In international trade, we have achieved intellectual clarity through value-added tax (VAT). VAT operates on the destination principle. Exports are zero-rated, ensuring that Indian steel leaves our borders free of domestic taxes, carrying the market price and devoid of all indirect taxes. Imports are taxed at the same rate as domestic goods. This ensures neutrality: The tax system does not distort the choice between an Indian product and a foreign one. A similar philosophy is seen in the Carbon Border Adjustment Mechanism (CBAM): Each country chooses its own carbon tax rate, but international trade is not distorted. Such neutrality is essential for harnessing globalisation.
When this reasoning is applied to finance, such neutrality requires “residence-based taxation”. Income from capital is taxed in the hands of the recipient, in their country of residence, not at the source where the investment is made. If a United States (US) pension fund invests in India, the returns should be taxed in the US, not in India.
This is not merely a theoretical preference; it is a strategic necessity for a capital-scarce economy. India requires a vast amount of capital to fund economic growth, which calls for foreign capital. Global capital seeks the highest post-tax risk-adjusted return. If India imposes source-based taxation — taxing foreign investors at our borders — we reduce their post-tax returns. To compensate for this tax cost, global investors demand a higher pre-tax return from Indian assets. Investment projects that would be viable at a 10 per cent cost of capital become unviable at 14 per cent. Source-based taxation acts as a tariff on capital, creating a friction at the border that retards investment, increases costs for Indian firms, and slows growth in gross domestic product (GDP). Ideally, India would have a low or zero tax rate on capital domestically to encourage capital deepening also. But even without that, adhering to residence-based taxation for foreign investors is critical.
For many years, we achieved this outcome through a “second-best” institutional arrangement. We utilised tax treaties to achieve de facto residence-based taxation.
There is a healthy role for hypocrisy in public affairs. In electoral democracies, populist rhetoric frequently demands that the state “tax the rich” or “tax foreigners”. However, the adults in the room understand that we have to create conditions for economic efficiency. Hence, the edifice of global capitalism often runs through efficient taxation obtained through tax-neutral conduits. Successful countries have generally managed a nice hypocrisy of saying populist things in public while ensuring that the world economy is properly organised through such mechanisms. In similar fashion, the Mauritius route allowed India to have residence-based taxation, ensuring that despite the vagaries of domestic tax policy, the cost of capital in India stayed down.
This equilibrium required legal certainty. The bedrock of this certainty was the Supreme Court judgment in the Azadi Bachao Andolan case, and the principles articulated by Justice B N Srikrishna. The standard was clear: A valid TRC issued by the Mauritian government was final. The Indian tax officer could not go behind this document to question the investor’s status.
This framework began to unravel in 2016. The tax treaty was amended to include a Limitation of Benefits (LOB) clause. While the stated intent was to curb abuse, the amendment fundamentally altered the rules of engagement. It replaced the objective standard of the TRC with subjective tests regarding the commercial substance of the entity. This shift empowered the tax department to “look through” the residency certificate. The recent ruling is the consequence of this shift, where the TRC is no longer a shield against the investigatory powers of the taxman. The mistakes of 2016 have come back to haunt us in 2026.
The 2016 shift coincides with broader difficulties in private investment. The structural break in foreign ownership of listed Indian companies is striking. Foreign ownership rose from 8.38 per cent in 2000-01 to a peak of 19.19 per cent in 2015-16. Since then, this metric has stagnated and reversed. By 2024-25, foreign ownership had dropped to 16.04 per cent. In a successful emerging market, we expect “home bias” to decline over time. As the economy matures and integrates with the world, the share of foreign ownership in equity assets should steadily rise. But it hasn’t.
The judiciary needs to act as a check on executive overreach. The essence of the rule of law is predictability. When courts reopen settled questions or allow the retrospective application of new standards, they increase the ex ante risk of investing in India. A foreign investor today must price in not only the business risk but also the risk that the tax treaty signed today will be reinterpreted tomorrow. We are now in the grip of tax authorities who have weak knowledge of economic growth, and a judicial system which has failed to uphold the sanctity of contracts and the finality of the TRC.
A country cannot be better than its thinkers. Four policy projects should be high on the agenda of the people who care about Indian economic growth: Remove customs tariffs, remove blockages of input credit in goods and services tax, get to a carbon tax, and get to residence-based taxation. This understanding must diffuse into the bureaucracy, the revenue department, and the judiciary.
The authors are, respectively, researcher, XKDR Forum, and managing director, TrustBridge Rule of Law Foundation
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