For obvious reasons, it created a political ruckus. The Indian stockmarket was booming at that time, the Sensex was being driven to greater heights by huge FII inflows. The finance ministry felt that any move to tax the Mauritius-registered FIIs would lead to huge outflows, crash the stockmarket and dent the shining India image. In a great hurry, the CBDT issued a circular stating that tax officials should accept the local registration of Mauritius-based firms, even if they were being operated from third countries, including India.
Subsequently, the Delhi High Court deemed the circular as "bad in law", but a Supreme Court judgement (October 7, 2003) upheld it with the caveat that it in no way "crib, cabin or confine the powers of the (tax) assessing officer with regard to any assessment". Thus, it allowed tax officials to investigate the veracity of companies clamouring for tax exemptions under the treaty. But earlier, in February 2003, the finance ministry had closed the doors for this too.
Another circular (February 10, 2003) allowed tax sleuths to investigate entities that were residents of both India and Mauritius—or encouraged intervention in round-tripping cases—but didn't allow them to proceed in cases of treaty shopping. It was clear that the then nda government didn't want to hurt the interests of the FIIs and other foreign firms operating via the Mauritius route. In fact, it didn't put too much pressure on Mauritius, and accepted the latter's decision to change domestic laws to stop registration of companies with an Indian parent. This too impacted round-tripping (albeit in a small way), and not treaty shopping (or FIIs).
Unfortunately, the UPA government fell into the same trap, thanks to a sustained bull run on the Indian bourses in 2004-06. The current policymakers decided not to rock the boom boat, and to sign similar taxation treaties with other nations like Singapore (mid-2005) which, according to Bratcher, "removed much of the Mauritius tax market advantage, (but) at the cost of further cutting off their tax footing to spite the particular source of abuse". And now, the UPA finds itself in a difficult situation as other nations like Saudi Arabia and Kuwait are asking for the "Singapore treatment". This is possibly one of the main reasons that the finance ministry has now agreed to renegotiate the Indo-Mauritius treaty.
In retrospect, the fear among Indian politicians that changing the critical clauses of the treaty would adversely affect foreign inflows, was wrong. The 2005 CAG report, which audited 1,732 tax assessments under several DTAS and found mistakes in 314 cases, revealed there wasn't any impact on FII inflows in 2000. During January-March 2000, when the Indian authorities denied tax benefits to FIIs, "there was a net increase in investment". And "subsequent to the issue of (the April 2000) circular", which asked the assessing officers to accept residency proof furnished by Mauritius entities, "there was, in fact, a net outflow of investment," stated the report. (Now that the finance ministry is confident that FIIs are not going to run away from potentially-attractive emerging markets like India, and newer FIIs from Japan are not taking the Mauritius route, it has decided to review the treaty.)
Bratcher also dispels the notion, propagated by Chidambaram, that India was not able to renegotiate the treaty due to political and diplomatic reasons. He points out that Indonesia "did away with its DTA with Mauritius since January 1, 2005, precisely on the grounds that Mauritius had in 2001 allowed non-residents of that country to use its companies' act to set up front companies, and thus enabled treaty shopping—thus giving lie to India's protestations that it could do nothing".
Even more surprising is that, in private and to various government committees, the finance ministry has repeatedly accepted that there are problems with the DTAS, including the one with Mauritius. In July 1995, the finance ministry opined that "for Indian investors to be globally competitive, facilities available to foreign investors to use the relative advantages of Mauritius should also be available to Indian investors". But, in February 2003, the CBDT circular acted against Indian entities investing via Mauritius, and not the foreigners.
In its admission to a joint parliamentary committee set up to probe the Ketan Parikh stockmarket scam, the finance ministry accepted "there were problems in DTAA with 17 other countries (excluding Mauritius) as well pertaining to taxation of long-term capital gains". In fact, the ministry officials told the JPC that the situation in the Mauritius treaty had become one of "fait accompli, and progress, if any, to remedy the situation has been slow". Ironically, the JPC, in its December 2003 report, had noted that the problem with the Indo-Mauritius treaty was with "residents of third countries exploiting the favourable dispensation sought to be granted to bona fide residents of Mauritius through 'post box companies'".
Specifically, in the case of FIIs, the CAG report found that the finance ministry didn't have "any centralised or alternate effective mechanism to correlate or utilise the details available with SEBI relating to inflows and outflows of FIIs". The report urged the CBDT to scrutinise FII accounts, specially the 4,000 sub-accounts via which money was flowing into the Indian capital markets. (Right now, there are also concerns regarding inflows through participatory notes, which account for majority of the foreign investment in Indian equities and whose identities are totally hidden.)
Hopefully, the situation will change. Hopefully, India will insist on crucial changes in the Indo-Mauritius treaty to plug gaps to stop both round-tripping and treaty shopping. Hopefully, FIIs will continue to stay invested in profitable and mature markets like India. Hopefully, the treaty will help to encourage Indian investments in Mauritius, rather than the other way around. Hopefully, Mauritius will agree to the changes as it's confident that having signed similar DTAS with ASEAN nations, it'll be able "to expand its attraction as a tax haven".
