by Ashish Goel
India and Singapore on December 30, 2016, signed a protocol to their double tax avoidance agreement, aiming to prevent tax treaty shopping and round tripping of domestic black money in the guise of foreign investments routed through Singapore.
The protocol, which is expected to enter into force in April this year, amends Article 13 of the India-Singapore tax treaty, allocating the right to tax capital gains to the source country (with a reduced tax rate to apply during the transition period); revises the limitation of benefits clause in force currently; and inserts provisions to facilitate economic double taxation relief in transfer pricing cases, among others.
The revisions contained in the protocol are largely similar to May 10, 2016, revisions made to India’s tax treaty with Mauritius; and November 18, 2016, revisions made to India’s treaty with Cyprus.
Source-based tax on capital gains
In 2005, India and Singapore signed a protocol to their tax treaty to give the resident country the right to tax gains derived by residents of a treaty country from the alienation of any property, including shares.
Article 6 of the 2005 protocol, however, states that the residence-based taxation of capital gains will only remain in force as long as India’s tax treaty with Mauritius provides for the identical tax treatment of capital gains. Now, with the recent revisions made to India’s tax treaty with Mauritius, the capital gains tax exemption granted under the second protocol had to be similarly phased out.
In line with the changes made to India’s tax treaty with Mauritius and Cyprus, the new protocol thus provides for a source-based taxation of capital gains. Under the new protocol, gains arising from transfer of shares acquired on or after April 1, 2017, by a Singaporean tax resident in an Indian company may be taxed in India.
The protocol also grandfathers existing investments and provides for a two-year transitional arrangement for shares acquired between April 1, 2017, and March 31, 2019.
Under these rules, the capital gains tax rate on shares acquired during the transition period will not exceed 50 percent of India’s domestic tax rate. From April 1, 2019, capital gains arising from transfer of shares will be newly subject to the then applicable tax rate in India.
Limitation of benefits
The new protocol revises the limitation of benefits provision introduced in the 2005 protocol to prevent grant of treaty benefits in inappropriate circumstances.
According to the new agreement, a resident of a contracting state will not be entitled to benefit from the grandfathering provision or from the transitional arrangement if its affairs were arranged with the “primary purpose” to take advantage of the treaty benefits.
The protocol also specifically provides that a shell company or a conduit company will not be entitled to benefit from the grandfathering provision or from the transitional arrangement of the revised treaty.
A shell company or a conduit company is defined as a legal entity with negligible business operations or with no real and continuous business activities in the resident state.
More specifically, the company must have annual expenditure on operations in the resident state that do not exceed SGD200,000 (INR5m/USD 73,000) for the following periods:
- In case of the grandfathering rules, for each of the 12-month periods in the immediately preceding period of 24 months from the date on which the gains arise;
- In case of the transition rules, for the immediately preceding period of 12 months from the date on which the gains arise.
The protocol clarifies that a resident is deemed to be a genuine company if it is listed on a recognized stock exchange of the resident state and fulfils the abovementioned conditions.
Mutual agreement procedure
The protocol also updates Article 9 of the India-Singapore tax treaty on associated enterprises to facilitate both contracting states in entering into bilateral discussions for elimination of double taxation arising from transfer pricing or pricing of related-party transactions.
Once the protocol enters into force, an appropriate adjustment will need to be made to the income of an enterprise of a contracting state in the event that the other contracting state makes an addition to the income of its associated enterprise. The protocol requires contracting states to adhere to the provisions of the agreement in determining such adjustments and consult with each other, if required.
The move, according to the Indian Finance Ministry, is “taxpayer friendly” and is in line with India’s commitment, under the base erosion and profit shifting project, to provide access to the mutual agreement procedure framework in transfer pricing matters.
Withholding tax rates
Unlike the protocol signed between India and Mauritius, which provides for a reduced withholding tax of 7.5 percent of the gross amount of the interest on interest payments (subject of course to the domestic general anti-avoidance rule as and when it is implemented), India’s protocol with Singapore does not propose any such amendment to Article 11 of the tax treaty, on taxation of interest payments.
In this regard, the India-Mauritius tax treaty stands on a stronger footing as compared to the India-Singapore tax treaty in that the latter provides for a 15 percent withholding tax rate on interest payments in all cases except where the interest is paid towards a loan granted by a bank carrying out genuine banking activity or by a similar financial institution.
Paving way for the general anti-avoidance rule
Last, the protocol with Singapore inserts a new Article 28A in the tax treaty to enable contracting states to apply their domestic general anti-avoidance rules to prevent tax avoidance or tax evasion, a change that is missing in India’s protocol with Mauritius.
India first proposed a general anti-avoidance rule (GAAR) in Budget 2012/13, but its implementation has since been deferred year after year. The rule is likely to be implemented this year without any further deferrals. Under the GAAR, a tax arrangement may be declared to be an impermissible avoidance arrangement if the main purpose of the arrangement is to obtain a tax benefit or it lacks commercial substance (such as round tripping financing) and in such cases, treaty benefits may be denied (although it will be difficult to invoke GAAR if the conditions stipulated in the limitation of benefits Article of the tax treaty are satisfied).
The main objective behind the phasing out of capital gains tax exemption currently granted under the India’s tax treaty with Singapore is to prevent treaty shopping and round tripping of funds (as is also the case with Mauritius and Cyprus).
I have elsewhere argued, in the context of the revisions made in India’s tax treaty with Mauritius, that it may not be a good idea to tax capital gains on the noble pretext of tackling treaty abuse. The questions that we need to ask ourselves is whether the new protocol will have an adverse impact on foreign investments flowing from Singapore, which was India’s top foreign direct investment source in the last financial year with USD 13.69bn, and whether the Indian government has struck the right balance between limiting tax treaty abuse and facilitating mutual trade and investment. Only time has the answer.