Most Favoured Nation (MFN) Clause in DTAAs: Interpretation, Judicial Precedents, and India's Stand

Introduction

The Most Favoured Nation (MFN) clause in Double Taxation Avoidance Agreements (DTAAs) plays a crucial role in ensuring equitable tax treatment among treaty partners. This clause grants a contracting state the benefit of more favorable tax provisions that a country may subsequently offer to a third state. By doing so, the MFN clause promotes fair competition, prevents treaty shopping, and fosters uniformity in international taxation. However, its interpretation and application have been the subject of extensive debate, particularly in the context of judicial rulings and unilateral administrative positions. Over the years, the interpretation of MFN clauses has evolved, particularly in response to disputes regarding whether their application is automatic or requires a separate notification or protocol between treaty partners. By this article, the author focuses on the issues relating to the interpretation of the MFN clause and judicial precedents (across the Globe) relating to the interpretation and application of the MFN clause.

Historical Background

The concept of MFN treatment originates from international trade law and was later adapted into tax treaties. It traces its roots back to early bilateral trade agreements, where nations sought assurances that their exporters would not be disadvantaged compared to competitors from other countries. In the tax domain, the MFN clause was first incorporated into DTAAs to address disparities in withholding tax rates and other treaty benefits.

Model tax conventions and MFN

Neither the UN Model Tax Convention nor the OECD Model Tax Convention explicitly includes a Most Favoured Nation clause in their standard treaty provisions. The primary reason is that both models aim to provide a uniform framework for tax treaties, whereas an MFN clause inherently introduces variability by linking one treaty’s benefits to those granted in another. Additionally, MFN clauses can create interpretational challenges, such as whether they apply automatically or require formal amendments, and whether they operate retroactively or prospectively. Given these complexities, the OECD and UN models avoid including MFN provisions and instead leave it to bilateral negotiations between countries.

Despite their absence from the model conventions, MFN clauses are frequently found in bilateral tax treaties, particularly in protocols or side agreements. Countries often include them to preserve competitive tax advantages, particularly in withholding tax rates on dividends, interest, and royalties. These clauses are common in treaties involving European and South Asian countries, where tax authorities seek to ensure that treaty partners do not receive less favorable terms than those granted to third countries. While MFN clauses offer benefits in ensuring parity, their interpretation and enforcement remain contentious in various jurisdictions.

Example

Consider a DTAA between Country A and Country B, where a 15% withholding tax rate on dividends is agreed upon. The treaty includes an MFN clause, stating that if Country B subsequently signs a tax treaty with any third country (Country C) offering a lower withholding tax rate, then the same lower rate shall apply to Country A as well. Later, Country B signs a DTAA with Country C, granting a 10% withholding tax rate on dividends. The natural expectation is that Country A should now benefit from this reduced rate.

Issues Surrounding MFN Clause:

1. Automatic vs. Non-Automatic Application: Some countries argue that the MFN clause applies automatically when a more favorable provision is granted to another country, while others insist that a formal notification or separate agreement is required.
2. Requirement of Similarity in Treaty Partners: Many treaties specify that the MFN clause applies only if the third country has a similar level of economic development or if it belongs to a particular group (e.g., OECD membership).
3. Interpretation of "More Favorable Treatment”: There is no uniform definition of what constitutes “more favorable treatment” under an MFN clause. Some jurisdictions interpret it strictly (limited to tax rates), while others include broader treaty provisions such as capital gains exemptions.
4. Domestic Law vs. Treaty Interpretation: Some countries apply domestic tax law principles (rather than international treaty interpretation standards) when assessing MFN clauses, leading to inconsistencies and unilateral positions.
5. Withholding Tax Reductions and Treaty Shopping Concerns: Some countries fear that the MFN clause may be exploited for treaty shopping, where investors structure transactions through jurisdictions with the most favorable tax rates.
6. Retroactive vs. Prospective Application: A key dispute is whether MFN benefits should apply retroactively (from the date the third-country treaty was signed) or only prospectively after formal recognition by the tax authorities.
7. Unilateral Denial of MFN Benefits: Some countries have unilaterally denied MFN benefits even when their treaties clearly provide for them, leading to tax litigation and arbitration cases. Example: In Pakistan, the tax authority has refused to grant lower withholding tax rates under MFN clauses, leading to multiple tax disputes.

Judicial Pronouncements on MFN Clause in DTAAs

India’s Stand on MFN

The Supreme Court of India made a landmark decision in the case of Nestle SA v. Assessing Officer Circle (International Taxation) on October 19, 2023. This decision significantly impacted the application of the Most-Favoured-Nation (MFN) clause in Double Taxation Avoidance Agreements (DTAAs). The court ruled that for the MFN clause to be operational, a specific notification under Section 90 of the Income-tax Act, 1961, is mandatory. This means that even if the MFN clause is present in the treaty, its benefits cannot be availed automatically without such a notification. The SC also dismiss the review petition vide Diary No. 54088 of 2023) IN CIVIL APPEAL NO. 1427 OF 2023.

Recently, India has invoked the “Most Favoured Nation” (MFN) clause in its income tax treaty with Spain, reducing the tax rate on royalties for technical services from the standard 20% under Article 13 of the treaty to 10%. This adjustment follows a protocol in the treaty, which stipulates that if India enters into an income tax treaty with another OECD member state after 1 January 1990, imposing a lower tax rate on such royalties, the same rate shall apply to the India-Spain treaty. Crucially, this benefit has been extended through a formal government notification. On 19 March 2024, the Indian Ministry of Finance issued a notification confirming that the conditions for invoking the MFN clause had been satisfied, citing the India-Germany income tax treaty as the basis for the reduced rate. The revised 10% tax rate will take effect from the financial year 2024-25.

The judgment has significant implications for taxpayers and international agreements. Taxpayers intending to avail benefits under the MFN clause of a DTAA must ensure that the requisite notifications have been issued by the Indian government. Without such notifications, the MFN provisions remain inoperative. The decision also highlights the critical interplay between international agreements and domestic law, emphasizing the procedural compliance required to implement treaty benefits. Furthermore, in response to this ruling, Switzerland unilaterally announced the suspension of India's MFN status effective January 1, 2025, citing the Supreme Court's judgment as a basis for this decision.

Disclaimer:

The views expressed in this article are the author’s personal opinions and do not constitute legal, tax, or financial advice. While every effort has been made to ensure accuracy, readers are advised to consult with a professional advisor before making any decisions based on the content. The author and publisher disclaim any liability for any errors or omissions in the information provided. This article is for informational purposes only and does not represent the official stance of any institution or organization.