The government is set to act on the suggestions made by the Comptroller and Auditor General of India (CAG) to plug the possible misuse of the Indo-Mauritius taxation treaty by residents of other countries and shell companies.

The CAG has now asked the Central Board of Direct Taxes (CBDT) to consider giving instructions to assessing officers (AO) to ensure that third country residents do not get the benefit of capital gains tax waiver on income from sale of shares under the Indo-Mauritius tax treaty.

The suggestion comes even as India is trying to re-negotiate the double taxation avoidance convention (DTAC) with Mauritius to plug possible misuse.

Mauritius does not tax capital gains. Mauritius-based FIIs are therefore exempt from paying capital gains tax in India both long-term and short-term on income from sale of shares. Routing investments through Mauritius has partly lost sheen after the abolition of long-term capital gains tax on sale of listed securities. FIIs routing their investments from other destinations have to pay a 10% short-term capital gains tax.

However, the resident of a third country could take advantage of the Indo-Mauritius tax treaty and escape paying short-term capital gains tax in India. This practice is called treaty shopping and results in revenue loss to the exchequer.

An audit scrutiny of the assessments of entities that were stated to have been incorporated in Mauritius revealed that the benefit of capital gains tax waiver under the Indo Mauritius tax treaty was allowed based on incomplete data, according to CAGs report tabled in Parliament last year.

It now reckons that instructions to AOs are necessary to ensure consistency in assessments, considering that there were instances where the benefit was given based on incomplete data which did not establish the effective place of management. The ministry (finance ministry) should examine and issue suitable instructions in this regard, states the vetted audit comment.

The uncertainty over the tax liability of Mauritius-based FIIs on their investments in India was, in fact, cleared by the Supreme Court in 04 when it upheld a circular issued by the CBDT. The circular (April 00) broadly said that a certificate of residence from Mauritius issued by its government was sufficient evidence to accept the status of residence as well as beneficial ownership.

The CBDT issued another circular in 03 to check the check misuse of this treaty by Indian companies registering shell companies in Mauritius to route their investments in India. The circular held that companies resident in Mauritius could be taxed in India if the departments finds that the company is also resident in India and effectively managed from here.

The income tax department has finalised assessments of Mauritius-based FIIs for end March 04 in March 05. In all the cases that were taken up for scrutiny, the directors of companies were found to be non-residents having their permanent addresses in foreign countries and such it could not be said that the control and management was in India, according to the ministry. The CAG has now questioned the efficacy of the 03 circular.