The Mauritius code

Indian Express, 12 July 2010

The bulk of foreign investment in India comes through Mauritius. The Double Tax Avoidance Agreement between India and Mauritius allows investors to avoid paying taxes to Indian authorities. The original draft of the proposed Direct Tax Code (DTC) had proposed over-riding the DTAA with Mauritius. However, now revised DTC has dropped this plan. The Mauritius tax treaty is an odd one and needs to be reconsidered. But this is only politically feasible when it is one component of a larger movement by India towards sensible tax treaties with major countries.

Many decades ago, when globalisation was a new force reshaping the world, the question for policy makers was: How can tax policy be made compatible with globalisation? On one hand, each country should have the legitimate choice of choosing its own tax rates and tax/GDP ratio. At the same time, tax policy must not interfere with globalisation. How are these two goals to be simultaneously achieved?

The first element of the answer lay in the approach of the Value Added Tax (VAT) towards international trade. The VAT is a complex tax applying at every layer of production. If a country raises its own VAT rate, this would render local production uncompetitive when compared with importing. How can countries achieve autonomy of setting their own VAT rate, while simultaneously not modifying the competitive landscape between imports and exports?

The answer was found in focusing taxation upon residents. Under this, each country has legitimate taxing powers over its own residents, however, no country can tax non-residents. If India tries to tax the British buyer of Indian steel, that buyer will simply move his business to Korean producers of steel. Hence, the VAT solution lies in `zero rating' of exports. At the point of export, the Indian exporter (i.e. the foreign consumer) is paid the full burden of Indian VAT that has been applied on the exported product, by the government. Through this, the high seas price of all goods is free of the VAT.

Conversely, when goods come into India, the Indian VAT is applied at the point of entry. This VAT on imports levels the playing field between a foreign producer (where high seas prices are free of tax) and the local producer (who has paid VAT at many stages of production).

Under this arrangement India taxes the consumption of residents. Regardless of the nationality of the buyer or the location of the producer, if a person on Indian soil buys a shirt, he pays the Indian VAT on this shirt. Simultaneously, India does not tax non-residents, by refunding the VAT collections embedded in the exported shirt.

The same questions have appeared in finance. How should German tax policy view the American buyer of currency futures traded in Germany? The principle to follow would be that tax policy should not generate the slightest bias for the American or German buyer, to favour the currency futures found in either country.

This can be achieved through residence-based taxation. The American authorities tax the global income of American residents (and exempt the financial activities in America by all non-residents). The German authorities tax the global income of German residents (and exempt the financial activities in Germany by all non-residents). Through this, it becomes the legitimate right of each country to set tax policy for its own residents, but tax policy generates no distortion in the global financial system. German and American producers of currency futures compete without tax considerations changing the behaviour of their customers.

According to India tax laws non-residents doing financial activities in India are taxed. Ordinarily, this would create distortions and make India uncompetitive. In practice, India has avoided these problems by signing a Double Taxation Avoidance Agreement with Mauritius. A large fraction of non-resident financial activity in India is routed through Mauritius, and is thus not taxed. If the DTAA with Mauritius were to be overriden by the DTC, and this route is closed in isolation, it would have destabilising effects. That would be tantamount to imposing an onerous set of capital controls. In addition, a good deal of India-related financial activity would shift from India to offshore venues. Indian firms with foreign investors would be adversely affected if India moved away from the residence-based taxation implicit in the Mauritius treaty. It is not surprising that every time the government has proposed doing something new on the Mauritius tax treaty, there has been a backlash from the private sector. This could explain the change in government plans that the DTC should override the Mauritius treaty.

How should the issue be resolved? The solution lies in seeing the Mauritius tax treaty in its larger context. As long as India lacks residence based taxation against major countries, the Mauritius treaty is a critical pillar of Indian tax policy in that it delivers a residence-based system, at least for some foreigners, who choose to come via this route. From 1991 to 2010, this treaty has been a little understood foundation of India's financial globalisation.

To resolve the question, our tax treaties with all major countries need to enshrine residence-based taxation. This network of tax treaties needs to be put into place before any modifications to the Mauritius treaty are made, so as to avoid destabilising the financial markets. This would get rid of the costs imposed on foreign investors by making them set up offices in Mauritius. By making India as much more attractive, it would reduce the cost of capital for Indian firms. It would offer a more stable policy framework, because at present, there is always the sword of scrapping of the Mauritius treaty hanging over the heads of market participants. India is globalising at a very fast pace and such issues need to be resoved, rather than postponed indefinitely.

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