Executive summary
On 3 February 2022, the Indian Government issued a Circular1 clarifying the applicability of the Most Favored Nation (MFN) clause found in some of India’s Double Taxation Avoidance Agreements (DTAAs). The Circular restricts the applicability of the MFN clause in a DTAA between India and another country (the second State) to cases where all the following conditions are satisfied:
- India’s DTAA with the country which has a lower rate or restricted scope (the third State) is entered into after the signature/entry into force (depending on language of MFN Clause) of India’s DTAA with the second State.
- The third State has to be an OECD2 member at the time of signing its DTAA with India.
- India limits its taxing rights in relation to the rate or scope of taxation in its DTAA with the third State.
- India issues a separate notification under the Income Tax Law (ITL) for importing the favorable benefits of the DTAA with the third State into the DTAA with the second State.
The above Circular will not be applicable in the case of taxpayers who have received a favorable decision by any court on the applicability of the MFN clause.
This Alert summarizes the Circular and its implications for taxpayers.
Detailed discussion
Background
India’s DTAAs with certain countries3 have an MFN clause which provides that if, after the signature/entry into force of those DTAAs, India enters into a DTAA on a later date with another OECD member country, providing a beneficial rate or restrictive scope of taxation of dividends, interest, royalties, etc., then a similar benefit should be accorded under the former DTAAs.
Illustratively, DTAAs signed subsequently by India with countries like Slovenia, Colombia and Lithuania provide for a lower withholding tax (WHT) rate of 5% for dividends, subject to certain conditions. However, these countries were not OECD members when their respective DTAAs with India were entered into but became OECD members only at a later date.4 There was a lack of judicial guidance on whether the beneficial WHT rate on dividends under the DTAAs with Slovenia, Lithuania and Colombia could be applied to other DTAAs which have an MFN clause. A Court ruling5 interpreted the MFN provisions in favor of the taxpayer, granting the benefit of the lower WHT rate and this ruling was subsequently followed by various other Indian Courts.
In addition, countries like the Netherlands and France published a unilateral decree6/ notification7 which categorically provides that the benefit of 5% dividend WHT rate as available in the DTAA with Slovenia shall be made applicable to the DTAA with the Netherlands and France. The Swiss competent authorities also released a similar statement on 13 August 2021.
Due to lack of guidance in the Indian context, representations were filed before the Indian tax authorities seeking clarification on India’s stand on the application of MFN clause. In this context, the Indian Government issued the Circular clarifying its position.
Clarification provided in the Circular
The Circular clarifies India’s position on the interpretation of the MFN clause present in the Protocol to India's DTAAs, especially with certain European states and OECD member countries, as follows:
A plain reading of the MFN clause in the DTAA provides that the third State has to be a member of the OECD both at the time of conclusion of the respective DTAA with India as well as at the time of applicability of the MFN clause.
Unilateral decrees, notifications, and clarifications given by the treaty partner(s) do not represent a shared understanding on the applicability of the MFN clause and have no binding effect on India as the same have been issued without any consultation with India.
The concessional rate or restricted scope of taxation is to apply from the date of entry into force of the DTAA with the third State and not from the date on which such third State becomes an OECD member.
A notification under the provisions of the ITL is required to implement the provisions of a DTAA. India has not issued any notification importing the beneficial provisions from DTAAs with Slovenia, Lithuania and Colombia to the DTAAs with France, Netherlands or Switzerland.
Selective invocation and application of the MFN clause as reflected in the unilateral instruments of the Netherlands, France, and Switzerland are not permitted as per the rules of interpretation of international treaties. For example, the India-Lithuania DTAA provides for the beneficial WHT rate of 5% on dividend income only if the company receiving the dividends holds directly at least 10% of the capital of the company paying the dividends. However, in all other cases, the WHT rate prescribed is 15%. Import of only the concessional rate of 5% and not the 15% rate for other cases by invoking the MFN clause is not justified.
The Circular clarifies that the benefit of a lower rate and restricted scope under the MFN clause will be provided only when all the following conditions are satisfied cumulatively:
India’s DTAA with the third State is entered into after the signature/entry into force (depending on the language of the MFN clause) of India’s DTAA with the second State.
The third State has to be an OECD member at the time of signing its DTAA with India.
India limits its taxing rights in relation to the rate or scope of taxation in its DTAA with the third State.
India issues a separate notification under the ITL for importing the favorable benefits of the DTAA with the third State into the DTAA with the second state.
However, it is also clarified that the Circular will not be applicable to taxpayers that have received a favorable decision by any court on this issue.
Implications
The Circular clarifies India’s position on the applicability of MFN clause. This position is divergent from the legal positions upheld by Courts in India. For example, the Delhi High Court in separate rulings has held that: (i) the conditions for applicability of the MFN clause should be tested as of the date of the transaction rather than the date when the DTAA with the third State was entered into; and (ii) a generally accepted principle is that Protocol is an integral part of the DTAA and there is no need for a separate action for giving effect to the self-operational MFN clause provided in the DTAAs.
It is a well-accepted principle of interpretation that the Circular binds taxpayers only if it is favorable to taxpayers. Taxpayers intending to apply the MFN clause in the Indian context will need to evaluate the impact of the Circular, taking into account the applicable legal position and considering the risk and consequences of a short deduction or short payment of tax.
For additional information with respect to this Alert, please contact the following:
Ernst & Young LLP (India)
Pranav Sayta, National Leader, International Tax and Transaction Services
Rajendra Nayak, National Leader, International Corporate Tax Advisory
Ernst & Young LLP (United States), Indian Tax Desk, New York
Roshan Samuel
Chintan Gala
Arpita Khubani
Ernst & Young LLP (United States), Indian Tax Desk, San Jose
- Archit Shah
Ernst & Young Solutions LLP, Indian Tax Desk, Singapore
Gaurav Ashar
Ernst & Young LLP (United Kingdom), Indian Tax Desk, London
Amit B Jain
Ronak Sethi
Ernst & Young LLP (United States), Asia Pacific Business Group, New York
Chris Finnerty
Gagan Malik
Bee Khun Yap
Dhara Sampat
Ernst & Young LLP (United States), Asia Pacific Business Group, Chicago
- Pongpat Kitsanayothin
For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.
