Elephant in the room

The thought of bureaucrats in New Delhi discussing minutiae of Indian capital gains tax law may sound painfully banal. But for many in Mauritius, a small island nation 900 kilometers off the coast of Madagascar, it’s absolutely terrifying.

Thanks to a generous tax treaty with India, the country of just 1.3 million people has developed a sophisticated financial services industry that now accounts for about a quarter of its total economy. This has in turn made Mauritius the second-wealthiest nation in Africa by per capita GDP. The World Bank, IMF and Nobel Prize-winning economist Joseph Stiglitz have all feted its economy as a model for development.

Yet the good times may not last for long. India is considering revisions to both its tax code and international treaties, changes that threaten Mauritius’ status as the financial gateway to the subcontinent. In response, the country is rapidly trying to wean itself from reliance on the Indian market – and with China’s interests in Africa growing rapidly, some in Mauritius hope to present the country as a platform for Chinese investment into the continent.

“I think many local professionals [in Mauritius] realize they would do well if they did not rely too much on India, and they need to look at the bigger picture,” said Christian Li, CEO of CKLB, a corporate service provider. “And the bigger picture is that we clearly need to diversify away from India.”

For many in the country, this shift has so far been easier said than done.

India’s recent “season of scandals” – including the allegedly rigged allocation of 2G telecoms contracts, malfeasance during construction of the 2010 Commonwealth Games and the trial of the country’s anti-corruption watchdog – has generated a frenzied atmosphere, and Mauritius has served as a convenient straw man for the Indian press. Variously billed as the “Cayman of the East” and the “Switzerland of Africa,” Mauritius has recently been pilloried as one of a handful of offshore tax jurisdictions that helped to launder illicitly gotten gains from corrupt Indian businessmen and officials.

 

India’s tax collectors have also taken aim at “round tripping,” the practice of Indian firms and investors moving assets to domicile in Mauritius, then re-investing those assets back into India. This time-consuming route is economical only because of the substantial tax incentives on offer.

India’s corporate tax rate is 30% – although thanks to special-interest giveaways the average is closer to 20% – and Indian investors pay 15% on capital gains if they buy and sell equity shares within a year of purchase. Under the 1982 double taxation treaty (DTT) between Mauritius and India, however, a company domiciled in Mauritius is not subject to these capital gains taxes on its Indian shares. The levy is based on Mauritian tax law, which has no capital gains or withholding tax, and a maximum corporate tax rate of just 3%.

As a result of these incentives, around 44% of foreign direct investment into India comes via Mauritius, and 42% of India-investing funds are domiciled in Mauritius, according the research consultancy Eurekahedge.

This has proven a boon for the Mauritian economy: Financial services – around 60-70% of which are focused on India – have swollen to a quarter of GDP, and the World Bank forecasts 5.2% growth in the sector this year.

“India and corporate services have been the mainstay of Mauritius’ financial activities,” said Dharmesh Naik, managing director of OCRA Mauritius, a corporate service provider. In return for these benefits, Mauritius has dutifully supported India’s bid to become a permanent member of the UN Security Council.

 

Such support may no longer be enough. With reports reckoning that round-tripping deprives the Indian government of around US$443 million in tax revenues each year, New Delhi is eager to change the rules. India’s Direct Taxes Code, a piece of legislation floated in 2009 and due to be implemented in April 2012, seeks to shore up tax revenue lost in the country’s outdated 1961 tax code via a series of wide-ranging reforms. While details are still being negotiated, the version most likely to pass includes a bill that could override the capital tax provisions in India’s DTTs.

“We’re all waiting to see the final regulation and will be scrutinizing it very closely, because it is a very serious threat to Mauritius’ route into India,” said Francoise Chan, executive director of Mauritius-based Intercontinental Trust.

More worryingly, the Indian government has made serious noises about renegotiating its double taxation treaty with Mauritius specifically. A report by the Organization for Economic Cooperation and Development (OECD) in January highlighted a number of loopholes in the DTT that may allow Indians to launder money through Mauritius.

“The main thing is the uncertainty in the industry; at the moment it’s a ‘wait-and-see’ feeling,” said Rizwana Ameer, director of Consilex, a fiduciary and corporate services provider.

Mauritian authorities are taking steps to demonstrate good faith and thereby dampen the blow. In February they provided Indian authorities with information on 90 suspected cases of tax evasion. But as India’s economy falters – foreign direct investment fell 48% year-on-year in January, and some analysts say the country could have a net decrease in 2011 – many are understandably still keen to seek an alternative revenue stream.

 

Consilex’s Ameer points out that while no one is looking to scrap tried and tested Indian trade flows just yet, the focus of attention is moving west. “The trend over the past year is that we’re looking at Africa.”

The continent’s total GDP is set to rise from US$1.5 trillion in 2010 to US$3 trillion in 2015, according to a February report by South Africa’s Standard Bank – and China has become one of the biggest investors in the African growth story. A series of major resource extraction projects and bank acquisitions drove China’s trade with Africa up tenfold between 2001 and 2009.

Standard Bank forecasts that Chinese investment into Africa will surge 70% from 2009 levels to US$50 billion by 2015. Broader Sino-African trade stood at US$150 billion last year, and analysts say the figure will double to US$300 billion by 2015.

“Africa is definitely the next emerging market, purely because it’s a virgin market that people haven’t really been concentrating on,” said OCRA’s Naik. “And we’re now seeing a lot more Chinese investment flowing in.”

Many in Mauritius argue that the country is well-placed to tap that flow. First and foremost, the country has an unusually good DTT with China. Vimal Damry, managing director of Premier Financial Services, reckons it to be as generous as India’s – though many of the biggest loopholes were renegotiated in 2006, mitigating capital flows from Mauritius into China.

Companies domiciled in Mauritius pay a 5% withholding tax on dividends, interest payments and royalties derived from operations in China – a better rate than Hong Kong’s 10% withholding tax for investors owning less than 50% of the China-based asset.

Mauritius’ diplomats have also been quietly but effectively expanding the country’s DTT network into Africa – including such Chinese investment hotspots as South Africa, Botswana, Namibia and Zimbabwe. Many of these treaties have been negotiated with an eye to giving firms domiciled in Mauritius relief from the continent’s burdensome regulation and high taxes, and will no doubt catch the eye of many multinationals.

The country has also been growing its Investment Promotion and Protection Treaties (IPPTs) network. These treaties parlay the country’ competitive advantage in rule of la
w, as both the Chinese investor and African intermediary or consumer can agree in advance that disputes will be adjudicated in Mauritius.

“Let’s say for example that you’re a Chinese company looking to invest in assets in Zimbabwe,” said CKLB’s Li. “You could domicile your investment vehicle in Mauritius and then use the domestic laws to settle legal problems here, where there’s much stronger rule of law than in the end investment country. We find this route is very popular because it gives comfort to people.”

 

Treaties aside, Mauritius is attractive to businesses because its financial infrastructure is developed enough to support complex financial services and transactions that could overwhelm resources in other African countries. Major international accountancies, banks, law firms and corporate service providers have a much stronger presence in Mauritius than elsewhere in Africa, bar South Africa and Nigeria.

“It’s one of the best performers of Africa in terms of creating a business-friendly environment,” said Constantine Chikosi, head of the World Bank in Mauritius, adding that the country comes in 20th in the organization’s global “Doing Business” ranking.

Human resources are sufficient for complex financial services because the country’s population is relatively well-educated. About two-thirds of the population have attended high school, and around 40% of college-age Mauritians are enrolled in a degree program – well above the African average. The largely bilingual country also offers easy access to Francophone Africa, something not normally found in the southern Africa region.

Service providers are also quick to point out that they are a two-hour flight from Johannesburg and a four-hour flight from Nairobi. Henry Loo, managing director of Octagon Development, an investment firm, says that recently introduced direct flights to mainland China are proving an enormous boon for Chinese business.

More prosaic reasons contribute to Mauritius’ brand as well. “I wouldn’t discount the possibility that a lot of investors choose Mauritius in part because they can spend a day at the beach,” said OCRA’s Naik.

Some observers point to anecdotal evidence in arguing that Chinese investors are taking the bait.

“Over the last three years I’ve seen many Chinese firms, institutions and individuals investing a lot in Africa. Especially in the commodity and resources industries, and especially in Namibia, South Africa, Mozambique and Zimbabwe,” said Naik.

 

Others are less sure. The World Bank’s Chikosi points out that Chinese investment comprised just 2% of total FDI in 2010. “The trend is that there’s a lot more sovereign money going into Africa rather than private,” said Consilex’s Ameer.

This is less than ideal for Mauritian industry. Intercontinental Trust’s Chan points out that China’s state-owned enterprises often don’t need as many global investment entities and services because they can invest directly and negotiate tax deals on a government-to-government basis.

Mauritius also has a few obstacles of its own – the country faces stiff regional competition. Its nearest rival, the Seychelles, has attracted considerable attention from Chinese investments due to its cheap offerings. Botswana is also trying to cash in on the game, touting its proximity to end investment locations.

Moreover, Mauritius’ financial services industry, while considerably developed for a country of its size and income, still has a limited portfolio of financial products. It has long relied on modified versions of two corporate structures – one that can access DTTs and another with little regulatory oversight – but lack of standalone private wealth offerings are a common complaint.

“Corporate services and DTTs are great, but Mauritius also needs to become an international financial center with private wealth management,” said CKLB’s Li. “The field is a lot bigger for private wealth business.”

While Mauritius has made some attempts to decrease its reliance on DTTs and become a standalone financial services center, that push has largely plateaued in recent years. In the words of one service provider, the country is now looking to “consolidate” its existing products – perhaps as a result of considerable international pressure on the offshore wealth management industry.

 

One sticking point may be a lack of political will: “The major challenge we face is that if you compare us to other jurisdictions, Mauritius does not only rely on being a financial center,” said Premier Financial Service’s Damry. Service providers grouse that unlike other jurisdictions, Mauritian manufacturers – whose main export markets are the UK and France – pressure politicians to cave at the first whiff of financial transparency and tax pressures from large economies.

This has become increasingly important since the OECD and G20 launched a tax information transparency drive in 2009, putting pressure on offshore centers like Mauritius. While the country satisfied the OECD “white list” requirement that it sign tax information exchange agreements with at least 12 other countries, it failed a more qualitative OECD “peer review” in January.

Mauritian politicians may have also painted themselves into a corner in their relationship with India. “Nobody can take a unilateral decision in a matter as sensitive as Indo-Mauritius treaty,” said the country’s finance minister, Ramakrishna Sithanen, who has repeatedly called on the Indian government not to single out Mauritius. Consilex’s Ameer says that the government is currently engaged in talks with the Indian government to see how it can amend the Direct Taxes Code.

India’s attempts to renege on its DTTs have been widely criticized, and international observers and investors will be watching to see if Mauritius can stand by public pronouncements that it will not allow India to unilaterally renegotiate. 

If Mauritius lacks the political will to stand up to India – in effect, losing market credibility –  many Chinese investors and intermediaries will no doubt conclude that it will fare little better if Beijing comes calling.

African growth story or not, the country’s attempts to attract Chinese investment will hinge on its ability to secure victories in New Delhi. Mundane as they appear, these Indian parliamentary tax battles may decide the future of Mauritius’ economy.