India: International Investment Gateways To India

This article was published in slightly different form in the November 2007 issue of theIndia Business
Law Journal.

Choosing the best offshore center for India-bound investment requires careful consideration of the risks
and financial rewards. Nandan Nelivigi and Brendan McNallen compare the attractions of Mauritius,
Cyprus and Singapore.

Foreign direct investment into India from the tiny island nation of Mauritius exceeds the inflows from any
other country in the world.

Inflows from Mauritius were more than double those from the second-largest investor, the United States,
throughout the decade, leading up to 2002 and more than quadrupled the total over the last ten months,
according to statistics published by the Indian government.

This is not because Mauritius in itself is an overpowering economy, but rather because the island is an
ideal route for investments into India. In addition to Mauritius, the Republic of Cyprus (Greek Cyprus)
and Singapore have also emerged as popular routes for India-bound direct investment.

All three jurisdictions enjoy double tax avoidance agreements (DTAA) with India, but it is worth
examining these agreements carefully and also considering several other key factors before choosing
the best investment route.

Key Considerations

The capital gains from sale of shares, dividends and interest are the principal means for foreign
investors to realize their returns from investments.

Aside from foreign investment regulations, there are a number of important considerations for direct
investors targeting any country. Foremost among these are tax efficiency in repatriating funds, the
absence of foreign exchange restrictions and the ease of establishing and operating entities in
intermediate countries.

Tax regulations and any agreements between the country where the investment is made and the
country of origin are relevant in determining tax efficiency. The key question while investing in India is:
what is the applicable tax on capital gains, dividends and interest in India and in the intermediate
jurisdictions through which proceeds are routed?

Corporate regulations in the country of investment and any intermediate jurisdictions are equally
relevant. Foreign investors must understand the minimum capitalization rules and whether there are
restrictions on the distribution of dividends in order to determine whether capital should be structured as
debt or equity.

The provisions of any existing DTAAs are important because they typically modify or determine how the
country of investment will tax capital gains, dividends, interest or other applicable proceeds payable to a
foreign investor. To benefit from a DTAA, it is critical that the investor is a tax resident of the country
from which the investment is made and does not have a "permanent establishment" in the country of
investment.

Tax On Share Sales

Under the provisions of the Indian Income Tax Act, 1961, gains from the sale of shares of Indian
companies are taxable in India. The level of tax is determined by whether the gains from the purchase
and sale of shares are deemed business income or capital gains and in turn, whether capital gains are
long-term (from shares held longer than 12 months) or short-term (from shares held for 12 months or
less).

If a foreign investor is an active trader and Indian revenue authorities classify the investor’s gains from
the sale of shares as business income, India will usually tax such business income only if the investor
has a tax residence in India. As a result, the country from which the investments have been made—and
any prevailing DTAA—is not usually relevant in determining tax liability as long as the investor has no
tax residence in India.

If, however, the profits are deemed to be capital gains, the investor will incur Indian capital gains taxes
ranging from approximately 10.5 percent to 42 percent depending on whether the gains are from the
sale of shares of a private company or of a listed company, whether the sale was on or outside of a
recognized Indian stock exchange and whether the gains were short-term gains or long-term gains.

India currently does not impose capital gains tax on long-term gains from shares sold on a recognized
Indian stock exchange. For all off-exchange share sales, the provisions of the DTAA are important
indetermining whether the investor can avoid paying capital gains tax in India.

Dividends And Interest Payments

Corporate law allows Indian companies to distribute dividends solely out of net profits.

In addition, except in certain specified sectors (such as banking, finance and insurance), Indian laws do
not have material requirements relating to minimum capitalization.

While these considerations typically support a capital structure with a significant debt component, Indian
foreign exchange regulations have historically imposed stringent restrictions on Indian companies from
incurring foreign debt. Recent changes, which reflect a tightening credit policy, have severely limited
foreign debt for domestic expenditure.

The government has also clarified that foreign investment in preference shares of Indian companies
must be in the form of fully convertible preference shares in order to be considered share capital and not
debt, which is subject to a number of restrictions. Likewise, only debentures that are fully and
mandatorily convertible into equity within a specified time qualify as equity.

Dividends on preference shares, unlike equity shares, are subject to a cap under Indian foreign
exchange regulations. These regulations have significantly reduced the ability of foreign investors to
structure their investments in Indian companies in the form of preference shares or debt instruments.

Fully convertible preference shares are treated as equity for the purposes of Indian foreign investment
regulations. Dividends on these shares are taxed in the same manner as dividends on equity shares.

Fully convertible debentures are also treated as equity but returns on investment can be structured as
interest payments for the purposes of Indian tax regulations

Current Indian laws do not tax dividends in the hands of a shareholder. However, Indian companies are
subject to a dividend distribution tax at an effective rate of 16.995 percent on the amount they distribute
as dividends.

Some of the DTAAs India has entered into (with Mauritius, for example) stipulate a concessional tax rate
on dividends received by investors who are tax residents of the applicable country. Since India has
eliminated dividend taxes in the hands of a recipient of such dividends, these provisions are not relevant
at the moment.

Interest income, on the other hand, is subject to withholding tax at an effective rate of approximately 42
percent for a foreign company and 23 percent for an Indian company. The provisions of a DTAA,
however, may modify this tax rate.

Mauritius

Since independence in 1968, the Indian Ocean island of Mauritius has emerged as a successful open
economy and (nominally at least) the world’s largest investor into India.

Under the India-Mauritius DTAA, Mauritian tax residents without a permanent establishment in India are
not taxed in India on capital gains from the sale of shares of an Indian company. This allows Mauritian
tax residents to avoid the approximately 10.5 percent to 42 percent tax on capital gains from the sale of
shares under domestic Indian tax laws.

The India-Mauritius DTAA does not provide any concession with respect to Indian tax on interest
payments, so Mauritian tax residents will pay an approximate rate of 42 percent on interest income
received from Indian companies.

Mauritius does not tax capital gains from the sale of shares in an Indian company. Nor does it tax
dividends received from an Indian company if the Mauritian entity owns more than five percent of that
company. Where the ownership is less than five percent, it is generally possible to reduce the three
percent Mauritius income tax to effectively zero. These favourable local tax features have been noticed
by international investors.
Furthermore, investors from Mauritius have clarity on how to establish tax residency in Mauritius for
purposes of the DTAA. The Indian Supreme Court, in the Azadi Bachao Andolan case in 2003, held that
companies can establish Mauritian tax residency under the DTAA simply by obtaining a tax residence
certificate from the government of Mauritius. In order to obtain a tax residence certificate, Mauritius
requires, among other conditions, that at least two directors are resident in Mauritius, a bank account is
maintained in Mauritius and a Mauritius auditor is appointed.

While the Indian Supreme Court decision and the clarity of the Mauritian regulations provide comfort to
Mauritius-based investors of their tax residency status, prudent investors typically take additional
measures in terms of corporate formalities to bolster their substance as Mauritius residents and avoid
the accusation of "treaty-shopping."

Investors through Mauritius enjoy the benefits of Mauritius’ status as India’s primary investment hub with
a reasonably stable government, a well-developed legal system and flexible corporate laws. The
administrative infrastructure for establishing and operating special-purpose entities in Mauritius is well
established. Furthermore, given the considerable business interests already exercising their rights under
the treaty, the potential for a major disruption in the flow of foreign investments into India is likely to act
as a brake on any steps by India to take away the benefits under the DTAA.

To cater to the needs of the large number of investors routing their money through the country, Mauritius
has a well-developed business services sector that includes lawyers, accountants and bankers as well
as providers of end-to-end incorporation and management services. These companies handle the
appointment of resident directors and look after tax, corporate and regulatory compliance in Mauritius.
From a timing standpoint, although the government agencies will grant the registration within a short
period with a complete application, given the requirements of the application, it would normally take
much longer than expected to complete the registration process from start to finish. Experienced
advisers can reduce this wait time, but the wise investor will start the corporate formation as soon as
possible.

Cyprus

A popular alternative to Mauritius as an investment gateway to India is the Mediterranean island of

Cyprus.

As with the India-Mauritius DTAA, the agreement between India and Cyprus provides exemptions from
Indian capital gains tax from the sale of shares in an Indian company by a Cyprus tax resident without a
permanent establishment in India.

Unlike the India-Mauritius agreement, the India-Cyprus DTAA caps the withholding tax on interest
income paid to a Cyprus tax resident at 10 percent (as opposed to approximately 42 percent to which a
Mauritius resident would be subject). However, the tax savings may be limited due to restrictions under
Indian law in respect of the amount of interest payable on debt instruments.

Under Cyprus law, tax on interest could be as low as 10 percent, the effect of which could be further
limited to the net interest margin ultimately retained by the Cyprus resident company. Cyprus does not
impose any taxes on dividends received by a Cyprus tax resident from an Indian operating company in
which it owns more than one percent of the share capital if certain conditions are met. Capital gains are
not subject to any tax in Cyprus.

In order to enjoy the benefits of the India-Cyprus DTAA, the Cyprus company must be the beneficial
owner of the relevant asset from which the revenue is derived and must be a tax resident of Cyprus,
which under the India-Cyprus DTAA means a person who is liable to pay tax in Cyprus by reason of
domicile, residence, place of management or other similar criterion.

Without a clear-cut definition of residence, some advisers have taken the stance that the standard will
be satisfied if: (i) either the affairs of the company are managed by the board members, the majority of
whom are tax residents of Cyprus and board meetings take place in Cyprus or (ii) any other body
manages and controls the company, such as the shareholders or an investment committee and such
shareholders or investment committee are tax residents.

This ambiguous standard of "management and control" creates uncertainties alleviated by the clear-cut
requirements for Mauritius residency.

Furthermore, since the India-Cyprus route has not been as heavily relied upon by investors as the
Mauritian route, the DTAA may be more vulnerable to an amendment. Whispers of negotiations
between the governments of India and Cyprus to remove the capital gains exemption are commonly
heard and while it is unclear if (or when) an amendment will be made, investors should certainly plan for
this eventuality. Cyprus recently enacted laws to facilitate the re-domiciliation of its corporate entities,
but those mechanics are yet untested and their effectiveness in the eyes of Indian tax regulators is
unclear.

Since its accession to the European Union, Cyprus has slowly but steadily developed a combination of
favorable features, from an investor-friendly tax regime to better enforcement of money laundering laws,
which have increased its attractiveness to India-bound investors. However, as with Mauritius, in practice
Cyprus proves slow-going for those looking to establish business entities quickly. Coordinating the
necessary approvals takes up to six weeks or more yet, investors can reduce their wait time by using
off-the-shelf companies already created.

Investors should establish entities as early as possible and be prepared to work around a number of
rigid provisions under Cyprus corporate laws.

Singapore

Moving from the Mediterranean to the Malay Peninsula, Singapore also entices India-bound investors
with an array of offshore advantages.

Under the India Singapore DTAA, which was amended in 2005, a Singapore tax resident is not subject
to Indian taxes on capital gains derived from the sale of shares in an Indian company.

Furthermore, interest payments on fully convertible debentures paid to Singapore tax residents incur a
15 percent tax rate; lower than the approximately 42 percent rate in Mauritius but higher than the 10
percent in Cyprus.

Under Singapore law, interest payments received in Singapore by a Singapore tax resident company
would generally be taxed at 18 percent, subject to a potential foreign tax credit for any Indian tax paid.
Dividends may be exempt from Singapore income tax if certain prescribed conditions are satisfied.

Singapore generally does not tax capital gains if they are not from trading activities.

Changes introduced in 2005 put the Singapore DTAA on par with the India-Mauritius DTAA with respect
to tax exemption on capital gains but include two important limitations on beneficial treatment for capital
gains.

First, investors from Singapore do not receive an exemption from Indian capital gains tax if the affairs of
the company were arranged with the "primary purpose" of taking advantage of the capital gains
exemption (the so-called "limitation on benefits"). Specifically, a "shell/conduit" company cannot avail
itself of the capital gains exemption, but provides a safe harbour for companies listed in India or
Singapore or a company with more than S$200,000 or Rs. 5 million of total annual expenditures on
operations in Singapore in the preceding 24-month period.

A second important limitation ties the fate of the capital gains exemption under the Singapore DTAA to
the India-Mauritius DTAA. Investors from Singapore will lose their capital gains exemption if India and
Mauritius amend their DTAA to take away the corresponding exemption.

The tax residency requirements under the India-Singapore DTAA are more stringent than those of
Mauritius and arguably more so than Cyprus. However, they do offer two major advantages over the
Cyprus requirements.

First, Singapore’s bright-line requirements reduce the risk of misinterpretation and avoid the ambiguity of
the malleable "management and control" standard used in Cyprus. Second, as an established hub of
international finance, Singapore is already the home to many investors and more likely than Cyprus to
house established subsidiaries to international companies interested in investing into India with the
expenditures in excess of the safe harbour thresholds.

While the tax rate on interest payments is lower under the India-Cyprus DTAA than the India-Singapore
DTAA, Singapore may provide other benefits. As a larger source of foreign direct investment than
Cyprus, it may prove favorable to investors concerned about treaty amendments and accusations of
"treaty-shopping".

The express link between the capital gains exemption in Singapore and the India-Mauritius DTAA
increases risk, but opposition to any amendment of the India-Mauritius DTAA militates against such risk
and offers additional protection to Singapore investors.
In terms of establishing business entities, Singapore is more attractive than Mauritius and Cyprus. An
entity can be established in Singapore within a week or two. Furthermore, the network of experienced
and sophisticated advisers who have already built Singapore into a pan-Asian financial center offers
significant advantages to investors heading into India.

Island Hopping

The offshore attractions of Mauritius, Cyprus and Singapore*

Mauritius Cyprus Singapore

Photograph of Mauritius Photograph of Cyprus Photograph of Singapore

Location Indian Ocean Mediterranean Sea Southeast Asia

Population 1.2 million 788,500 4.68 million

Indian tax payable on Mauritius tax residents Cyprus tax residents Singapore tax residents
capital gains from sale are exempt. are exempt. are exempt.
of shares in Indian
companies

Indian tax payable on 42.23 percent 10 percent 15 percent

interest received from
Indian companies

Local tax on capital None. None. Generally none.

gains from the sale of
shares in Indian
companies

Local tax on interest None for a business 10 percent or more. 18 percent, however
received from Indian holding a global foreign tax credit may be
companies business license available.
category one.

Local tax on dividends None if more than 5 None if certain None to 18 percent
received from Indian percent of the Indian conditions are met, depending on
companies company is owned. 3 including more than one circumstances of
percent otherwise. percent of the Indian investment and possible
company is owned. 15 foreign tax credit.
percent otherwise.

Length of time needed Four to six weeks to Six weeks or more, One to two weeks.
to incorporate a assemble investor’s due however, off-the-shelf
company diligence information. companies require one
week.

Other advantages Strength in numbers: EU membership. Clear-cut (albeit strict)

Mauritius is India’s process for establishing
largest investor. tax residency.

Clarity in the process for International financial

 establishing tax center with world-class
residency. business advisory
services.
Mauritius tax residency
supported by legal
precedent in India.

Any amendment to the

DTAA will face fierce
opposition.

Flexible corporate laws

which offer both
common law and civil
law concepts.

Disadvantages Time-consuming to Ambiguity in the Capital gains exemption

assemble investor’s due process for establishing does not apply if the
diligence information for tax residency. company was formed
corporate formation with the "primary
purposes. DTAA may be purpose" of taking
vulnerable to changes. advantage of this
exemption.
Slow incorporation
process. Capital gains exemption
will end if India and
Rigid corporate laws. Mauritius take away the
corresponding
exemption from their
DTAA.

Strict requirements for

establishing tax
residency.

*All rates are subject to detailed requirements under the applicable laws and regulations not fully
discussed within the article and the rates provided in the chart are based on common investment
scenarios.

Future Concerns

The two primary risks associated with structuring investments through Mauritius, Cyprus or Singapore
are the risk of amendments to the respective DTAA and the risk of running afoul of the residency
requirements of a particular jurisdiction.

India and the United Arab Emirates recently signed a protocol amending their DTAA to eliminate capital
gains exemptions for the sales of shares of companies resident in one country by shareholders resident
in the other. The sophisticated investor must stay apprised of the rumblings concerning treaty
amendments and prepare for the event that such rumors reach fruition.

Many paths lead to successful investment into India. The savvy investor must evaluate the options and
weigh his or her appetite for risk against the material benefits offered by India’s DTAAs to choose the
most appropriate route.

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