CBDT Issues Clarificatory Circular on MFN Clause in Tax Treaties

International tax treaties are complicated agreements involving multiple legal protocols. One of the most important clauses of these treaties is the Most Favoured Nation clause. There has been a recent ruling by the Delhi High Court on Most Favoured Nation Clause that can result in multiple litigations and has created ambiguity in the minds of the taxpayers, especially after the follow-on clarificatory circular issued by the CBDT on MFN clause. What is the MFN clause, Delhi High Court judgement and the CBDT circular on MFN Clause that is doing rounds in the minds of taxpayers and tax professionals? Let’s find out!

What is Most Favoured Nation (MFN) Clause?

The Most Favoured Nation clause implies that the countries entering into the contract shall offer similar trade terms to all the trading partners. For the countries being the members of the Organisation for Economic Co-operation and Development (OECD), the MFN clause ensures that the favourable treatment provided to one member of OECD is also provided to other members of the OECD.

The Case

The present case is one of the recent Delhi High Court rulings of Concentrix Services Netherlands B.V. vs. ITO (TDS) [TS-286-HC-2021] that raises questions regarding the applicability of the Most Favoured Nation (MFN) clause for India’s tax treaties.

Facts of the Case

The appellant company (resident of the Netherlands) applied a lower rate of tax for the dividend that it earned from its Indian subsidiary as per the Indian tax treaties with Lithuania, Slovenia and Colombia by invoking the provisions of the MFN clause in the India-Netherlands treaty.

Analysis of the Case

As per the unilateral decree issued by the Netherlands, the company resorted that the lower tax rate shall apply as per the India-Slovenia treaty by invoking the MFN clause of the India-Netherlands treaty. The Delhi High Court ruled in favour of the company on the grounds of ‘common interpretation’ and upon the contention of the company that on the date of transaction, these countries (Slovenia, Colombia and Lithuania) were members of the OECD and therefore, the benefit of the lower tax rate shall be applicable. This is despite of the fact that Slovenia, Colombia and Lithuania were not the members of OECD on the date on which Indian tax treaties with these were entered into force and the MFN clause became effective. The case is now before the Supreme Court which will further decide on the issue.

The Domino Effect

Further, the Federal Department of Finance, Swiss Confederation has issued a clarification for the MFN clause in the India-Switzerland tax treaty in lines with the decree issued by the Netherlands.

The Federal Department of Finance, Swiss Confederation issued a unilateral publication that the tax rates on dividend as per their DTAA with India stands modified under the MFN clause. The new rate will be as per the DTAA entered by India with Lithuania and Colombia who became OECD members on 5^th July 2018 and 28^th April 2020.

The CBDT Circular on MFN Clause

The ruling pronounced by the Delhi High Court, followed by Swiss clarification induced the Central Board of Direct Taxes (CBDT) to issue Circular No. 3/2022 for the interpretation of MFN clauses. The CBDT clarified the applicability of the MFN clause after the issue of the above publications and decree. Following are the key points depicting India’s stand on the MFN clause:

1. The decrees / unilateral publications/bulletin does not represent the shared understandings of the treaty partners

India emphasized that the decrees, bulletins and unilateral publications were issued by the respective governments without any bilateral consultation with India. Therefore, they only represent the views of the concerned governments and have no binding force in so far as the interpretation of the MFN clause is concerned.

As Slovenia was not an OECD member when India entered DTAA with it, therefore, the lower tax rate as per the India-Slovenia treaty cannot be made applicable to the treaties with France and Netherlands. The same position applies to the treaty with the Swiss Confederation.

2. Condition of the third state being a member of OECD on the date of conclusion of the treaty

As per the plain reading of India’s DTAA, there is a clear requirement that the third state must be an OECD member both at the time of conclusion of the treaty and at the time of applicability of the MFN clause to avail benefit of the same.

3. Application of the restricted scope or concessional rate shall be from the date of DTAA being entered into force with the third country and not when the third state becomes a member of the OECD

The MFN clauses in India’s DTAA clearly state that the reduced rates shall become effective from the date of DTAA between India and the third country being entered into force. However, as per the bulletins, unilateral publications by France, Netherlands and Swiss Confederation, they sought applicability of reduced rate from the date on which the third state became a member of OECD which is at all irrelevant.

4. Notification requirement under section 90 of the Income Tax Act, 1961

Section 90(1) of the Income Tax Act, 1961 lays down the requirement that DTAA or any amendments thereof shall be implemented after its notification in the official gazette. Further, the benefit under section 90(2) comes into operation after the notification is issued.

5. There should be no selective import of concessional rates under the MFN clause

The MFN clause has been selectively imported by the above nations. They considered the tax rate of 5% in case the holding of the company receiving the dividend exceeds 10% in the dividend-paying company. However, there was no sound basis provided for the 15% tax rate in other cases that is also a part of the tax treaty with Lithuania and Slovenia.

The Conditions for MFN Clause

Thus, it has been clarified that the benefit of the lower rate and restricted scope of source taxation as provided in India’s DTAA with the third state will be available to the OECD (first) states only if all the following conditions are met:

1. The second treaty (with the third State) is entered into after the signature/ Entry into Force (depending upon the language of the MFN clause) of the treaty between India and the first State;
2. The second treaty is entered into between India and a 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 the rate or scope of taxation in respect of the relevant items of income; and
4. A separate notification has been issued by India, importing the benefits of the second treaty into the treaty with the first state

Final Thoughts

Many taxpayers resorted to the bulletins and publications by the other countries as well as the Delhi High Court ruling on MFN clause and applied the lower tax rate. It can be assumed that the taxpayers in Delhi might not get affected directly due to the judgement passed by the Delhi High Court and its precedent in the jurisdiction. Even though the circular is clarificatory in nature, it will be used by the tax officers in the cases pending before them. This is sure to create a series of litigations in the future. Rest assured, now it is upon the supreme court to resolve the matter.

In case of any query, please feel free to contact the ASC Group.

Also Read: Analysis on TDS Benefits / Perquisites - Section-194R of Income Tax Act

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