Dividend income (of French shareholders) from India, recent developments

India has been inviting investments into various sectors. With regard to trade and investment flows, France has been an important partner of India.

India has been inviting investments into various sectors. With regard to trade and investment flows, France has been an important partner of India. The return on capital invested could be in various forms, including dividend. In India, taxation of dividend paid by Indian entities to shareholders for an enterprise set up in France, has been a subject matter of conversation in recent times, more particularly with reference to the Most Favoured Nation (MFN) clause as contained in the double taxation avoidance agreements that India has signed.

The MFN clause is an instrument of economic liberalization based on preventing discrimination, linking bilateral agreements by ensuring that the parties to one agreement are not subjected to less favourable treatment than that provided to other parties under similar agreements.

Simply put, the MFN clause casts an obligation on one treaty state (X) to offer a ‘more favourable’ tax treatment than what is currently set out in the tax treaty with another state (Y), if in future, it offers a ‘more favourable’ tax treatment in any tax treaty which it enters

into with a third state (Z). In some tax treaties that India has entered into, the MFN clause enables limitation of taxation at source on dividends, interests, royalties and fees for technical services. The MFN clause is included by way of protocol to tax treaties, namely Netherlands, France, Switzerland, Sweden, Hungary and Finland.

On various occasions, Indian courts have pronounced rulings on the MFN clause, typically in favour of the taxpayer. The Central Board of Direct Taxes, Government of India on 3 February 2022 issued Circular No. 3 of 2022 (Circular) providing clarification regarding applicability of MFN clause in the protocol to India’s tax treaty with Netherlands, France and Switzerland, particularly income-tax rates on dividend, which stands reduced to 5%, by seeking application of India’s tax treaties with Slovenia, Lithuania and Colombia. The Circular provides that the applicability of the MFN clause and benefit of the lower rate or restricted scope of source taxation rights in relation to certain items of income provided in India's tax treaties with third states will be available to the first (OECD) state by date as per the provisions of the MFN clause, after following the due procedure under Indian Income-tax Act, only when all the following conditions are met:

• The second treaty (with the third state) is entered into after the signature or entry into force (depending upon the language of the MFN clause) of the treaty between India and the first state;
• The second treaty is entered into between India and a state which is a member of the OECD at the time of signing the treaty with it;
• India limits its taxing rights in the second treaty in relation to rate or scope of taxation in respect of the relevant items of income; and
• A separate notification has been issued by India, importing the benefits of the second treaty into the treaty with the first state, as required by the provisions of 90(1) of the Income-tax Act, 1961.

It appears that after the Circular, tax authorities have denied application of the 5% tax rate in relation to dividend income. This position appears to have been taken on the grounds that all conditions stated in the Circular are not met. It is important to highlight that there are favourable judgements passed by High Courts which had dealt with the applicability of the MFN clause.

The actions taken by Indian tax authorities to deny lower rate of tax by applying the MFN clause has been challenged by taxpayers in courts. The Karnataka High Court in case of a Swiss shareholder and a Dutch shareholder and the Delhi High Court in case of a French shareholder, have admitted writ petitions of the taxpayers where they were denied lower withholding tax certificate based on the Circular.

Having highlighted the issue, the discussion that follows focusses on the MFN clause as contained in the India-France tax treaty, particularly dividend income.

As per India-France tax treaty, dividend paid by an Indian company to a French shareholder may be subject to tax in India at the rate of 15% if the shareholder is beneficial owner of the dividend. The Protocol to India-France tax treaty which was signed at the time of the tax treaty itself (1-9-1992), provides MFN clause in respect of dividends, interest, royalties, fees for technical services or payments for the use of equipment.

Courts have held that the Protocol of India-France tax treaty makes it self-operational, which is also evident from the preamble to the Protocol. Upon tax treaty containing the Protocol at the time of signing being notified, there is no need for another notification for application of beneficial provisions in some other tax treaty. It is important to note that India signed tax treaties with Slovenia, Lithuania and Colombia after India-France tax treaty. However, these countries were not OECD members at that time. With regard to the requirement of third states (i.e., Slovenia, Lithuania, Colombia) to be OECD members at the time they signed their tax treaties with India, courts in the case of India-Netherlands tax treaty (which contains substantially similar wordings of the MFN clause in India-France tax treaty) have held that the language of the MFN clause does not explicitly or implicitly suggest the tax treaty between India and the third state should have been signed when the third state was an OECD member.

Also, the MFN clause makes the concessional dividend tax rate applicable from the date on which the above tax treaties enter into force. This result is inconsistent due to the fact that the third states became an OECD member only after their tax treaties with India entered into force. Interpreted plainly, it will allow French residents to claim a concessional tax rate w.e.f. date prior to the third state’s OECD membership, something which was not given to any OECD country at that time and therefore would have actually been outside the purview of the MFN clause at that time.The circular has clarified that importation of the concessional tax rate can happen only with effect from the date of entry into force of the third state tax treaty and cannot happen with effect from the date of OECD membership of the third state. However, based on the language of the MFN clause and the court observation, it may be possible to take a view that the importation of the concessional tax rate happens with effect from the date of OECD membership of the third state.

It is indeed important to highlight that the courts did not have the benefit of the Circular while deciding the case in favour of the taxpayer. Having said that, a reading of the judgements suggests that courts have taken cognizance (explicitly or implicitly) of all aspects dealt with by the Circular while rendering its judgement. However, it may be noted that tax authorities have preferred an appeal in the Supreme Court against these judgements, which are admitted and pending adjudication.

Considering the spirit of the MFN clause, it is possible to avail the benefit of the 5% tax rate on dividends as per the India-Slovenia tax treaty from the date of Slovenia’s OECD membership in case of the India-France tax treaty.

This uncertainty on taxation of dividend in India could cause challenges for shareholders who may or may not have claimed credit for taxes paid in India in their home country i.e. France. Effectively, if the rate of tax on dividends is increased and that too retrospectively as a consequence of the Circular that has been issued, it is likely to result into uncertainty for investors who have already accounted for the dividend income and / or credit for taxes paid in India.

The Circular makes the issue of applicability or benefit under MFN clause litigative. In order to attract investments and provide certainty, the following may be considered : (a) A bilateral understanding is arrived at between India and France (and other countries, as applicable) to determine the applicability of the MFN clause; (b) Government of India issues further clarifications aligned to the bilateral understanding between parties; and (c) the matters pending before the Supreme Court of India are adjudicated which help in providing finality to the interpretation that needs to be adopted on applicability of the MFN clause.

Information for the editor for reference purposes only

Vijay Dhingra is a Partner with Deloitte Haskins and Sells LLP, Urvashi Agarwal is Manager with Deloitte Haskins and Sells LLP and Charmy Poldiya is Assistant Manager with Deloitte Haskins and Sells LLP