New Delhi, March 1: The finance ministry has agreed to amend a contentious tax proposal in the Finance Bill that had threatened to lift the veil and identify the real investors pumping money into India through tax havens like Mauritius.

The proviso had sent a frisson of fear through investors who mauled the markets on Thursday after learning that it wouldn’t be enough to produce tax residency certificates (TRCs) from places like Mauritius to qualify for tax reliefs enshrined in India’s agreements with the countries.

“They might also have to prove beneficial ownership of the entities that were claiming the tax breaks,” finance minister P. Chidambaram had told a media conference on Thursday after the presentation of his budget.

The big beef was over Section 90 of the Finance Bill that said the tax residency certificate was a “necessary, but not a sufficient condition”, for claiming benefits under the double tax avoidance agreements (DTAA) with India.

Today, the finance ministry issued a statement: “Since a concern has been expressed about the language of sub-section (5) of Section 90, this concern will be addressed suitably when the Finance Bill is taken up for consideration.”

The ministry said: “The tax residency certificate produced by a resident of a contracting state will be accepted as evidence that he is a resident of that contracting state and the income tax authorities in India will not go behind the TRC and question his resident status.”

Chidambaram himself went into damage control mode by stating in a televised interview: “There was never any intent to question the residence status of a person who produces a TRC.”

The BSE sensex, which had tumbled 290 points yesterday, rose to 18987.58 in the afternoon after the ministry’s clarification before closing at 18918.52 points, a gain of 56.98 points over Thursday’s close.

The Finance Bill will be taken up for consideration in April and the change in the wording will become clear only then, officials said.

The finance ministry seemed to be bemused by the brouhaha since the offending phrase had been used in the explanatory memorandum to the Finance Bill 2012 tabled last year by then finance minister Pranab Mukherjee.

The ministry said: “In the explanatory memorandum to the Finance Act, 2012, it was stated that the tax residency certificate containing prescribed particulars is a necessary but not sufficient condition for availing benefits of the DTAA. The same words are proposed to be introduced in the Income-Tax Act as sub-section (5) of Section 90. Hence, it will be clear that nothing new has been done this year which was not there already last year.”

A close reading of last year’s explanatory memorandum indicates that this is true but with a slight difference.

Last year’s memorandum says the ministry had noticed that a number of “third-party residents” were claiming treaty benefits and that’s why it was making the submission of the tax residency certificate as a necessary, but not sufficient, condition for availing themselves of benefits under the agreement.

Who are these third-party residents?

The suspicion is that a number of resident taxpayers have been round-tripping funds into India through foreign institutional investors (FIIs) through a mechanism called participatory notes (or PNs).

The PN is an instrument that derives its value from underlying investment — in this case stocks of Indian companies into which the investors’ money has been routed. The PN is an arrangement between the FII and the investor whose name is never disclosed to the Indian regulatory or tax authorities.

This year, there is no reference to third-party residents, though one might argue that it is anyway implied. But if it isn’t explicitly stated, it becomes open to a variety of interpretations — and could open a new can of worms.

Explained Rohan Solankar, senior director with consultancy Deloitte: “The words used in the Finance Bill’s explanatory memorandum which was released yesterday seemed to indicate that the TRC was not enough and taxmen could ask for more documentation… this lack of clarity obviously was not acceptable to foreign investors.”

“Today’s press note seems to clear the air for foreign investors,” Solankar said, adding “markets will be waiting for an appropriate amendment”.

If the clause isn’t re-phrased to make it acceptable, it “could pose more problems and legal challenges for the government.”

But some experts continue to express reservations over the new sub-section 5 in Section 90 — and their disquiet did not end even after today’s clarification.

Said Sudhir Kapadia, national tax leader at Ernst & Young: “Ideally, when the Finance Bill is presented for passing in Parliament, this proposed amendment should be scrapped altogether.”

Kapadia added: “Otherwise, questions relating to other treaties with Singapore and Cyprus may still remain open to interpretation.”

With respect to Mauritius — which has become the most sought-after headland for investments into India — the ministry said: “Circular no. 789 dated April 13, 2000 continues to be in force, pending ongoing discussions between India and Mauritius.”

Circular No.789 had clarified that any certificate of residence issued by Mauritian authorities would be accepted as sufficient evidence to accept both the status of residence as well as beneficial ownership for claiming tax benefits of the Indo-Mauritian agreement.

The circular made it clear that this would apply to income from capital gains on the sale of shares. Tax analysts pointed out that this circular forms the bedrock on which foreign institutional investors (FIIs) based out of Mauritius trade on Indian bourses without paying taxes when repatriating the profits they make.

The 2000 circular — which was issued by the Central Board of Direct Taxes (CBDT) under the finance ministry — has an interesting history. It effectively barred income tax officers from conducting detailed investigations into the activities of Mauritius-based FIIs if such investors produced a tax residency certificate from the Mauritius government.

This circular was challenged in court through two public interest litigations. A bench of Delhi High Court ruled that “mere production of a certificate by a company that it was registered in Mauritius is not sufficient proof for claiming the (tax) benefit under the double taxation avoidance treaty.”

The NDA-ruled government appealed against the Delhi High Court judgment in the Supreme Court, arguing that the CBDT circular was needed to attract foreign investment.

In 2003, the apex court ruled that this device was an act of legitimate tax planning.

It ruled that “many developed countries tolerate or encourage treaty shopping even if it was unintended, improper and unjustified for non-tax reasons, unless it leads to a significant loss of revenue”.

The apex court added: “The court cannot judge the legality of treaty shopping merely because one section of thought considers it improper, neither can it characterise the act of incorporation under the Mauritius law as a sham or a device actuated by improper motives.”