No changes planned for India-Netherlands tax treaty but BEPS multilateral instrument looms

by Sriram Govind

India has reportedly decided it will not attempt to modify its tax treaty with the Netherlands despite its recent well-publicized crack-down on tax treaties that permit source country taxation of capital gains on sale of shares.

The decision was confirmed by several Indian sources and Netherlands officials, according to an Economic Times article published last week.

The news is surprising as it was widely expected that similar changes to the India-Netherlands tax treaty would follow those made to the treaties with Mauritius, Cyprus, and most recently, Singapore.

Interestingly, though, despite this development, it appears that Mauritius could still be a more attractive route for foreign investment than the Netherlands in many cases once expected developments take shape regarding the multilateral instrument proposed as part of Action Plan 15 of the OECD/G20 base erosion profit shifting (BEPS) project.

India-Netherlands tax treaty

The India-Netherlands tax treaty has several taxpayer-favorable provisions. Most importantly, it allows taxation of capital gains on sale of shares only in the residence state, except where the holding is in excess of 10% and the buyer is a source state resident (in situations which are not reorganizations) or where the seller is an individual who was resident in the source state at any point in the preceding 5 years.

Moreover, capital gains on indirect sale of immovable property (similar to Article 13(4) of the OECD Model) is very flexible, allowing source state taxation only if the shares being sold are of a residence state based company, excluding third state holding company structures.

The announcement, plus recent changes to the Mauritius, Cyprus, and Singapore tax treaties, has led some investors to now eye the Netherlands as an alternative jurisdiction through which Indian investments may be routed.

However, the status of the India-Netherlands treaty must also be read in the context of the impending ratification of the BEPS multilateral instrument.

Multilateral instrument

The multilateral instrument will be a multilateral treaty between countries which will modify each notified bilateral double tax treaty between two of such countries as regards base erosion and profit shifting measures. Both India and Netherlands played an active part in the ad hoc group for the multilateral instrument and are expected to become parties.

Although this is just speculation, even though Mauritius, Singapore, and Cyprus are part of the ad hoc group for the multilateral instrument as well, India may have felt lesser of a guarantee that they would participate in the instrument by modifying their treaties with India – which may have led to bilateral renegotiation in these cases.

It is important to note that the multilateral instrument would, as a minimum standard, modify notified bilateral tax treaties to implement either a principal purpose test (a broad treaty level GAAR) – with a simplified limitation on benefits or not, or a detailed limitation on benefits provision. The instrument will also modify the preamble of such treaties to clarify that the use of the treaty to achieve double non-taxation should not be allowed.

The addition of a principal purpose test or a limitation on benefits test to the India-Netherlands tax treaty would effectively safeguard both states from the use of the treaty for tax-motivated structuring. Therefore, even though the India-Netherlands tax treaty is flexible as of now as compared to the Mauritius, Singapore or Cyprus treaties, one should wait and watch whether the two states modify this treaty under the multilateral instrument.

Several benefits of the India-Netherlands treaty may remain untouched in cases not involving aggressive tax planning, such as the most-favoured nation clause as against OECD member states for dividends, interest, royalties, and technical services (including new levies covered therein); the flexible fees for technical services provision that contains the ‘make available’ criterion; and the lack of a service PE provision or ‘supervisory services’ in the building site/assembly PE provision.

Investment through Mauritius

However, in the event that the treaty is modified under the multilateral instrument (and the other abovementioned treaties are not), in light of the Indian revenue’s aggressive stance against tax abuse and tax treaty shopping, Mauritius may generally still remain the most favored option for financial investments into India for several reasons.

First, the India-Mauritius treaty does not contain an anti-abuse provision (except for share transfers till 2017), unlike the new India-Singapore treaty that allows the use of the Indian domestic GAAR at a treaty level (Even though the Indian GAAR includes a domestic treaty override, this has not been dealt with at a judicial level yet in India and Azadi Bachao Andolan still remains law of the land in India in the absence of a treaty level anti-abuse provision).

Also, the residual paragraph of the capital gains provision in the India-Mauritius treaty allows taxation only in the residence state for instruments other than shares such as debentures. Coupled with the newly negotiated 7.5% source withholding tax rate for interest for debt (lesser than the 10% rate in the Cyprus or Singapore treaties), investments by way of convertible debentures from Mauritius have been boosted.

These are exciting times for people who follow the Indian market and developments in 2017, including the upcoming Budget and the multilateral instrument, might present some new and interesting challenges to investors.