Direct Tax Alert - MFN clause in India-Netherlands Protocol applicable from date when third State became OECD member

Background

Some of the Double Tax Avoidance Agreement (DTAA) contains a Most Favoured Nations (MFN) clause. As per this clause, one country agrees to accord to another country a treatment that is no less favourable than the one which it accords to other or third countries. Some of the DTAA entered by India do contain an MFN Clause. As per most of India’s DTAAs where MFN clauses are present, if India enters into a DTAA with a OECD member country, after signing of the DTAA and the provision of such DTAA are more beneficial, such beneficial provisions would apply to other DTAAs entered with OCED member countries. An MFN clause not only grant a concessional tax rate, but it could also permit application of narrowed scope.

A question could arise as to if the country becomes an OECD member after India had entered into the DTAA with that country, whether the MFN clause could be invoked and the beneficial provision of such DTAA could be availed or not. In this regard, recently, the Delhi High Court¹ (High Court) had an occasion to examine this issue with respect to an MFN clause present in the India-Netherland DTAA.

We, at BDO in India, have summarised the ruling of the High Court and provided our comments on the impact of this decision hereunder:

Facts of the case

The taxpayer, resident of Netherlands, had a wholly owned subsidiary in India. During the Fiscal Year (FY) 2020-21, its Indian subsidiary proposed to distribute dividend. With abolishment of Dividend Distribution Tax (DDT), the dividend was taxable in the hands of taxpayer. Hence, the taxpayer made an application under section 197 of the Income-tax Act, 1961 (IT Act) with the Tax Officer for issuance of lower withholding certificate. The taxpayer requested the Tax Officer to grant lower withholding rate of 5%. The taxpayer contended that while the India-Netherland DTAA provided taxing dividend at 10%, in terms of MFN clause it was entitled to apply the tax rate mentioned in India-Slovenia DTAA / India-Lithuania DTAA / India-Columbia DTAA which is 5%. However, the tax officer was of the view that in absence of any specific notification to extend the benefit of lower tax rate of 5% to India-Netherland DTAA, the same cannot be applied automatically. Hence, the tax officer issued lower withholding certificate at the rate mentioned in the India-Netherland DTAA i.e. 10%. Aggrieved, the taxpayers filed a writ petition before the Delhi High Court.

High Court’s Ruling

The High Court allowed the taxpayer’s claim of 5% withholding rate and thereby directed the revenue authorities to issue a fresh certificate. While coming to this conclusion, the High Court made the following observations:

• A perusal of Article 10 of the India-Netherlands DTAA would show that when dividends are paid by an Indian Company to a resident of Netherlands, it may be taxed in Netherlands. However, such dividend can also be taxed in India provided the recipients are beneficial owners of the dividends and the tax rate does not exceed 10% of the gross amount of such dividends.
• The protocol forms an integral part of the DTAA. Therefore, no separate notification is required, in so far as the applicability of provisions of the Protocol is concerned. Reliance can be placed on the Division Bench’s decision in case of Steria (India) Ltd².
• The protocol incorporates the principle of parity between the India-Netherlands DTAA and the tax treaties executed thereafter qua the rate of withholding tax or the scope of the tax treaties in respect of items of income concerning dividends, interest, royalties, fees for technical services or payments for use of equipment. The principle of parity kicks-in only if
  • the third State with whom India enters into a DTAA is an OECD member.
  • India should have, in its DTAA, executed with the third State, limited its rate of withholding tax, on subject remittances, at a rate lower or a scope more restricted, than the rate or scope provided in subject DTAA.

On fulfilling the aforesaid conditions, the same rate of withholding tax or scope as provided in the DTAA executed between India and third State would apply to the subject DTAA. The same rate or scope shall be applicable from the date on which the DTAA between India and third State comes into force. Therefore, the argument of revenue authorities that the beneficial provisions contained in the DTAAs, executed prior to or after the coming into force of the India-Netherlands DTAA (i.e. 21 January 1989), could not be made applicable to the recipients of remittances covered under the subject DTAA, despite the concerned third State being an OECD member, is completely misconceived and contrary to the plain terms of the protocol appended to the subject DTAA.

• The construct of protocol is such that in certain cases there could be a hiatus between the dates on which the DTAA is executed between India and the third State and the date when such third State becomes a member of OECD. The limit on the lower rate of tax or the scope more restricted contained in the DTAA executed between India and the third State can only apply when the third State fulfils the attribute of being a member of the OECD. The word “is”³ provided in the MFN clause of the DTAA describes a state of affairs that should exist not necessarily at the time when the subject DTAA was executed but when a request is made by the taxpayer or deductee for issuance of a lower rate withholding tax certificate under section 197 of the IT Act.
• The Netherlands interpreted the protocol appended to the DTAA in a manner that the lower rate of tax in the India-Slovenia DTAA will be applicable on the date when Slovenia became a member of the OECD i.e. from 21 July 2010, although, such DTAA came into force on 17 February, 2005. Therefore, participation dividend paid by Companies resident in the Netherlands to an Indian resident will bear a lower withholding tax rate of 5%. Since one of the contracting State i.e. Netherlands has interpreted the protocol in a particular way (as above), in the fitness of things, the principle of common interpretation should apply on all fours to ensure consistency and equal allocation of tax claims between the Contracting States.
• Reference is also made to the decision of Azadi Bachao Andolan⁴ wherein the Apex Court has observed that the core function of a tax treaty is to aid commercial relations and equitable distribution of taxes between the contracting States. Further, the rules of interpretation that apply to domestic or municipal law need not be applied since the tax treaties are negotiated by diplomats and not necessarily by men instructed in the law.                               

BDO comments

This is a welcome ruling. With the abolition of the DDT regime, the dividend is now taxable in the hands of shareholder. This Ruling will help non-resident shareholders to evaluate whether the DTAA between India and their residence contains an MFN clause or not. If yes, relying on this Ruling, a shareholder could consider applying the concessional rate mentioned in other DTAAs executed post entering of the DTAA by India.

While this decision pertains to dividend, it could be relevant for other sources of income – interest, royalty, fees for technical services, subject to the MFN clause contained in such a DTAA. One should read the language of the MFN clause before placing reliance on this decision. This Ruling could be beneficial not only to Dutch investors but also to investors of other countries such as France, Switzerland etc. having similar MFN clauses in their DTAAs with India. However, while applying the MFN clause, taxpayers need to be cautious with respect to the beneficial ownership criteria as provided in India’s DTAA with Slovenia and Lithuania. Further, with India ratifying Multilateral Instruments (MLI), one needs to take cognisance of its impact on the MFN clause.

The High Court’s reliance on the decree passed by the Netherland was to maintain consistency in the interpretation of the provision of the tax authority and courts of the concerned country. Hence, one should not lose the sight of the decision / decree in the other country while applying the MFN Clause. If the other Country had denied the benefits, then the Indian authorities could follow the same. Thus, apart from analysing the MFN clause and making complete reliance on this decision, the taxpayer should also evaluate the judicial precedents in that other jurisdiction.