Today's Editorial

Today's Editorial - 02 November 2023

Supreme Court’s decision on tax treaties

Relevance: GS-III: 

  • Prelims: Section 90 of the IT Act; Most Favored Nation; Income Tax Act 1961; Double Taxation Avoidance Agreement; 
  • Mains: Effects of liberalization on the economy, changes in industrial policy, and their effects on industrial growth.

Why in the News?

The Hon'ble Supreme Court delivered its judgment in the ‘Most Favored Nation (MFN)’ Clause controversy that has repercussions on Multi-National Companies across the board due to the principles enunciated in India's treaty practice.

Background:

  • In India, treaty-making is neither wholly an Executive Power nor wholly a Legislative Act. Treaty-making involves both these Constitutional organs and Non-constitutional organs, especially when it can impact or interfere with Municipal Laws or the Rights of its people. 
  • This Judgment is one that shows cases an approach, which is a timely and meaningful interpretation of International Treaties.
  • This Judgment is an indication of the Nation’s arrival into this Think Tank of Trade and Business Ideologies of the Future World and will act as a bridge to connect both ends of the world allowing free, fair, and reasonable flow of trade and commerce to the mutual benefit of one and all.
Trade without discrimination:Most-favored-nation (MFN): 
  • Under the WTO agreements, countries cannot normally discriminate between their trading partners. 
  • If a country grants any country a special favor (such as a lower customs duty rate for one of their products) then it has to do the same for all other WTO members. 
  • This principle is known as most-favored-nation (MFN) treatment.

What is the Most Favored Nation Clause in Indian Tax treaties?
  • The Central Board of Direct Taxes (“CBDT”) issued a circular in Feb 2022, clarifying the applicability of Most-Favored Nation (“MFN”) clauses in tax treaties of India with certain circular jurisdictions.
  • The effect of an MFN clause is that one state obligates itself to its treaty partner with respect to offering it a ‘more favorable’ tax treatment (than what is set out in its own tax treaty).
  • If such ‘more favorable’ tax treatment is offered by the first state in its tax treaty provisions with a different third state. Both the second and the third states will need to be OECD members for the MFN to apply.
  • The rationale is for all members of the OECD to be afforded similar treatment in their tax treaties with the same country.
  • The SC has examined the MFN clauses with respect to   Netherlands-India, France-India, and Switzerland treaties. It primarily clarified points related to
    • The need for a notification u/s. 90(1) of the Income Tax Act 1961 (the Act) for availing the benefit of MFN and to give effect to the treaty by changing the terms and conditions that alter the existing provisions of the law.
    • The relevant date for another state to be a member of the OECD.
  • MFN clauses are not uncommon in tax treaties, through this clause one State A obligates to the other treaty partner State B, that it would offer the same treatment (more favorable) than what is agreed in the treaty, if any other State C is offered more favorable treatment in another treaty, both State B and State C being OECD members. 
  • The intention is that all OECD members be given similar treatment in their treaties with the same state, something like an anti-discrimination clause. Such favorable treatment could be of withholding tax rates, scope of income, definitions or any other nature.
BEYOND EDITORIAL:
Supreme Court’s Ruling:
Hon’ble Supreme Court came to the following conclusion:
  • Notification under Section 90 of the IT Act is a necessary and mandatory condition for a Court/ Authority/Tribunal to give effect to DTAA or any Protocol which has the effect of altering the existing provisions or law.
  • Section 90 refers to tax relief under DTAA between the Indian government and foreign governments, Section 90A refers to DTAA between an Indian organization and a foreign organization. On the other hand, both tax credit and exemption are possible under Section 90, but only credit is possible under Section 90A.
  • The requirement that beneficial treatment contained in the Double Taxation Avoidance Agreement (DTAA) entered with one nation (say X Country) (subject to it being part of OECD) subsequent to entering into DTAA with another nation (say Y Country), will not operate automatically. 
    • In such event, the terms of DTAA (i.e., with Y Country) require to be amended through a separate notification under Section 90 of the IT Act.
  • Therefore, for a party to claim the benefit of a “same treatment” clause, based on the entry of DTAA between India and another state that is a member of OECD, the relevant date is entering into a treaty with India, and not a later date, when, after entering into DTAA with India, such country becomes an OECD member, in terms of India’s practice.

While coming to the above conclusions, the Hon’ble Supreme Court made the following observations:
  • Upon India entering into a treaty or protocol does not result in its automatic enforceability in courts and tribunals until notifications are issued, in terms of Section 90(1) of IT Act;
  • The structure of the main DTAA, and its phraseology, based on negotiations with the countries concerned, i.e., Netherlands, France, and Switzerland, also plays a role in the kind of benefits that are assured through it. The structure and terms of other DTAAs might be different; the coverage and definition of certain terms (FTS, permanent establishment, etc.) might be dissimilar. The revenue’s argument that granting automatic benefits based on the other country’s entry into the OECD is unfeasible, has merit.
  • In relation to the India-France DTAA, the Protocol of 2000 did not extend the expanded definition, and instead confined the benefits to the definition and treatment of income from dividends, interest, and royalties. The “make available” condition, in other DTAAs, was consciously omitted from the notification.
  • The status of treaties and conventions and the manner of their assimilation is radically different from what the Constitution of India mandates. In each of the said three countries, every DTAA entered into the executive government needs ratification. 
  • In India, either the treaty concerned must be legislatively embodied in law, through a separate statute, or assimilated through a legislative device.
  • The treaties constituting are binding obligations upon their signatories.


What is a Double Taxation Avoidance Agreement (DTAA)?

  • DTAA is essential to avoid multiple levels of taxation on the same income, as well as to provide a certain degree of certainty to non-resident taxpayers.  
  • DTAAs entered into by India with certain developed economies, in addition to providing tax concessions; contain a Most Favored Nation (MFN) clause, which enables the residents of such countries to enjoy any additional benefit extended to any third country. 
  • Such MFN clauses have been existing in treaties entered into by India, for more than 40 years.  

Indian and DTAA:

  • India has a vast network of DTAAs with other countries under Section 90 of the Income Tax Act, of 1961. Currently, India has established 94 comprehensive DTAAs and eight limited DTAAs. 
  • While comprehensive agreements address all sources of income, the scope of limited agreements is, as indicated, limited to specific sources.
  • A DTAA between India and other countries is drafted on a reciprocal basis and covers only residents of India and the residents of the negotiating country.
  • Any person or company that is not resident, either in India or in another country that has entered into an agreement with India, cannot claim benefits under the signed DTAA.

What will be the consequences of this judgment?

  • Far-reaching impact across industries: Considering the benefits from the MFN clause, this ruling would have a far-reaching impact across industries on all the past decisions for example, the third state that was a member of the OECD at the time of applying the benefit. 
  • Impact on the Incomes: This will have an impact on all streams of income such as dividends, royalties, fees for technical services, and interest to which the MFN clause is applicable – be it applying beneficial scope or beneficial tax rate. 
    • It may be noted that the Supreme Court’s decision is in line with the CBDT’s Circular of 2022 wherein one of the conditions for availing DTAA benefits under the MFN route was that the second country should have been notified. 
  • Difficulty in availing benefits: Currently, as India has not notified any country for the purpose of the MFN Clause, availing benefits under the MFN clause will be difficult. 
  • Detagged/Unresolved issues: It may be pertinent to note that the Supreme Court has specifically excluded interpretation of the matter involving India-Spain DTAA and detagged it. Thus, one needs to analyze the applicability of this decision to the MFN clause under India-Spain DTAA.

Way Forward:

DTAA aims to promote cross-border trade and investment by providing a predictable and stable tax environment. By clarifying the taxation rules and providing incentives to investors, it will encourage Global economic cooperation between the countries. We need to ensure fairness and equity in the international tax system.

PYQs

Mains:

Q1). Comment on the important changes introduced in respect of the Long term Capital Gains Tax (LCGT) and Dividend Distribution Tax (DDT) in the Union Budget for 2018-2019.  (2018)

Prelims:

Q1). With reference to India’s decision to levy an equalization tax of 6% on online advertisement services offered by non-resident entities, which of the following statements is/are correct? (2018)

  1. It is introduced as a part of Income Tax Act.
  2. Non-resident entities that offer advertisement services in India can claim a tax credit in their home country under the “Double Taxation Avoidance Agreements”.

Select the correct answer using the codes given below:

  1. 1 only
  2. 2 only
  3. Both 1 and 2
  4. Neither 1 nor 2

 

 

 
 
 

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