By Ritu Shaktawat, Partner & Rahul Jain, Principal Associate, Khaitan & Co, Mumbai, India
The High Court of Delhi on 22 April ruled in a landmark judgment that the dividend income earned by a resident of the Netherlands from an Indian company is taxable at 5%, rather than at 10%, as is generally provided under the India-Netherlands tax treaty.
The court’s view is based on a liberal interpretation of the most favored nation clause under the India-Netherlands tax treaty. This is the first ruling dealing with the issue.
Under Indian tax law, dividends received by a non-resident from an Indian company are generally taxable at 20% (plus applicable surcharge and cess), subject to any lower rate applicable under a tax treaty. The distributing Indian company is required to withhold applicable tax at the time of the dividend distribution.
The taxpayers, in this case, were two Netherlands-based entities (Concentrix Services Netherlands B.V. and Optum Global Solutions International B.V.) and each had a subsidiary in India.
Under the India-Netherlands tax treaty and corresponding protocol, which has the most favored nation clause, dividends earned by a resident of Netherlands generally should be taxable in India at 10%. However, the treaty’s most favored nation clause is triggered if India, subsequent to entering into the tax treaty with Netherlands, agrees to a lower tax rate in another tax treaty with an OECD member country. In such a case, the lower rate so agreed by India with the OECD member country shall extend to the India-Netherlands tax treaty from the date the tax treaty with the OECD member enters into force.
Notably, India, in its tax treaties with Slovenia, Lithuania, and Columbia, has agreed to a tax rate of 5% on dividend income. However, these countries became OECD members post-execution of their respective tax treaties with India, which is at the centre of the debate.
The taxpayers applied to the Indian tax authorities to issue a certificate allowing their Indian subsidiaries to remit dividends after applying the withholding tax rate of 5%. The tax authorities denied the benefit of 5% and instead issued the certificate confirming a withholding tax rate of 10%.
The taxpayers challenged the position in a petition filed before the High Court. The key contentions of the tax authorities were two-fold. First, no separate notification was issued to give effect to the lower tax rate under the India-Netherlands tax treaty, and, therefore, it is not effective. Second, the most favored nation clause under the India-Netherlands tax treaty can be invoked only where the lower tax rate is agreed with a country which was an OECD member at the time of execution of the India-Netherlands tax treaty. Given that Slovenia, Lithuania and Columbia were not OECD members at the time of execution of the India-Netherlands tax treaty, nor at the time when they executed tax treaties with India, the benefit of the 5% tax rate on dividend income should be denied to the taxpayers.
The court did not agree with these contentions. On the first issue, regarding the requirement of a separate notification, it held that the protocol, which has the most favored nation clause, forms an integral part of the tax treaty. Therefore, there is no requirement of specifically notifying the lower tax rate to give effect to the most favored nation clause.
On the second contention that the third country should be an OECD member at the time of execution of the India-Netherlands tax treaty, the issue centered on the interpretation of the term “is” used in the most favored nation clause. The court held that this term describes the state of affairs at the time of claiming the tax treaty benefits and not necessarily at the time of execution of the India-Netherlands tax treaty. The court also referred to the interpretation of the most favored nation clause adopted by Netherlands with respect to taxability of dividend income pursuant to Slovenia’s OECD membership. The decree issued by the Kingdom of Netherlands clearly recorded that the tax rate of 5% for the dividend income shall be effective under the India-Netherlands tax treaty from the date Slovenia became an OECD member.
Given the position adopted by Netherlands and noting that one of the avowed purposes of entering into a tax treaty is the equitable allocation of taxes concerning transactions that are taxable in both states, the court referred to the principle of ‘common interpretation’. It also stated that the courts of the contracting states are required to ensure that tax treaties are applied efficiently and fairly, so that there is consistency in the interpretation of the provisions by the tax authority and courts of the concerned contracting states.
In addition to certain international rulings, the court also relied on the observations of the Supreme Court of India in the case of Azadi Bachao Andolan in relation to interpretation of tax treaties and observed that the tax treaties are negotiated by diplomats and not by people instructed in law. Hence, when interpreting tax treaties, the rules of interpretation that apply to domestic or municipal law need not be applied.
Accordingly, based on the court’s own interpretation, Netherlands position on the most favored nation clause and the principles of common interpretation of international tax treaties, the court held that dividend income should be taxed at 5%, because Slovenia, Lithuania and Columbia were OECD members at the time when the benefit was being claimed.
Comments
Until 31 March 2020, dividends were subject to distribution tax payable by the Indian distributing companies, and the non-resident shareholders were exempt from any further tax in India. In absence of any withholding tax on dividends, application of tax treaties was doubtful.
Under current law, application of tax treaties is clear. However, in the context of tax treaties which have most favored nation clauses, the position with respect to availability of lower rates has been a grey area as the relevant countries were not OECD members at the time of signing tax treaties with India but became OECD members thereafter. This ruling has therefore come well in time and provides much needed relief to investors from jurisdictions having similar most favored nation clauses in their tax treaties with India, such as Switzerland and France.
The court decided one more interesting issue – the date when the 5% tax rate can be said to be effective from. As per the most favored nation clause, the benefit of the lower rate should be available from the date when the tax treaty between India and the third country (which is an OECD member) enters into force. However, given that the relevant jurisdictions were not OECD members at the time their treaties with India entered into force, the court determined that the date when the relevant jurisdiction became an OECD member was the relevant date for this purpose.
The ruling is well reasoned. However, whether the tax authorities will accept this position and how other courts will view and interpret this issue remains to be seen.
The views of the author(s) in this article are personal and do not constitute legal/professional advice of Khaitan & Co. For any further queries or follow up please contact us at [email protected].
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Ritu Shaktawat is a partner at Khaitan & Co, Mumbai, India.
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Rahul Jain is a principal associate with Khaitan & Co, Mumbai, India.
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