Tax Friendly Angel Investment Routes in India for US Investors: Understanding the DTAAs and LOB Clauses
Angel investing in India for US investors can be a lucrative endeavor, but navigating the complexities of tax laws can be challenging. This article delves into the most tax-friendly routes and highlights the impact of Double Taxation Avoidance Agreements (DTAAs) and the Limitation of Benefit (LOB) clause on foreign direct investment (FDI). While India has signed DTAAs with 80 countries, only three—Mauritius, Singapore, and Cyprus—provide relief on capital gains taxes. Understanding these provisions is critical for investors aiming to minimize their tax burden.
Understanding the DTAAs and LOB Clauses
India has signed DTAAs with countries to avoid double taxation. For capital gains tax, these treaties are only mandatory in three countries—Mauritius, Singapore, and Cyprus. This means that capital gains are not withheld in these countries, and the tax is levied by the source or residence country. As a result, many foreign direct investments (FDIs) in India are routed through these jurisdictions. Mauritius accounts for approximately 38% of FDI inflows, while Singapore accounts for about 10%, as of 2012/13.
However, the Indian government is not pleased with this trend. One of the primary reasons is the round-tripping of funds by Indian tax residents to avoid paying taxes. A common avoidance strategy involves setting up shell investment companies in these three countries, transferring funds out of India, and then investing them back in India as a foreign investor. Upon exit, India honors the DTAAs and does not withhold capital gains taxes, whereas the countries of the shell company do not have a domestic capital gains tax. This scenario is appealing to tax evaders.
Tightening of Regulations
To combat this tax avoidance ploy, India is tightening its regulations. Cyprus, for instance, has been blacklisted for not sharing enough information with India, leading to it falling out of favor as a destination for foreign investment. India has initiated an initiative with Mauritius and Singapore to include a Limitation of Benefit (LOB) clause in the DTAAs. The LOB clause imposes strict guidelines on the types of investors who can benefit from the capital gains exemption, typically limiting it to actual resident individuals and corporations and/or requiring a minimum local investment annually.
The LOB clause is already in place for the treaty with Singapore, and Mauritius has opposed it for some time. However, after a period of uncertainty, Mauritius is now in the final stages of negotiations. The uncertainty surrounding the LOB clause with Mauritius has made Singapore more attractive for legitimate foreign investors, as the clause is now certain. Reports suggest that Singapore has overtaken Mauritius as the primary source of FDI inflow to India.
Most Tax Friendly Route
For legitimate global investment funds, the most tax-friendly route is to have a fund in Mauritius, Singapore, or Cyprus that complies with the LOB clauses and invests in Indian startups through that fund. For individual investors who do not meet the LOB guidelines, it becomes more challenging. Unless one is willing to use a shell corporation and risk legal trouble, it is advisable to pay the correct taxes.
Alternatively, individual investors can explore investing in Singapore or Mauritius-based funds that can legally claim tax benefits, provided they have the necessary investment capacity and are allowed to do so.
Conclusion
The India-US dual taxation treaty is an important consideration for US investors looking to enter the Indian market. However, the landscape is evolving, with tighter regulations and the introduction of LOB clauses. Understanding the impact of DTAAs and LOB clauses is crucial for minimizing tax burdens and ensuring compliance. Legitimate investors should stay informed and seek professional advice to navigate these complex tax environments successfully.
Disclaimer: I am not a certified tax advisor. For professional tax advice, please consult a qualified tax expert.