India Cyprus Tax Treaty revised with Source based taxation of Capital Gains

India Cyprus DTAA Amendment in line with Mauritius Tax Treaty

India Cyprus Tax Treaty revised with Source based taxation of Capital Gains; Retrospective removal of Cyprus from blacklisting notification

The Union cabinet recently approved the revised double taxation avoidance agreement (DTAA) with Cyprus. The new agreement, which will replace the 1994 treaty, will enable Indian authorities to tax capital gains on investments routed through Cyprus; it will also lead to the removal of the Mediterranean island nation from an Indian government blacklist on which it was placed for not providing financial information sought by India.

In 2015-16, Cyprus ranked eighth in terms of foreign direct investment into India at $3.3 billion. The existing treaty provided for capital gains tax on residence basis and a low withholding tax rate of 10% on interest payments made to entities based in Cyprus.

The provisions in the earlier treaty for residence-based taxation were leading to distortion of financial and real investment flows by artificial diversion of various investments from their actual countries of origin, for avoiding tax. As in the case of Mauritius, this amendment will deter such activities. The proposed DTAA provides for source based taxation of capital gains on transfer of shares, instead of residence based taxation as provided in the existing DTAA.

The revised version will give India right to tax on capital gains arising from Indian shares, taxation of profits of permanent establishment on source basis, taxation of royalty, fees from technically services and more importantly, smooth flow of exchange of information for varied purposes.

Besides capital gains taxation of share transactions in India, the proposed treaty also permits taxation of capital gains from transfer of shares of any company that has immovable property in the country. The treaty also expands the scope of the permanent establishments to allow for source-based taxation of business income.

Indian tax authorities will be able to levy capital gains tax on sale of shares by firms based in Cyprus after April 1, 2017, as there is a grand fathering provision in the agreement. A grandfathering clause provides for an old rule to apply to existing cases and a new rule to future ones.

All existing investments, including those made up to 31 March 2017, have been sought to be grandfathered like the Mauritius Treaty. However, Mauritius treaty additionally provides for 50% capital gains tax exemption for two years from 1 April 2017 to 31 March 2019, subject to fulfilment of limitation of benefit conditions. This appears to be absent in the revised Cyprus treaty.

Also, In the past, Cyprus was more preferred by debt funds because of the low withholding tax of 10 percent on interest and now Mauritius debt funds will now get a better treatment because of the 7.5 percent withholding tax rate under the revised Mauritius treaty. However, any fresh investments from April 1 2017, either in equity or debt will be subject to India’s new GAAR provisions.

The agreement provides clarification about taxation of dividends in India that are subjected to dividend distribution tax, and clarifies that provisions on assistance in collection of taxes shall not be construed to impose any obligation that is at variance with the laws, practices or public policy of a contracting state.

It also provides for a revised provision for exchange of information that would enable the use of information exchanged for other purposes, with the permission of the competent authority of the country providing the information.

India had put Cyprus on a blacklist in Nov 2013 for failing to share information on tax evasion. With the revision of the treaty, India is expected to remove Cyprus from that list with retrospective effect, which will provide relief to investors from that country who had seen increase in compliance costs.

At present, any payment to a Cypriot entity attracts a withholding tax of 30%. No deduction in respect of any other expenditure or allowance arising from a transaction with a person in Cyprus, or a payment made to a financial institution, is allowed unless the assessee provides the required documents.

If an assessee enters into a transaction with any entity in Cyprus, it is treated as an associate enterprise and the deal as an international transaction attracting transfer pricing regulations.

If the blacklisting notification is withdrawn with retrospective effect, excessive taxes paid earlier by way of higher withholding taxes since November 2013 could possibly be claimed as refunds. Further, the deemed application of the transfer pricing provisions and cumbersome documentation requirements shall be done away with which were required to be maintained on certain transactions with Cyprus entities vide the section 94A notification.

It needs to be seen how the refunds shall be granted by the Indian government and how withholding tax return could be revised or refund could be claimed. If the assessment of Indian entities who have transacted with Cyprus entity in past has entailed an addition in their income under transfer pricing, then how will the CBDT (Central Board of Direct Taxes) provide for revision of return/assessment order to nullify the effect of Cyprus notification retrospectively? In substance, retrospective application of withdrawal of Cyprus notification shall come with riders.

The development on the India Cyprus tax treaty is welcome step towards providing certainty in tax. The text has been agreed between the two negotiating teams of the contracting states and will contribute to further develop the trade and economic links between Cyprus and India, as well as with other countries.

Tax authorities now need to revise a similar treaty with Netherlands as treaty with Netherlands also provides for residence based taxation for capital gains on transfer of shares and hence majority of investments are routed through Netherlands.

The author can also be reached at ca.guptarohit@gmail.com.