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Interpreting the Most Favoured Nation Clause: Implications from Delhi High Court's Ruling and Supreme Court's Shift

[Rupam Dubey & Siddharth Kumar are third year B.A.LLB student from the National Law School of India University Bangalore (NLSIU)]

In October 2023, the Supreme Court of India ruled on a case involving Concentrix Services Netherlands BV and Optum Global Solutions International BV. The dispute in the case pertained to a Most Favoured Nation ('MFN') provision in the 1988 India-Netherlands tax treaty. Originally, the treaty limited withholding taxes on dividends to 15 percent for residents of one contracting state receiving dividends from the other. However, a clause in the MFN protocol granted Netherlands MFN status, requiring India to limit its withholding tax rates or scope of income items to the extent agreed in another agreement with an OECD member. This condition came into force when the India ratified the OECD rules.

India's tax treaties with countries like Slovenia, Lithuania, and Colombia capped withholding tax on dividends at 5 percent for residents of the other contracting state. Although these nations were OECD members during the litigation, their tax treaties with India were established before their OECD accession, raising complexities in applying the MFN clause.

Interpretation of MFN Clause in the Delhi High Court Ruling

The case revolved around the interpretation of the MFN clause. The question primarily was whether the clause applied solely to limitations on tax rates and income scopes that were agreed upon between India and third states (that were OECD members when the 1988 tax treaty was made), or it also encompassed restrictions agreed before the third states in question became OECD members. The Delhi High Court sided with the broader interpretation, that is the latter one, concluding that the MFN clause extended to limitations on tax rates and income scopes agreed between India and third states even before those states joined the OECD. Consequently, the court directed the tax authorities to apply a 5 percent withholding tax on dividends received by the petitioners, overturning the earlier 10 percent rate set by the tax authorities.

The established rules for treaty interpretation, based on the Vienna Convention, emphasize interpreting treaty terms in good faith, considering their ordinary meaning in context and in line with the treaty's objective. Parties' subsequent practices and intentions should also guide interpretation, allowing for supplementary means when the general interpretation leads to ambiguity or absurd results.

Vienna Convention and Treaty Interpretation

Regarding the interpretation of the MFN clause, the text specifies conditions related to India's taxation on various incomes. The tax authorities argued that the provision applied only to OECD member countries at the time of the 1988 protocol's conclusion, citing the use of the present tense in "a third State which is a member of the OECD." However, the Delhi High Court rejected this argument, stating that the word "is" allowed for broader interpretations beyond a purely self-descriptive term. Additionally, the court highlighted that the proposed interpretation by the tax authorities seemed impractical when considering the phrase "after the signature of the Convention."

Therefore, it appears reasonable to interpret the provision as having a dynamic reference to OECD membership. Notably, the court referenced the Dutch state secretary of finance's decree (Nr. IFZ 2012/54M) to understand the intent of the contracting states. This decree explained how India's tax treaty with Slovenia impacted the India-Netherlands tax treaty through the MFN clause. According to the Dutch interpretation, the provision affected the Netherlands' taxation rights on dividends between Dutch and Indian residents.

The Court argued that since the Netherlands had interpreted Clause IV(2) of the Indian-Slovenian treaty to incorporate its rules into the India-Netherlands tax treaty, it should be reciprocated. However, this reliance on a common interpretation contradicts established principles in tax treaty interpretation. While international jurisprudence can influence common interpretation, it does not imply that one state's case law should bind the tax authorities of another state without review.

The Court also addressed the concept of a "hiatus" period. It acknowledged a potential timing mismatch when a treaty entered into force before a state's OECD accession, labelling it a hiatus. Despite this, the court suggested that the MFN clause would not have retrospective effect, taking effect only from the date of the third state's OECD accession. However, this interpretation seemingly contradicts the principle of giving effect to treaty terms rather than ignoring them, as outlined in the Vienna Convention on treaty interpretation.

The court's interpretation ignored the significant date when limitations in India's tax treaty with third states would affect its treaty with the Netherlands, potentially misinterpreting the term's meaning. An interpretation considering limitations agreed upon between India and a third state after the third state's accession to the OECD would align more meaningfully with the MFN clause.

Policy Implications and Considerations

From a policy perspective, India's capital export pattern suggests it might benefit more from non-OECD countries like Slovenia, Lithuania, and Colombia in terms of revenue from treaties with stricter withholding tax limitations. However, Indian negotiators, aware of the limited MFN clauses with countries like the Netherlands, likely factored this in when concluding treaties with those third states, potentially invalidating the court's interpretation.

The court's reference to the principles outlined in the Azadi Bachao Andolan case, although not binding, might have influenced its interpretation. However, this reference to "sloppy drafting" doesn't reflect the reality of tax treaties. Historical documents tracing OECD model creation, commentaries, and the technical scrutiny of new provisions under OECD's projects show meticulous drafting. Deviations like the MFN clause in the India-Netherlands treaty shouldn't be assumed as sloppy drafting, instead they require interpretation in line with the Vienna Convention.

The court rejected the tax authorities' argument that implementing the MFN clause required notification by both Netherlands and India. It based this decision on the understanding that the clause, being part of the protocol integral to the tax treaty, didn't demand separate notification. This aligned with the court's interpretation in a previous case involving the France-India tax treaty. However, the court didn't explore whether subsequent practices by both nations could have altered their original intent, as the treaty and protocol were silent on invoking the MFN clause's effect.

India announced amendments to the 1988 India-Netherlands tax treaty through a 1999 administrative notification, citing the MFN clause retrospectively. However, it seems the Dutch tax authorities didn't make corresponding changes, with only the 2012 decree from the state secretary of finance indicating the government's interpretation of the MFN clause.

The ruling marks a significant shift from previous interpretations by various High Courts and tribunals regarding the necessity of a notification requirement. In India, as a dualist state, each Double Taxation Avoidance Agreement ('DTAA') and any accompanying protocols are separately notified by tax authorities. The MFN clause, being an inherent part of the DTAA, is consequently notified through this process. Previously, it was believed that since the MFN clause, whether within the main text or a protocol, was notified alongside the DTAA, there was no need for individual notifications each time it was triggered. However, the Supreme Court now recognizes that the MFN clause, through its operation, amends the DTAA it is a part of. Hence, the apex court asserts that a separate notification is necessary to actualize such an amendment.

Moreover, taxpayers from MFN countries were asserting a reduced taxation rate on dividends (e.g., 5% instead of 10%) based on favorable Delhi High Court rulings. As the Supreme Court’s decision holds authority over lower courts and taxpayers, it becomes a pivotal judgment, setting a precedent for interpreting DTAAs. This ruling is poised to significantly impact ongoing and pending cases, especially those where taxpayers based their claims on the earlier interpretations established by lower courts.

No subsequent practice under the Vienna Convention's terms seems to have altered the common intention of the contracting states regarding implementing the protocol. In this aspect, the court's refusal to accept the tax authorities' argument appears accurate.

Conclusion: The Path Forward

The landmark ruling on India's DTAAs resolves a long-debated issue, offering clarity on how these clauses operate and should be understood. While it's seen as a win for Indian tax authorities, it poses challenges for taxpayers who had trusted and relied upon these clauses in good faith. The decision sparks worries about the consistency and predictability of India's tax treaty policies and neglects the justified expectations of taxpayers. It highlights the necessity for a transparent and consistent approach in interpreting and applying these clauses across India's tax treaties. To address this, there's a suggestion for the government to issue a notification or circular, clarifying the stance on these clauses and offering relief to affected taxpayers facing retroactive tax claims, interest charges, or penalties. Additionally, there's a call to review or renegotiate these clauses in India's tax treaties to ensure they align with present and future developments in international tax frameworks, fostering non-discrimination, reciprocity, and fairness among the treaty partners.

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