Most favoured nation clauses in India tax treaties – continuing conundrum

Background

• The Central Board of Direct Taxes (“CBDT”) has recently issued a circular dated February 03, 2022, clarifying the applicability of Most Favored Nation (“MFN”) clauses in tax treaties of India with certain jurisdictions.
• The effect of an MFN clause is that one state obligates itself to its treaty partner offering it a “more favorable” tax treatment than what is set out in their own tax treaty, if such ‘more favourable’ tax treatment is offered by the first state in its tax treaty provisions with a different third state. 

MFN CLAUSE

• For an MFN clause to apply, both jurisdictions will need to be members of the OECD.
• An important note is that the language of MFN clauses obligates the source jurisdiction (i.e., State A) to offer the more favorable treatment while withholding taxes on certain items such as royalties, dividends, interest, fee for technical services. For example, if the source jurisdiction’s (State A) right to tax dividends is restricted to 15% in the treaty between State A and B (assuming that the Protocol between State A and B contains an MFN clause); and State A enters into a treaty with State C (who is also an OECD member) wherein source jurisdiction’s (State A) right to tax dividends has been restricted to 5%, then the same favorable treatment (i.e., 5% rate) must be applicable on dividend taxation between States A and B as well.
• However, a contentious issue may arise with respect to the applicability of the MFN clause where one of the jurisdictions is not a OECD member at time treaty came into force.
  1. Protocol to State A and B’s tax treaty contains an MFN clause. The source jurisdiction’s right to tax dividends is restricted to 15% as per the treaty.
  2. State A enters a treaty with State C who is not an OECD member at the time when the treaty comes into force. Tax treaty between State A and C restricts the source jurisdiction’s right to tax dividends at 5%. Given that State C is not an OECD member, despite having a more favourable treatment in this treaty between States A and C, the MFN clause between State A and any other country will not come into effect.
  3. However, State C subsequently becomes an OECD member at a later date.

In such circumstances, does the MFN clause between States A and B come into effect (resulting in the more favorable rate 5% from date when treaty between State A and State C came into force or State C becoming OECD member?

INDIAN TAX TREATIES

• The issue has gone through litigation at various level of appellate authorities specifically, the Protocol to India’s treaties with Netherlands, France and Switzerland wherein all contain MFN clauses that are applicable from the date when India signs a tax treaty with another OECD member, while offering a more favorable treatment. India’s right to withhold taxes on dividends is restricted to 10-15% in these treaties.
• On the other hand, India’s treaties with Slovenia, Lithuania, and Colombia restrict India’s right to withhold taxes on dividends paid at the rate of 5%, if the beneficial owner of the dividend is a resident of the other state.
  1. India-Slovenia tax treaty: Entered into effect in 2006; joined the OECD in 2010.
  2. India-Lithuania tax treaty: Entered into effect in 2013; joined the OECD in 2018.
  3. India-Colombia tax treaty: Entered into effect in 2015; joined OECD in 2020.
• Consequently, France, Netherlands, and Switzerland have 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.
• The directives of France and Netherlands further set out that the ‘more favorable’ rate is to apply retrospectively from the dates when Slovenia became a member of the OECD (rather from the date India – Slovenia treaty came into force). Similarly, the directive from Switzerland sets out the ‘more favorable’ treatment (as per the India – Lithuania treaty) to apply from Lithuania’s date of joining the OECD (2018); and the ‘more favorable’ treatment (as per the India-Colombia treaty) to apply from Colombia’s date of joining the OECD (2020).
• The question that arises, is whether the MFN clause entered between India and the OECD members (France, Switzerland and Netherlands) has the effect of further restricting India’s right to withhold taxes on dividend, if India enters a treaty (setting out a lower rate) with a third country which is not an OECD member at the time of the treaty coming into force but becomes an OECD member at a later date.
• While this question has been answered in favor of the taxpayer in a few decisions, but the position has been vehemently and consistently opposed by the India tax department.
• It must also be noted that India has communicated its position to all three jurisdictions stating that the lower rate cannot be imported through an MFN clause, as Slovenia, Colombia, and Lithuania were not members of the OECD at the time when India entered into the respective tax treaties with them; but has not received any responses to India’s interpretation.

CBDT CLARIFIES ON APPLICABILITY OF MFN CLAUSE:

• The Ministry of Finance through the CBDT Circular dated February 03, 2022, has clarified that the ‘more favorable’ rates on dividend taxation within India’s tax treaties with Colombia, Slovenia, or Lithuania will not be applicable to India’s treaties with France, Netherlands, and Switzerland. The CBDT has set out the following mandatory conditions to be fulfilled for an MFN clause to apply:
  1. The second treaty (with the third state) is entered into after the signature / entry into force of the treaty between India and the first OECD state;
  2. The second treaty is entered into between India and a third state which is a member of the OECD at the time of signing the treaty with it;
  3. India limits its taxing rights in the second treaty in relation to rate or scope of taxation only in respect of relevant items of income i.e., those items of income as set out in the MFN clause to the relevant Protocol;
  4. A separate notification is issued by India, importing the benefits of the second treaty with the first state, as required by the provisions of Section 90(1) of the Income Tax Act, 1961 (“ITA”).
• While the MFN clauses to all the relevant Protocols are drafted slightly differently, the point of consistency in all the clauses is that the MFN clause applies if after the date of signing the respective tax treaty with that state, a different tax treaty is entered “between India and a third State which is a member of the OECD” and which provides for a more beneficial rate or a more restricted scope.
• The word “is” to mean that the third state mandatorily needs to be an OECD member, both at the time of conclusion of India’s treaty with them, and at the time of applicability of the MFN clause, for the MFN clause to be applicable.
• Given that Slovenia, Columbia, and Lithuania were not OECD members at the time of their respective treaties with India entering into force, the MFN clauses cannot modify the tax rates in their respective treaties i.e. France, Netherlands, and Switzerland.
• The CBDT Circular has inferred that any interpretation to their contrary would render the language of the MFN clause redundant and lead to a manifestly absurd situation; especially when the ordinary language of the clause makes the position clear.
• Under section 90(1) of the IT Act, DTAA or amendment to DTAA are implemented after its notification in the Official Gazette. India has not issued any notification importing the benefit of DTAA with Slovenia, Lithuania and Colombia to DTAA with The Netherlands, France or Swiss Confederation and hence there should not be selective import of concessional rates under the MFN Clause.
• India’s DTAA with Slovenia and Lithuania consist of a split rate of tax for dividend. The beneficial rate of 5% dividend income is applicable only if the company receiving dividend holds directly at least 10% of the company paying the dividends. Even though The Netherlands, France and the Swiss Confederation have taken this into account in their decree/bulletin/publication by providing that 5% rate will be applicable only when the condition of 10% ownership is satisfied, there is no sound rationale / basis provided for the selective import on account of not switching to 15% tax rate in other cases.

OUR COMMENTS

• The Circular provides that in case of a taxpayer, where there is any decision by any court on this issue favorable to such taxpayer this circular will not affect the implementation of the court order in such case. However, it is silent whether this exception will be limited to only that particular year for which the Court has given its ruling or to all the years.
• The exception is granted to only a Court order and not Tribunal / First Appellate Order /Tax Order. Hence, it needs to be seen whether the concluded matters which have not travelled to High Court could be selected for reopening / revision by Revenue.
• It is pertinent to note that this Circular will impact even a situation where the second DTAA is executed with an OECD member country, but the said DTAA is not notified by India, in light of the fourth condition. Thus, the beneficial tax rate / scope mentioned in the second country shall not apply automatically.
• While the Circular is binding on a Tax Officer, the taxpayer can contend that it is not applicable to it and thereby if the above-mentioned conditions (especially fourth condition) are not satisfied, the benefit of DTAA should not be denied.
• The situation as it stands today is that tax authorities of Netherlands, France and Switzerland have provided administrative guidance and Delhi HC’s decisions are in favor of taxpayers, whereas the Circular (being an administrative guidance) is on a different note. A pragmatic approach to settle the issue is that the Revenue and tax authority of the respective country issue a joint statement clarifying the position.

Let’s have detailed discussion on how it may affect your business.