India, in the 21st century, has one of the biggest economies in the world. Post liberalization in 1991, India opened its doors to foreign companies and investment. What followed was an economic boom. During this time, GDP growth numbers reached as high as 8% per quarter. To sustain these numbers, the government has been trying to reduce restrictions, improve ease of doing business, and promote foreign direct investment (FDI) into the country. Since 2000, India has adopted policies to increase FDI and use it to enhance growth and employment. Among the prominent investors were the imperial west, which included countries like the USA, UK and Netherlands. However, the biggest of them was an unlikely small East African island nation famous for its beaches and lagoons, Mauritius. This article analyzes how such a small nation became the largest foreign direct investment source for Asia’s second-largest economy.
CURRENT FDI NUMBERS
Foreign Direct Investment into India during the past year has grown by almost 20% to $60 Billion, according to the Department for Promotion of Industry and Internal Trade (DPIIT). This growth has been credited to government measures, policy reform, and investment facilitation. Total FDI, including equity, reinvestment earning, and capital, rose by 10% to $81 billion. This growth has been mainly due to increased investment coming from the west, as it sees India as a potential competitor to China’s rise and dominance in Asia. The US, under President Trump and now Biden, has reiterated the need for strong US-India economic relations.
FDI into India is predominantly focused on the computer software and hardware sector, followed by infrastructure and service. In the past year, the United States of America overtook Mauritius to become the second-largest source of FDI into India. The US invested $13.82 billion in the country during the financial year 2020/21, while Singapore remained at the top with $17.41 billion. Mauritius used to be, until recently, the largest source of investment for India. In the last financial year, Mauritius still managed to “invest” over $5 billion into India despite the pandemic.
MAURITIUS IS ABLE TO INVEST BILLIONS OF DOLLARS
The question then begging to be asked is how a country with a GDP of $12 billion invest so much every year? As mentioned earlier, the Indian government, since liberalization, had been pushing for more FDI into the country. During this process, Mauritius and Singapore came out as the biggest investors. This was primarily because they became tax havens for investors looking to invest in India from abroad. An example of how these tax havens are used is one of the biggest FDI in recent history was Walmart buying 77 percent of Flipkart, an Indian online retailer, for $16 billion in 2018. Walmart made this investment through its Singapore-based entity to save some tax money.
FDI from Mauritius into India
Similarly, many investments are routed through Mauritius, so even though it might seem like FDI is coming from Mauritius, it is being sourced from somewhere else. Between 2000-2017, 34% of all of India’s FDI came from Mauritius. This amounted to a whopping 134 billion dollars (USD).
How is money “routed” through Mauritius? Well, for reference, let’s use this chart:
The above chart shows the different ways in which a company could hypothetically route the investment. A hypothetical company based in the UK can use two ways to invest in India. One is the direct way; In this, the company would have to adhere to Indian taxation law, British taxation law and the double tax avoidance agreement (DTAA) between the two countries. The second way would be “routing” it through Mauritius. If money is being routed through Mauritius, said company would have to follow Mauritius tax laws and the Indo-Mauritius treaty. Here the company would save a significant amount of money due to the low tax rates in Mauritius. The corporate tax rate in Mauritius is 15%, but the effective tax rate after government schemes is about 3%. This is coupled with no withholding tax and no capital gains tax on dividend payments. Hence, it would be more beneficial for a company to establish a “shell” company in Mauritius and invest in India. As seen in this case, taking advantage of a treaty between countries to avoid taxes is called treaty shopping.
We can see in the table below that in order to avoid taxes, investment is often routed through other countries on its way to India:
More than 90% of investments are “routed flows” when it comes to Mauritius and Singapore, two of India’s most prominent investors. This means that companies are using these countries to treaty-shop.
There is another similar sort of tax evasion that occurs called “investment round-tripping”. Capital investment is routed through low tax regions and sent back to the original country as FDI. A big chunk of investment from Mauritius follows this route. Another common practice is called “re-invoicing”. In this, hypothetical, Indian companies would invoice their goods through Mauritius. Doing this would save tax on any profit they make, as Mauritius has low tax rates.
There is a need for transparency as differentiating between actual investment, and sourced investment is difficult for taxing authorities. Experts estimate India loses hundreds of millions of dollars due to the sort of tax evasion mentioned above.
ON THE ROAD TO TRANSPARENCY
In order to bring more transparency and prevent tax fraud, the Indian government recently started to crack down on tax havens. The Modi government successfully negotiated to amend the 1982 tax treaty with Mauritius. This amendment allowed India to tax capital gains on the transfer of Indian shares from April 2017 onwards. Similarly, in December 2016, Singapore and India signed a revised double tax avoidance agreement to tax capital gains on investments from the island country. This was supplemented by new Indian regulation, which discourages foreign companies from setting up overseas entities purely to avoid taxes by denying them local tax benefits.
In 2020, the Reserve Bank of India, took the stance that setting up financial firms with funding from Mauritius and other non-FATF compliant countries was no longer allowed. This, if implemented correctly, would bring further transparency into the funding of the sector. However, some professionals in this field have warned that the move will also impact overall funding. Tackling China is also an essential objective of this move. Experts have pointed out that post the 2020 conflict between India and China in the Galwan Valley, there has been a surge of investment from China being routed through Mauritius. This is due to the restrictions placed on direct Chinese investment.
India has benefited from the FDI coming in from Mauritius, be it on employment or growth statistics. Introducing a new policy, which focuses on transparency, would help bring in more tax money, but it might deteriorate the overall investment. It seems India is facing a catch 22 situation. If it stays in its current state, it might miss billions of dollars worth of taxes. This money could be used to lift millions out of poverty. However, if it does not act cautiously, it might end up scaring away potential and current investors. Regulation of FDI is vital for financial as well as national security purposes. While looking out for its financial gains, India must also prevent money from its enemies coming in.
Aviral Anand is a rising second year student at Ashoka University