Aspects to be Considered on Application of MFN Clause of Tax Treaty

Background

Section 90(1) of the Income-tax Act, 1961 (the Act) empowers Central Government to enter into an agreement with the Government of any country outside India or specified territory for the following purposes:

1. Granting of relief in respect of double taxation;
2. Avoidance of double taxation;
3. Exchange of information;
4. Recovery of income tax.

Accordingly, India has entered into the Double Taxation Avoidance Agreement (DTAA) with various countries for meeting the above purpose. The DTAAs are generally based upon two models:

1. The Organisation for Economic Co-operation and Development (OECD) Model
2. United Nation Model (UN Model)

OECD Models are generally adopted by developed nations and their emphasis is on residency-based taxation. UN Model emphasis is on the source-based taxation and generally adopted by the developing nations. Most of India’s DTAAs are based on UN Model.

Over the period of time, there is a need for amending such DTAA. For amending such DTAA, India has signed protocols with different countries. Generally, the purpose of signing protocol is to reduce the scope of non-taxation or reduced taxation through tax evasion. Delhi High Court in the case of Steria (India) Ltd. v. CIT [2016] 72 taxmann.com 1/241 Taxman 268/386 ITR 390held that protocol is an integral part of DTAA and it will have equal effect as that of articles contained in DTAA. Further, in several other cases, the validity of protocol has been upheld.

Some of the protocols¹ signed by India contain the Most Favored Nation Clause (MFN Clause). By virtue of the MFN clause, one state binds itself to another state with respect to favorable treatment afforded by it in the future to a third State. For example, the MFN clause under the protocol of India-

Belgium DTAA is reproduced below:

“1. Ad Articles 5, 7 and 12

If under any Convention or Agreement between India and a third State being a member of the OECD which enters into force after 1st January 1990, India limits its taxation on royalties or fees for technical services to a rate lower or a scope more restricted than the rate or scope provided for in the present Agreement on the said items of income, the same rate or scope as provided for in that Convention or Agreement on the said items of income shall also apply under the present Agreement with effect from the date from which the present Agreement or the said Convention or Agreement is effective, whichever date is later.

In the above MFN clause, Belgium has bound India that if India after the date of the agreement with Belgium limits its taxation on royalties or fees for technical services (FTS) to a rate lower or a more restricted scope with any other state, the same rate or scope shall also apply under the agreement with Belgium.

In the above backdrop, we will evaluate the types of MFN clause and aspects of considerations while applying it.

Types of MFN Clause- As per the wordings of MFN clause under different DTAAs, it may be categorized into two types as below:

1. Self-operational MFN Clause– This type of MFN Clause will apply automatically and does not need to be notified separately by the Government of both countries. For instance, the MFN clause as mentioned under the protocol of India-Belgium DTAA (reproduced above) is self-operational. Similarly, the MFN clause in the protocols of India-UK DTAA, India- Sweden DTAA, India-Switzerland DTAA, India-France DTAA, India-Netherlands DTAA, India-Hungary DTAA, and India-Spain DTAA contain similar language and hence, may be categorized as self-operational.
2. Non-self-operational MFN Clause- This type of MFN Clause would require the intervention of the Government of the respective country for notification of a more favourable clause that state B has with state C. For instance, the MFN clause as appearing in the protocol of India-Philippines DTAA requires notification by India if Philippines agrees to a lower or nil rate of tax with a third State in respect of income under Article 8 (Air Transport) or Article 9 (Shipping):

“4. With reference to Articles 8 and 9 if at any time after the date of signature of the Convention the Philippines agrees to a lower or nil rate of tax with a third State the Government of the Republic of the Philippines shall without undue delay inform the Government of India through diplomatic channels and the two Governments will undertake to review these Articles with a view to providing such lower or nil rate to profits of the same kind derived under similar circumstances by enterprises of both Contracting States.”

Aspects to be considered while applying the MFN Clause- While applying the MFN clause, a taxpayer may consider the following aspects:

1. Types of MFN Clause: While applying the MFN clause, a taxpayer need to check the type of MFN clause. If the MFN clause is not self-operational, the taxpayer may not apply it unless it has been notified separately by the Government. However, in case of self-operational MFN clause, there is no need of separate notification. This view has been upheld by Delhi High Court in Steria (India) Ltd. (supra). Further, in the context of MFN clause under the protocol of India-France DTAA which contains a self-operational MFN clause, various courts² have allowed the benefit without requiring any separate notification by Government.
2. Date of agreement: As discussed above, MFN clause applies when state B after entering into DTAA with state A, enters into DTAA with state C which has a more beneficial clause in respect of specified nature of income (generally royalty or FTS). Therefore, the date of DTAA between state ‘A’ and state ‘B’ and between state ‘B’ and state ‘C’ will be a very important aspect to check.
3. OECD Member: Generally, the MFN clause requires the third state (State C) with which state B has entered into DTAA with more beneficial provision, to be member of OCED. Therefore, it is important to see whether the third state is a member of OECD. So far, there are 37 countries³ which have become the member of OECD.
4. Date of becoming OECD Member: As per the language of MFN clause, it appears that state ‘C’ shall become the member of OECD prior to entering into DTAA with state ‘B’.Therefore, the date of becoming a member of OECD also has a very vital role in the application of DTAA.

Conclusion: The MFN clause can be applied by a non-resident taxpayer while computing his tax liability. It can also be applied while withholding taxes by the resident payer in view of various judicial precedents⁴ and CBDT Circular No. 728 dated 30 October 1995. Further, CBDT has recently notified Form 15E for application for grant of certificate under section 195(2) and 195(7). One of the clauses⁵ of this Form seeks information in regard to the ‘Make Available’ clause in the DTAA, or such claim is invoked through MFN clause and if the notification requirement is fulfilled or otherwise.

Therefore, a person can apply MFN clause both at the time computing his tax liability or while withholding tax. However, considering the penal consequences of short withholding or non-withholding of taxes or failure to disclose proper income, it would be advisable to consider all the aspects of MFN clause of applicable DTAA.

——————————————————————————————————————————————————————————

1. Protocol with Sweden, Swiss Confederation, France, Israel, Philippines, Belgium, Netherlands, Kazakhstan, Hungary and Spain contain MFN clause
2. Kolkata ITAT Dy. CIT v. ITC Ltd. [2002] 82 ITD 239 (Kol.), Karnataka High Court CIT v. ISRO Satellite Centre [2013] 35 taxmann.com 352/218 Taxman 74 (Karn.), Mumbai ITAT Dy. DIT v. IATA BSP India [2014] 46 taxmann.com 150/64 SOT 290 (Mum. – Trib.), Mumbai ITAT National Organic Chemical Industries Ltd. v. Dy. CIT [2006] 5 SOT 317 (Mum.), AAR Poonawalla Aviation (P.) Ltd., In re [2011] 16 taxmann.com 120/[2012] 343 ITR 202 (AAR – New Delhi)
3. Source – http://www.oecd.org/about/members-and-partners/
4. Engineering Analysis Centre of Excellence (P.) Ltd. v. CIT [2021] 125 taxmann.com 42 (SC), GE India Technology (P.) Ltd. v. CIT [2010] 187 Taxman 110 (SC), Vodafone
5. point 5(D)(b)(ii)/(iii)/(iv)) in the said form.