And so, the flip-flop over taxation of foreign institutional investment through Mauritius in the Indian stock market continues. The latest episode was played out on Budget day when the stock market crashed following a provision in the Finance Bill that sought to explain that a certificate from Mauritius proving the residency of the investor was not sufficient to avoid paying capital gains tax in India. The pressure on the government was such that Finance Minister P. Chidambaram was forced to clarify the very next day that FIIs (foreign institutional investors) were safe and that their scheme of taxation would remain unchanged. And the Central Board of Direct Taxes issued a clarification on the new provision the same day as a measure of reassurance. Ever since FIIs started using the Mauritius route in the early 1990s, there have been at least three occasions — the first one as early as in 1994 — when the government sought to tax their capital gains only to beat a hasty retreat after the markets reacted adversely. It was after one such episode in April 2000 that the government issued the infamous Circular 789, which said that a tax residency certificate from Mauritius was sufficient for investors to claim benefit under the India-Mauritius Double Tax Avoidance Agreement (DTAA).
The government’s nervousness is understandable but it has only itself to blame for the embarrassment now. With a $75 billion deficit in the current account, there is little scope to antagonise FIIs, whose money the government hopes to tap to fill a part of that gaping hole. The last thing it wants is for foreign investors to pull out their money and set off a balance of payments crisis. Yet, the episode only proves the tactless way in which this sensitive issue has been addressed over the years. That FIIs should pay capital gains tax is unexceptionable but the way to go about it is not through clarifications and provisions in the Finance Bill. The proper way is to re-negotiate the DTAA and insert clauses that limit benefits based on certain parameters, just as in the India-Singapore tax treaty. That tiny Mauritius is the biggest foreign investor in India speaks volumes about how it has been misused as a conduit by investors who reside elsewhere in the world. There are also concerns of “round tripping,” where black money from India finds its way back into the market through Mauritius. The two countries set up a working group in 2006 to address issues in the DTAA but it has made little progress. The government should use this forum to re-negotiate the agreement and importantly, phase out the benefit gradually. For some policy moves, timing is all-important. This is one such.