Foreign portfolio investors (FPIs) on Friday pulled out Rs 8,000 crore or nearly $1 billion from Dalal Street and made the Sensex drop by about 800 points after India and Mauritius tweaked a treaty to impose higher scrutiny on investments made in India via the island nation.

The two countries have agreed to a protocol to alter a double taxation avoidance agreement (DTAA) stating that tax relief cannot be for the indirect benefit of residents of another country.

In almost all cases, investors in Mauritius entities making investments in India are from other countries.

“There is a provision of principal purpose test (PPT) which requires that FPIs or any other investors which are based in Mauritius need to have a commercial rationale or a justification to be based in Mauritius. Now, this amendment is proposed in the India-Mauritius tax treaty and that could become effective at any point in time now once the protocol is notified by both the countries. This PPT test is actually much more stringent and has a much higher threshold of the commercial rationale to be based in Mauritius as compared to the GAAR provisions where only substance was required,” said Punit Shah of Dhruva Advisors.

Also read | Govt ends easy tax relief for Mauritius-based FPIs

As a result, all FPIs will have to examine whether they have enough commercial rationale to be based in Mauritius when the tax scrutiny happens. If they can convince tax authorities about their presence in Mauritius, the tax exemption should continue for them, Shah said.Tax experts say the way the protocol is drafted and designed, it looks like the governments want a retrospective application.”It may not have retrospective application for past transactions where exits have happened in the past, I think that may be a little bit of a far stretch to apply the law and create unnecessary nervousness in the market. But at least for past investments, I think they will certainly want to apply this law,” said Rajesh Gandhi, Partner, Deloitte India.

Also read | Sensex falls 793 points. Mauritius link and 5 other factors behind the selloff

Mauritius is currently the fourth-largest source of FDI inflows to India. In FY23, Mauritius was the second largest source of FDI with inflows of $6.1 billion.

As far as the impact on Dalal Street is concerned, experts say the domestic liquidity is strong enough to absorb outflows. Even during today’s session, DIIs were net buyers to the tune of over Rs 6,300 crore.

“We expect markets to remain volatile in the near term given the global concerns and the start of an election next week. With the onset of the earning season, the focus will shift more toward domestic cues along with macro data points. Markets on Monday will react to India’s inflation data and TCS Q4 numbers which will be released today,” said Siddhartha Khemka of Motilal Oswal Financial Services.

Later on the Income Tax department tried to soothe investor nerves by clarifying that the concerns are premature at the moment since the Protocol is yet to be ratified and notified under Section 90 of the Income-tax Act, 1961.

“As and when the Protocol comes into force, queries, if any, will be addressed, wherever necessary,” it said in a statement on X.

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