BACKGROUND
A tax treaty is usually bilateral in nature and is limited to two
countries: Resident country and Source country. When two bilateral treaties are
compared, there ought to be substantial or minor differences on account of the
different strategies and the negotiation power of the competent authorities of
the respective countries. The question is whether the taxpayer can rely on
another bilateral tax treaty, one that is not applicable to him. The answer is
clearly ‘No’.
The taxpayer relies on the tax treaty entered into by his resident
country for the income that has arisen in the source country. For his
taxability, the taxpayer is restricted to the applicable tax treaty only.
However, the tax treaty mechanism is such that, if expressly provided for in
his treaty, the taxpayer is permitted to enforce the beneficial provisions of
another bilateral tax treaty, though subject to conditions. This is widely termed
as the Most Favoured Nation clause (MFN clause). It prevents discrimination
amongst the OECD member states. Its application cannot be implicit but has to
be expressly provided for. If not expressed, a tax treaty cannot oblige another
tax treaty to apply its beneficial provisions (whether in terms of scope or tax
rate).
In the Indian context, the MFN clause is usually found in the Protocol to
its tax treaties, for example, the Protocol to the India-Netherlands TT, the
India-France TT, the India-Sweden TT, etc. For instance, article 12(3)(b) of the India-Sweden Tax Treaty
defines the Fees for Technical Services (FTS) as ‘(b) The term “fees for
technical services” means payment of any kind in consideration for the
rendering of any managerial, technical or consultancy services, including the
provision of services by technical or other personnel but does not include
payment for services mentioned in articles 14 and 15 of this Convention’.
If the Indian taxpayer is making payment for commercial service, the
payment would primarily be covered under this FTS article. It would be interesting to then look into the Protocol
to the India-Sweden DTA that reads as under:
‘In respect of
Articles 10 (Dividends), 11 (Interest) and 12 (Royalties and fees for technical
services) if under any Convention, Agreement or Protocol between India and a
third State which is a member of the OECD, India limits its taxation at source
on dividends, interest, royalties, or fees for technical services to a rate
lower or a scope more restricted than the rate or scope provided for in this
Convention on the said items of income, the same rate or scope as provided for
in that Convention, Agreement or Protocol on the said items of income shall
also apply under this Convention.’
Taking benefit of
the FTS clause (or Fees for Included Services) in the India-USA tax treaty or
the India-UK tax treaty, where USA is the OECD member state, the scope for FTS
in the India-Sweden tax treaty would be reduced to make-available
technical services. Where the FTS is not make-available, the FTS would
be subject to tax only when the taxpayer has a permanent establishment in India
in accordance with Article 7 of that treaty. In other words, if the taxpayer
has no permanent establishment, the FTS income that is not make-available
service would not be taxed in India. This is how the MFN clause would apply and
be beneficial to the taxpayer.
FOREIGN
COURT DECISION
In this context,
the author has discussed a recent foreign court decision on the MFN clause. It
is significant in terms of the manner in which this clause should be applied.
The decision articulates the importance of the phrase ‘limits its taxation at
source’, in respect of interpreting the phrase ‘a rate lower or a scope more
restricted’. It looks into the resultant tax effect, rather than the rate or
scope prescribed in another Tax Treaty (referred to as TT). The decision is
explained in detail below:
South Africa
Tax Court in
Cape Town
ABC Proprietary Limited vs. Commissioner (No.
14287)
Date of Order:
12th June, 2019
(i) FACTS
The taxpayer is a
South African tax resident company and a shareholder of a Dutch company. The
Dutch company declared dividend to the South African taxpayer in respect of
which it withheld dividend tax at the rate of 5% and paid it to the Dutch Tax
Authorities. The taxpayer subsequently requested a refund of the dividend tax
paid to the Dutch Tax Authorities on account of the MFN clause in the
Netherlands-South Africa Tax Treaty (NL-SA TT). It contended as follows:
(a) NL-SA TT
provides for 5% withholding tax;
(b) MFN of NL-SA TT
referred to the South Africa-Sweden Tax Treaty (SA-SW TT) that also provides
for 10% withholding tax; but the second MFN of the SA-SW TT provides for an
effective withholding tax rate of 0% after referring to the South Africa-Kuwait
Tax Treaty (SA-Kuwait TT).
The peculiarity of
this decision is the extent to which the second MFN influences the effective
withholding tax rate in the NL-SA DTA. Coincidentally, the recent judgment of
the Dutch Supreme Court on 18th January, 2019 in case number
17/04584 is on similar facts with a similar outcome. Both the decisions are
discussed together.
(ii) TT ANALYSIS
To understand the
importance of this decision, it is equally important to have the extract of the
relevant clauses for our benefit.
NL-SA TT
Article 10 of the
NL-SA TT provides for a 5% dividend withholding tax on distribution of
dividends if the beneficial owner is a company holding at least 10% of the
capital in the company paying the dividends. The MFN clause in article 10(10)
is given as under:
(10) If under
any convention for the avoidance of double taxation concluded after the date of
conclusion of this Convention between the Republic of South Africa and a third
country, South Africa limits its taxation on dividends as contemplated in
sub-paragraph (a) of paragraph 2 of this Article to a rate lower, including
exemption from taxation or taxation on a reduced taxable base, than the rate
provided for in sub-paragraph (a) of paragraph 2 of this Article, the same
rate, the same exemption or the same reduced taxable base as provided for in
the convention with that third State shall automatically apply in both
Contracting States under this Convention as from the date of the entry into
force of the convention with that third State.
It can be observed from the above that the MFN clause of the NL-SA TT
has a time limitation to its applicability. Only the OECD member state DTAs,
that are concluded by South Africa after the signing of the NL-SA TT, would be
looked into. Once applied, the beneficial tax rate or scope for taxation of FTS
in third state TTs would also apply in the NL-SA TT. Accordingly, the SA-SW DTA
satisfied the condition. The analysis of the SA-SW DTA is discussed below.
SA-SW TT
Originally, the
SA-SW TT was concluded prior to the conclusion of the NL-SA TT, however, the
Protocol, wherein the 10% dividend withholding tax rate and the second MFN
clause was provided for, was concluded after the conclusion of the NL-SA TT.
The Court and the tax authority did not think that this would be an issue and
both concluded that since the Protocol was concluded after the date of
conclusion of the NL-SA TT, the SA-SW TT would continue to apply.
Article 10 of the
SA-SW TT read with the Protocol did not provide for any concession in the tax
rate (i.e. 5% withholding tax rate in the NL-SA TT; whereas it was 15% in the
SA-SW TT). However, the Protocol introduced Article 10(6) to the SA-SW TT and
read as follows:
(6) If any
agreement or convention between South Africa and a third state provides that
South Africa shall exempt from tax dividends (either generally or in respect of
specific categories of dividends) arising in South Africa, or limit the tax
charged in South Africa on such dividends (either generally or in respect of
specific categories of dividends) to a rate lower than that provided for in
sub-paragraph (a) of paragraph 2, such exemption or lower rate shall
automatically apply to dividends (either generally or in respect of those
specific categories of dividends) arising in South Africa and beneficially
owned by a resident of Sweden and dividends (either generally or in respect of
those specific categories of dividends) arising in Sweden and beneficially
owned by a resident of South Africa, under the same conditions as if such
exemption or lower rate had been specified in that sub-paragraph.
It can be observed from the above that the time limitation present in
the NL-SA TT is not present in the SA-SW TT. Hence, in the absence of any
limitation, the MFN clause of the SA-SW TT is open to all member states (no
time limitation and no OECD member state limitation). This is where the
SA-Kuwait TT was applied wherein the dividend withholding tax rate is 0% when
dividends arise in South Africa.
SA-Kuwait TT
Article 10(1) of
the SA-Kuwait TT provides that the ‘Dividends paid by a company which is a
resident of a Contracting State to a resident of the other Contracting State
who is the beneficial owner of such dividends shall be taxable only in that
other Contracting State.’ In other words, the dividend paid by the South
African company would be exempt from withholding tax. Kuwait is a non-OECD
member and the SA-Kuwait TT was concluded prior to the date of conclusion of
the NL-SA TT and hence direct reference to this TT was not possible.
(iii) TAX AUTHORITIES’ CONTENTION
The tax authorities
denied the benefit of exemption for various reasons: (a) the benefit of the
SA-Kuwait TT is not available directly to the NL-SA DTA; (b) the purpose of the
MFN clause is to provide additional benefit and bring parity with other OECD
member states. The clause should be read literally and not be open to
interpretation on the basis of another MFN in another DTA, i.e., the SA-SW TT;
and (c) the intention of the MFN clause is to look into the tax rates as
specified in other DTAs, without considering any other MFN clause or other
influence. The MFN clause should be interpreted to bring parity with the
‘specified’ tax rate, rather than the ‘applied’ / ‘effective’ tax rate. The tax
authorities refused to exempt the withholding tax rate.
(iv) ISSUE
Whether the
dividend withholding tax rate is exempt under the NL-SA TT, by virtue of the
MFN clause in that TT and in the SA-SW TT?
(v) DECISION
The Tax Court of
South Africa gave its judgment in favour of the taxpayer that dividends arising
from South Africa would be exempt from withholding tax. It is identical to the
one given by the Hon’ble Supreme Court of the Netherlands. It gave the
following reasons:
(a) The MFN clause to be interpreted based on its
plain meaning. It cannot be contended that the MFN clause is not intended to be
triggered by MFN clauses in treaties concluded thereafter.
(b) The South African tax authorities had in
practice exempted the withholding tax on dividends arising from South Africa;
when the SA-SW TT, read with the SA-Kuwait TT, was applied.
(c) From the perspective of the NL-SA TT, the real
tax effect has to be seen while contemplating the beneficial effects of the MFN
clause.
(d) Accordingly, once it was clear that the SA-SW
TT is a qualified TT, the effective / resultant withholding tax rate would
apply to the NL-SA TT. The indirect effect of the SA-Kuwait TT, that was
concluded prior to the NL-SA TT, is purely coincidental.
IN AN INDIAN CONTEXT
From an Indian perspective, we do not have judgments on any similar
issue. Hence, it becomes imperative to analyse the above decision from the
perspective of Indian tax treaties. Let’s take an example of payments being
made by an Indian resident to a Dutch company in the nature of Fees for
Technical Services. We have considered the India-Netherlands Tax Treaty (Ind-NL
TT), the India-Sweden Tax Treaty (Ind-SW TT) and the India-Greece Tax Treaty
(Ind-Gr TT).
Ind-NL TT
Article 12 of the Ind-NL TT provides for a 20% withholding tax rate and
defines FTS as: The term ‘fees for technical services’ as used in this
Article means payments of any kind to any person, other than payments to an
employee of the person making the payments and to any individual for
independent personal services mentioned in Article 14, in consideration for
services of a managerial, technical or consultancy nature.
The extract of the Protocol to the Ind-NL TT is given below:
If after the signature of this Convention under any
Convention or Agreement between India and a third State, which is a member of
the OECD, India should limit its taxation at source on dividends, interest,
royalties, fees for technical services or payments for the use of equipment to
a rate lower or a scope more restricted than the rate or scope provided for in
this Convention on the said items of income, then, as from the date on which
the relevant India Convention or Agreement enters into force, 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.
It can be observed that, like the NL-SA TT, the Ind-NL TT provides for a
time limitation and the OECD member-state condition for applicability of the
MFN clause.
Ind-SW TT
The Ind-SW TT
(conclusion date: 24th June, 1997) was concluded after the date of
conclusion of the Ind-NL TT (conclusion date: 30th July, 1988);
accordingly, Ind-SW is a qualified TT for application of the MFN clause.
Article 12 of the
Ind-SW TT provides for a 10% withholding tax rate and defines FTS as: The
term ‘fees for technical services’ means payment of any kind in consideration
for the rendering of any managerial, technical or consultancy services,
including the provision of services by technical or other personnel, but does
not include payments for services mentioned in Articles 14 and 15 of this
Convention.
The extract of the Protocol to the Ind-SW TT is given below:
In respect of
Articles 10 (Dividends), 11 (Interest) and 12 (Royalties and fees for technical
services), if under any Convention, Agreement or Protocol between India and a
third State which is a member of the OECD, India limits its taxation at source
on dividends, interest, royalties or fees for technical services to a rate
lower than or a scope more restricted than the rate or scope provided for in
this Convention on the said items of income, the same rate or scope as provided
for in that Convention, Agreement or Protocol on the said items of income shall
also apply under this Convention.
It can be observed that,
like the SA-SW TT, the Ind-SW TT also does not provide for any time limitation,
although it does specify an OECD member-state condition.
Ind-Gr TT
The Ind-Gr TT was concluded on 11th February, 1965, that is,
prior to the date of conclusion of the Ind-NL TT dated 30th July,
1988 and hence, like the above decision, direct reference to this TT was not
possible. But Greece is an OECD member state and, thus, satisfied the MFN
clause of the Ind-SW TT. The Ind-Gr TT does not have the FTS article and hence
the income from performance of services would be taxable under Article 3 for
industrial or commercial services, or under Article 14 for professional
services. The threshold requirements in Article 3 and Article 14 would
accordingly apply in the present case. These provide for a reduced scope that
is ‘more restricted’, resulting in limiting India’s right to tax FTS and,
hence, could be read into the Ind-SW TT and thereafter into the Ind-NL TT.
Another argument that can also come up for analysis is whether the ‘scope
more restricted’ in the Ind-SW TT takes into account a complete absence of the
FTS article or takes into account a mere tax effect on FTS? Reliance can be
placed on another foreign court decision by the Supreme Court of Kazakhstan in
the case of The Kazmunai Services (Case No. 3??-77-16), dated 3rd
February, 2016, wherein the taxpayer applied the MFN clause of
the Kazakhstan-India DTA and wanted to benefit from the missing FTS article in
the Kazakhstan-Germany DTA, the Kazakhstan-UK DTA and the Kazakhstan-Russia
DTA. The Supreme Court denied the benefit of the MFN clause without discussing
its applicability and the issue about the absent FTS article.
In response, it could be stated that the MFN clause refers to the nature
of income (FTS), rather than the FTS article in itself. The phrase used in the
MFN clause of the Ind-SW TT is ‘India limits its taxation at source on
dividends, interest, royalties or fees for technical services to a
rate lower or a scope more restricted than the rate or scope provided for in
this Convention [emphasis] on the said items of income’.
Therefore, in the case of complete absence of FTS, the MFN clause could still
apply when the comparative TT provides for a reduced taxing right on FTS, and
thereby affecting the Source State’s right to ‘taxation at source’.
CONCLUSION
The MFN clause, when applied through the Protocol, is assumed to have an
automatic application, i.e., without the need for a formal approval from tax
authorities1, similar to the MFN clause in the SA-SW TT above. The
past decisions on the MFN clause2
are usually from the perspective of the scope of FTS, wherein, the scope
for FTS is reduced to either ‘make-available’ technical services or removing
managerial service from FTS, or from the perspective of reducing the tax rate
on FTS; all to the extent of the scope or tax rate as ‘specified’ in the
qualifying TT. None of the Indian decisions goes past the ‘specified’ scope or
tax rate in the qualified TT. The objective of this article is to be aware of
its possibility and its planning opportunities.
Observing the similarities between the above foreign decision and the
above example, the MFN clause in the Ind-NL TT refers to two important terms,
‘limits its taxation at source’ and ‘a rate lower or scope more restricted’.
It highlights the resultant scope or resultant rate that limits India’s taxation at source. We
know that the TT merely provides for an allocation of taxing rights between the
resident and the source country. If another TT with another OECD member state
provides for a reduced scope or a lower rate, and thereby limiting India’s
right to ‘taxation at source’, the MFN clause of the Ind-SW TT will get
triggered. India’s right to taxation at
source is determined after taking into account the final tax rate
and provides for an observation to the resulting tax outcome. The scope of the
MFN clause needs to be seen from the perspective of the net result. Whether we
can derive the same result before the Indian judiciary as in the above foreign
decision, only time will tell.
