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Skip Navigation LinksHome :: Back Issues :: Tax issue raises heat and dust

May 2000

Tax issue raises heat and dust





       
Taxmen sought the pot of gold
The beautiful island of Mauritius in the Indian Ocean is today a key outpost for a liberalizing India, thanks to an obscure tax treaty. Nearly half India's foreign portfolio investment, currently around $ 11.7 billion, is routed through the island and so is a large chunk of foreign direct investment.
But in early April this arrangement was put in jeopardy when Indian tax officials swooped on five foreign funds based in Mauritius demanding taxes owed by them, sparking a market collapse and possibly the worst standoff to date between foreign investors and the Indian government.
Mauritius owes its tax haven status to a bilateral treaty with India. In 1983, long before India embarked on economic reforms, the two countries signed a double taxation treaty that allows residents of Mauritius who invest in India to be taxed under Mauritian law rather than Indian law. India has a 30% tax on short-term (under a year) capital gains and 10% on long-term capital gains.
In the early 1990s, when India opened its doors to foreign portfolio investors, many decided to base their operations in Mauritius, which does not tax dividend and capital gains as India does. The Indian government ignored this partly for political reasons. Says UR Bhat, chief investment officer for Jardine Fleming, a large equity investor in India: "It was like an open secret. The treaty put India on a par with most other countries in the region that do not tax capital gains and enabled the government to avoid taking a tricky political decision to exempt foreigners from paying Indian taxes."
Helpful Indian lawyers and accountants soon perfected the process, making it almost seamless. Says Rajesh Dhume, head of Ernst&Young's tax practice in India, who advises several foreign investors: "In any case, initially when the Indian stock markets were in a bear grip foreign investors lost money so there were no profits to tax."
But in recent years, the Authority for Advance Ruling (AAR), a body that clarifies the tax status of non-resident investors, was ambiguous in its interpretation of the benefits of the Indo-Mauritian treaty. When NatWest Markets set up a Mauritius subsidiary to invest in a private Indian bank in 1995, it was denied tax breaks under the treaty because the AAR held that it had set up a shell company with just one beneficiary, the UK company. However, a year later the American Insurance Group was allowed those breaks when it set up a fund in Mauritius to invest in India simply because it had a pool of investors. But matters came to a head at the end of March this year, the fiscal year-end, when five foreign funds managed by HSBC, Robert Fleming, Morgan Stanley and Guinness Flight were asked for taxes on dividends earned in the year ended March 1997.
Rumours that the government planned to tax foreign investors sparked free fall on Mumbai stock markets when they opened on Tuesday, April 4.
The timing was awful: the markets were jittery anyway following losses on Nasdaq and local mutual funds were under year-end pressure to take profits to pay out dividends. By late afternoon the newly-appointed chairperson of the Central Board of Direct Taxes downplayed the matter as a routine tax scrutiny, adding that the fund managers could appeal against the decision. It also emerged that the sum of back taxes being demanded was a paltry Rs90 million ($2 million).
But this did not calm foreign investors; one irate fund manager on a television channel declared: "We're just getting out." By the end of the day the 30-share Sensex of the Bombay Stock Exchange (BSE) had tumbled 361 points or 7% - its worst-ever single-day fall.
A worried finance ministry said there was no move to change the terms of the Indo-Mauritian tax treaty. Equally worried BSE officials decided, wisely, to cancel a festival holiday the next day and allow trading. Next morning finance minister Yashwant Sinha was on television reassuring foreign investors that they could depend on the rule of law in India but warning against "fly-by-night" operators and "deliberately engineered panic" in the stock markets. Trading was nervous even though the market closed 66 points higher.
HSBC and Robert Fleming suspended dealings in their $250 million and $220 million India funds to protect investors. Guinness Flight placed an advertisement in the Financial Times that said it had frozen dealings in its India fund.
"At that point there was a lot of uncertainty," says Jardine's Bhat. "Chartered accountants were refusing to give us the tax certificate needed to repatriate funds and custodians said they could not make payments."
That evening Securities Exchange Board of India officials invited foreign fund managers from Morgan Stanley, Jardine Fleming, Templeton, Credit Suisse First Boston, Sun F&C and others, their custodians and chartered accountants to thrash out the matter with top income tax officials at its office in downtown Mumbai. A joint secretary from the revenue ministry flew down from Delhi to sit in.
Emotions were running high. Fund managers claimed a breach of confidence, even warning that India would join the ranks of investment pariah countries such as Malaysia and Pakistan. Tax officials accused foreign fund managers of treaty-shopping to evade tax and acting in collusion to drag down the market.
"There was a lot of mutual suspicion," says a fund manager who was there. "What was appalling was the ignorance of the issues involved. The tax officials simply didn't understand that you cannot ask open-ended funds to cough up taxes two years down the line; that the law cannot be changed by them."
Top officials of the Securities Exchange Board of India (SEBI) reportedly urged the finance minister to act decisively. SEBI chairman DR Mehta declined to comment directly on the issue, but said: "It is for the ministry of finance and the external affairs ministry to decide whether India needs foreign investment and under what terms." One foreign fund manager managed to get to the minister on the phone in Delhi. Sinha, who was scheduled to visit Mumbai the next day, agreed to meet the fund managers. Eventually, late on Thursday, the finance ministry withdrew the tax notices and said that foreign investors that had been issued a certificate of residence by the Mauritius government would not be taxed in India. The markets rebounded and the crisis blew over.
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