Why Mauritius Has Everything To Do With The Stockmarket Scandal

What does an idyllic island in the middle of the Indian Ocean have to do with the recent financial scam that broke out in Asia's oldest (and until recently, India's largest) stock exchange at Mumbai? What indeed does Mauritius have to with a stockmarket scandal that is currently being investigated by a Joint Parliamentary Committee (JPC) in New Delhi? Answer: Quite a lot, if not, everything.

In August 1982, the governments of India and Mauritius signed a double-taxation avoidance treaty (DTAT) ostensibly aimed at boosting the economies of both nations. India has signed more than 50 such treaties with different countries, including at least 16 which are virtually identical to the one signed with Mauritius.

Yet, the Mauritius treaty has been -- and continues to be -- misused as a conduit to launder illegal money. Because of its reputation as a tax haven, a claim that is officially denied, Mauritius has been a favourite destination for much of the black money generated in India, including a large proportion of the slush funds stashed away by some of the country's most powerful politicians and industrialists.

A set of glaring loopholes have been deliberately left wide open in this country's laws to enable racketeers of various hues to use the Mauritius route for a range of nefarious activities. These include the manipulation of India's notoriously corrupt stock exchanges.

There are significant disclosures to this effect in a report which has been circulated among members of the JPC by the so-called watchdog of the country's capital markets, the Securities and Exchange Board of India (SEBI). These revelations are contained in pages 23 to 25 of the 92-page SEBI report (excluding annexures) entitled "Investigation in Market Manipulation in the Context of Recent Market Behaviour".

The report talks about the "possible misuse of investment and automatic repatriation facility" granted to foreign institutional investors (FIIs) operating in India through a system of what is known as "participatory notes".

The SEBI report has a flow diagram to explain the manner in which the mechanism works.

Take the case of a pension fund, XYZ plc, incorporated in the United States and registered as an FII in India. The US based pension fund has a subsidiary called XYZ Mauritius Ltd which is a company incorporated in Mauritius and registered as a "sub-account" of the above FII in India. This company then issues a participatory note (PN) to "any entity" which intends purchasing equity shares of companies in India.

The foreign broking house in India executes an order for the sub-account of the FII that is actually for the benefit of the holder of the PN. A rate of commission varying between 1.5 per cent and 2.5 per cent of the transacted value is paid as buying/selling and custodial charges. The funds thus flow into Indian stock exchanges.

This is what the SEBI report has categorically stated: "This mechanism of trading through PNs outside India is utilised by the FIIs by entering into transactions by the clients who are otherwise not eligible for registration as (an) FII to trade in Indian markets or those who may or may not be eligible but want to hide their identities. Further, these PNs can enable the participant to whom these instruments are issued by FIIs to take benefit of (the) Mauritius Double Taxation Avoidance Treaty."

The point that the SEBI report drives home is that PNs issued by FIIs to any individual or corporate body outside India enables participants to trade anonymously in the equity shares of Indian companies. Since the identities of these participants are not known, they can conveniently circumvent different laws, including the corporate takeover code.

Thus, if a promoter wants to illegally ramp up the prices of his company's shares, he has a ready-made route available to him, namely, the PN issued to him by the Mauritius-based sub-account of a FII registered to operate in Indian stock exchanges. This is the essence of the current scam. "It also opens the possibility of repatriation of profits based on the rigged prices and in the process, causing foreign exchange drain," the SEBI report added.

A brief look at the track record of previous governments -- ones headed by the Indian National Congress as well as the Bharatiya Janata Party-led National Democratic Alliance -- will confirm the reasons why one is so cynical about the Mauritius route remaining unplugged for quite some time to come. If the loopholes in the law eventually get plugged, it would have something to do with international (especially American) pressure on the Mauritius government to change its tax laws and would have nothing to do with the great Bharat sarkar.

FIIs operating in India are required to pay taxes on short-term capital gains (at a rate varying between 20 per cent and 30 per cent in recent years) if these entities repatriate their earnings in less than a year.

The tax rate is lower at 10 per cent if the earnings remain within the country for more than a year. However, the best way out for FIIs is not to pay any tax at all irrespective of the time taken to repatriate capital gains. This is done by registering a sub-account in Mauritius which country does not levy any capital gains tax. Voila!

In the early-1990s, the India-Mauritius DTAT was criticised since Mauritius-based FIIs were at an "unfair" advantage over competing firms based in other countries. This issue got resolved after virtually each and every FII and foreign investor realised that the way to do business in India was to set up a "shelf" company in Maurtius.

This is precisely why an island state whose economy is 100 times smaller than the Indian economy has, over the last few years, become the single largest "investor" in India. During the decade of the 1990s, investment inflows from Mauritius have exceeded Rs 14,000 crore, the highest among all countries and a good 50 per cent higher than the inflow from the world's largest economy, the USA.

To return to the question raised earlier, if India has 16 DTATs similar to the one signed with Mauritius, why is the island the favoured choice of virtually all foreign investors doing business with India? For a decade after the India-Mauritius treaty was signed in 1982, FIIs were simply not allowed to invest in India. In 1992, the year FIIs were allowed to operate in the country, Mauritius enacted its Offshore Business Activities Act.

This Act, among other things, provides a range of facilities to foreign corporate entities wishing to invest in India.

These include fast incorporation of companies (within a fortnight), total exemption from payment of capital gains taxes over and above a fully convertible currency. Mauritius has large numbers of lawyers and accountants who assure complete secrecy to foreign investors (like the Swiss banks used to do in their heydays) -- the salubrious climate and the golden beaches are merely the icing on the cake.

Estimates vary, but the extent of loss of capital gains taxes which would have been paid had FIIs and their sub-account holders been incorporated in India vary between Rs 5,000 crore and Rs 10,000 crore. A complete conspiracy of silence has prevailed over the manner in which the Mauritius route has been used to launder black money generated in India. Few economists, leave alone government officials or politicians, are willing to go on record criticising the modus operandi of such activities on the plea that it would jeopardise relations with a friendly nation.

A rare exception is economist S L Rao, former head of the Central Electricity Regulatory Authority and the National Council for Applied Economic Research. In an interview conducted in 1995, this is what Rao had told this correspondent: "In my view, the entire episode is scandalous.

It is a matter of serious concern if certain Mauritius-based FIIs, which are nothing but nameplate companies, can get away without paying any tax. This is a way of encouraging hot money flows which the country can do without."

Individuals like Rao have suggested that the Mauritius loophole can be easily plugged should the Indian authorities want to. A simple way to do this would be to levy a flat "service charge" of, say, 10 per cent on all outflows of capital gains made by FIIs which are repatriated within a particular time frame, for example, one year.

Far from initiating measures to plug these glaring loopholes, the Union Ministry of Finance has bent over backwards to accommodate the interests of FIIs in this respect. One important reason why the India-Mauritius DTAT facilitates nefarious transactions is the somewhat ambiguous definition of a company's resident status in Mauritius. The treaty states that a company is considered to be "based in Mauritius" if its "effective management" is located in that island nation.

In late-March 2000, a group of officials in the income tax department of the Central Board of Direct Taxes (CBDT) decided to review the tax exemptions granted to a handful of Mauritius-based FIIs and slapped show-cause notices on them asking them to pay tax arrears since 1997. The Indian tax authorities had, in the past, rejected the claims of some two dozen companies that had argued that their "effective management" was in Mauritius.

This time round, however, all hell broke loose.

A Mumbai-based tax consultancy outfit issued a "red alert" to all FIIs that their profits were going to be taxed and the sensitive index of the Bombay Stock Exchange collapsed like a pack of cards in early-April. None other than Union Finance Minister Yashwant Sinha reportedly panicked when he was told horror stories about how foreign investors were packing their bags to leave India. The tax assessment proceedings were immediately stalled.

On 13 April that year, the CBDT issued a new circular "clarifying" the government's position that a certificate of residence issued by the Mauritius government would be "adequate evidence" that a company's effective management was located in Mauritius. The Indian government claimed that this circular reiterated a point made in an earlier circular issued in March 1994, namely, that any resident of Mauritius deriving income from alienation of shares of Indian companies would be liable to pay capital gains tax only in Mauritius and would not have any such tax liability in India.

The story does not end here. High-powered delegations came to India from Mauritius and vice versa. For instance, in December 2000, after meeting Finance Minister Sinha, the Economic Development Minister of Mauritius Sushil K C Khushiram told journalists that "the double taxation agreement between the two countries is working well and there is no question of amending or altering it."

Not surprisingly, the Mauritius minister disagreed with the suggestion that his country was being used to launder illegal funds and route them to Indian stockmarkets.

"We are seen as a clean and credible financial centre with effective regulation," he added, pointing out that Mauritius had in June 1999 enacted legislation to check money laundering and economic offences.

What is more, the minister said the island nation had been excluded from a "black-list" that had earlier been prepared by the powerful club of developed countries, that is, the Paris-based Organisation of Economic Cooperation and Development (OECD). Earlier, from 1998 onwards, the Forum on Financial Stability based in Basel under the OECD had been engaged in an exercise to identify countries indulging in "harmful tax practices" and had named Mauritius as one such country.

Thereafter, in June 2000, thanks to the persistent prodding of the OECD, six countries including Mauritius (the others being Bermuda, the Cayman Islands, Cyprus, Malta and San Marino) agreed to end tax practices which had conferred on them the status of "tax havens" over a period of five years. The then US Treasury Secretary Lawrence Summers described the announcement as an "important milestone" in the international effort to "put an end to . tax practices that encourage tax evasion and improper tax avoidance which) distort capital flows."

In India, despite the best efforts of the Finance Minister and his senior bureaucrats ensconced in North Block, a different drama was being enacted under their very nose involving a relatively unknown official body, the Authority on Advance Rulings (AAR) which operates under the CBDT. The AAR, which in 1997 had claimed that the India-Mauritius DTAT was not a tax-avoidance tool but served to promote investment in India while helping the economy of friendly Mauritius, decided to do an about-turn in a case involving the TCW-ICICI India Equity Fund based in Mauritius.

In April 2001, in a landmark ruling, the AAR effectively reversed the position taken by the income tax department on taxing capital gains of corporate entities and sub-accounts of Mauritius-based FIIs operating in India. The AAR ruled that the gains accruing from the sale of shares by the Mauritius-based private equity fund, in this case, the one set up by TCW-ICICI, would be treated as business profits and not capital gains.

Only if a corporate entity did not have a permanent establishment in India would its business profits be taxed in Mauritius and not in India, the AAR ruled. In its judgement, the AAR said it had considered all aspects of the structure of a private equity fund and on the "basis of facts", ruled that both the investment advisor and the custodian of the fund "were acting in the ordinary course of business and were agents of independent status".

It remains to be seen whether the JPC investigating the stockmarket scandal would accept SEBI's recommendation to plug the Mauritius loophole. More importantly, even if such advice is given, it is not clear whether the powers-that-be in New Delhi would "offend" their friends in Mauritius by changing this country's tax laws in a manner in which it would become unnecessary for FIIs and other foreign investors to come to India only via Mauritius.

It is not just SEBI but different organs of the Union government and the Ministry of Finance (such as the Directorate of Revenue Intelligence, the Economic Intelligence Bureau and the Enforcement Directorate, Foreign Exchange Management Act) that have, for many years now, been aware of the manner in which the provisions of the India-Mauritius DTAT have been (and still are) abused with impunity.

Having stated what it has in such black-and-white terms, the SEBI report remains strangely reticent about what needs to be done to check such blatant manipulation of share prices. Perhaps the authors of the SEBI report believe the government of India and the JPC will not do a damn thing to check this form of market rigging.

If indeed this is correct, this author regrets to state that he shares such a cynical perception. Too much is at stake, not merely cordial relations with a friendly country. What is involved is the ill-gotten loot of India's politicians, bureaucrats and businesspersons. This powerful elite will collude to ensure that the Mauritius route will remain wide open to launder black money, JPC or no JPC.

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