In another instance of Indian tax authorities adopting a hard-nosed stance to prevent abuse of tax avoidance treaties, the revenue department recently opposed a proposal of a Cyprus-based company to increase its stake in an Indian telecom services company from 40 per cent to nearly 74 per cent.

Cyprus-based Daltotrade Ltd had proposed to raise its stake in Meta Telecomm Pvt Ltd, a company registered in India that has applied for licences to offer domestic and international long-distance services.

Earlier this month, the Foreign Investment Promotion Board (FIPB) rejected the proposal on security concerns and the revenue department saying the source of funds is not clear.

Advising FIPB, the nodal agency for approving foreign investment proposals, to reject the proposal, the department pointed out that gains from the future sale of the shares in question would not be taxable in India due to the double taxation avoidance agreement (DTAA) with Cyprus.

Under the DTAA, Cyprus residents (individuals and companies) are exempt from capital gains tax in India. Cyprus also does not levy capital gains tax on its residents. This effectively provides for double exemption for such investors, a feature prevalent in other similar treaties that India has with countries like Mauritius.

The revenue departments stance assumes importance given that India is trying to renegotiate the Cyprus treaty with an eye on taxing capital gains taxable in the jurisdiction in which the income is earned. This is not the first instance of such an effort by India. In fact, it has already reworked the DTAA with the United Arab Emirates and removed the capital gains tax exemption clause. India is also trying to renegotiate a similar treaty with Mauritius.

It may be recalled that the tax department is currently in litigation with Vodafone on paying withholding tax for acquiring Hong Kong-based Hutchisons stake in a Mauritius-based outfit that held a majority stake in Indian mobile service provider Hutch-Essar.

FDI is rising sharply from Cyprus and Mauritius, compared with inflows from developed countries like the United States and the United Kingdom. From an inflow of $58 million in 2006-07, FDI from Cyprus rose sharply to $834 million in 2007-08. In the first two months of the current fiscal, FDI from Cyprus stood at $177 million.

Similarly, FDI from Mauritius rose from $6.3 billion in 2006-07 to $11 billion the next year. In the first two months of the current fiscal, FDI from Mauritius stood at $2.85 billion.

With overseas companies structuring their investments to maximise benefits and minimise tax cost by routing investments through tax havens, preventing abuse of tax treaties is high on the agenda of the Indian revenue authorities.

However, tax consultants disagree. "Investment coming from a DTAA country should not be the criterion for not allowing it. Even if residency is not proved, investments may be allowed without the benefit of a tax treaty," said Gaurav Taneja, partner, Ernst & Young. He added that lack of clarity on the source of funds is a valid reason for opposing an investment.