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Amendments in Tax Treaties: A Close Look

February 14, 2017[2017] 78 taxmann.com 153 (Article)

Last year and a half or so has been a landmark period with respect of treaty amendment. Some of the prominent features of these amended tax treaties have been the introduction of source based taxation of capital gains, grandfathering provisions for investments, transitionary provisions with respect to capital gains, the Limitation of benefits (LoB) clause and tax rate on interest and other income. It will be interesting to look at some of the amended provisions of tax treaties with different countries to comprehend the differentiating factors amidst each of them.

It all started with the notification of India-Thailand tax treaty in December 2015 with the latest being the India-Austriatreaty amendment protocol signed as recently as February 2017.The chart below recapitulates recently signed protocols by India with various countries since December 2015:

image

However, the focus of this article is discussion of the amendment in Mauritius, Singapore, Cyprus and South Korea treaties where the major change has been with respect to shift from residence based taxation to source based taxation.

Mauritius treaty amendment and status of the Singapore treaty

During May 2016, Mauritius treaty was amended and Indian government got back the right to tax capital gains on transfer of Indian company shares by a Mauritius company. Not only capital gains tax, there were sweeping changes in other provisions like Other Income and Interest withholding tax. While the Other Income clause was amended and now any residual income (say, gift of shares) not dealt in the treaty was made taxable in India, a beneficial withholding tax rate of 7.5% on interest brought in much needed cheer for the investor as prior to the amendment, the withholding on interest was as high as 40%. Although amendment in the Mauritius treaty brought in much needed clarity, it resulted in uncertainty with respect to the India-Singapore treaty. It will be interesting to note at this point that Singapore treaty was amended in 2005 to provide benefits similar to the Mauritius treaty on capital gains tax i.e. the same will not be taxable in India subject to the LOB clause. However, it came with a rider that the said benefit will be applicable only if the India-Mauritius treaty continues to provide such similar benefit. With a change in India-Mauritius treaty, the capital gains tax clause under the India-Singapore treaty was hung in limbo amidst clamour, expert opinions, dampening investors morale until clarity was given by way of amendment in the India-Singapore treaty in December 2016

Next in line was amendment in the India-Cyprus treaty in November 2016. Interestingly alongwith the change in the India-Cyprus treaty, India also rescinded notification on notified jurisdictional area (NJA) which settled the long drawn doubt regarding the capital gains tax in case of sale of Indian company shares by a Cyprus company. Since per the India-Cyprus treaty, capital gains tax was exempt and due to the NJA notification was liable to charge withholding tax at the rate of 30% on capital gains.

Subsequently, amendment in South Korea and Singapore treaty followed in October 2016 and December 2016 respectively.

Grandfathering Provision

  Though the amended tax treaties now provide for source based taxation of capital gains, grandfathering for existing investments have been provided in these tax treaties. Introduction of grandfathering provisions though have been a big relief and certainty to exiting investors with respect to the existing investments and at the same time the government also maintained its promise to not to bring retrospective taxation. However, some clarity with respect to grand fathering provision is still required such as whether the grandfathering provisions will be extended to compulsorily convertible preference shares, compulsorily convertible debentures, bonus shares, shares issued pursuant to reorganizations such as demerger, merger, share consolidation and split. Notably, the Finance Ministry has already issued a clarification on availability of GAAR grandfathering to compulsorily convertible instruments, bonus issuances or split / consolidation of holdings in respect of investments made prior to 1st April 2017 in the hands of the same investor.
  Though the amended tax treaties now provide for source based taxation of capital gains in all four treaties discussed above, there was a distinguishing factor between tax treaty of India with South Korea vis-à-vis Mauritius, Singapore and Cyprus that the treaty with former does not provide grandfathering provision for investments made prior to 1April, 2017.
  Also, the reason for not bringing in grandfathering with respect to the South Korea treaty amendment is not clear. One point of view may be that unlike Mauritius, Singapore and Cyprus, South Korea enforces capital gains tax as per local laws on sale of shares of Indian company by South Korean company and therefore South Korea is not particularly used by investors other than South Korean residents for making investment into India and thus, grandfathering is not required.

Transitionary window

A peculiar feature of tax treaty protocol with Mauritius and Singapore has been the transitionary window with respect to shares acquired post 1 April, 2017 and disposed before 1st April, 2019. In such cases, the capital gains on disposal of investments are taxable in India per the Indian tax laws, but the tax rate will be equal to 50% of the applicable tax rate for such capital gains subject to fulfilment of conditions specified under LoB clause. However, the tax treaty with Cyprus and South Korea remains silent of such aspect.

Snapshot of treaty amendments with respect to capital gains taxation:

Amended Provisions Mauritius Singapore South Korea Cyprus
Source based taxation of capital gains Yes Yes Yes, if the alienator holds at least 5% of the capital any time during the preceding 12 months Yes
Grandfathering provisions Investments made prior to 1st April, 2017 are grandfathered1 No Yes
Transitionary Window Available for investments made after 1st April, 2017 and disposed prior to 1st April, 2019 No No
Tax rate during Transitionary Window Tax rate reduced to 50% of the applicable capital gains tax rate during the transitionary window subject to fulfilment of conditions specified in LoB clause NA NA
LoB Clause Applicable Applicable No No

The amendment seeks to tax gains on sale of shares and thus gainsarising on sale of instruments such as compulsory convertible debentures (CCDs), derivatives, etc. should continue to be exempt in India even after 1 April 2017.

Tax rate on Interest

Under the amended tax treaty provisions between India and Mauritius, tax rate on interest income arising in India and paid to a resident of Mauritius cannot exceed 7.5% of the gross amount of interest if the beneficial owner of the interest is a resident of Mauritius. Further, tax rate on interest income has been reduced from 15% to 10% under the amended India-South Korea tax treaty. There has been no amendment in tax rates of interest income under India-Singapore and India- Cyprus tax treaty and they continue to be 15% and 10% respectively.

The reduced tax rate of 7.5% on interest income may make Mauritius a preferred jurisdiction for investments through debt by way of External Commercial Borrowings (ECBs), listed and unlisted NCDs, CCDs, etc.

Amendment in India-Netherlands treaty

As per news reports, India is unlikely to amend its tax treaty with the Netherlands as Netherlands is not used for tax planning2.

Parting thoughts

Although the above mentioned amendments have brought source based taxation of capital gains into the ambit, taxability of indirect transfers under the treaties still remains an open question.

Until now, Mauritius and Singapore have been one of the top sources of FDI in India. Considering source based taxation of capital gains under India-Mauritius treaty and status-quo of India-Netherlands treaty, Netherlands may seem to be a preferred jurisdiction for investments into India.

However, Mauritius continues to provide a benefit lower tax rate of 7.5% on interest income vis-à-vis other jurisdictions. It may be important to analyze whether the MFN clause provided under the India-Netherlands tax treaty can be entailed to confer that lower tax rate of 7.5% on interest income is applicable on debt investment from Netherlands also.

Despite many amendments in tax treaties to attain efficiency, there may still be possibility of the investment structure and funding instruments are better planned. However, it goes without saying that the same needs to be looked in the light of purpose test under the GAAR provisions applicable from April 2017.

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1. In case of Singapore, grandfathering for investments made prior to 1st April, 2017 are available subject to fulfilment of LoB conditions specified for the same

2. http://economictimes.indiatimes.com/ news/economy /foreign-trade/ india-may-leave -tax-treaty- with-netherlands -unchanged/ articleshow/ 56464679.cms

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