Annex 3A: Investment Hubs: The India-Mauritius Connection and How Singapore Fits In

countering the stereotype of the similarity of endowments among South Asian countries. The wide variety of investments pursued with varying start-up costs shows how OFDI participation is quite inclusive.

Some important policy implications result from this analysis. First, by incorporating an outward investment lens in the context of a firm choosing from among alternative engagement modes, the analysis brings attention to the stark distortions resulting from the OFDI policies of most countries in the region. Most OFDI arrangements are restrictive, discretionary, and lack transparency, with the exception of India and to a lesser extent Sri Lanka. Second, the diverse motivations of regional pioneers highlight new benefits of OFDI specific to emerging market multinationals, heightening the need for policy action on OFDI, even for small economies and those with balance of payments concerns. Third, region-specific IFDI and OFDI policies remain in place, distorting investment flows in the region.

The chapter also highlights the important role of investment hubs for the region. Estimates of ultimate investors suggest that intraregional investment is only marginally higher compared with unadjusted figures, but roundtripping is likely a larger issue. A study of South Asian firms, particularly in Dubai and Singapore, will likely produce a refined set of constraints that South Asian regulatory arrangements are imposing on actual and potential outward investors. Dubai and Singapore are not only global commercial port hubs but also demonstrate a strong presence of the diaspora and expatriate populations of many nations of South Asia.

The next chapter identifies the determinants of investment entry and the characteristics of firms and investors that succeed and the constraints they face. The econometric estimation relies on the framework for international engagement developed in chapter 2. Chapter 4 first establishes the low levels of, and high variance in, knowledge connectivity, networks, and trust across 56 bilateral pairs of countries and proceeds to estimate the importance of knowledge connectivity, among other factors, for South Asian investors.

Mauritius plays a role that is much larger than expected in India’s foreign investment landscape. Data on inward foreign direct investment (FDI) stocks show Mauritius as the largest source of FDI to India, with US$87 billion at the end of 2017. Similarly, for outward FDI from India, Mauritius shows up prominently (a close third place destination, after Singapore and the Netherlands, as measured by FDI stocks). How could this country, which is 200 times smaller than India in gross domestic product (GDP) (but five times richer in GDP per capita), become India’s largest source of capital? What is driving this phenomenon? The foundation for this outcome is the Double Taxation Avoidance Agreement (DTAA), which India signed with Mauritius in 1982, when

Mauritius had just become the first African nation to undergo a change of government in a democratic process. As a leader in the nonaligned movement, India supported democracy in Mauritius with the DTAA, which was set up to boost trade and investment between the two countries.

At the core of the DTAA is a clause that allows investors from Mauritius to invest in the Indian stock market and pay capital gains tax in Mauritius—a “residence-based” tax principle, in which taxation occurs in the jurisdiction where the company is based. The alternative is a “source-based” structure, in which the tax is levied where the money is made. Mauritius does not and has not taxed the capital gains of any investor registered in Mauritius and investing offshore. Mauritius also had a low (5 percent) withholding tax on dividends (now zero) and a low corporate tax rate that could be effectively 3 percent (for exporters; 15 percent otherwise). Given the relatively low tax rates compared with India, the result was that Mauritius became a platform from which to invest in India for many countries, including the United States and the United Kingdom. One Cathedral Square on Jules Koenig Street in the country’s capital city of Port Louis became the famous address of investment firms. These addresses were mostly mailboxes, which was initially sufficient to get the stamp of Mauritian residency.

Tracing investments back to their origin, Jaiswal (2017) finds that 97 percent of FDI flows from Mauritius to India during 2004–14 were routed flows—that is, the investor’s headquarters is in a country other than Mauritius. Similarly, high shares of routed flows are found for inflows from the hubs in Cyprus, Singapore, and the Netherlands. By contrast, all Japanese investment inflows into India come directly from Japan-based firms (figure 3A.1). The loss of capital gains tax revenue to India was clear. In addition, there were potentially other tax losses from the profit-shifting behavior of multinational firms using transfer pricing. Transfer pricing happens when firms and their subsidiaries overinvoice or underinvoice to shift profits to a low-taxation territory. For example, an Indian firm that set up a subsidiary in Mauritius could export to Europe through the subsidiary. Through appropriate pricing, the profit accrues only to the firm in Mauritius, which pays a corporate tax of 3 percent compared with India’s 15 percent. Then the profits could be remitted back to India as inward FDI from Mauritius.

Further, because Mauritius is also one of the largest destinations for Indian outward investment, these Indian outflows could possibly reflect some amount of roundtripping. Roundtripping is the concept of an Indian investor setting up a shell company in Mauritius (Indian OFDI) to invest back in India to avoid paying higher Indian corporate income taxes. The investor also would have been able to receive investment incentives for foreign investors.

During the early postliberalization period, the government of India was cautious about this issue because it needed foreign funds to flow into its stock market in the form of foreign portfolio investment, given that there were restrictions on FDI through the 1990s and early 2000s. Announcements by public officials of greater scrutiny of investment from Mauritius would lead to large drops in the stock market index and rescinding of initial intentions.