Circular was affirmed by the Supreme Court (SC) in the case of Azadi Bachao Andolan [2]. The SC had also held that DTAA benefits cannot be denied in the absence of antiabuse provisions in the 1982 DTAA. However, challenges on the eligibility of the 1982 DTAA continued, especially on allegations of round tripping and treaty shopping. This has often resulted in long-drawn and protracted litigation between taxpayers and the Tax Authority. Not surprisingly, for a long time now, the media was flooded with news of possible changes that were expected to be made to the 1982 DTAA, leading to increased uncertainty and enhanced apprehensions. The signing of the 2016 Protocol puts an end to all such speculation and ushers in the much needed certainty for businesses. The amendments to the 1982 DTAA, especially the withdrawal of capital gains exemption, reflects the influence of the principles laid down by the Base Erosion and Profit Shifting (BEPS) project of the OECD in which India continues to play a prominent role. At the same time, the prospective application of capital gains provisions and grandfathering of past investments, both in shares and debt, comes as a relief to taxpayers. Also welcome is the restriction on source country taxation rights on interest income, which is now being capped at 7.5% on gross interest. The 2016 Protocol will also have an impact on the India-Singapore DTAA and the capital gains taxation therein, which is linked to the benefits available under the 1982 DTAA. Taxpayers will have to evaluate the impact of the 2016 Protocol based on the facts of their specific cases. [2] [263 ITR 706]

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