The recently amended Double Taxation Avoidance Agreement (DTAA) between India and Mauritius dates back to 1983. In that era India's DTAAs were intended to promote foreign direct investment. Subsequently, when prospects for foreign institutional investors (FIIs) investing in Indian stocks brightened post reforms of the early 1990s this agreement's provisions were extended to FIIs. It could be said that foreign exchange (FX) inflows have been significantly higher because India cynically concluded DTAAs with extremely low tax regime countries. And, this was critically important in managing the recurrent risk of balance of payments crisis stemming from India's perennial and substantial deficits in trade in goods.
Past governments including the United Progressive Alliance (UPA) government during 2004-2014 had full understanding of the taxes foregone and the round-tripping aspect of the DTAA with Mauritius but balked at confronting domestic vested interests. The refrain from Mauritius was that they needed time to adjust to lower government revenues if the DTAA was to be amended. India chose to remain mired in discussions with Mauritius to provide compensation to the latter. Another red herring which distracted India was the dangling of naval facilities on one of Mauritius' islands.
Reverting to the present, the National Democratic Alliance government deserves accolades for deciding to bite the bullet and announcing significant changes in the DTAA with Mauritius. Implementation of the revised DTAA is stretched over the next three years after which domestic and foreign investments via Mauritius would be subject to the same tax rates on capital gains. However, on 13 May, the government was reported to have confirmed that derivatives and debentures would not be covered by the amendments in the DTAA with Mauritius. If this information is correct, that would be surprising. This is because the markets in call and put options in listed Indian stocks are adequately liquid such that these exchange traded derivatives can be used to duplicate the pay-off from underlying shares.
Specifically, the basic put-call parity equation which is mathematically precise can be used to exactly replicate the future price movements of listed stocks. Put-call parity holds when the options are "European" which can only be exercised at maturity as distinct from "American" options which can be exercised at any time between purchase and maturity date. The parity equation (explanation available in any basic book on derivatives) is:
S = C + PV (X) - P
S: spot stock price; C: call option premium; PV (X): present value of strike price X discounted from date of maturity of option at risk-free rate; P: put option premium.
If an investor were to buy a call option, lend the present value of the strike price at the risk free rate and sell a put option at the same strike price the resulting exposure is exactly the same as if the investor had bought one share at price S at time t = 0. That is, investors could continue to use the Mauritius route to avoid capital gains taxes even after 1 April 2017 by using derivatives instead of investing directly in shares. Of course, for investors to take large positions in stocks using derivatives, deep and liquid markets for call and put options are needed. The open interest in exchange traded derivatives (an indication of the size of the stock of options) for most major listed companies has grown and Indian options markets are large enough. It is also not clear why debentures have been excluded from this amended DTAA with Mauritius. Convertible (to equity) debentures could be issued in Mauritius to avoid taxes in India post April 2017.
In the past 10 years every time the government or Sebi has sought greater transparency about the beneficiary ownership and details of participatory notes (PNs), FIIs have sold precipitously and Indian share prices have tumbled. The subsequent Sebi reaction has been to turn tail and make soothing noises not to roil stock markets further. PNs are probably mostly leveraged or derivatives positions on Indian stocks. It is time for Sebi at its board meeting on 20 May to grit its teeth and seek more details about PN structures and ownership since it is likely that round-tripping is involved.
High profile tax disputes such as the Vodafone case arise because foreign companies route investments via low tax jurisdictions with which India has DTAAs to reduce tax incidence. Additionally, those who have access to unaccounted funds and are based in India or elsewhere, route their investments through such tax havens. Consequently, it would be useful to review and transparently implement provisions of the general anti (tax) avoidance rules (GAAR) as soon as feasible.
More broadly, it has been long-standing Indian policy to make a distinction between domestic and skittish foreign investors and to woo the latter with financial/tax incentives. For instance, higher than market interest rates on hard currency non-resident Indian (NRI) term deposits is an example of market distortion. It was distortionary to set up standing and episodic FX deposit schemes for NRIs which were called India Millennium Bonds, Resurgent India Bonds and the RBI sponsored scheme of September 2013. If India is short of FX reserves we may need to offer marked up interest rates on FX deposits but these opportunities should not be restricted to NRIs. Such schemes carry a sovereign guarantee on the rupee exchange rate and should be on offer to anyone who makes deposits through recognised banking channels. Further, the economic cost of holding higher FX reserves would be lower than offering high interest rates on FX deposits. It would also be lower-cost for the Indian government to issue sovereign bonds instead of implicitly guaranteeing FX deposit schemes of public sector banks or RBI.
To sum up, government should not distort markets by using differential tax regimes or interest rates to favour foreign sources of funds. India should also no longer connive at obtaining funding from dubious sources. It cannot be sound policy to persist with discriminating against domestic investors in favour of foreigners or NRIs.
j.bhagwati@gmail.com
The writer is a professor at ICRIER
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
