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Nov 7, 20234 min read

Supreme Court of India rules on the application of the Most Favoured Nation Clause in Tax Treaties



The Supreme Court of India recently delivered a groundbreaking judgment that has far-reaching implications for the interpretation and implementation of the Most Favoured Nation (MFN) clause in various tax treaties between India and other OECD member countries. This landmark decision redefines the applicability and scope of the MFN clause, making it clear that its activation requires a separate notification under Section 90(1) of the Income Tax Act, 1961. Moreover, the judgment narrows the MFN clause's purview to tax rates, excluding its extension to the scope or definition of taxable income. Let's delve into the details of this significant legal development and its implications.


The Most Favoured Nation Clause: An Overview


The MFN clause is a common feature in many bilateral tax treaties, serving to prevent discrimination between contracting states in favor of a third state. It stipulates that if one contracting state offers more favourable treatment to a third state concerning specific items of income (such as dividends, interest, royalties, or fees for technical services), the same treatment should also apply to the other contracting state. To illustrate, if India has a tax treaty with France prescribing a 10% withholding tax rate on dividends paid to French residents, and India subsequently enters a tax treaty with Slovenia setting a 5% withholding tax rate on dividends, the MFN clause in the India-France tax treaty enables French residents to claim the lower 5% rate on dividends from India.


The Supreme Court's Perspective: A Paradigm Shift


The central issue before the Supreme Court was whether the MFN clause in various Indian tax treaties with OECD countries, such as the Netherlands, France, Switzerland, and Sweden, was automatically activated when India entered subsequent tax treaties with other OECD countries, like Slovenia, Lithuania, and Colombia, containing more favourable provisions for specific items of income. Taxpayers contended that they were entitled to benefit from these subsequent tax treaties through the MFN clause, without requiring a separate government notification. They also argued that the MFN clause extended beyond tax rates and should affect the scope or definition of taxable income. For instance, they posited that if a later tax treaty introduced a 'make available' clause, narrowing the definition of fees for technical services (FTS), this restriction should apply retroactively to existing tax treaties through the MFN clause.


However, the Supreme Court dismissed these arguments and upheld the position of the revenue authorities. The court emphasized that the MFN clause was not an integral part of the tax treaty itself but formed a section of the protocol or memorandum of understanding attached to it. These protocols or memoranda were non-binding unless notified under Section 90(1) of the Income Tax Act, which empowers the Central Government to enter into international agreements concerning double taxation and the exchange of information. The court viewed Section 90(1) as mandatory and essential for giving effect to any tax treaty or protocol that altered or superseded any provision of law.


Moreover, Section 90(3) required that every such notification be presented before each House of Parliament as soon as possible after its issuance. These provisions were deemed necessary to ensure parliamentary oversight and public awareness of any changes in taxation laws resulting from international agreements.


The Scope of the MFN Clause: A Narrow Focus


The Supreme Court clarified that even if a notification under Section 90(1) were issued, it would only give effect to provisions of subsequent tax treaties with OECD countries explicitly mentioned in the MFN clause. The court made it abundantly clear that the MFN clause exclusively applied to items of income for which various tax treaties prescribed different tax rates. It could not be extended to modify the scope or definition of any income category, such as FTS.


Extending the MFN clause in this manner, the court contended, would constitute a rewriting or amendment of the original tax treaty. This went beyond the intended scope and purpose of the MFN clause, which was to ensure that contracting states did not discriminate against each other regarding tax rates, rather than altering the definitions and scopes of taxable income.


Implications of the Supreme Court's Ruling


The Supreme Court's judgment carries significant implications for the interpretation and implementation of the MFN clause in Indian tax treaties. It underscores the need for a separate government notification to activate the MFN clause, ensuring transparency and parliamentary oversight. Furthermore, the ruling reaffirms the principles of party autonomy and contractual sanctity in international taxation. The Supreme Court has upheld the sanctity of the original tax treaty's terms while emphasizing that the MFN clause is not a gateway to reshape the definitions and scopes of taxable income.


In a world where international tax treaties play an increasingly pivotal role in cross-border commerce, this judgment provides much-needed clarity and stability to the interpretation of the MFN clause in the Indian context. It ensures that the original intent of these treaties remains preserved, and that the scope for change is subject to a rigorous and transparent process. While this decision may reshape the landscape of international taxation in India, it underlines the importance of respecting and upholding the sanctity of contractual obligations and international agreements in the ever-evolving world of law and commerce.


In conclusion, the Supreme Court's judgment marks a pivotal moment in the realm of Indian taxation and underscores the critical role that transparency, parliamentary oversight, and clarity of international agreements play in a dynamic and ever-changing legal landscape.


References:



REPORTABLE IN THE SUPREME COURT OF INDIA CIVIL APPELLATE JURISDICTION .... https://main.sci.gov.in/supremecourt/2022/6394/6394_2022_8_1502_47832_Judgement_19-Oct-2023.pdf.



The MFN clause in tax treaties is jeopardising tax revenue for ... - ICTD. https://www.ictd.ac/blog/mfn-clause-tax-treaties-jeopardising-tax-revenue-lower-income-countries/.

 

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