The official statistics provided by the department of industrial policy and promotion (DIPP) under the ministry of commerce and industry shows that between January 2000 and December 2017, India received $368 billion of foreign direct investment (FDI). It also says that Mauritius was the source of $125 billion of FDI, meaning this tiny island nation contributed 34 percent of the total FDI inflows to India in this period. The next four countries in the list of largest sources of FDI to India are Singapore ($53 bn or 16 percent), Japan ($25 bn or 8 percent), the UK ($24 bn, or 7 percent) and the USA ($20 bn or 6 percent). These figures raise an important question: how did a country with population of 13 lakh and an annual GDP of $12 billion (around 0.5 percent of India’s GDP) become the largest source of FDI to India, much ahead of bigger economies like the USA, the UK and Japan?

The Centre for Budget and Governance Accountability (CBGA), a Delhi-based think tank, recently did a study focusing on FDI in India during 2004 to 2014. This study, ‘Foreign Direct Investment in India and Role of Tax Havens’, makes use of the ISID FDI dataset which was developed by Prof CS Chalapati Rao, based at the Institute for Studies in Industrial Development (ISID), Delhi.

The dataset analyses every single FDI inflow to India and traces the ultimate owner(s)/controlling entity of that investment, along with the headquarters’ location or its home country. This dataset, thus, helps to identify if a particular investment is actually coming from the country reported in the official statistics by DIPP, or is merely being routed through there. The adjoining figure explains the distinction between the investment coming from the reported country and being routed through there.

Consider an investor (individual or a firm) based in the USA who wants to invest in India. There are two possibilities for the investor to bring his/her investment to India. In the first case, it comes directly from the USA to India; while in the second case, he/she first establishes an intermediary firm in Mauritius, then sends the capital to that firm and finally invest in India through that firm (we will discuss the reasons). In the first case, both the home country of investor and the reported country in DIPP data are the same. However, in the second case, Mauritius will be reported as the source of FDI in India while the investment is in fact coming from the USA.

Based on this distinction between the actual home country of the investor as against the reported country, the findings of the study reveal some interesting new information. The above chart shows the top 10 countries as they are reported in the official statistics versus top 10 countries where the owner/controlling entity is actually based. Contrary to the official statistics and in accordance with doubts raised by many, Mauritius is not the largest source of FDI but merely a transit point used by investors from other countries. The largest share of FDI in India in fact comes from USA-based investors, which is in line with its global economic prominence. Surprisingly though, the second largest share (17.1 percent) is actually contributed by India-based entities. Another two percent is contributed by a group named ‘India+’. These are entities which have some investment from Indian investors/companies along with entities from other countries. The two groups combined make nearly 20 percent of all the FDI inflows coming to India. Investors/companies from USA and India are followed by those from the UK, Japan, Germany and France.

This stark difference between DIPP-reported statistics and the actual source of FDI inflows highlights a phenomenon in which investing entities route their investment through a third country. The study estimates that out of total FDI inflows to India between 2004 and 2014, only 26 percent came directly from the home country of the investor, 68 percent were in fact routed through a third country; details couldn’t be identified for the remaining six percent. Among the top 10 countries in DIPP statistics, the main countries to be used for routing investment flows are – Mauritius, Singapore, Cyprus and Netherlands, with the share of routed funds as 97, 90, 94 and 83 percent respectively. An analysis of investors routing their investments through each of the above country provides the picture shown in this page. Close to a third of investments coming from Mauritius are actually made by USA-based investors, while 25 percent are by Indian entities. USA investors are the major players in all four countries, so are the Indians except in case of Netherlands. Apart from USA and India, UK-based investors are also present in all four countries.

This phenomenon of routing of investment through a third country can be explained through the concepts of treaty shopping and shell companies. In treaty shopping, cross-border capital/investment flows are routed through a third country merely to take advantage of the treaties of that jurisdiction. And shell companies are firms that don’t engage in any real business/economic activity, but are merely used by the owner/controller to carry out financial/legal works. Generally, a shell company has very few employees and symbolic office premise merely to fulfil legal requirements. For example, Mauritius had a double tax avoidance agreement (DTAA) with India, under which rights to tax capital gains were assigned to the resident country. It means, in case of a Mauritian investor earning capital gains in India, he/she would pay corresponding capital gains tax in Mauritius, however in the domestic law of Mauritius, there is no capital gains tax. This effectively meant that a Mauritian investor didn’t have to pay capital gains tax on income earned in India.

Since this benefit of ‘no capital gains tax on the investments in India’ was available only to the residents of Mauritius, investors from other countries would first create a shell company in Mauritius, and take the legal identity as a Mauritian resident. This way, even a non-Mauritian investor could own a company with Mauritian identity with little extra cost, and then this company could be used to route the investment to India, and enjoy the benefits available to the Mauritian entity. Similar beneficial taxation provisions were also present in the India’s DTAAs with Singapore, Cyprus and Netherlands. And this led to investors from all around the world first going to these countries and routing their investment to India through them. This method was in fact so beneficial and popular that even Indian investors would first take their funds out of the country, and then bring them back in the form of foreign investment through these countries. This process is known as round tripping. The fact that close to 20 percent of FDI in India is by investors/companies based in India adds weight to the clamour of round tripping. However, it should be noted that many a time, Indian companies do raise funds abroad through different legitimate channels, like stock markets, bank loans and individual investors. Hence, all the investment inflows controlled by Indian entities are not necessarily part of round tripping.
Nevertheless, the huge magnitude of such flows makes the case for deeper scrutiny.

In 2016, India amended its DTAAs with Mauritius, Singapore and Cyprus. These amendments changed the provision on capital gains, which was the main motivation behind the routing of investment through these countries. Starting financial year 2017-18, the capital gains made by investors from these three countries are taxed at half the rate prescribed in India law. From the next financial year (2019-20), the gains will be taxed at the rates prescribed by the Indian law. With the main motivation behind routing investment through these countries disappearing, it is expected that prominence of Mauritius and Singapore in FDI inflows to India would decrease.