Case Law Analysis – SC Verdict on ‘Most Favoured Nation’ clause

The Honourable Supreme Court of India delivered an important judgment on October 19, 2023, in the case of Assessing Officer Circle (International Taxation) 2(2)(2) New Delhi vs. Nestle SA. This judgement addressed the interpretation and application of the Most Favoured Nation (MFN) clauses in India’s Double Tax Avoidance Agreements (DTAAs) with the Netherlands, France, and Switzerland. It overturned the previous decisions by the Honourable Delhi High Court that favoured taxpayers with lower withholding tax rates or narrower income scopes based on MFN clauses.

Understanding the Background of the MFN Debate

India’s DTAAs with the Netherlands, France, and Switzerland included MFN clauses, which stated that if India signed a DTAA with another country offering a lower tax rate on dividends, the same lower rate would apply to the residents of the above-mentioned MFN countries.

India later signed DTAAs with Slovenia, Lithuania, and Colombia, offering lower tax rates. At that time, they were not OECD members. This raised the question of whether the MFN clauses in earlier DTAAs would apply. This means, do the Netherlands, France, and Switzerland claim lower tax rates offered to Slovenia, Lithuania, and Colombia?

The Delhi High Court previously ruled that these MFN clauses were triggered by India’s DTAAs with these non-OECD countries, granting the Netherlands, France, and Switzerland taxpayers the lower rates automatically without requiring separate government notification. To understand the problems better, let us clarify two basic things.

What is DTAA?

A Double Tax Avoidance Agreement (DTAA) is a bilateral treaty that prevents double taxation of income by establishing rules to eliminate double taxation, such as exemptions or credits. These agreements promote economic cooperation and combat tax evasion between the contracting countries.

What is MFN?

The Most Favoured Nation (MFN) clause in a DTAA ensures that residents of one contracting state receive treatment as favourable as that given to residents of a third country under a different DTAA. This clause, based on non-discrimination, typically applies to specific types of income like dividends, interest, royalties, and Fees for Technical Services (FTS).

The Legal Battle on the MFN Clause

In the legal battle concerning the Most Favoured Nation (MFN) tax clause, the Delhi High Court delivered a notable verdict favoring the taxpayer. The applicants, primarily multinational companies including Concentrix Services Netherlands BV and Nestle SA, sought the application of the MFN clause to benefit from lower withholding tax rates specified in other treaties. The respondents were the Indian tax authorities who rejected the taxpayers’ claims for reduced withholding tax rates on dividends, arguing that the benefits did not apply automatically without a specific notification under Indian law.

The Delhi High Court ruled that the MFN clause could indeed be invoked to benefit from the lower tax rates once a contracting state becomes an OECD member, thus granting the applicants a reduced withholding tax rate of 5%​ (EY Home)​​ (BDO in India)​. However, the tax authorities challenged this ruling in the Supreme Court, arguing that such benefits should not be applied automatically without an explicit notification under Section 90 of the Income Tax Act.

Arguments in SC from Taxpayers side:

1. The government notified the relevant DTAAs, including the MFN clause, and the same notification is alive. Even the DTAAs do not mandate any fresh notification to apply the MFN clause. So, a new separate notification to activate the MFN clause is not required.

2. The agreement doesn’t mean that the DTAA-entering countries must be OECD members while signing with India.

3. The executive decrees issued by the Swiss, French, and Dutch authorities have clarified the automatic application of the MFN clause. Therefore, they are demanding that the Indian Government extend the tax benefits to the taxpayers.

Arguments from Revenue Authorities:

1. If there is no legislation (such as a notification), the advantageous tax rate would lack legal force, and then the provisions of international treaties would be enforced like municipal laws.

2. The MFN clause in the Relevant DTAA would apply only if the New DTAA signing Country was a member of the OECD as on the date of signing its DTAA with India and not where the countries entered the OECD membership after signing.

3. The Executive decrees issued by the Swiss, French, and Dutch authorities declaring their interpretation of the MFN clause do not bind the Indian Revenue Authorities. The Indian Revenue Authorities, like the Income Tax Department, are bound by Indian domestic law.

Supreme Court Judgement:

After hearing both sides, the Indian Apex Court reversed the Delhi High Court’s findings and provided clarity on two key issues:

Separate Notification Required – The Court ruled that a separate notification under Section 90(1) of the Income Tax Act, 1961, is mandatory to give effect to the MFN clause and any resulting tax rate changes. The Court emphasized that since the MFN clause amends the DTAA, such amendments require legislative action by Parliament. And, the court said there is a clear precedent of India’s conduct of giving express notification to the relevant DTAAs with another OECD country.

OECD Membership – The Apex Court clarified that the MFN clause applies only if the third country is an OECD member when signing the DTAA with India.

What are the Implications of the Judgement?

Tax Authorities – The judgment supports the Indian tax authorities’ position, validating their requirement for a separate notification to implement the MFN clause. This allows the authorities to recover taxes from those who claimed lower rates based on the MFN clause without proper notification.

For Taxpayers – The ruling is a setback for taxpayers from MFN countries, denying them the lower tax rates they had claimed. The DTAA country taxpayers may face potential tax demands for previous years. They may seek relief by challenging the constitutional validity of the circular or invoking the mutual agreement procedure under DTAAs.

Industry View on the Judgement:

The judgment creates uncertainty about the MFN clause’s applicability and interpretation in other DTAAs. The loss of lower tax rate benefits may discourage investments in India through MFN countries.

Critics argue that the Court ignored the general rule of interpretation in the Vienna Convention on the Law of Treaties (VCLT) and adopted a very narrow interpretation of the MFN clause. They also contend that requiring government notification lacks support and violates treaty autonomy.

The Supreme Court’s judgment on MFN clauses in India’s DTAAs provides clarity but raises concerns about the consistency and predictability of India’s tax treaty policy. The government should consider issuing notifications to clarify the MFN clause’s application and renegotiate DTAAs to reflect current international tax standards, promoting fairness and non-discrimination.