The Indian domestic tax laws in relation to taxation of dividend income were amended by the Finance Act of 2020 restoring taxability of dividend income distributed by companies to the classical system of taxation of such income in the hands of the shareholder. Prior to this amendment, for some time, dividend distributed by a company was subject to dividend distribution tax (‘DDT’) in the hands of the company and exempt in the hands of the shareholder. DDT paid by the company, arguably, did not enjoy benefit of lower withholding tax (‘WHT’) rate prescribed under Double Tax Avoidance Agreements (‘DTAA’), though during the last few years prior to the amendment now made, attempts had been made by taxpayers to claim the DTAA rates; an issue which is currently sub judice.
The change has once again brought the relevance of DTAAs to forefront given that DTAAs in most case prescribe a lower rate of WHT vis-à-vis the WHT rate of 20% applicable on dividend income in the hands of non-resident under the domestic tax law. Generally, application of a WHT rate prescribed under a DTAA is simple and straight forward. However, applying WHT rate where DTAAs have a Most Favored Nation (‘MFN’) clause has its nuances which have from time to time been examined by Indian courts.
In this respect, the Delhi High Court in a recent case of Concentrix Service Netherlands B.V. vs Deputy Commissioner of Income Tax & Anr.[1] (‘Concentrix’) had the occasion to examine applicability of MFN clause under the India-Netherlands DTAA in context of WHT rate applicable on dividend income received by the Dutch parent company from its India subsidiary. Under Article 10 of the India-Netherlands DTAA, dividend received by a resident of one country from the payer of the other resident country is subject to 10% WHT. However the protocol provides a MFN clause stating that in respect of dividend, interest, royalties and fee for technical services (‘FTS’), if after signing of the DTAA, under any Convention or Agreement between India and a third State which is a member of the OECD, India limits its taxation at source on such income to a rate lower or a scope more restricted than the rate or scope provided for in India – Netherlands DTAA, the same rate or scope as provided for in that Convention or Agreement on the said items of income shall also apply under this Convention. Simply put, if the provision of another DTAA subsequently entered between India and OECD member country is beneficial to the stated nature of payments, the same would apply notwithstanding the provisions of India-Netherlands DTAA.
Taxpayer’s Contention
In Concentric, the taxpayer had applied for a WHT order before the tax authorities seeking 5% WHT rate (as against 10% prescribed under India-Netherlands DTAA) in relation to divided income taking the benefit of MFN clause and applying the rates applicable under India-Slovenia[2], India – Lithuania[3] and India – Columbia[4] DTAA. It was contended that since India has executed DTAAs with such other countries which were members of OECD, the lower rate, or the restricted scope in the DTAA executed between India and such other country would automatically apply to India-Netherlands DTAA. This is considering the protocol which inter alia stated that the protocol “shall form part an integral part of the Convention” i.e., the subject DTAA.
In support of this plea, reliance was placed on the judgements in the case of Steria (India) Ltd. vs. Commissioner of Income-tax-VI[5], Apollo Tyres Ltd. vs. Commissioner of Income Tax, International Taxation[6].
Tax Authorities Contention
The tax authorities however contested the claim putting forth the following argument:
- that the protocol appended to the India-Netherlands DTAA providing benefit of the lower rate of WHT or a scope more restricted would be available only if the country with which India enters into a DTAA was a member of the OECD at the time of the execution of the India-Netherlands DTAA, and
- the DTAAs with such third States were entered while such States were OECD member countries.
India’s DTAA with Slovenia, Lithuania and Columbia were executed prior to such countries becoming OECD member countries. Since none of the countries, i.e., Slovenia, Lithuania, and Columbia were members of the OECD, on the date when such States executed DTAAs with India, protocol appended to the DTAA would have no applicability.
The Ruling
The Court however ruled in favour of taxpayer holding that:
- the protocol forms an integral part of the DTAA and therefore no separate notification is required, insofar as the applicability of provisions of the protocol is concerned,
- the state of affairs i.e. the point of time when the third State should be a member of OECD, should exist not necessarily at the time when the subject DTAA (India – Netherlands DTAA) was executed but when a request is made by the taxpayer or deductee for issuance of a lower rate withholding tax certificate.
The Court went on to draw reference to the decree issued by the Kingdom of Netherlands on 28.02.2012[7] wherein it was thus specified:
“Slovenia became a member of the OECD on 21 July 2010. Under the most favored nation clause in the Protocol to the Convention, this event has the effect that, with retroactive effect to July 21, 2010, a rate of 5 per cent will apply to participation dividends paid by a company resident in the Netherlands to a body resident in India.”
The Court made an important observation regarding principle of “Common Interpretation” to be adopted by courts of the contracting States. This would ensure that Conventions/DTAAs are applied efficiently and fairly so that there is consistency in the interpretation of the provisions by the tax authority and courts of the concerned contracting State. The Court accordingly accepted application of WHT rate of 5% prescribed under the DTAA with Slovenia, applying the MFN clause.
Insight for taxpayers
The court ruling reinforces importance of MFN clauses in DTAAs which, if applied judiciously, present significant opportunity of tax saving. The ruling provides credence to the application of MFN clause under DTAAs with countries such as Netherland, France, Sweden, Hungry and Switzerland enabling application of lower rate of WHT of 5% on dividend payment as against the 10% prescribed under the respective DTAAs. The MFN clause also aids in reading down the scope of certain categories of income, more specifically FTS in DTAA such as with France, Sweden, Hungry, Belgium and Spain, restricting taxability in the state of residence only in case of a permanent establishment in the country of source.
Appropriate application of MFN clause also becomes important considering that the resident State may allow credit of tax payable in the country only to the extent of appropriate tax applicable under DTAA. For instance, Indian DTAAs such as with Netherlands and France prescribe a period of three years within which application for refund of excess tax levied at source should be filed. Further, applications for the refund of the excess amount of tax will have to be lodged with the authority of the State having levied the tax. This makes it critical to evaluate impact of MFN clause under the applicable DTAA.
It is also relevant to take note that the Finance Act of 2020 has materially amended provisions relating to filing of income tax returns by non-residents. As per the current provisions, a non-resident taxpayer will mandatorily be required to file an Indian tax return where lower WHT rates as prescribe under DTAA are applied in respect of income in the nature of royalty/FTS (taxable on gross basis), interest or dividend. Dispensation to file the tax return is available only where WHT has been deducted at the rate prescribed under the domestic tax law. A non-compliance has penal implications.
Given the significance of MFN clause under DTAAs and the opportunity such clause offers to reduce the tax cost, taxpayers will be well advised to evaluate MFN clause under the relevant DTAA while at the same time ensuring timely fiscal compliance to remain on the right side of law.
Contributed by Yatin Sharma. Yatin can be reached at yatin.sharma@aureuslaw.com
[1] W.P.(C) 9051/2020, judgement dated 22 April 2021
[2] DTAA executed between India and Slovenia; which came into force on 17.02.2005 and was notified on 31.05.20
[3] DTAA executed between India and Lithuania; which came into force on 10.07.2012 and was notified on 25.07.2012
[4] DTAA executed between India and Columbia; which came into force on 07.07.2014 and was notified on 23.09.2014
[5] [2016] 386 ITR 390 (Delhi)
[6] [2018] 92 taxmann.com 166 (Karnataka)
[7] [No. IFZ 2012/54M, Tax Treaties, India], published on 13.03.2012