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HARMFUL TAX COMPETITION: A SPECIAL REFERENCE TO
MAURITIUS INVESTMENT
A SPECIAL REF. TO
MAURITIUS INVEST.
HARMFUL
TAX
COMPETITION
ssssss
PRESENTED BY
HILAL AHMAD MALLA
2
Introduction
“Competition among nations tends to produce a race to the top rather than to the bottom by limiting the
ability of powerful and voracious groups and politicians in each nation to impose their will at the expense of
the interests of the vast majority of their populations.”
The growing globalization of the world economy and the consequent vanishing of national
borders in cross border trade have resulted in an increasing mobility of economic activities.
There are many different economic, social and institutional factors influencing the
competitive position of a country and the investment decision taken by companies and
individuals. Taxation is normally just one of these factors. However, the rise in mobility of
economic activities and the disappearance of various international and legal impediments to
cross border trade have significantly increased the importance of the tax factor. This has been
at the expense of other factors that have traditionally tendered to determine location
decisions, for example the infrastructure of a country. This is particularly true in the case of
economic activities, such as financial services, that can be easily relocated to another country.
In these situations, the differences between countries, national taxation rapidly result in
economic activities moving to the country with the lowest effective burden.
This increased mobility has resulted in sharp increase in the tax competition between
countries, with each government seeking to attract or retain economic activities by creating a
favorable tax climate able to compete with those of other countries. These developments
have been particularly marked within the European Union, partly because of the creation
of common market and the introduction of the euro and partly because of the ever-increasing
integration of the policy in other areas. As a result direct taxation is now one of the most
important economic tools left available to the member states available at National Level.
In certain countries, tax competition has laid to tax reform, with tax bases being broadened
and the tax rates cut. Other countries have introduced preferential tax regimes, which
provide low effective tax rates for specific mobile business activities such as group
financing? The increasing tax competition emphasized the direct effects of such competition,
for example a healthy downward pressure on overall tax levels and a reduction in govt. size,
whilst opponents pointed to the undesired or harmful effects of certain forms of tax
competition such as the erosion of tax bases, a shift of the tax burden from capital to labour
and distortion of the market mechanisms. According to these opponents, the later situation
should be combated by taking countermeasures.
3
So the aim and objective is to prevent the downward pressure on overall tax levels, erosion of
tax bases, a shift of tax burden from capital to labour and distortion of the market mechanism,
this is what we call Harmful Tax Competition.
MEANING AND DEFINITION OF TAX COMPETITION
Tax competition, a form of regulatory competition, exists when governments are encouraged
to lower fiscal burdens to either encourage the inflow of productive resources or discourage
the exodus of those resources. Often, this means a governmental strategy of attracting foreign
direct investment, foreign indirect investment (financial investment), and high value human
resources by minimizing the overall taxation level and/or special tax preferences, creating a
comparative advantage. Some observers suggest that tax competition is generally a central
part of a government policy for improving the lot of labour by creating well-paid jobs (often
in countries or regions with very limited job prospects). Others suggest that it is beneficial
mainly for investors, as workers could have been better paid (both through lower taxation on
them, and through higher redistribution of wealth) if it was not for tax competition lowering
taxation on corporation. Many economists also argue that tax competition is beneficial in
raising total tax intake due to low corporate tax rates stimulating economic growth.1
It has also been argued that just as competition is good for businesses, competition is good
for governments as it drives efficiencies and good governance of the public budget.2
HISTORY OF TAX COMPITITION
From the mid 1900s governments had more freedom in setting their taxes as the barriers to
free movement of capital and people were high. The gradual process of globalization is
lowering these barriers and results in rising capital flows and greater manpower mobility.
The European Union (EU) illustrates the role of tax competition. The barriers to free
movement of capital and people were reduced close to nonexistence. Some countries (e.g.
Republic of Ireland) utilized their low levels of corporate tax to attract large amounts of
foreign investment while paying for the necessary infrastructure (roads, telecommunication)
from EU funds. The net contributors (like Germany) strongly oppose the idea of
1 Brill, Alex; Hassett, Kevin (31 July 2007), "Revenue Maximising Corporate Income Taxes: The Laffer Curve in OECD Countries",
Working paper 137 (American Express Institute).
2Hines, James R. (2005), "Do Tax Havens Flourish?", Tax Policy and the Economy (Cambridge, MA: MIT Press)
4
infrastructure transfers to low tax countries. Net contributors have not complained, however,
about recipient nations such as Greece and Portugal, which have kept taxes high and not
prospered. EU integration brings continuing pressure for consumption tax harmonization as
well. EU member nations must have a value-added tax (VAT) of at least 15 percent (the main
VAT band) and limits the set of products and services that can be included in the preferential
tax band. Still this policy does not stop people utilizing the difference in VAT levels when
purchasing certain goods (e.g. cars). The contributing factor is the single currency (Euro),
growth of e-commerce and geographical proximity. The political pressure for tax
harmonization extends beyond EU borders. Some neighboring countries with special tax
regimes (e.g. Switzerland) were already forced to some concessions in this area.
With tax competition in the era of globalization politicians have to keep tax rates
“reasonable” to dissuade workers and investors from moving to a lower tax environment.
Most countries started to reform their tax policies to improve their competitiveness. However,
the tax burden is just one part of a complex formula describing national competitiveness. The
other criteria like total manpower cost, labor market flexibility, education levels, political
stability, legal system stability and efficiency are also important. Governments typically react
with "carrot-and-stick" policies such as:3
reduction of both personal and corporate income tax rates
tax breaks/holidays (i.e. time limited tax exemptions)
favorable tax policies for non-residents
raising the barriers to free movement of capital
not allowing companies domiciled in tax havens to bid for public contracts
Political pressure on lower tax countries to “harmonize” (i.e. rise) their taxes.
3 Ruding report. P.29
5
CHAPTER 1
TAX COMPETITION: A GLOBAL PHENOMENON
Introduction
Globalization is one of the greatest economic events of the 20th century. It has positive
effects on the development of tax systems and has encouraged countries to engage in base
broadening and rate reducing tax reforms. However, it has also created an environment in
which tax havens thrive and jurisdictions are induced to adopt harmful preferential tax
regimes to attract mobile activities. This tax competition in the form of harmful tax practices
can distort trade and investment patterns, erode national tax bases, thus adversely affecting
and undermining the fairness of tax structures. Further, if this undercutting continues,
business location and financing decisions could become primarily tax driven and real
economic factors would take a backseat in business decisions.
The impact of these developments has already been quite significant. For example, foreign
direct investment by G7 countries through low-tax jurisdictions, increased to more than
US$200 billion over the period 1985-1994 and the rate of increase is well above that of total
outbound foreign direct investment by the G7. The accelerating process of globalization of
trade and investment has fundamentally changed the relationship among domestic tax
systems. Globalization has also been one of the driving forces behind tax reforms, which
have focused on base broadening and rate reductions, thereby minimizing tax induced
distortions. Globalization has also encouraged countries to assess continually their tax
systems and public expenditures with a view to making adjustments where appropriate to
improve the “fiscal climate” for investment. Globalization and the increased mobility of
capital has also promoted the development of capital and financial markets and has
encouraged countries to reduce tax barriers to capital flows and to modernize their tax
systems to reflect these developments. Many of these reforms have also addressed the need to
adapt tax systems to this new global environment. The process of globalization has led to
increased competition among businesses in the global market place. Multinational enterprises
(MNEs) are increasingly developing global strategies and their links with any one country are
becoming more tenuous. In addition, technological innovation has affected the way in which
MNEs are managed and made the physical location of management and other service
activities much less important to the MNE. International financial markets continue to
6
expand, a development that facilitates global welfare-enhancing cross-border capital flows.
This process has improved welfare and living standards around the world by creating a more
efficient allocation and utilization of resources.
As mentioned above, globalization has had a positive effect on the development of tax
systems. Globalization has, however, also had the negative effects of opening up new ways
by which companies and individuals can minimize and avoid taxes and in which countries
can exploit these new opportunities by developing tax policies aimed primarily at diverting
financial and other geographically mobile capital. These actions induce potential distortions
in the patterns of trade and investment and reduce global welfare. As discussed in detail
below, these schemes can erode national tax bases of other countries, may alter the structure
of taxation (by shifting part of the tax burden from mobile to relatively immobile factors and
from income to consumption) and may hamper the application of progressive tax rates and
the achievement of redistributive goals. Pressure of this sort can result in changes in tax
structures in which all countries may be forced by spillover effects to modify their tax bases,
even though a more desirable result could have been achieved through intensifying
international co-operation. More generally, tax policies in one economy are now more likely
to have repercussions on other economies. These new pressures on tax systems apply to both
business income in the corporate sector and to personal investment income.4
Tax havens or harmful preferential tax regimes that drive the effective tax rate levied on
income from the mobile activities significantly below rates in other countries have the
potential to cause harm by:
Distorting financial and, indirectly, real investment flows;
Undermining the integrity and fairness of tax structures;
Discouraging compliance by all taxpayers;
Re-shaping the desired level and mix of taxes and public spending;
Causing undesired shifts of part of the tax burden to less mobile tax bases, such as
labour, property and consumption,
Increasing the administrative costs and compliance burdens on tax authorities and
taxpayers.
4 OECD report ,455
7
What is considered harmful tax competition in the different states of the
world?
Various developments have contributed to an increase in the phenomenon of tax competition,
as outlined in the introduction to the previous chapter. The main causes of competition are
discussed in more detail below, with a distinction being drawn between general, worldwide
developments on the one hand and specific developments within the EU on the other hand.
5Over the past few decades the economy has become increasingly globalized .the vanishing
of national borders in cross-border trade ,the lifting of restrictions on capital markets and also
technical innovation have all contributed to a massive growth in international trade and
capital flows. This growth has in turn led to an increase in the mobility of certain economic
activities. Globalization results in a variety of different consequences. On the one hand there
are the positive consequences such as a more efficient allocation of production factors,6 a
more extensive range of goods available, a reduction in the costs of capital, a reduction in
transport costs and greater exchange of information and knowledge7.on the other hand;
however there are also certain negative consequences. Rising international trade volumes and
greater mobility of economic activities have led to external factors and undesired side effects
having a cross border impact on production and consumption, for example increasing
pressure on environment. In this sense globalization has contributed to transforming what
were previously national issues into international issues. It has therefore, become more
difficult for governments to pursue purely national policies. This tendency can also be clearly
perceived in respect of the levying of taxes.
Many countries’ tax systems date back to an era when companies were largely closed, with
limited cross border movements of goods and capital. Cross border trade flows were
frequently discouraged by protectionist import duties or physical barriers (for example,
limited availability of transportation), whilst capital flows controlled. As a result businesses
and individuals normally generated almost all of their income from activities or investments
in their countries of residence. Income and expenditure flows were largely restricted to a
single national economy, thus enabling tax to be levied in one country without conflicting
5 "Organisation for European Economic Co-operation", OECD. Retrieved 2008-07.
6 Cf .OECD Report, 522
7 The impact of economic globalization on taxation by TANZI V
8
with the levying of tax with the other country. Globalization has fundamentally changed the
relationship between national tax systems and their impact upon each other. Whereas in the
past governments could pursue national tax policies without regard for development in other
countries, they have now lost an element of their freedom to make policy since they now
have to take account of the cross border consequences( spill-over effects )of any taxes they
may propose or levy. These effects are reflected in various ways and at various levels of
taxation.
There are many economic, social and institutional factors affecting a country’s competitive
position and therefore the willingness of businesses and individuals to invest. Tax is normally
just one of these factors.8 In addition to tax, the political and economic stability of a country,
its social physical and communication infrastructures, the existing and potential size of a
market sector, labour costs, the availability of a skilled workforce and the size of financial
sector etc. are all factors influencing the choice of location. Increased mobility has, however,
led to the sharp increase in the importance of a tax as a factor, and this has been at the
expense of the more traditional reason for choosing a location.9 The types of economic
activity concerned are mainly those which can easily be relocated from one country to
another, such as capital (i.e. investments and savings), financial services, insurance and
leasing activities, patents and licensing management and highly skilled work. (E.g. in the
field of management, information and communications technology and research and
development).In these cases, the rate of tax levied by a country can be of vital importance in
respect of investment and location decisions.
FORMS OF TAX COMPETITION
In general terms, tax competition can be defined as:
Improving the relative competition position of one country vis-à-vis other countries by
reducing the tax burden on businesses and individuals in order to retain, gain or regain mobile
economic activities and the corresponding tax base. Tax competition can arise many different
ways. Tax measures designed to reduce the effective tax burden can be introduced in a
country in the form of legislative or administrative provisions or administrative practices.
Such measures can relate to both direct and indirect taxes, levied at either national
8 See OECD report.s6 9 See pinto, c EU and OECD to find Harmful tax competition :has the right path been undertaken.vol 26-12..p
.394
9
government or local government (I.e. Provincial or municipal) levels. A distinction can be
drawn generic and specific tax measures. Generic measures are those designed to achieve an
overall improvement in a country’s fiscal competitive position, for example a wide- ranging
programme of tax reforms. These could take the form, for instance, of a general reduction in
a country’s corporation tax rate.
The most striking example of a generic tax measure in the EU is Ireland’s is Ireland’s
reduction in its corporation tax rate to 12.5% as of 1st January 2003. Specific measures, which
are also referred to as 12.5% as of first January 2003.specific measures which are also
referred to as preferential tax measures are in contrast designed to improve the competitive
position of specific sector in a country’s economy for the primary purpose of attracting
mobile economic activities.
Consequences of tax competition
Tax competition has been found to be on the increase between EU member states. Depending
on the form in which tax competition appears and the perspective from which it is considered,
the consequences of tax competition may be either desirable or undesirable, as the following
simple example illustrates.10
Continent x comprises the countries A and B. Country A is a large, rich country with
substantial Capital and capital income and a high level of collective provisions. In the starting
situation, both countries levy corporate income tax of 35%.
Starting situation
Country A B Total
C.I.T Rate 35% 35% 35 % (average)
Taxable capital income 1000 100 1100
Tax revenues 350 35 385
In an attempt to strengthen its position as a financial centre, Country B then decides to
introduce special regulation for capital income by cutting its corporate income tax rate from
35 % to 10 % this makes it attractive for investments in tangible assets in country A to be
financed from country B and for investment to be transferred to companies registered in
10 Example taken from Daniel,A.H.M
10
country B. if , for example , this preferential treatment were to result in half of the total
capital being transferred from Country A to Country B. the position will be as follows:
Situation after introduction of preferential tax regime:
Country A B TOTAL
CIT rate 35% 10% 21%
Taxable capital income 500% 600% 1100%
Tax revenues 175 60 235
The change in tax rates results in a 25% increase in Country B’s tax revenues, whilst country
A’s tax revenues are halved. This fall in tax revenue will have to be compensated by an
increase in country A’s tax on non –mobile factors, an increase in govt. borrowings or by
reduction in public spending.
Position of harmful tax competition in India
Developing nations like India are also not unaffected of these developments. A significant
portion of the foreign institutional and foreign direct investments are structured through low-
tax jurisdictions resulting in loss of revenue especially in form of capital gain taxes. This is
evident in the ongoing controversy of applicability of beneficial provisions of India's treaty
with certain low-tax jurisdictions, where enterprises investing in India are availing these
benefits merely by registering themselves in such jurisdictions without having any substantial
presence.
In this regard, it is pertinent to note the proposed amendments in tax laws of Mauritius (being
one of the countries which has made an 'advance commitment'), whereby with effect from 1st
July 2000, the tax rate for all offshore corporations will be flat 15% as against optional tax @
0-35% on all offshore companies incorporated before July 1, 1998. Further, the deemed
foreign tax credit of 90% is proposed to be reduced to 80% and may be reduced even further
in future.
11
CHAPTER 2
FACTORS TO IDENTIFY TAX HAVENS AND HARMFUL
PREFERENTIAL TAX REGIMES!
INTRODUCTION
This Chapter discusses the factors to be used in identifying, tax-haven jurisdictions and
harmful preferential tax regimes in non-haven jurisdictions. It focuses on identifying the
factors that enable tax havens and harmful preferential tax regimes in OECD Member and
non-member countries to attract highly mobile activities, such as financial and other service
activities. The Chapter provides practical guidelines to assist governments in identifying tax
havens and in distinguishing between acceptable and harmful preferential tax regimes.
The Chapter takes a necessary and practical step towards explaining further why governments
are concerned about harmful tax competition. It does this by first identifying and discussing
factors that characterize tax havens. It then discusses factors that may identify preferential tax
regimes that can be considered to lead to harmful tax competition.
At the outset, a distinction must be made between three broad categories of situations in
which the tax levied in one country on income from geographically mobile activities, such as
financial and other service activities, is lower than the tax that would be levied on the same
income in another country:11
The first country is a tax haven and, as such, generally imposes no or only nominal
tax on that income the first country collects significant revenues from tax imposed on
income at the individual or corporate level but its tax system has preferential features
that allow the relevant income to be subject to low or no taxation;
The first country collects significant revenues from tax imposed on income at the
individual or corporate level but the effective tax rate that is generally applicable at
that level in that country is lower than that levied in the second country.
11 http://www.oecd.org/document/58/0,3746,en_2649_201185_18894
12
All three categories of situations may have undesirable effects from the perspective of the
other country. Above, globalization has had a positive effect on the development of tax
systems, being, for instance, the driving force behind tax reforms which have focused on base
broadening and rate reductions, thereby minimizing tax induced distortions. Accordingly, and
insofar as the other factors referred to in this Chapter are not present, the issues arising in this
third category are outside the scope of this study. Any spillover effects for the revenue of the
other country may be dealt with by a variety of means at the unilateral or bilateral level It is
not intended to explicitly or implicitly suggest that there is some general minimum effective
rate of tax to be imposed on income below which a country would be considered to be
engaging in harmful tax competition.12
The first two categories, which are the focus of this chapter, are dealt with differently. While
the concept of “tax haven” does not have a precise technical meaning, it is recognized that a
useful distinction may be made between, on the one hand, countries that are able to finance
their public services with no or nominal income taxes and that offer themselves as places to
be used by non-residents to escape tax in their country of residence and, on the other hand,
countries which raise significant revenues from their income tax but whose tax system has
features constituting harmful tax competition. In the first case, the country has no interest in
trying to curb the “race to the bottom” with respect to income tax and is actively contributing
to the erosion of income tax revenues in other countries. For that reason, these countries are
unlikely to co-operate in curbing harmful tax competition. By contrast, in the second case, a
country may have a significant amount of revenues which are at risk from the spread of
harmful tax competition and it is therefore more likely to agree on concerted action. Because
of this difference, this Report distinguishes between jurisdictions in the first category, which
are referred to as tax havens, and jurisdictions in the second category, which are considered
as countries which have potentially harmful preferential tax regimes.. Many factors may
contribute to the classification of the actual or potential effects of tax practices as harmful.
Any evaluation should be based on an overall assessment of the relevant factors. The absence
of tax or a low effective tax rate on the relevant income is the starting point of any evaluation.
No or only nominal taxation combined with the fact that a country offers itself as a place, or
is perceived to be a place, to be used by non-residents to escape tax in their country of
residence may be sufficient to classify that jurisdiction as a tax haven. Similarly, no or only
12 "Shaping Policies for a Digital World". OECD (Retrieved 16-01-2010)
13
nominal taxation combined with serious limitations on the ability of other countries to obtain
information from that country for tax purposes would typically identify a tax haven. With
respect to preferential tax regimes, key factors, other than no or low effective taxation on the
relevant income, include: whether the regime is restricted to non-residents and whether it is
otherwise isolated from the domestic economy (i.e., ring-fencing), non-transparency and a
lack of access to information on taxpayers benefiting from a preferential tax regime.
TAX HAVENS
Many fiscally sovereign territories and countries use tax and non-tax incentives to attract
activities in the financial and other services sectors. These territories and countries offer the
foreign investor an environment with a no or only nominal taxation which is usually coupled
with a reduction in regulatory or administrative constraints. The activity is usually not subject
to information exchange because, for example, of strict bank secrecy provisions. Tax havens
generally rely on the existing global financial infrastructure and have traditionally facilitated
capital flows and improved financial market liquidity. Now that the non-haven countries have
liberalized and de-regulated their financial markets, any potential benefits brought about by
tax havens in this connection are more than offset by their adverse tax effects. Since tax and
non-tax advantages tend to divert financial capital away from other countries, tax havens
have a large adverse impact on the revenue bases of other countries. Because tax havens offer
a way to minimize taxes and to obtain financial confidentiality, tax havens are appealing to
corporate and individual investors. Tax havens serve three main purposes: they provide a
location for holding passive investments (“money boxes”); they provide a location where
“paper” profits can be booked; and they enable the affairs of taxpayers, particularly their
bank accounts, to be effectively shielded from scrutiny by tax authorities of other countries.
All of these functions may potentially cause harm to the tax systems of other countries as
they facilitate both corporate and individual income tax avoidance and evasion.13
A 1987 Report by the OECD recognized the difficulties involved in providing an objective
definition of a tax haven1. That Report concluded that a good indicator that a country is
playing the role of a tax haven is where the country or territory offers itself or is generally
recognized as a tax haven. While this is known as the “reputation test”, the present Report
sets out various factors to identify tax havens.
13 Text of the OECD Guidelines for Multinational Enterprises
14
HOW TO IDENTIFY TAX HAVENS
The necessary starting point to identify a tax haven is to ask (a) Whether a jurisdiction
imposes no or only nominal taxes (generally or in special circumstances) and offers itself, or
is perceived to offer itself, as a place to be used by non-residents to escape tax in their
country of residence. Other key factors which can confirm the existence of a tax haven (b)
laws or administrative practices which prevent the effective exchange of relevant information
with other governments on taxpayers benefiting from the low or no tax jurisdiction; (c) lack
of transparency and (d) the absence of a requirement that the activity be substantial, since it
would suggest that a jurisdiction may be attempting to attract investment or transactions that
are purely tax driven (transactions may be booked there without the requirement of adding
value so that there is little real activity, i.e. these jurisdictions are essentially “booking
centres”). 14
Only nominal taxation is a necessary condition for the identification of a tax haven. if
combined with a situation where the jurisdiction offers or is perceived to offer itself as a
place where non-residents can escape tax in their country of residence, it may be sufficient to
identify a tax haven.
14 "17 countries call for new 'tax haven blacklist'". EURO News. 2008-10-22. Retrieved 2008-10-22.
15
KEY FACTORS IN IDENTIFYING TAX HAVENS FOR THE
a) No or only nominal taxes
No or only nominal taxation on the relevant income is the starting point to classify a jurisdiction
as a tax haven.
b) Lack of effective exchange of information
Tax havens typically have in place laws or administrative practices under which businesses and
individuals can benefit from strict secrecy rules and other protections against scrutiny by tax
authorities thereby preventing the effective exchange of information on taxpayers benefiting
from the low tax jurisdiction.
c) Lack of transparency
A lack of transparency in the operation of the legislative, legal or administrative provisions is
another factor in identifying tax havens.
d) No substantial activities
The absence of a requirement that the activity be substantial is important since it would suggest
that a jurisdiction may be attempting to attract investment or transactions that are purely tax
driven.
In general, the importance of each of the other key factors referred to above very much
depends on the particular context. Even if the tax haven does impose tax, the definition of
domestic source income may be so restricted as to result in very little income being taxed.
16
CHAPTER 3
MAURITIUS INVESTMENT
INTRODUCTION
THE logic of a liberal economic regime can result in apparent paradoxes. Mauritius, a tiny
speck in the Indian Ocean, with a population of 1.2 million and an economy one-hundredth
the size of the Indian economy, is the biggest exporter of capital to India.
The use of Mauritius as a gateway to funnel foreign investments into India has always been
controversial. The island nation's financial regime, endowed with the key characteristics of a
quasi tax haven, has facilitated this. Curiously, successive Indian governments, which have
cried themselves hoarse about a runaway fiscal deficit and a resource crunch, have indulged
in self-denial and have refused to tax the earnings of these foreign entities. But the issue is
much more than lost revenues. The question is of equity. Can ordinary citizens be asked to
pay taxes even as a small body of foreign-based entities is not even asked to pay a fraction of
their earnings made through speculation on Indian soil? Although the Supreme Court on
October 7 quelled the legal challenge to the government's refusal to clamp down on the
Mauritius gateway, the controversy refuses to die.
The key to the apparent paradox lies in the provisions of a two-decade-old bilateral
agreement, the Double Taxation Avoidance Convention (DTAC). Foreign entities have set
up paper companies in Mauritius, claiming to be Mauritian residents. These companies,
masquerading as Mauritian companies, have invested in India. And, taking advantage of the
DTAC they avoid paying any taxes in India. They pay no taxes in Mauritius too.
MAURITIUS A SOURCE OF INVESTMENT
Mauritius is the single biggest source of foreign direct investment (FDI) in India - amounting
to $534 million in 2002-03 (about one-third of all FDI). But that is not all. Mauritius-based
foreign institutional investors (FII) are also believed to be major players in the Indian
bourses. FII investment in Indian stock markets between April and October this year
amounted to almost $5 billion - almost ten times what they invested in the whole of the last
financial year. Indeed, they are believed to be the ones leading the current boom in the stock
markets. But the Mauritius angle does not end there. Reports in the financial media indicate
that a substantial part of FII investment is believed to be coming from Non-resident Indians
17
(NRIs) bringing back funds to participate in the ongoing speculative orgy in the Indian stock
markets, much of which is said to be routed through Mauritius-based paper companies.
Mauritius is also reportedly the base of much of the hedge funds that are reported to be
active in the current boom. Hedge funds, which deploy large volumes of funds in thin
arbitrage deals made for very short-term gains, account for at least 30 per cent of the FII
activity in the ongoing boom in the bourses. These entities, using the device of Participatory
Notes, and dealing through the sub-accounts of the FIIs, which need not be registered with
regulatory agencies such as the Securities and Exchange Board of India (SEBI) or the
Reserve Bank of India (RBI), constitute the core of the speculative excess that is currently on.
This bout of speculation is not confined to the stock markets. In fact, from an economic
perspective, this boom is far more dangerous than previous episodes because these players
are betting simultaneously in several markets. While bringing in dollar denominated funds
and thereby adding to the burgeoning foreign exchange reserves, currently amounting to over
$90 billion, they are betting in stocks, the Indian currency and also speculating on the interest
rates, all at the same time. That Mauritius is a home base for all this is common knowledge.
The lack of regulatory oversight means that one is unable to quantify the funds coming in
from the tax haven. Although the losses to the government are difficult to estimate, primarily
because it is difficult to ascertain how much comes through the Mauritius route, it is reckoned
that the potential losses because of the loophole could run into several thousand crores since
1991, when India opened the floodgates to foreign investment. The government has
repeatedly fought shy of taking on foreign investors. Instead, it has restrained its own arm,
the Income Tax (I.T.) Department, from investigating the misuse of the bilateral agreement
by foreign investors.
ALTHOUGH successive governments have refused to plug the loopholes in the DTAC,
Indian regulators have always viewed them with suspicion. In late March 2000, officials in
the I.T. Department in Mumbai investigated 24 Mauritius-based entities and issued
"assessment orders" on them. The officers, racing against time to file their orders before the
March 31 deadline, were basically engaged in lifting the corporate veil covering these
entities. For instance, the I.T. Department's assessment of Cox and Kings Overseas Funds
(Mauritius), made on March 29, 2000 for the company's assessment year 1997-98, showed
that the company was in fact a subsidiary of Cox and Kings Overseas Fund Incorporated in
Luxembourg. The assessment order revealed that the company routed its investment through
18
Mauritius because "it realized that if it directly made investments in India, it will be liable to
pay Indian income tax on investment including capital gains". Aware that if investments were
made through a Mauritius-based company it would not have to pay taxes in India, it floated a
fully owned subsidiary in the island nation. In 1994, Cox and Kings incorporated the
subsidiary in Mauritius. It hired professional consultants, who were readily available for hire
in Mauritius, to serve on the subsidiary's board. The subsidiary's business of investing funds
in India was handled entirely by J. Henry Schroeder Bank AG, based in Switzerland.
The sole business of the subsidiary in Mauritius was to undertake investments outside
Mauritius. In fact, Mauritius laws proscribed it from acquiring property or raising funds in the
country. In fact it was not allowed to engage in any kind of business activity in Mauritius.
Thus, the I.T. Department found that the company's sole motive for existence as an entity in
Mauritius was to enable it to funnel investments overseas, particularly India. On the basis of
its investigation, the I.T. Department's assessment order observed that "the real control of
affairs of the Mauritian company is in the hands of the holding company incorporated outside
Mauritius". It also noted that "the Mauritian subsidiary has been created with the main
purpose to avoid tax". On the basis of its investigation of 24 cases, including Cox and Kings,
the I.T. Department thus issued show-cause notices to them. It pointed out that they were not
eligible for benefits of the DTAC since they were "not bona fide and genuine residents of
Mauritius". The department also alleged that the abuse of the DTAC by entities from third
countries amounted to "treaty shopping".
Soon after the orders were served on the FIIs, all hell broke loose. Amidst the controversy
there were also allegations that the then Union Minister for Finance Yashwant Sinha's
daughter-in-law was working for a Mauritius-based FII investing in India. The lobbies went
into overdrive and there were dark hints that the stock market would collapse because FIIs
would pull out of the Indian markets. On April 13, 2000, the Central Board of Direct Taxes,
the apex body governing the Income Tax Department, issued Circular Number 789, which
has since then been a subject of fierce litigation. The circular "clarified" that the production
of a "certificate of residence" issued by the Mauritius authorities would "constitute sufficient
evidence for accepting the status of residence as well as beneficial ownership for applying the
DTAC accordingly". It also clarified that FIIs and other entities based in Mauritius "should
not be taxable in India on income from capital gains arising in India".
19
The Joint Parliamentary Committee (JPC) probe into the 2001 stock market scam, in which
the broker Ketan Parekh was the kingpin, revealed large-scale abuse of Mauritius-based
entities. It revealed that Overseas Corporate Bodies (OCB), which are primarily vehicles
floated by NRIs but which can act as fronts for other foreign investors, acted in concert with
Ketan Parekh to siphon funds out of the country. In fact, there were allegations that Yashwant
Sinha kept the Mauritius gate wide open so that speculators could avoid paying taxes in India.
In fact, in his written submission to the JPC, after he was no longer Finance Minister, Sinha
said that the revenue losses on account of the abuse of the Mauritius route were only
"notional". In fact, he admitted that although he was aware of the abuse of the route, he did
not plug the holes in the DTAC because the inflow of foreign investments was considered
more important than raising revenue.
THE CBDT circular was challenged in the Delhi High Court by public interest petitions
filed by the Azadi Bachao Andolan (represented by Prashanth Bhushan) and a former Chief
Commissioner of Income Tax, Shiva Kant Jha. The latter, who is also an advocate with the
Supreme Court Bar, argued that the Government of Mauritius, through "reforms" undertaken
in the early 1990s, had transformed its legal and financial system into a veritable tax haven
(see interview). He said that third-country entities were using the provisions of the DTAC to
establish "conduit companies" in Mauritius and using them as vehicles to invest in India with
the sole objective of dodging tax in India. Shiva Kant Jha pointed out that the CBDT circular,
by asking I.T. officers to accept at face value the "certificate of residence" provided by the
Mauritian authorities, effectively curtailed their ability to investigate whether they were really
residents of Mauritius. He pointed out that the circular prevented officers from discharging
their duties by "investigating the matrix of facts to determine whether a company seeking
benefits under the convention was really a Mauritian resident". Shiva Kant Jha pointed out
that the Mauritius-based entities were not paying any capital gains tax either in India or in
Mauritius. He said that although Section 90 of the Income Tax Act provided the government
with the authority to enter into agreements with other countries, these powers were
specifically for entering into agreements on double taxation, that is, the elimination of a
similar tax on the same set of entities for identical transactions in two different locations. Jha
pointed out that the DTAC was meant to prevent double taxation, not tax evasion or
avoidance. He also said that the government had failed to discharge its duties by causing
wrongful revenue losses.
20
In May 2002, the Delhi High Court struck down circular 78915
. It observed that it was the
duty of the I.T. Department to find out whether an assessee was taking shelter under the
DTAC to avoid tax. In this, it was well within its right to make every endeavor to lift the
corporate veil to find the true intent of these entities. It also observed that the abuse of a
treaty or "treaty shopping" to "be illegal and thus necessarily forbidden".
The government filed an appeal against the High Court order in the Supreme Court in
October 2002. A consortium of international investors, represented by the Global Business
Institute (GBI), joined the government in filing the appeal. Interestingly, in February 2003,
Arun Jaitley, currently Union Minister for Law and Justice and Commerce and Industry, who
at that time was not a member of the Cabinet, donned his lawyer's robes to appear on behalf
of the GBI. In its judgment, the Supreme Court ruled that it was the sovereign right of the
state to enter into treaties with other countries. By taking a technical approach, the court ruled
that Mauritius-based companies were liable to pay tax in Mauritius; it just so happens that
they are not levied taxes there. It also ruled that the certificate of residence could not be
disputed because as a sovereign state Mauritius had the power to determine who ought to be a
resident of that nation. However, the Supreme Court observed that the Indo-Mauritius DTAC
was in marked contrast to the Indo-U.S. DTAC. Shiva Kant Jha had pointed out that the Indo-
U.S. DTAC provided for credits for taxes paid in either country, but had a specific provision
that barred third-country entities from taking advantage of the bilateral treaty.
HOW much has the Indian state lost in revenues? Data are hard to come by to make an
accurate estimate. However, one can hazard a guess on the basis of the value of securities
sold by FIIs. The long-term capital gains tax, applicable on investments sold after holding
them for more than a year, is at the rate of 10 per cent. Short-term rates are applied at the
rate of 30 per cent when investments are liquidated. It is well known that the bulk of the FII
investments are routed through Mauritius. Applying a uniform rate of 10 per cent capital
gains tax on the gross sales made by FIIs would give at the very least a ballpark figure.
Although it can be argued that this would overestimate the extent of lost revenue because it
would not account for losses that FIIs made when they made sales, the fact that short-term
capital gains are not being factored into the estimate offsets this reasonably.
15 Income Tax Department, issued Circular Number
21
On the basis of the figures presented in the table the losses to the exchequer on account of
lost capital gains tax in the last decade would amount to a whopping Rs.28, 139 crores. Even
if it is an admitted policy of the state to woo foreign capital at any cost, the question is
whether losses of this kind are acceptable to the polity at large. The average annual loss to the
exchequer amounts to over Rs.2, 300 crores. To get some idea of the magnitude of these
losses in relation to the Union Budget, these magnitudes amount to roughly 10 per cent of the
gross tax revenues of the Union projected for 2003-04. To put it more provocatively, in the
context of the ongoing controversy surrounding the privatization programme, the extent of
lost revenues could easily have saved companies such as Balco, VSNL, IPCL and several
others from being sold off to private parties; indeed, privatization as an option would appear
irrational if the executive chose not to forgo these taxes.
Tax havens are an important feature of the globalised world of financial speculation. Shiva
Kant Jha believes that there is tension between the needs of the globalised system and the
sovereignty of nation states. While financial entities want to move funds across a seamless
world at will, nation states are finding that their traditionally accepted sovereign right to tax
any economic entities active within their frontiers is increasingly coming under pressure from
powerful players in the financial world. The rise of Mauritius as a tax haven in the 1990s,
specializing in funneling investments into India, reflects this reality. It is obvious that
successive Indian governments have chosen to let this happen while creating two sets of tax
payers within India - a privileged set of foreign entities who pay no taxes even as they engage
in speculative excesses and ordinary Indians who have to pay taxes. Some would even regard
the "notional" tax losses as subsidies paid to the well-heeled.16
Conclusion
Based on the research done on this project the following overall conclusion can be drawn.
Harmful tax competition has become a major issue in the whole world. Globalization has
acted as a catalyst in integrating economies, dissolving political boundaries and changing
system of governance, politics, finance, trade and investment. Now the World is witnessing
reduced trade barriers, loosened exchange control, increased mobility of capital, skilled labor
and other factors of production. This has led to increased competition amongst countries
(similar to businesses competing domestically) to attract trade and investment.
16 http://www.frontlineonnet.com/fl2023/stories/20031121002108900.htm
22
There are many factors governing choice of the investors for e.g. stable currency, trustworthy
legal system, transparent financial markets, infrastructure, skilled labor, tax incentives etc .
Countries which are relatively less fortunate in terms of natural resources and geographical
locations stands at a disadvantageous position to attract investment to boost their economies.
Equity and fair competition demands that these countries should be provided with a level
playing field and stronger economies should be discouraged from interfering with the
capacity of these countries to pursue policies which are in their best interests. It is widely
accepted that with increased capital mobility tax considerations are playing a pivotal role in
deciding business locations and making investment choices. There seems to be no
justification in prohibiting countries (particularly the disadvantageous ones) to follow
aggressive tax policies except for some plausible reason such as terrorism, money laundering
etc. It is completely with in sovereign realms of the countries to pursue such aggressive tax
policies, suiting their own interests.
Suggestions
The rules regulating practices of countries to compete with each other should perpetuate
global interests rather than interests of some powerful nations intending to bully weak nations
and to grind their own axe. Any effort to regulate tax competition should be taken up by a
forum representing diverse interests of the world and not merely a particular group of
powerful nations like OECD, which has suo motto assumed the responsibility to correct the
world.
India should also take necessary steps to remove the loop holes embedded in the two-decade-
old bilateral agreement, the Double Taxation Avoidance Convention (DTAC), because this
Provides an open opportunity to the foreign investors to get in and take benefit of the
outdated treaties.
23
Bibliography
Books
Harmful tax competition in the European Union, code of conduct, counters measures
and EU Law, Kluwer law international publishing, 2004
Angharad Miller and Lynne Oats, Principles of International Taxation, Tottel
Publishing, 2006
Andrea Amatucci, International Tax Law, Kluwer Law International publishing,2007
OECD documents
OECD 1998 Report “ Harmful tax competition; An emerging global issue”, available
at <www.oecd.org/dataoecd/33/1/1904184.pdf>, OECD 2000 Report available at www.oecd.org/dataoecd/9/61/2090192.pdf OECD 2001 Report available at www.oecd.org/dataoecd/60/28/2664438.pdf OECD 2004 Report available at www.oecd.org/dataoecd/60/33/30901115.pdf Business and Industrial Advisory Committee to OECD, A Business View On Tax
Competition, June 1999 available at www.biac.org/statements/tax/htc.pdfBIAC OECD Revenue Statistics-Comparative tables available at
www.stats.oecd.org/wbos/Default.aspx
Journals and Articles
Alexander Townsend Jr., The Global Schoolyard Bully: The Organization Of
Economic Development’s coercive efforts to control tax competition, 25 Fordham
Int’l L.J 215 (2001-2002)
Michael Littlewood, Tax competition: Harmful to whom?, 26 Mich. J. Int’l L. 411
(2004-2005),
Mitchell B. Weiss, International Tax Competition; An efficient or inefficient
phenomenon?, 16 Akron J. 99 (2001)
Javier G. Salinas, The OECD tax competition initiative: A critique of its merits in the
global market place, 25 Hous. J. Int’l L. 531 (2002-2003)
Kimberley Carlson, When Cows have wings: An analysis of OECD’s tax haven work
as it relates to Globalization, Sovereignty and Privacy, 35 J. Marshall L. Rev. 163
(2001-2002)
Julie Roin, Competition and evasion: Another perspective on International tax
competition, 89 Geo L.J 543 (2000-2001)
Yoram Margolith, Tax competition, foreign direct investment and growth: Using tax
system in promoting developing countries, 23 Va. Tax Rev. 161 (2003-2004)
Almeida, Tax Havens: An Analysis of the OECD work with policy recommendations,