SUMMARY
Capital gains tax could be applied to all Mauritius-based shell companies investing in India
Tiger Global’s capital gains tax exemption plea was rejected as the “head and brain” of the company was based in US, not Mauritius
With Indian startups already seeing a drop in funding, will this move further worsen the investment outlook for 2020?
With venture capitalists sceptical about new investments and startups running out of cash, the recent tax setback for US-based VC firm Tiger Global may further demotivate fresh capital infusions in the Indian startup ecosystem.
Last week, the Authority for Advance Rulings (AAR) rejected Tiger Global’s application seeking tax exemption from capital gains from its stake sale in Flipkart during its acquisition by US retail giant Walmart in 2018.
In its ruling, AAR pointed out that the ‘transaction was designed prima facie for the avoidance of tax.’ AAR also noted that there is an “inescapable conclusion” that Tiger Global entities in Mauritius were established to get benefit under the India-Mauritius Double Taxation Avoidance Agreement (DTAA).
According to the treaty, any Mauritius-based investing firm, which had invested in an Indian company, will pay capital gains tax only in Mauritius. However, the government had amended the treaty in 2016 and according to the new rules, the investing firm will have to pay capital gains tax in India as well for any investment made after April 2017.
As Tiger Global had invested in Flipkart prior to April 2017, the firm is now seeking the benefits under the treaty. But the income tax department and AAR pointed out that as Tiger Global had sold shares of a Singapore-based entity of Flipkart, the deal cannot get the benefits of DTAA.
Mauritius Route Under Scrutiny
Speaking to Inc42, Vaibhav Gupta, partner at Dhruva Advisors, said that the treaty has been under the scrutiny of tax authorities for quite some time. “Although there have been positive rulings as well, it seems like that authorities are now dissecting the way investors operate through Mauritius.”
Currently, it seems that the tax departments are interested in finding out where the key decision-makers sit and what role tax havens such as Mauritius and other island states play. Gupta said that there has been a lot of focus on finding out where the investment decisions were made, which would be key to applying the relevant tax laws.
In the Tiger Global case also, the AAR pointed out specifically that the “head and brain” of these companies were based in the US and not in Mauritius. “Income tax department seems to be very determined to have decided to not provide tax benefits to investors which just have a paper company in countries like Mauritius,” said Gupta.
But the existing laws under the DTAA don’t mention rules for this type of arrangement. “If there is something which is silent, it leaves with multiple interpretations for everyone,” said Niraj Bora, founder of Surmount Business Advisors, a Pune-based business advisory firm.
Bora suggested that rules need to be stated explicitly to avoid such confusion. “If the tax department already had pointed out that these cases will be handled in this manner then there’s no room left for ambiguity.”
Earlier this year, the Financial Action Task Force (FATF) also marked Mauritius under its grey list. Mauritius was put on the list of jurisdictions that require increased monitoring from authorities due to suspected money laundering.
In response to FATF’s decision, custodian banks and advisors to foreign portfolio investors (FPIs) reached out to SEBI for clarification to measure the impact of this grey-listing. SEBI ruled that foreign investors from Mauritius will continue to be eligible for FPI registration with increased monitoring as per international norms.
After the 2016 decision mentioned above, many private equity and venture capital companies changed the registered location of their shell companies from Mauritius to other countries like the Netherlands where the treaties with the Indian government are favourable from a tax perspective. For instance, the Netherlands is now the third biggest contributor of FDI to India. In the financial year 2020, INR 46,071 Cr came from the Netherlands as FDI.
However, the real problem will be faced by investment firms which invested from a Mauritius-based company prior to April 2017. These firms might have to workout on plans on how they can escape from paying capital gains tax in India.
Besides seeking the benefits under the DTAA treaty, Tiger Global also pointed out that it had sold its stake in a Singapore-based entity of Flipkart. Based on this, the VC company urged that it need not pay the capital gains tax in India.
It is worth noting that Tiger Global’s stake in Flipkart’s Singapore based entity was sold to Walmart’s Luxembourg entity FIT Holdings for over INR 14,500 Cr in 2018. Notably, Tiger Global had invested in Flipkart through Mauritius-based Tiger Global International II, III and IV Holdings.
In response, AAR said that although Tiger Global had sold stakes in a Singapore-based entity of Flipkart, the ecommerce major reported most of its revenues coming from India. Therefore, the AAR now wants Tiger Global to pay the capital gains taxes in India.
Why Indian Startups Choose The Singapore Route?
In the last decade, many Indian startups followed Flipkart’s approach and restructured themselves to set up a Singapore-based entity. While India and Singapore share a lot in terms of culture and history, it is the tax benefits which appeal the Indian startups most to get an operating entity in Singapore.
For instance, the corporate tax rate, which was over 30% until 2018, for domestic companies in India stands at around 25.17% in 2020. On the other hand, Singapore charges only 17% corporate tax.
Further, In India, dividend distribution is taxed at 15%. This means that all the shareholders of the company will have to pay taxes on the distribution of profits (dividends). However, Singapore avoids any such double taxation and therefore the dividends to the shareholders are not taxed separately.
Further, capital gains tax in India is taxed around 20%, which can be seen penalising the risk-taking appetite of investors. Contrary to India, no tax is due on the sales of shares, properties and intangible assets in Singapore. This is one of the major reasons why Indian startups have set up a Singapore-based entity as well.
PE and VC investors take a huge amount of risks to invest in startups. In return, they have to pay around 20% capital gains tax in India if they hold the share for more than 24 months.
Bora said that the capital gains tax doesn’t become unattractive for investors as well as startup founders. “20% is a significant amount and the balance sheet takes a decent hit after paying this tax,” Bora said.
Will Investors Pull Out From India?
Meanwhile, in the current scenario, where most of the deals are postponing due to the economic downturn, turning off investors doesn’t seem to be an effective approach.
Industry experts are expecting the government to create an investment-friendly ecosystem in India. On the other hand, rulings like AAR may turn away investors from the country as the policies still remain blurry while tax departments increase their scrutiny.
For many of such startups and investors, the recent ARR decision might seem like a setback. Dhruva Advisors’s Gupta said, “If the tax department increases the scrutiny on startups having Singapore-based entities then their entire restructuring plans are in shackles.”
However, for every problem, there’s a solution and for this, experts suggest that opening up offshore businesses might help. One of the possible solutions is that if any Singapore based entity can show that its major business is from outside India then the income tax department can’t force investors, at the time of exit, to pay capital gains tax in India.
