Context: India and Mauritius are continuing efforts to combat tax avoidance by amending their Double Taxation Avoidance Agreement (DTAA) with a new Principal Purpose Test (PPT).

About Double Taxation Avoidance Agreement (DTAA)

• A DTAA is a bilateral agreement between two countries with the aim of preventing individuals and companies from being taxed on the same income in both countries.

• The purpose of such agreements is to promote international trade and investment by providing clarity on the taxing rights of each country.

India and Mauritius DTAA

• The DTAA between India and Mauritius was first signed in 1982 and later amended in 2016.

Latest amendment

• Investment vehicles based out of Mauritius will now have to pass the principal purpose test (PPT).

• Meaning, they will have to show proof that the Mauritian entity is not merely a shell company, but that it is a well-staffed properly functioning unit.

• While the requirement for substance has always existed, the inclusion of the PPT will necessitate FPIs to demonstrate compliance by maintaining physical presence, employing local staff, appointing local directors, and conducting all operations in Mauritius.

Significance of DTAA

• Avoidance of double taxation: DTAA ensures that individuals or businesses do not pay taxes on the same income in both countries.

• Promotion of cross-border investment: DTAA can encourage increased foreign investment in India by reducing the tax burden on foreign investors.

• Facilitation of trade: DTAA can facilitate international trade by reducing the tax burden on businesses engaged in cross-border transactions.

• Avoidance of double taxation on capital gains: DTAA also covers the taxation of capital gains, which is a significant advantage for investors.

• Enhanced transparency: DTAA requires countries to exchange information and cooperate in enforcing tax laws.

Issues associated with DTAA

• Many companies and individuals set up investment vehicles in country with lower taxes and route investments through them just to save on tax.

• For example until 2016, investments from Mauritius-based structures paid near-zero capital gains tax due to a DTAA clause that stated investors from Mauritius in India would be taxed at the lower of the rates in the two countries.

• In India, long-term capital gains tax was 10%, while in Mauritius it was near zero.

• Treaty Shopping: It occurs when residents of a country not party to the DTAA exploit its provisions.

• For example, residents of China opening a shell company in Mauritius to invest in India.

• Differential interpretations of tax treaties: It can lead to prolonged legal disputes between two countries.