The Indian Supreme Court’s landmark decision on the MFN clauses concerning dividends taxation under the tax treaties

 By: Dr. Amar Mehta  -  October 19, 2023

19 October 2023

Introduction

The Indian Supreme Court just pronounced a landmark decision on the most-favoured-nation (MFN) clause in the tax treaties. That decision would certainly have significant consequences for a large number of multinational enterprises having subsidiaries in India. Further, it would also adversely affect many portfolio investors earning dividend income from India.

Since few years, many multinational companies have been invoking the MFN clauses contained in the India-Netherlands and the India-Switzerland tax treaties. On that basis, they have been claiming that the 5% dividend withholding tax rate stipulated in the 2005 India-Slovenia tax treaty ought to be imported into the India-Netherlands (1988) and the India-Switzerland (1994) tax treaties. The Indian tax authorities rejected that proposition, and the taxpayers preferred writ petitions before the Delhi High Court.

The Delhi High Court had ruled in favour of the taxpayers. Thereafter, Indian tax authorities had challenged those decisions before the Indian Supreme Court.

On October 19, 2023, the Supreme Court pronounced its verdict on the issue.

Background

Art. 10(2) of the India-Netherlands tax treaty stipulates 10% dividend withholding tax in case of dividends paid by the Indian companies, provided the recipient (tax resident of the Netherlands) is the beneficial owner of the dividend income. Art. 10(2) in the 1994 tax treaty between India and Switzerland contains a similar provision.

As mentioned earlier, several taxpayers claimed that – by virtue of the MFN clause contained in the India-Netherlands and the India-Switzerland tax treaties and in view of the lower withholding tax rate stipulated in the India-Slovenia tax treaty – the dividends withholding tax rate under the India-Netherlands and India–Switzerland tax treaties had to be restricted to 5%. That was despite the fact that Slovenia had become an OECD member after the India-Slovenia tax treaty was concluded, and even though India had not issued a separate notification with respect to importation of the beneficial dividends tax treatment from the India-Slovenia into the India-Netherlands tax treaty.

As mentioned earlier, the Delhi High Court had ruled in favour of the taxpayers.

The Indian Supreme Court’s decision (19 October 2023)

The two issues

The Indian Supreme Court pronounced its verdict on the following two crucial issues concerning the MFN clauses in the tax treaties:

1. Whether the MFN clause in the tax treaties granted a benefit to the relevant taxpayers (who were entitled to apply, say, the tax treaty between India and Country A) when a third country (Country B) was not member of the OECD when India concluded a tax treaty with Country B; and
2. Whether an MFN clause applied ‘automatically’ or whether its application required issuance of a separate notification by India.

The Indian tax authorities’ arguments before the Supreme Court

The Indian tax authorities submitted before the Supreme Court that, under the Constitution of India, particularly by operation of Art. 253, Parliament possessed the exclusive power to legislate in respect of any treaty entered into by India with any other nation. Such a treaty could be entered only through exercise of the ‘executive power’ of the Union of India. Without a legislation enacted by Parliament, such treaties could not be enforced in India.

The Indian tax authorities also submitted before the Supreme Court that India followed the ‘dualist’ approach. Accordingly, the international treaties did not gain enforceability merely upon ratification, they required enabling legislation. Further, Sec. 90 of the Income Tax Act, 1961 ("the Act") warranted issuance of a notification for giving effect to a tax treaty.

The Indian tax authorities contended that application of the above-mentioned MFN clauses in the tax treaties required a separate notification, and the fact that Slovenia, Lithuania, and Columbia had gained membership of the OECD, ipso facto, could not lead to a beneficial tax treatment under India’s tax treaties with the Netherlands and Switzerland.

The Indian tax authorities also submitted before the Supreme Court that though the tax authorities in the Netherlands, Switzerland, and France had issued decrees in respect of the MFN clause contained in their tax treaties with India, such executive decrees were not binding on the Indian tax authorities.

The taxpayers’ arguments before the Supreme Court

On the other hand, the counsels for the taxpayers submitted before the Supreme Court, inter alia, that the protocols to the respective tax treaties, which contained the MFN clauses, were already notified under Sec. 90(1) of the Act. Therefore, there was no further requirement to separately notify applicability of the MFN clauses in those tax treaties.

The Supreme Court’s approach

The Indian Supreme Court noted, inter alia, that entering into a treaty was an attribute of sovereignty, and the power to do so vested solely in the executive wing of the Union of India. Art. 253 of the Constitution of India clearly stipulated that a treaty was enforceable in India only when it was either enacted by law or when it was enabled through legislation.

The Supreme Court also reviewed various judicial precedents on the issue of a treaty’s enforceability. In that regard, the Supreme Court noted that the terms of a treaty ratified by the Union did not (ipso facto) acquire enforceability. Thus, the treaties were not “by their own force binding upon Indian nationals”.

Thereafter, the Supreme Court opined that unless a notification was issued under Sec. 90(1) of the Act, a protocol to the tax treaty did not gain enforceability in India. It also noted that Lithuania, Columbia, and Slovenia were not OECD members when those countries had concluded the tax treaties with India. They had become the members of the OECD only subsequently.

Also, the Supreme Court opined that the word “is” appearing in the MFN clauses in the respective tax treaties had a ‘present signification’ and that it derived meaning from the context. Therefore, when a third country entered into a tax treaty with India, it had to be a member of the OECD. If not, then the beneficial provisions contained in India’s tax treaty with that third country could not be imported into the relevant tax treaty by virtue of the MFN clause.

The Supreme Court also noted India’s (unilateral) practice of issuance of notifications for giving effect to the MFN clauses in the tax treaties (for instance, the notification issued in August 1999 with respect to the MFN clause giving effect of the beneficial provisions contained in India’s subsequent tax treaties with Germany, Switzerland, Sweden, and the United States). In the Supreme Court’s view, such practice meant that India did not automatically extend the benefits under the MFN clauses in the tax treaties. In that context, the Court referred to Art. 31(3) of the Vienna Convention on the Law of Treaties, 1969.

Further, the Supreme Court opined that the context of the above-mentioned executive decrees (issued by the authorities in the Netherlands, Switzerland, and France) had to be understood in relation to each country’s manner of assimilation of treaties in the municipal or national law. In the Court’s view, the treaty practice of Switzerland, the Netherlands, and France was dictated by the conditions peculiar to their constitutional and legal regimes. Likewise, the treaty practice in India pointed to a consistent pattern of behaviour.

The Supreme Court’s verdict

In conclusion, the Supreme Court of India held that a notification under Sec. 90(1) of the Act was required for giving effect to the MFN clause contained in a protocol to a tax treaty. Such an MFN clause could not automatically lead to its integration into the tax treaty. In other words, the MFN clause could not, on its own, extend a benefit at par with the more favourable provisions contained in another tax treaty.

Accordingly, the Supreme Court of India held that the Indian tax authorities were justified in rejecting the taxpayers’ claims that the 5% dividend withholding tax rate stipulated in the India-Slovenia tax treaty had to be read into Art. 10(2) in the India’s tax treaties with the Netherlands and Switzerland – automatically – by virtue of the MFN clauses contained in the protocols to those tax treaties.

Conclusion

The Indian Supreme Court’s decision would lead to severely adverse implications for a large number of multinational enterprises earning dividend income from Indian companies.

By virtue of Art. 141 of the Constitution of India, the above-discussed decision of the Supreme Court is now the law of the land, and it is binding on all courts in India.

To be published Soon:

Critical analysis of the Indian Supreme Court’s landmark decision on the MFN clauses in the tax treaties, including various aspects such as the good faith principle, VCLT Art. 31, principle of parity, etc.