India: Most Favoured Nation Clause causes controversy

India has signed double tax avoidance agreement (DTAA) treaties with several countries and entered into a protocol, inter-alia, containing the Most Favoured Nation (MFN) clause with 13 countries including France, Belgium, Spain, Sweden Switzerland, and the Netherlands. The MFN clause usually states that if, after date of entry into force of the tax treaty between India and the MFN treaty state, India enters into a tax treaty with a country that is a member of the Organisation of Economic, Cooperation, and Development (OECD), but not a party to the tax treaty, then the tax benefits of the MFN clause cannot be worse.  Thus, where the subsequent treaty taxation limits on dividends, interest, fees for technical services, or royalties at a rate lower or a more restricted scope than that provided in the MFN clause, then such beneficial treatment shall also be extended to the MFN state. In other words, the lower rate of tax, or the more restricted, shall be imported into the tax treaty with the MFN state.

Fees for technical service applicability and definition problems

Prior to 2000, MFN state resident foreign companies liable to tax in India on Indian-sourced fees for technical service (FTS) took advantage of the benefit of the MFN clause by importing the ‘make available^’[1] definition of FTS from India-UK, India-US, and other treaties. Also, Indian companies are liable to withhold tax on payment of FTS to foreign company residents in an MFN state availed themselves of the same benefit.

Indian taxpayers also took advantage of the ‘make available’ definition of FTS given in DTAAs with third state countries and did not withhold tax on FTS payments made to foreign companies resident in MFN states. This was on the basis that the payment made to the foreign company did not constitute FTS under the restricted definition, which was imported from India’s tax treaty with the third state. It, therefore, constituted business income in the hands of the foreign company not liable to tax in India in the absence of a permanent establishment of the foreign company in India. The benefit was taken even though the use of the narrower definition of FTS was not notified by the Indian tax authorities. Indian companies contended that their use of the narrower third state FTS clause was automatic.

The Indian tax authorities were reluctant to give the benefit of the narrow definition as, in their view, the protocol was not self-operational. However, the Income Tax Appellate Tribunal^[2] (ITAT) Kolkata Bench applied the restrictive definition of FTS in the India-UK tax treaty to the India-France Tax Treaty (MFN state) and held that the protocol forms an integral part of the tax treaty with the same binding force as the principal treaty. Even after the decision of the Income Tax Appellate Tribunal (ITAT) Kolkata Bench, the controversy continued in another case at the Delhi High Court^[3]. However, the Court approved the rationale of the (ITAT) Kolkata Bench in the context of the MFN clause in the India-French tax treaty. It is pertinent to point out that the Indian Government has, by an official notification dated 10 July 2000, amended the India-France tax treaty with respect to a lower rate of tax on dividends and interest envisaged in the tax treaties with India-Germany and India-USA, but not with respect to the narrower scope of FTS in India-UK or the India-USA tax treaty.

Also, the India-Finland tax treaty provides that the competent authorities of both states shall inform each other and issue a notification on importing the treaty and the benefit of the lower rate or restricted scope given in the treaty between India and an OECD member third state.

Dividend questions raised

For many years, dividend income was exempt in the hands of shareholders, instead, the company distributing the dividend required to pay Dividend Distribution Tax (DDT). However, with effect from 1 April 2020, provisions for dividend tax were amended to shift the taxation of dividends from the company to the shareholders. As a result of this change, companies distributing dividends to non-resident shareholders were required to give their foreign shareholders the benefit of a lower tax rate under the relevant tax treaty when withholding tax from dividends.

India’s tax treaty with Slovenia (2003), Lithuania (2012), and Colombia (2014) provide a lower tax rate of 5% on dividends as compared to other tax treaties where the tax rate on dividends is generally 10%. However, Slovenia in 2010, Lithuania in 2018, and Colombia in 2020 became OECD members after their tax treaties with India were signed. In other words, these countries were not OECD members at the time of entering into a tax treaty with India.

However, France, Netherlands, and Switzerland have released unilateral directives on 28 February 2012, 4 November 2016, and 13 August 2021 declaring that the respective tax treaties with India are modified by the MFN clause by virtue of Slovenia becoming a member of the OECD. However, India has denied the applicability of the MFN clause to taxpayers resident in these jurisdictions, as the said directives were issued without bilateral consultation with India. India’s stand on this issue is discussed later in this article.

However, before India clarified its stance on the issue, taxpayers who were tax residents of MFN states claimed the benefit of the lower rates applied in tax treaties with Lithuania, Slovenia, and Colombia under the MFN principle.  In the case of dividend payments by Indian companies to its foreign shareholders, being tax residents of Switzerland and the Netherlands, the Delhi High Court^[4] has upheld the lower withholding tax rate of 5% of the India-Slovenia tax treaty being applied to the India-Netherlands and India-Switzerland tax treaties using the MFN clause in that:

1. The third state should be a member of the OECD at the time of availing the benefit of the treaty with the MFN state and not at the time of signing the agreement with India.
2. Protocol forming part of the treaty does not require a separate notification, nor does the import of beneficial provisions in some other convention between India and another OECD country require separate notification.

Circulars issued by India on the applicability of the MFN clause^[5] 

India has clarified its stance on the applicability of the MFN clause by issuing a circular to say that tax residents of MFN states will be entitled to import the benefits of a third party treaty if:

1. The treaty with the third state is entered into after the date of signature or entry into force of the treaty with the MFN state.
2. The third state is a member of the OECD at the time of signing the treaty with India.
3. India limits its taxing rights in the treaty with the third state
4. India issues a notification importing benefits of the treaty with the third state in the treaty with the MFN state.

Tax ruling in favour of the taxpayer after India clarifies its stand on MFN clause applicability^[6]

Post the said notification there is a ruling by (ITAT) Pune Bench that:

• The circular issued by India clarifying its stance is binding on the tax authorities and not on the taxpayer or the appellate authorities.
  
  
• The India-Spain tax treaty protocol is notified simultaneously with the notification of the tax treaty. Therefore there is no need for a notification to import the third party state treaty benefits into the MFN state tax treaty.
• The said circular is prospective in operation and does not apply to disputes regarding the applicability of the MFN clause which has arisen in preceding years.

Pune Bench’s ruling was in connection with the applicability of the MFN clause under the India-Spain treaty in respect of royalties and FTS.

Key takeaways

We summarise below the stance taken by various courts on the said issue

However, it may be pertinent to note that the last ruling above was pronounced after the circular was issued by Indian authorities.

Revenue authorities in India are likely to challenge the rulings of the Tribunal and High Court before a higher forum.  A claim in respect of MFN clause benefits in the absence of a notification importing third party tax treaty benefits into the MFN state tax treaty is more likely to lead to litigation. Taxpayers should take appropriate tax advice on whether and how to claim the benefit of the MFN clause.

^[1] ‘make available’ definition of FTS is narrower as it excludes any service that does not make technology available to the person acquiring the service. Technology is considered “made available” when the person acquiring the service is enabled to apply the technology.

^[2] ITC Ltd. (2002) 82 ITD 239

^[3] Steria (India) Ltd. (TS-416-HC-2016)

^[4] Concentrix Services Netherlands B.V. (2021) (434 ITR 516); Nestle SA (W.P. (C) No.3243 of 2021; Deccan Holdings BV (133 taxmann.com 94); Cotenca Inspection SA (2022) (136 taxmann.com 368);

^[5] Circular No.3/2022 dated 3^rd February 2022

^[6] GRI Renewable Industries S.L. (TS-79-ITAT-2022)