Indian Tax Authorities Favoured: Supreme Court Rules On The 'Most Favoured Nation' Controversy

Background of the Controversy

A DTAA is an agreement between two or more countries designed to prevent the double taxation of income by establishing rules for allocating taxing rights. DTAAs may contain an MFN clause, at the discretion of the contracting states, to ensure consistent benefits across various DTAAs. Through the MFN clause, residents of one contracting state are entitled to treatment at least as favourable as that granted to residents of a third country under a different DTAA.

In the context of India's DTAA agreements, the MFN clause typically mandates that if India enters into a subsequent DTAA with an Organization for Economic Cooperation and Development (“OECD”) member country, offering favourable taxation, then a similar benefit should be extended to the country involved in the initial DTAA, either after the agreement's signature or entry into force.

The controversy arose when India signed DTAAs with Slovenia, Lithuania, and Colombia, offering a lower tax rate on dividend income. Although these countries were not OECD members at the time of the agreement, they later joined the organization. This led to a disagreement between the MFN Countries, including Netherlands, France, and Switzerland, and Indian tax authorities. The Delhi High Court had favoured the MFN Countries, relying on their unilateral declarations that sought benefits from the date these non-OECD countries became members. The High Court stated that MFN clauses were triggered by India's treaties with the countries, which had concluded their treaties with India before they became OECD members, and that the benefits automatically applied through the MFN clauses in the treaties, requiring no separate government notification.

In response, Indian tax authorities issued a circular specifying that the MFN clause becomes effective only when certain conditions are met. These include the subsequent DTAA with the third country featuring the beneficial tax rate being concluded after the DTAA with the MFN clause, the third country being an OECD member when signing the DTAA with India, a favourable scope of taxation in the DTAA with the third country, and a separate notification importing such beneficial taxation into the DTAA with the MFN clause must be issued.

It is crucial to note that, in the context of the circular, the MFN clause in the DTAA with the MFN Countries does not require a separate notification for its operation, unlike the India-Finland DTAA. Previous decisions have established that MFN clauses in agreements with MFN Countries or similarly worded clauses are self-operational, eliminating the need for an additional notification. Consequently, a key question arises: whether Indian authorities must issue a notification to grant the benefits of the MFN clause and integrate it into domestic law, or if the clause automatically applies.

SC's Ruling

The Indian tax authorities challenging the decisions of the Delhi High Court provided the SC with an opportunity to address key issues, namely, the applicability of the MFN clause when third countries were not OECD members at the time of their DTAAs' entry into force and whether a separate notification was necessary to incorporate these benefits into the DTAA with the MFN Countries.

The SC established that a separate notification, as per Section 90(1) of the Income Tax Act, 1961 (“ITA”), is obligatory to implement any DTAA or its protocol that effectively amends existing legal provisions. The SC reasoned that while the Union holds exclusive power to enter into DTAA, the Parliament has the exclusive authority to enact these agreements into law. Without such enactment, DTAA provisions are not inherently binding on Indian nationals. Legislative action is crucial when these agreements impact citizens' rights or modify Indian law. No legislation is required only when citizens' rights remain unaffected, or the law remains unaltered. The SC also emphasized that unilateral orders and decrees from other countries cannot be relied upon to interpret DTAA, as the assimilation process in other countries differs significantly from India's legislative-driven approach. In India, the general practice is to apply the MFN clause benefits post the issuance of a separate notification under Section 90 of the ITA, a practice the SC asserted cannot be undermined.

Addressing whether the third country must be an OECD member at the time of its DTAA coming into force, the SC clarified in its ruling that the phrase "is a member" implies present significance. Therefore, for the earlier DTAA beneficiary to claim applicability of the MFN clause, the third country must be an OECD member when entering into a DTAA with India.

Moving Forward

Taxpayers from the MFN Countries had been claiming a reduced tax rate on dividends based on favourable decisions from the Delhi High Court. However, this SC ruling holds binding authority over lower courts and taxpayers, establishing a significant precedent for interpreting DTAAs.

The SC's decision marks a departure from prior rulings by various High Courts and tribunals, where the necessity for a notification was not considered mandatory. India notifies every DTAA, and previous interpretations suggested that since the MFN clause is automatically notified with the DTAA. However, the SC recognizes that the MFN clause, through its operation, amends the DTAA it is a part of. Consequently, a separate notification is essential to effectuate such an amendment.

The SC's validation of the circular issued by the tax authorities, necessitating a separate notification for the MFN clause's activation, strengthens the authorities' position. It empowers them to recover outstanding tax amounts from individuals who previously claimed reduced tax rates on dividend income using the MFN clause. On the other hand, the ruling delivers a setback to taxpayers from MFN countries, negating their access to the lower tax rates previously asserted under the MFN clause, and disregarding the legitimate expectations of taxpayers.

While the SC's ruling brings clarity and consistency to the implementation and enforcement of the MFN clause in India's DTAAs, there is a potential risk of deterring investments in India through MFN countries. This risk arises from the possibility of losing favourable tax rates. Consequently, it is imperative for the Indian Government to carefully assess the potential implications and take proactive measures. These measures are essential to mitigate adverse effects and sustain a favourable, incentivized environment that fosters investor confidence and encourages international investments.