April 10, 2010 | By Keith Martin in Washington, DC

India reaffirmed in late March that companies based in Mauritius do not have to pay capital gains taxes when they sell shares they own in Indian companies.

An E*Trade subsidiary in Mauritius sold shares in an Indian company to an HSBC investment vehicle also in Mauritius. The sale generated a long-term capital gain for E*Trade. The Indian authorities challenged E*Trade on its position that it was entitled to an exemption from capital gains taxes in India under article 13(4) of the India-Mauritius tax treaty, which says that a Mauritius resident can only be taxed in Mauritius on its gains, arguing that the E*Trade subsidiary in Mauritius was merely a shell company and the real owner of the shares in the Indian company was the E*Trade parent company in the United States. The Indian authorities directed HSBC to withhold 21.11% of the sales price for the capital gains taxes. E*Trade appealed.

The Authority for Advance Rulings held that India had to honor the treaty exemption, ruling essentially that there is no prohibition against treaty shopping. It also questioned the continuing viability of the treaty.

The Mauritius treaty used to confer two benefits. One was a reduced withholding tax on dividends received from Indian companies. The other is an exemption from capital gains taxes. India cut off the withholding tax benefit by converting its withholding tax to a tax on the Indian company paying the dividend. It has periodically fought exemption claims on capital gains taxes.
In 2000, the Central Board of Direct Taxes said in Circular 789 that Indian tax collectors must honor certificates of tax residency from the Mauritius authorities. The circular was temporarily set aside by the Delhi high court before being reinstated by the Supreme Court in 2003.

The Indian government is moving to replace its existing income tax code with a new “direct” tax code. The proposed new tax code would give the government additional tools to ignore the form of transactions and focus on the substance, for example by declaring transactions as “impermissible avoidance arrangements.” This may be used to attack treaty transactions.
In a related case, an income tax appellate tribunal in Mumbai held in March that a service company in Dubai could take advantage of the India-United Arab Emirates tax treaty to avoid withholding taxes on fees that the Dubai service company, Caltex, received from an oil refinery in India.

Caltex could only benefit from the treaty if it was “liable to tax” in Dubai. It did not pay any taxes in fact. The tribunal cited a Canadian court decision for the proposition that actual current taxation is not required; it is enough that Caltex could be taxed in Dubai should the government choose to tax it. The case is Hindustan Petroleum Corporation, Ltd. v. ACIT.