India–Mauritius Tax Treaty and the Cost of Capital: Why Legal Certainty Matters More Than Ever

Recent developments around the India–Mauritius tax treaty have reopened a fundamental debate in international taxation: should India tax foreign capital at source, or respect residence-based taxation anchored in treaty certainty? A fresh ruling that allows tax authorities to look beyond a tax-residency certificate (TRC) to deny treaty benefits has unsettled global investors. But the anxiety is not about one judgment alone. It reflects deeper unease about India’s evolving tax philosophy, the weakening of predictability, and the implications for long-term economic growth.

Why tax neutrality is central to economic growth

In international trade, there is broad intellectual clarity around tax neutrality. Value-added tax (VAT) follows the destination principle: exports are zero-rated, imports are taxed at the same rate as domestic goods. This ensures that taxation does not distort the choice between domestic and foreign products. A similar logic underpins newer ideas such as the Carbon Border Adjustment Mechanism, where countries may choose different carbon taxes, but trade itself is not distorted.

Finance demands the same neutrality. In cross-border capital flows, this translates into residence-based taxation—capital income is taxed in the investor’s country of residence, not where the investment is made. If a US pension fund invests in India, the returns should be taxed in the US, not in India. For a capital-scarce economy like India, this is not an academic preference but a strategic necessity.

Source-based taxation as a tariff on capital

Global capital moves towards the highest post-tax, risk-adjusted returns. When India imposes source-based taxation on foreign investors, it lowers their post-tax returns. To compensate, investors demand higher pre-tax returns from Indian assets. Projects that are viable at a 10% cost of capital become unviable at 14%.

In effect, source-based taxation functions like a tariff on capital. It creates friction at the border, raises costs for Indian firms, discourages investment, and ultimately slows GDP growth. Even if India cannot immediately adopt low domestic taxes on capital, maintaining residence-based taxation for foreign investors is critical to keeping the cost of capital down.

The Mauritius route and a deliberate second-best solution

For years, India achieved de facto residence-based taxation through tax treaties, most notably with Mauritius. This was a classic “second-best” institutional solution. Public rhetoric in democracies often demands taxing the rich or taxing foreigners. But successful economies quietly preserve efficiency through tax-neutral conduits.

The Mauritius route allowed India to attract foreign capital at a lower cost, insulating investors from domestic tax uncertainty. This equilibrium rested on legal certainty. The cornerstone was the Supreme Court’s judgment in “Azadi Bachao Andolan vs Union of India”, authored by Justice B. N. Srikrishna. The principle was unambiguous: a valid TRC issued by the Mauritian authorities was conclusive. Indian tax officers could not go behind it.

How the 2016 amendment changed the rules

This certainty began to erode in 2016, when the India–Mauritius tax treaty was amended to include a Limitation of Benefits (LOB) clause. While officially framed as a measure to curb abuse, the amendment fundamentally altered the framework. The objective standard of a TRC was replaced with subjective assessments of commercial substance.

This empowered tax authorities to “look through” residency certificates and reassess investor intent. The recent ruling is a logical outcome of that shift: the TRC is no longer a shield against investigative discretion. What was once settled law has become a moving target.

The investment fallout: signals from the data

The timing of this shift is telling. It coincides with a broader slowdown in private investment and a structural break in foreign participation in Indian equity markets. Foreign ownership of listed Indian companies rose steadily from 8.38% in 2000–01 to a peak of 19.19% in 2015–16. Since then, it has stagnated and reversed, falling to about 16.04% by 2024–25.

In a successful emerging market, home bias should decline over time. As economies mature and integrate globally, foreign ownership typically rises. India’s reversal suggests rising friction and growing investor caution—consistent with higher perceived policy and legal risk.

Rule of law, predictability, and judicial responsibility

At its core, the issue is about the rule of law. Predictability is its essence. When courts reopen settled questions or allow reinterpretation of long-standing treaty principles, they increase the ex ante risk of investing in India. Today, a foreign investor must price not just business risk, but the risk that a treaty signed today will be reinterpreted tomorrow.

The judiciary is meant to act as a check on executive overreach. When it fails to uphold the sanctity of contracts and the finality of instruments like the TRC, uncertainty becomes systemic. Tax authorities with limited appreciation of growth economics, combined with judicial ambivalence on settled principles, impose a hidden but substantial cost on the economy.

A reform agenda for growth-oriented taxation

If India is serious about sustaining high growth, four policy projects must move to the forefront. First, remove customs tariffs that distort trade. Second, eliminate blockages of input tax credit under GST. Third, transition towards a coherent carbon tax framework. Fourth—and most urgently—return to residence-based taxation of capital.

This understanding must permeate the bureaucracy, the revenue department, and the judiciary alike. Capital is mobile, memory is long, and credibility is hard to rebuild once lost. In cross-border taxation, as in trade, neutrality and certainty are not concessions to investors—they are prerequisites for growth.