Cross border capital flows: abuse of tax treaty provisions; trends, practices and gap

Abstract

Unprecedented growth in foreign direct investment (FDI) in India and massive investments by FIIs in Indian capital market has ignited a substantial interest in identifying the determinants of this massive influx of investment finance. Even though macroeconomic fundamentals of host countries have been recognized as crucial factors for in-bound FDI, the importance of corporate tax rates and taxation policy have become increasingly significant given intense global rivalry in international tax competition. Using data from several countries, the dissertation uses a regression model to determine the impact that GDP, trade openness, inflation rate and various Taxes, have on FDI and concludes that corporate tax rates are statistically significant factor for determining FDI inflows into a host country. However, it is observed that the home country taxation structure and the double taxation agreement relief play a dominant role in attracting FDIs and Foreign Portfolio Investments into India. Mauritius has emerged as the largest source of FDI into India and investments are affected through Mauritius Offshore companies (MOCs), which are special purpose vehicles, which are utilised as investment platform benefiting from Double Taxation Treaty. It is also observed that residents of third country are availing the benefit of a double tax agreement between India and Mauritius interposing a company or other entity in one of them. These irregular transactions lead to several situations of disastrous economic consequences such as i. Treaty Shopping - As Mauritius-based FIIs are exempt from payment of tax on capital gains in India on the money received from sale of shares, it is possible that FIIs can route their investments through Mauritius through a shell company formed with the sole intention of routing investments to India, with no real or bona fide operation. ii. Round Tripping There are several instances which reveal the fact that black money originating from India leaves the country through hawala channel and is then reinvested in the form of FDI from Mauritius. iii. Money laundering iv. Equity Considerations v. Free Riders and vi. Erosion of Tax Base etc. In absence of any specific legislative provisions in the Income Tax Act or anti-avoidance provisions in bilateral tax treaties of India, the effort of the tax administration to counter treaty shopping and round tripping transactions is limited to application of judicial doctrine of =substance over form or =business purpose etc. However in a landmark judgment the Supreme Court of India ruled that an entity is eligible to treaty relief so long as it satisfied the explicit conditions in the treaty. The Court noted that the FIIs had satisfied the conditions, so could not be denied treaty relief. Further, the apex court also observed that if such entities are to be denied treaty relief, there ought to be specific provisions in the treaty or in legislation to achieve such an outcome. On this back ground some suggestions both legislative and administrative measures are proposed