The Mauritius Treaty at a Crossroads, Rule of Law, Capital Costs, and India’s Growth Imperative

The Mauritius Treaty at a Crossroads, Rule of Law, Capital Costs, and India’s Growth Imperative

Recent judicial rulings and administrative actions concerning the India-Mauritius Double Taxation Avoidance Agreement (DTAA) have ignited a profound debate that transcends mere tax technicalities. This debate strikes at the heart of India’s economic philosophy, its commitment to the rule of law, and its strategic positioning in the global competition for capital. As argued in a compelling recent analysis, the current trajectory—marked by a shift from predictable treaty benefits to subjective scrutiny—risks undermining a decades-old institutional arrangement that quietly fueled India’s integration into the global financial system. To understand the stakes, we must examine the principles of efficient taxation, the historical role of the Mauritius conduit, the consequences of its unraveling, and the urgent need for a coherent policy reset.

The Foundational Principle: The Case for Residence-Based Taxation

The core intellectual argument, elegantly drawn from international trade theory, centers on tax neutrality. In goods trade, the Value-Added Tax (VAT) system achieves this through the “destination principle.” An Indian-made product for export is zero-rated, stripped of all domestic indirect taxes, allowing it to compete abroad on pure price and quality. An imported product faces the same VAT as a domestic one, ensuring the tax system doesn’t bias consumers toward local or foreign goods. This neutrality minimizes economic distortion and harnesses globalization.

Applying this logic to cross-border finance leads to the principle of residence-based taxation. The returns on capital—dividends, interest, capital gains—should ideally be taxed in the hands of the ultimate investor, in their country of residence, not in the source country where the investment is made. If a pension fund in New York invests in an Indian infrastructure project, the principle holds that the profits should be taxed in the United States, according to US law, not at India’s border.

This is not academic idealism; for a capital-scarce, development-hungry economy like India’s, it is a strategic imperative. Global capital is mobile and ruthlessly efficient, seeking the highest possible post-tax, risk-adjusted return. When India imposes “source-based taxation”—taxing that New York pension fund’s gains at the point of origin—it directly reduces the investor’s final return. To compensate for this tax friction, investors demand a higher pre-tax return from Indian assets. This elevates the cost of capital for every Indian company seeking funding. Projects that are viable and job-creating at a 10% cost of capital become unfeasible at 14%. Source-based taxation thus acts as a tariff on capital imports, stifling investment, slowing GDP growth, and ultimately harming Indian entrepreneurs and workers.

The “Second-Best” Solution: The Mauritius Treaty as a Conduit for Neutrality

For decades, India’s tax policy presented a paradox. Domestic political rhetoric often leaned toward populist sentiments of “taxing the rich foreigner,” yet the pragmatic need for foreign capital was undeniable. The India-Mauritius DTAA, signed in 1983 and shaped by later protocols, became the elegant, if imperfect, institutional solution to this paradox—a mechanism for what has been termed “a healthy hypocrisy.”

Mauritius imposed no capital gains tax. The treaty, until 2016, assigned the right to tax capital gains from the sale of Indian shares solely to Mauritius. The result was a de facto residence-based taxation system for a massive flow of investments. A US fund would route its investment through a Mauritius entity. Upon exit, the gains were not taxed in India, and Mauritius didn’t tax them either. This kept India’s cost of capital competitive, channeling billions into startups, infrastructure, and public markets without the friction of a source tax.

The legal bedrock of this system was the Supreme Court’s 2003 verdict in Azadi Bachao Andolan. The court upheld the validity of “treaty shopping” and established a clear, objective standard: a Tax Residency Certificate (TRC) issued by the Mauritian authorities was conclusive proof of residency. Indian tax officers could not “look through” the certificate to question the substance or purpose of the Mauritius entity. This provided the predictability and finality that are the essence of the rule of law for investors. They could structure investments with certainty, knowing the rules would not change retroactively.

The Unraveling: The 2016 Amendment and the Erosion of Certainty

The pivotal shift came with the 2016 amendment to the treaty, driven by global pressures against Base Erosion and Profit Shifting (BEPS) and domestic concerns about revenue loss and round-tripping. The amendment introduced two critical changes:

1. Source-Based Taxation on Future Gains: It granted India the right to tax capital gains arising from the transfer of shares acquired after April 1, 2017 (with a reduced rate until March 2019).

2. Limitation of Benefits (LOB) Clause: This was the more insidious change for the principle of certainty. It allowed India to deny treaty benefits if the Mauritius entity was deemed to lack sufficient commercial substance—a subjective, facts-based test.

The LOB clause replaced the bright-line, objective test of the TRC with a nebulous standard of “substance.” It empowered tax authorities to become detectives, probing board minutes, employee locations, and decision-making processes to determine if a Mauritius company was a “shell” or “conduit.” The recent Supreme Court ruling in the Tiger Global case is the direct legal consequence of this shift. The court held that a TRC is not a “safeguard” against scrutiny and upheld the tax department’s right to deny treaty benefits based on a lack of beneficial ownership and economic substance. The finality promised by Azadi Bachao has been profoundly undermined.

The Tangible Consequences: Stagnant Investment and Heightened Risk

The analytical link between this policy shift and macroeconomic trends is striking. The period following the 2016 amendment coincides with a structural break in foreign investment patterns.

• Stagnating Foreign Ownership: Data shows foreign portfolio ownership of listed Indian companies rose steadily from 8.38% in 2000-01 to a peak of 19.19% in 2015-16—the very year of the treaty change. Since then, this metric has stagnated and reversed, falling to 16.04% by 2024-25. In a successfully globalizing emerging market, economic theory predicts a steady decline in “home bias” and a rising share of foreign ownership. India’s experience contradicts this, suggesting a loss of attractiveness relative to other destinations.

• The “India Risk Premium”: Beyond the raw numbers, the uncertainty has inflated the “India risk premium.” Investors must now price in not just business and regulatory risk, but tax treaty reinterpretation risk. The ex-ante cost of investing in India has risen because the rules are no longer stable. The fear is that a treaty benefit claimed today based on prevailing understanding could be challenged—and denied—years later upon exit, based on a new judicial interpretation of “substance.” This retrospective uncertainty is anathema to long-term capital.

The critique extends beyond the tax department to the judiciary. The rule of law requires that courts act as a check on executive overreach and uphold the sanctity of contracts and settled interpretations. By allowing a subjective, post-facto “substance” test to override an objective TRC, the courts have, in the view of the analysis, increased policy volatility and diminished India’s institutional credibility.

The Path Forward: Reclaiming Strategic Clarity

The argument presented is not for a return to an unregulated past of pure treaty shopping. It is a call for a principled, growth-oriented, and predictable tax policy framework. The solution lies not in ad-hoc scrutiny but in clear, prospectively applied rules. Several policy projects are highlighted as essential for reigniting investment-led growth:

1. Commit to Residence-Based Taxation in Principle: India should explicitly adopt residence-based taxation as a strategic goal for foreign portfolio and direct investment. This could be implemented through clear domestic legislation or through redesigned treaties that minimize source-based friction while incorporating robust, objective LOB criteria (e.g., a publicly traded test, a genuine business activities test) that are not subject to wide interpretive discretion.

2. Judicial Restoration of Certainty: The higher judiciary needs to re-establish clear boundaries. It should affirm that where investors comply with objective, pre-defined criteria (which could be more stringent than a mere TRC), their treaty benefits are secure. The goal should be to eliminate retrospective application of new “substance” standards.

3. Holistic Economic Competitiveness: The tax treaty debate cannot be isolated. It must be part of a broader competitiveness agenda that includes:

   • Removing Customs Tariffs: Another form of border friction that raises costs for Indian manufacturing.

   • Unblocking Input Tax Credits in GST: Solving this would provide a massive boost to domestic business efficiency.

   • Implementing a Carbon Tax: A sensible domestic climate policy that aligns with mechanisms like the EU’s CBAM.

4. Educating the Ecosystem: The understanding that “taxing capital at the border harms domestic growth” must diffuse deeply into the bureaucracy, the revenue department, and the judiciary. Policymaking must be informed by the economics of capital flows, not just short-term revenue collection or populist sentiment.

Conclusion: A Choice Between Two Philosophies

The Mauritius treaty saga presents India with a fundamental choice. One path is that of increasing administrative discretion, subjective tests, and a focus on maximizing tax revenue from each discrete transaction, regardless of its wider economic impact. This path risks viewing foreign capital with suspicion, seeing treaties as loopholes to be closed, and prioritizing immediate revenue over long-term growth capital.

The other path, as argued, is one of strategic enlightenment. It recognizes that in a world of mobile capital, nations compete on the quality of their institutions, the predictability of their rules, and the after-tax returns they offer. On this path, tax treaties are not loopholes but vital infrastructure for economic integration, akin to ports and highways. Their purpose is to minimize friction, not create it.

The “value of the Mauritius treaty” was never just about tax avoidance. It was the value of a predictable rule that lowered India’s cost of capital for a generation, helping build its modern corporate and startup landscape. The challenge now is to design a 21st-century framework that preserves that essential value—capital import neutrality—while addressing legitimate concerns about treaty abuse through clear, objective, and prospectively applied rules. India’s growth trajectory in the coming decade may well depend on which path it chooses.

Q&A: The India-Mauritius Treaty Debate

Q1: What is the core economic argument for “residence-based taxation” favored in the analysis?
A1: The core argument is that residence-based taxation promotes economic efficiency and growth for capital-importing countries like India. It holds that returns on capital should be taxed in the investor’s home country, not at the source (India). This is analogous to the “destination principle” in VAT for goods. By not imposing a source tax, India does not reduce the post-tax return for foreign investors. This keeps India’s cost of capital low, making more investment projects viable, fueling higher GDP growth, and creating jobs. Imposing source-based taxation acts like a tariff on capital, raising costs for Indian businesses and deterring investment.

Q2: How did the 2016 amendment to the India-Mauritius DTAA fundamentally change the game for investors?
A2: The 2016 amendment was a watershed in two ways:

1. Introduction of Source Tax: It granted India the right to tax capital gains on shares acquired after April 1, 2017, ending the era of complete tax exemption on future investments.

2. Limitation of Benefits (LOB) Clause: This was the more significant change for legal certainty. It moved the standard for claiming treaty benefits from an objective test (possessing a valid Tax Residency Certificate from Mauritius) to a subjective test (whether the Mauritius entity has sufficient “commercial substance”). This empowered tax authorities to “look through” legal structures and investigate operational realities, creating uncertainty and discretion where finality once existed.

Q3: What is the connection drawn between the treaty changes and trends in foreign investment in Indian markets?
A3: The analysis points to a stark correlation. Foreign portfolio ownership of Indian listed companies rose steadily to a peak of 19.19% in 2015-16, the year of the treaty amendment. Since then, this metric has stagnated and declined, falling to about 16% by 2024-25. This reversal contradicts the expected trend in a globalizing emerging market, where foreign ownership should gradually rise. The implication is that the increased tax uncertainty and cost introduced post-2016 have made Indian equities relatively less attractive, contributing to a stagnation in foreign capital inflows at a time when growth demands more.

Q4: What role does the analysis suggest the judiciary should play, and how has it fallen short?
A4: The analysis argues the judiciary should be the guardian of the rule of law and predictability. Its role is to check executive overreach and uphold the sanctity of contracts and settled interpretations. It fell short by moving away from the principle established in the Azadi Bachao Andolan case (where a TRC was considered conclusive). In recent rulings, by endorsing a subjective “substance over form” test that can override a TRC, the courts have introduced retrospective uncertainty. This allows tax authorities to reinterpret treaty benefits years after an investment is made, dramatically increasing the ex-ante risk for global investors and damaging India’s reputation for institutional stability.

Q5: What are the key policy prescriptions offered to restore a growth-friendly investment climate?
A5: The analysis proposes a multi-pronged approach:

1. Strategic Tax Policy: Explicitly embrace the principle of residence-based taxation for foreign capital to minimize friction, designing clear, objective LOB rules to prevent abuse without granting excessive discretion.

2. Judicial Clarity: The courts should re-establish bright-line rules that ensure predictability for compliant investors.

3. Broad Competitiveness Agenda: Integrate tax treaty reform with other essential reforms: eliminating customs tariffs, solving GST input credit blockages, and implementing a coherent carbon tax.

4. Intellectual Diffusion: Educate the bureaucracy, tax department, and judiciary on the macroeconomic link between capital cost, investment, and growth to inform policy-making beyond short-term revenue considerations.