Why Mauritius Has Everything To Do With The Stockmarket Scandal

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

In August 1982, the governments of India and Mauritiussigned a double-taxation avoidance treaty (DTAT)ostensibly aimed at boosting the economies of bothnations. India has signed more than 50 such treatieswith different countries, including at least 16 whichare virtually identical to the one signed withMauritius.

Yet, the Mauritius treaty has been -- and continues tobe -- misused as a conduit to launder illegal money.Because of its reputation as a tax haven, a claim thatis officially denied, Mauritius has been a favouritedestination for much of the black money generated inIndia, including a large proportion of the slush fundsstashed away by some of the country's most powerfulpoliticians and industrialists.

A set of glaring loopholes have been deliberately leftwide open in this country's laws to enable racketeersof various hues to use the Mauritius route for a rangeof nefarious activities. These include themanipulation of India's notoriously corrupt stockexchanges.

There are significant disclosures to this effect in areport which has been circulated among members of theJPC by the so-called watchdog of the country's capitalmarkets, the Securities and Exchange Board of India(SEBI). These revelations are contained in pages 23 to25 of the 92-page SEBI report (excluding annexures)entitled "Investigation in Market Manipulation in theContext of Recent Market Behaviour".

The report talks about the "possible misuse ofinvestment and automatic repatriation facility"granted to foreign institutional investors (FIIs)operating in India through a system of what is knownas "participatory notes". The SEBI report has a flowdiagram to explain the manner in which the mechanismworks.

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

The foreign broking house in India executes an orderfor the sub-account of the FII that is actually forthe benefit of the holder of the PN. A rate ofcommission varying between 1.5 per cent and 2.5 percent of the transacted value is paid as buying/sellingand custodial charges. The funds thus flow into Indianstock exchanges.

This is what the SEBI report has categorically stated:"This mechanism of trading through PNs outside Indiais utilised by the FIIs by entering into transactionsby the clients who are otherwise not eligible forregistration as (an) FII to trade in Indian markets orthose who may or may not be eligible but want to hidetheir identities. Further, these PNs can enable theparticipant to whom these instruments are issued byFIIs to take benefit of (the) Mauritius DoubleTaxation Avoidance Treaty."

The point that the SEBI report drives home is that PNsissued by FIIs to any individual or corporate bodyoutside India enables participants to tradeanonymously in the equity shares of Indian companies.Since the identities of these participants are notknown, they can conveniently circumvent differentlaws, including the corporate takeover code.

Thus, if a promoter wants to illegally ramp up theprices of his company's shares, he has a ready-maderoute available to him, namely, the PN issued to himby the Mauritius-based sub-account of a FII registeredto operate in Indian stock exchanges. This is theessence of the current scam. "It also opens thepossibility of repatriation of profits based on therigged prices and in the process, causing foreignexchange drain," the SEBI report added.

A brief look at the track record of previousgovernments -- ones headed by the Indian NationalCongress as well as the Bharatiya Janata Party-ledNational Democratic Alliance -- will confirm thereasons why one is so cynical about the Mauritiusroute remaining unplugged for quite some time to come.If the loopholes in the law eventually get plugged, itwould have something to do with international(especially American) pressure on the Mauritiusgovernment to change its tax laws and would havenothing to do with the great Bharat sarkar.

FIIs operating in India are required to pay taxes onshort-term capital gains (at a rate varying between20 per cent and 30 per cent in recent years) if theseentities repatriate their earnings in less than ayear. The tax rate is lower at 10 per cent if theearnings remain within the country for more than ayear. However, the best way out for FIIs is not to payany tax at all irrespective of the time taken torepatriate capital gains. This is done by registeringa sub-account in Mauritius which country does not levyany capital gains tax. Voila!

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

This is precisely why an island state whose economy is100 times smaller than the Indian economy has, overthe last few years, become the single largest"investor" in India. During the decade of the 1990s,investment inflows from Mauritius have exceeded Rs14,000 crore, the highest among all countries and agood 50 per cent higher than the inflow from theworld's largest economy, the USA.

To return to the question raised earlier, if India has16 DTATs similar to the one signed with Mauritius, whyis the island the favoured choice of virtually allforeign investors doing business with India? For adecade after the India-Mauritius treaty was signed in1982, FIIs were simply not allowed to invest in India.In 1992, the year FIIs were allowed to operate in thecountry, Mauritius enacted its Offshore BusinessActivities Act.

This Act, among other things, provides a range offacilities to foreign corporate entities wishing toinvest in India. These include fast incorporation ofcompanies (within a fortnight), total exemption frompayment of capital gains taxes over and above a fullyconvertible currency. Mauritius has large numbers oflawyers and accountants who assure complete secrecy toforeign investors (like the Swiss banks used to do intheir heydays) -- the salubrious climate and thegolden beaches are merely the icing on the cake.

Estimates vary, but the extent of loss of capitalgains taxes which would have been paid had FIIs andtheir sub-account holders been incorporated in Indiavary between Rs 5,000 crore and Rs 10,000 crore. Acomplete conspiracy of silence has prevailed over themanner in which the Mauritius route has been used tolaunder black money generated in India. Feweconomists, leave alone government officials orpoliticians, are willing to go on record criticisingthe modus operandi of such activities on the plea thatit would jeopardise relations with a friendly nation.

A rare exception is economist S L Rao, former head ofthe Central Electricity Regulatory Authority and theNational Council for Applied Economic Research. In aninterview conducted in 1995, this is what Rao had toldthis correspondent: "In my view, the entire episode isscandalous. It is a matter of serious concern ifcertain Mauritius-based FIIs, which are nothing butnameplate companies, can get away without paying anytax. This is a way of encouraging hot money flowswhich the country can do without."

Individuals like Rao have suggested that the Mauritiusloophole can be easily plugged should the Indianauthorities want to. A simple way to do this would beto levy a flat "service charge" of, say, 10 per centon all outflows of capital gains made by FIIs whichare repatriated within a particular time frame, forexample, one year.

Far from initiating measures to plug these glaringloopholes, the Union Ministry of Finance has bent overbackwards to accommodate the interests of FIIs in thisrespect. One important reason why the India-MauritiusDTAT facilitates nefarious transactions is thesomewhat ambiguous definition of a company's residentstatus in Mauritius. The treaty states that a companyis considered to be "based in Mauritius" if its"effective management" is located in that islandnation.

In late-March 2000, a group of officials in the incometax department of the Central Board of Direct Taxes(CBDT) decided to review the tax exemptions grantedto a handful of Mauritius-based FIIs and slappedshow-cause notices on them asking them to pay taxarrears since 1997. The Indian tax authorities had, inthe past, rejected the claims of some two dozencompanies that had argued that their "effectivemanagement" was in Mauritius. This time round,however, all hell broke loose.

A Mumbai-based tax consultancy outfit issued a "redalert" to all FIIs that their profits were going to betaxed and the sensitive index of the Bombay StockExchange collapsed like a pack of cards inearly-April. None other than Union Finance MinisterYashwant Sinha reportedly panicked when he was toldhorror stories about how foreign investors werepacking their bags to leave India. The tax assessmentproceedings were immediately stalled.

On 13 April that year, the CBDT issued a new circular"clarifying" the government's position that acertificate of residence issued by the Mauritiusgovernment would be "adequate evidence" that acompany's effective management was located inMauritius. The Indian government claimed that thiscircular reiterated a point made in an earliercircular issued in March 1994, namely, that anyresident of Mauritius deriving income from alienationof shares of Indian companies would be liable to paycapital gains tax only in Mauritius and would not haveany such tax liability in India.

The story does not end here. High-powered delegationscame to India from Mauritius and vice versa. Forinstance, in December 2000, after meeting FinanceMinister Sinha, the Economic Development Minister ofMauritius Sushil K C Khushiram told journalists that"the double taxation agreement between the twocountries is working well and there is no question ofamending or altering it."

Not surprisingly, the Mauritius minister disagreedwith the suggestion that his country was being used tolaunder illegal funds and route them to Indianstockmarkets. "We are seen as a clean and crediblefinancial centre with effective regulation," he added,pointing out that Mauritius had in June 1999 enactedlegislation to check money laundering and economicoffences.

What is more, the minister said the island nation hadbeen excluded from a "black-list" that had earlierbeen prepared by the powerful club of developedcountries, that is, the Paris-based Organisation ofEconomic Cooperation and Development (OECD). Earlier,from 1998 onwards, the Forum on Financial Stabilitybased in Basel under the OECD had been engaged in anexercise to identify countries indulging in "harmfultax practices" and had named Mauritius as one suchcountry.

Thereafter, in June 2000, thanks to the persistentprodding of the OECD, six countries includingMauritius (the others being Bermuda, the CaymanIslands, Cyprus, Malta and San Marino) agreed to endtax practices which had conferred on them the statusof "tax havens" over a period of five years. The thenUS Treasury Secretary Lawrence Summers described theannouncement as an "important milestone" in theinternational effort to "put an end to . tax practicesthat encourage tax evasion and improper tax avoidance which) distort capitalflows."

In India, despite the best efforts of the FinanceMinister and his senior bureaucrats ensconced in NorthBlock, a different drama was being enacted under theirvery nose involving a relatively unknown officialbody, the Authority on Advance Rulings (AAR) whichoperates under the CBDT. The AAR, which in 1997 hadclaimed that the India-Mauritius DTAT was not atax-avoidance tool but served to promote investment inIndia while helping the economy of friendly Mauritius,decided to do an about-turn in a case involving theTCW-ICICI India Equity Fund based in Mauritius.

In April 2001, in a landmark ruling, the AAReffectively reversed the position taken by the incometax department on taxing capital gains of corporateentities and sub-accounts of Mauritius-based FIIsoperating in India. The AAR ruled that the gainsaccruing from the sale of shares by theMauritius-based private equity fund, in this case, theone set up by TCW-ICICI, would be treated as businessprofits and not capital gains.

Only if a corporate entity did not have a permanentestablishment in India would its business profits betaxed in Mauritius and not in India, the AAR ruled. Inits judgement, the AAR said it had considered allaspects of the structure of a private equity fund andon the "basis of facts", ruled that both theinvestment advisor and the custodian of the fund "wereacting in the ordinary course of business and wereagents of independent status".

It remains to be seen whether the JPC investigatingthe stockmarket scandal would accept SEBI'srecommendation to plug the Mauritius loophole. Moreimportantly, even if such advice is given, it is notclear whether the powers-that-be in New Delhi would"offend" their friends in Mauritius by changing thiscountry's tax laws in a manner in which it wouldbecome unnecessary for FIIs and other foreigninvestors to come to India only via Mauritius.

It is not just SEBI but different organs of the Uniongovernment and the Ministry of Finance (such as theDirectorate of Revenue Intelligence, the EconomicIntelligence Bureau and the Enforcement Directorate,Foreign Exchange Management Act) that have, for manyyears now, been aware of the manner in which theprovisions of the India-Mauritius DTAT have been (andstill are) abused with impunity.

Having stated what it has in such black-and-whiteterms, the SEBI report remains strangely reticentabout what needs to be done to check such blatantmanipulation of share prices. Perhaps the authors ofthe SEBI report believe the government of India andthe JPC will not do a damn thing to check this form ofmarket rigging.

If indeed this is correct, this author regrets tostate that he shares such a cynical perception. Toomuch is at stake, not merely cordial relations with afriendly country. What is involved is the ill-gottenloot of India's politicians, bureaucrats andbusinesspersons. This powerful elite will collude toensure that the Mauritius route will remain wide opento launder black money, JPC or no JPC.