MFN - an instrument for taxation equality
Published: May 29, 2018
By Nilesh Bhagat & Pranjal Ayachit
A tax treaty is essentially an agreement based on negotiations between two countries of its taxing rights relating to identified income. A Most Favoured Nation (MFN) clause is included in a tax treaty with the objective to provide similar beneficial treatment, without the need to go back to the table for renegotiations, should one of the countries subsequently agree for comparatively more beneficial taxing provisions with a third country.
MFN clause arguably forms an important part of a tax treaty. MFN is a provision in international treaties under which a state agrees to accord to the contracting partner, treatment that is no less favourable than that which it accords to other or third states. The origin of MFN can be traced back to international trade agreements of the World Trade Organization (WTO). Under WTO agreements, countries were not allowed to discriminate between trading partners and were granted similar trade concessions. Similar to the WTO arrangement, in order to avoid tax discrimination between residents of two contracting states, MFN clause is incorporated in a protocol to a tax treaty.
MFN clause - how does it operate?
MFN clause represents the principle of non-discrimination. Depending on the specific wording of the protocol, the operation of MFN clause is automatic e.g. India-France tax treaty, whereas in other cases, a notification / re-negotiation is required e.g. India-Switzerland tax treaty.
While majority of tax treaties that India has entered into,appear to be requiring India to limit its taxation rights by virtue of the MFN clause, India has subsequently been able to negotiate with countries whereby similar MFN benefits are available to Indian residents. One such example is the India- Kazakhstan tax treaty, which categorically provides that the MFN clause will come into play when either India or Kazakhstan enter into more beneficial provision with a third country.
Key points to be considered while applying MFN clause
There are certain key points to be borne in mind while interpreting and applying MFN clause, such as:
- The date of applicability of the MFN clause i.e. whether from the date of signing the tax treaty or, entry into force or the effective date
- Reference made to the respective convention, agreement, protocol i.e. OECD countries/Non-OECD countries
- Nature of income that MFN clause relates to i.e. royalties, fees for technical service, dividends, interest, etc.
In the Indian context, various tax treaties have included the MFN clause. These include tax treaties with OECD member countries - Belgium, France, Hungary, Israel, Netherlands, Spain, Sweden, Switzerland, United Kingdom and with non-OECD member countries such as Kazakhstan, Nepal, Philippines, Russia, Saudi Arabia.
Court views on various aspects of MFN clause
On various occasions, the courts have pronounced rulings on the MFN clause, benefitting the taxpayer. In these cases, the courts have examined various aspects of the MFN clause, not just limited to rate or scope.
- Operation – whether automatic or not?
One of the important issues arising while applying the MFN is its effective operation i.e. whether it needs to be notified separately to be operational. This would differ from treaty to treaty, depending on how the countries had negotiated at the time of entering into the treaty and how the MFN clause is worded. As far as India-France tax treaty is concerned, in the case of Steria India Ltd, it was held that the MFN is self-operational, based on the specific wordings of the clause. The said position was reaffirmed in ITC Ltd. Also, a similar view is taken with respect to the MFN clause in the India-Netherlands tax treaty in Shell Global Solutions International BV.
- Benefit of more than one tax treaty
Another interesting issue related to MFN clause is cherry picking of tax treaties while applying the MFN clause i.e. whether it is possible to apply more than one tax treaty for restricting the scope or rate of tax. This proposition appears to have been accepted by the AAR in Steria India Ltd. The AAR on the contrary arguments of revenue that it is not permissible to rely upon one convention between India and an OECD member state for the purposes of taking advantage of a lower rate of tax and then refer to another convention between India and another OECD member state to take advantage of a more restricted scope, observed as under:
"The other expression used is 'if under any Convention, Agreement or Protocol signed after 1-9-1989 between India and a third State which is a member of the OECD'. This also indicates that the benefit could accrue in terms of lower rate or a more restrictive scope under more than one Convention which may be signed after 1-9-1989 between India and a State which is an OECD member. The purpose of clause 7 of the Protocol is to afford to a party to the Indo-France Convention the most beneficial of the provisions that may be available in another Convention between India and another OECD country."
The taxpayer, may, however adopt such a view with caution, bearing in mind that the tax authorities may challenge the above resulting in litigation.
- MFN applied for beneficial tax treatment for interest payment
The AAR in the case of Poonawalla Aviation Pvt Ltd dealt with the applicability of MFN clause for interest payment. In this case, the Indian company had entered into an agreement for purchase of aircraft from the French company. The French company provided credit facility to the Indian company. COFACE (Compagnie Françaised' Assurance pour le Commerce Extérieur), a leading French insurance company, insured the credit facility to be extended by the French company to the Indian company. The taxpayer sought to apply the exemption available under Article 12(3)(b) of India-France whereby interest arising in India is not taxable in India if it is derived in connection with a loan or credit extended or endorsed by COFACE. The AAR ruled that the mere fact that French insurance company is obliged to pay on happening of contingency, does not mean it endorsed the credit facility. Thus, the benefit of Article 12(3)(b) was not granted. The AAR, however, applied the MFN clause and considered the beneficial provisions contained in Article 11(3)(b) of India-Hungary, India-Ireland and India-Canada tax treaties. The said treaties provide that interest paid in respect of loan or credit extended / guaranteed / insured by the central bank or a leading financial institution (specified in the respective tax treaty) shall be exempt from tax in the source state. As can be seen, the exemption is also granted to interest arising in connection to loan or credit insured by the central bank / institution, which is absent in the India-France tax treaty. By importing the beneficial provisions of the above tax treaties, the AAR exempted the interest from tax in India.
- MFN clause could create adverse taxability – if not applied diligently
In Mersen India (P.) Ltd, the AAR took a different view while applying the MFN clause for managerial services. In this case, an Indian company entered into a service agreement with its group company in France (French Co). Under the service agreement, French Co undertook to provide advice and assistance on business strategy and general management, marketing and commercial matters, financial matters etc. French Co was also to impart training to the Indian company. The services were largely managerial in nature. The FTS payment was sought to be exempted by invoking the MFN clause and applying the ‘make available' criteria in India-USA tax treaty. The AAR observed that the definition of ‘included services' in India-US tax treaty covers only technical and consultancy services, and not managerial services. Thus, managerial services should not be given benefit of “make available” provisions in India US tax treaty which deals with only technical and consultancy services. The AAR held that even if concept of “make available” was to be invoked, payment for managerial services is “fees for technical services” under India-France tax treaty.
India-Finland tax treaty – possibility to explore
The possibility to explore MFN clause in a wider sense arises in the context of India-Finland tax treaty. Generally, under a tax treaty, the FTS is deemed to arise in the state in which payer is resident. However, as per Article 12, where FTS relates to services performed, within a Contracting State, then such FTS shall be deemed to arise in the state in which services are performed. Depending upon the facts of the case, it could be possible to claim exemption where the services are performed outside India by relying on the said clause.
Having broadly appreciated the benefits of MFN clause, it would be beneficial for the foreign taxpayer to take an informed decision in selecting which treaty to apply. As mentioned above, if a correct treaty is not applied, it could result in an adverse tax situation. At the same time, if correct treaty is selected, it may result in reduced or nil tax cost.