By Priyanshi Chokshi, Associate, Raghav Bajaj, Principal Associate, and Vinita Krishnan, Director, with Khaitan & Co., Mumbai
The apex tax administration body of India, otherwise known as the Central Board of Direct Taxes, has brought forth a significant development by clarifying the applicability of the “most favoured nation” (MFN) clauses in Indian tax treaties through its circular dated February 3, 2022.
Most favoured nation clause: The recent debate in the Indian context
In the field of international trade and international economic relations, tax treaties are the bedrock of nondiscriminatory trade policy. On similar lines, the MFN clause in international tax law (usually introduced in the protocol to tax treaties) also intends to promote nondiscrimination and parity in business and investment opportunities among treaty partner countries. The MFN clause, meant to accord equitable treatment to the treaty partner country vis-à-vis a third country, links agreements by ensuring that parties to one treaty are accorded treatment that is no less favourable than the treatment provided under other treaties in areas covered by the clause.
Though MFN clauses in tax treaties have different formulations, the general underlying provision is the same – i.e., all members of the OECD are to be afforded similar treatment in their tax treaties. Thus, the effect of such a clause is that one state is obligated to its treaty partner to offer it a more favourable tax treatment (than what is set out in their own tax treaty), if such favourable tax treatment is offered by the first state in its tax treaty provisions with a different state. The only criterion for its applicability is that the second and the third state will need to be OECD members for the MFN clause to apply.
India’s tax treaties with countries such as Slovenia, Colombia, and Lithuania provide for a lower rate of source taxation with respect to certain items of income. India has entered into tax treaties with Slovenia (2005), Lithuania (2012), and Colombia (2014) agreeing to a tax rate of 5% on dividend income if the recipient company holds 10% or more of the share capital in the Indian company. However, these countries became OECD members only after signing their tax treaties with India in the years 2010, 2018, and 2020, respectively.
Consequently, France, Netherlands, and Switzerland released unilateral directives dated 2016, 2012, and 2021, respectively, declaring that the tax rates on dividends under the respective tax treaties with India stand modified by way of the MFN clause, after India entered into a tax treaty with Slovenia. The directives further set out that the more favourable rate will apply retrospectively from the dates the respective countries became members of the OECD. Thus, the European nations have interpreted the MFN clause to mean that even if the third state with which India enters into a tax treaty is not an OECD member at the time of entering into the treaty, the moment the third state becomes an OECD member, the clause becomes operational and such beneficial provisions will apply retrospectively from the date the third state became an OECD member.
In this context, given that India now taxes dividends in the hands of shareholders as against the dividend-paying company itself, the core issue that has recently arisen is whether non-residents located in European nations (the Netherlands, France, the Swiss Confederation, Spain, and Hungary) are entitled to the concessional tax rate on dividend income that they receive from Indian companies, by virtue of the MFN clause in India’s tax treaties with these jurisdictions.
Indian courts addressed this issue by allowing for preferential treatment, as per the MFN clause. While taxpayers and courts have relied on these decisions as an interpretative tool, the circular now clearly sets out the CBDT’s position, which is contrary to the views expressed in the decisions, in relation to MFN clauses.
The circular’s clarifications
The circular lays down certain conditions that need to be fulfilled for the lower rate, or restricted scope, in the tax treaty to apply: First, the treaty with the third state must be entered into after the signature/entry into force of the tax treaty between India and the first state; second, the third state is an OECD member at the time of signing its tax treaty with India; third, the provision in the tax treaty with the third state is more beneficial vis-à-vis the relevant tax treaty; and fourth, India has specifically issued a separate notification to this effect.
Taking a contrary position to the interpretation of European nations and Indian courts, the CBDT has enumerated a host of reasons to substantiate its position and the conditionalities set out.
Relevance of the unilateral decree, bulletins, and publication issued by the contracting nations: As per the Indian government, the unilaterally-issued decrees, bulletins, and publications were merely each country’s interpretation of the MFN clause and were not binding on India. The decrees had been issued without any bilateral consultation and did not represent a shared understanding between the parties or its impact on the Indian tax laws. India has clarified its stance to these countries and is awaiting their response.
Interpretation of the MFN clause: A key question to be determined was whether the benefit from the other tax treaty could be borrowed as on the date of entry into force of the tax treaty or on the date of the third state becoming an OECD member. Clarifying its stance, the CBDT stated that an MFN clause in a treaty with another country cannot be imported unless the third state is a member of the OECD, both at the time of conclusion of the treaty with India as well as at the time of applicability of the MFN clause. Therefore, the benefit only will be available from the date of entry into force of the tax treaty with the third state and not when it becomes an OECD member. Any interpretation to the contrary would render the language of the MFN clause redundant.
Mandatory notification by the Indian government for application of the MFN clause: The circular clarifies that as per Indian law, the tax treaty or an amendment to the tax treaty could be implemented only after its notification in India’s official gazette. However, it is noteworthy that the protocol to tax treaties forms an integral part of the treaty, and no separate notification may be required to make its provisions into effect.
Selective import of concessional rates under the MFN clause: Additionally, the circular prohibits the “selective” import of concessional rates under the MFN clause. India’s treaties with Slovenia and Lithuania consist of a split rate of tax for dividends. The beneficial rate of tax on dividend income would be applicable only on satisfaction of specific conditions, and if not, a higher rate of tax would apply in the source jurisdiction. Therefore, even if the benefits under the MFN clause were extended to the tax treaties with the Netherlands, France, and Switzerland, then merely taking the beneficial rate of 5% without considering the associated conditions was not justified.
Key takeaways
While the circular clarifies the tax department’s position in clear terms, there exist substantial imbalances in the conception, implementation, and the potential aftermath of such provisions. The circular’s potential impact on taxpayers and various other stakeholders is depicted below:
Basic objective behind introduction of the MFN clause and impact on taxpayers
Before understanding the applicability of the MFN clause, it would be opportune to first understand the nature of tax treaties and MFN clauses. Tax treaties are such that they are automatic in nature; in other words, they do not prescribe any specific or express provision to give effect to the MFN status. A protocol to the tax treaty is to be considered as an integral part of the treaty. Therefore, the provisions of the protocol conferring, expanding, or reducing a particular benefit that is absent in the tax treaty are to be applicable and have the same binding force as any other clause. Now, coming to the objective behind the introduction of such clauses, it is important to understand that the MFN clauses are born out of trade negotiations between countries to bring parity between member states.
Contrary to the above, the circular deviates from the very nature of tax treaties and protocols in the first place. The requirement to have a separate notification under Indian law for importing the benefits of a second treaty into the treaty with the first state leaves the process of introduction/application of the MFN clause at the absolute discretion of the government of one country. The MFN treatment aims at reducing a state’s influence to the advantage of the taxpayer. However, the circular undermines this balance. Further, by placing a blanket restriction on MFN clauses in entirety, the circular also overrides the use and interpretation of different types of MFN clauses, and the fundamental concepts underlying the differentiation in such clauses.
For instance, the MFN clause in India’s tax treaties with the Netherlands and France is self-operational; it does not require any positive act (such as issuing a notification) for invoking the effect of the clause and various courts have relied on it for allowing the benefit of preferential treatment. Additionally, the protocol to the India-Switzerland tax treaty in respect of royalty or fees for technical services provides that if India imparts a more preferential treatment to another OECD member, Switzerland and India will enter negotiations without undue delay to provide the same treatment to Switzerland at par with the third state. In the India–Philippines tax treaty, the information about a liberal tax treatment for another jurisdiction is intimated to the other treaty partner-country through diplomatic channels to avail of the benefits under the concessional provisions and treat it at par with the tax treatment in the source jurisdiction. Tribunals in other cases also have provided the benefit of the “make available” clause under the India–Canada and India–U.S. tax treaties to the taxpayer, in view of the MFN clause under the India–Belgium tax treaty.
In this regard, it also would be opportune to quote the basic principles underlying the income tax laws in India that provide that where there exists uncertainty or ambiguity with respect to interpretation of the tax law provisions, an interpretation that is most favourable to the taxpayer should be taken into consideration.
Additionally, by failing to clearly provide a distinction between self-operational and other MFN clauses, the circular could significantly hamper the application of different types of MFN clauses. With multiple nations adopting the MFN clause—either directly or indirectly—the circular could impact its use from a domestic and global perspective. With the law continuously evolving, it would be most appropriate for contracting states to keep pace with changing laws and interpret provisions based on its relevance at the given point of time.
Impact on other streams of income
In today’s globalised world, with capital being highly mobile, taxpayers and companies tend to seek investment opportunities in various jurisdictions. The circular will have a bearing on the Indian arm of companies based in these countries and the agreements entered into between group entities.
The MFN clause does not apply to dividends only. Authorities in various countries have accepted the use of this clause with respect to tax rates on fees for technical services. The courts’ position has been that there is no need for the final protocol—or for the beneficial provisions in some other tax treaty between India and another OECD country—to be separately notified to avail of a preferential treatment provided under the treaties.
Thus the circular, though specifically referring to dividends, will have wide-ranging implications even on other streams of income in the nature of interest, royalties, and fees for technical services, which may not have been the circular’s intent.
Consequently, any positions taken on the basis of the MFN clause may need to be re-evaluated, such as in the case of services, royalties, and debt agreements, among others. Non-residents and persons making payments to non-residents who are required to withhold applicable taxes at source and taxpayers seeking refund claims or lower withholding tax certificates also may be impacted; it will be worthwhile to see if the positions adopted on the basis of judicial precedents would continue to hold, especially considering the circular’s nonbinding nature.
Conclusion
With campaigns like “Make in India,” “Atmanirbhar Bharat” and “Voluntary Dispute Resolution” schemes for the speedy disposal of cases, the Indian government on the one hand aims to develop a stable and predictable taxation regime in the country. On the other hand, the government, through this circular, has added to the hardship taxpayers face and brought in an element of uncertainty and ambiguity into international taxation laws. India’s taxation laws ought to encourage taxpayers, facilitate business and investment opportunities, and promote cooperative compliance rather than deter taxpayers and businesses with litigation or fine print. Until the issue is finally resolved, it will be interesting to note how tax authorities in the Netherlands, France, and Switzerland respond to the circular and to the practical positions that non-residents and persons making payments to non-residents may adopt in terms of the interpretation of MFN clauses in line with the circular or judicial precedents.
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Priyanshi Chokshi is an Associate, Raghav Bajaj is a Principal Associate, and Vinita Krishnan is a Director with Khaitan & Co. in Mumbai.
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