February 8, 2022
Indian Government releases restrictive interpretation of Most Favored Nation clause
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:
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.
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:
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:
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.
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)
Ernst & Young LLP (United States), Indian Tax Desk, New York
Ernst & Young LLP (United States), Indian Tax Desk, San Jose
Ernst & Young Solutions LLP, Indian Tax Desk, Singapore
Ernst & Young LLP (United Kingdom), Indian Tax Desk, London
Ernst & Young LLP (United States), Asia Pacific Business Group, New York
Ernst & Young LLP (United States), Asia Pacific Business Group, Chicago
1 Central Board of Direct Taxes Circular No. 3/2022 dated 3 February 2022.
2 Organisation for Economic Co-operation and Development.
3 Illustratively, the Netherlands, France, Switzerland, Sweden, Spain and Hungary.
4 For example, India signed its DTAA with Slovenia in February 2005, however, Slovenia became an OECD member only in July 2010.
5 The Delhi High Court in the case of Concentrix TS-286-HC-2021(DEL).
6 Decree No IFZ 2012/54M, dated 28 February 2012.
7 Bulletin Officiel des Finances Publiques-Impots dated 4 November 2016.