The MFN clause in tax treaties is jeopardising tax revenue for lower-income countries
The ‘Most Favoured Nation’ principle
In international economic relations, the Most Favoured Nation (MFN) principle is the bedrock of non-discriminatory trade policy. The underlying principle is, if a country extends favourable treatment to another country on a particular subject under a given agreement, it must treat other parties to the agreement equally regarding that subject. Along similar lines, the MFN clause in tax treaties also intends to promote non-discrimination and parity in business and investment opportunities among treaty partner countries.
The Organisation for Economic Cooperation and Development (OECD) Model Tax Convention on Income and on Capital and the United Nations (UN) Model Double Taxation Convention between Developed and Developing Countries do not have standard MFN provisions. These provisions are generally outcomes of negotiations between treaty partners, and most commonly find their place either in specific articles or more generally in the protocol of the agreement. The MFN principle ensures that a treaty partner under one agreement is not subjected to a treatment which is less favourable than treatment provided to other treaty partners under similar agreements.
Lately, the MFN provisions in the tax treaties between high-income and lower-income countries have started demonstrating disadvantageous effects for the source jurisdictions, with the potential of creating opportunities for “reduced taxation” and exposing source countries/lower-income countries to the risk of large-scale tax base erosion. The perils of MFN clauses were exposed in two recent cases involving treaties signed by both South Africa and India with the Netherlands.
The South African experience
In this case, the taxpayer (ABC (Pty) Ltd.) took a view that by virtue of the MFN clause present in South Africa-Netherlands DTAA, the dividend rates provided under South Africa-Sweden DTAA became applicable, as the amended agreement with Sweden was concluded after the date of conclusion of the South Africa-Netherlands DTAA. This interpretation was fair as far as the formulation of the MFN clause is concerned. However, the taxpayer went a step further, looking to the MFN clause for dividend taxation in the South Africa-Sweden DTAA, which provided that if any agreement between South Africa and a third state prescribes an exemption or lower rate for source taxation of dividends, the same beneficial treatment shall automatically apply to the South Africa-Sweden DTAA.
Thus, the taxpayer sought beneficial treatment provided under South Africa-Kuwait DTAA, which provided an exemption from source taxation on dividend income. The Kuwait DTAA was entered into force in 2006, long before the South Africa-Sweden DTAA of 2012. However, one crucial difference between the MFN clause in the Netherlands DTAA and the Sweden DTAA was the absence of the words “after the date of conclusion of this convention” in the Sweden DTAA. Thus, the interpretation was – as far as the MFN clause with Sweden is concerned – if any other contracting state gets beneficial treatment (whether existing or in the future), then those benefits shall also apply to Sweden. Therefore, taxpayer sought that the same beneficial treatment should also available to the residents of Netherlands by virtue of South Africa-Netherlands DTAA MFN clause.
The Tax Court of South Africa eventually passed judgement on June 12, 2019 (Case no. 14287), interpreting the MFN clause in favour of the taxpayer, and directing the South African Revenue Service (SARS) to refund all the tax withheld on the dividend income of Dutch shareholders during the relevant period, including the accumulated interest since April 1, 2012. Therefore, triggering the MFN clause stripped South Africa of its right to tax dividends declared by a resident company to Dutch shareholders. Thus, it appears that the MFN clauses may have had relevance as a negotiating tools in the past but in the present times, such future commitments under MFN clauses are proving to be strong forces leading the source countries into deep waters.
The Indian experience
On April 22, 2021, the High Court of Delhi passed a judgement, considered to be first of its kind, in the case of Concentrix Services Netherlands BV WP (C) 9051/2020 and Optum Global Solutions International BV WP (C) 882/2021. Known as the “Concentrix Case,” the court held that dividends paid by the Indian company to its Dutch shareholders is taxable at a withholding tax rate of 5%, by using the lower dividend tax rate available in the India-Slovenia DTAA by virtue of the MFN clause present in the India-Netherlands DTAA, which otherwise provides 10% withholding tax on dividend pay-outs under Article 10 of that treaty.
The Indian tax department argued strongly against invocation of the MFN clause in the India-Netherlands DTAA, as all the criteria were not fulfilled. As per the tax department, the basic condition for the third state (Slovenia) “to be a member of the OECD” should to be fulfilled not only at the time of application of the treaty but also at the time when India signed the treaty with Slovenia. The tax department therefore contended that since Slovenia was not an OECD member when the treaty was signed with India, the MFN clause in the India-Netherlands DTAA should not be applicable.
However, the court ruled in favour of the taxpayer, deciding that the condition of the third state being an OECD member has to be fulfilled at the time of claiming the MFN benefit, and not at the time of the treaty signing with said third state. This ambulatory interpretation goes beyond the original purpose of the MFN clause in the treaty. Given the objective of the clause and the intention of the Indian negotiators, it is very unlikely that they would have agreed to the lower rate of 5% if Slovenia had been a member of the OECD at the time. It is much more likely that India would have agreed a rate more similar to those agreed with other OECD member countries at the time which was 10-15%. Therefore, the ruling of the Hight Court appears to violate the good faith principle of the “Pacta sunt servanda” as enshrined in Article 26 of the Vienna Convention on the Law of Treaties. Nevertheless, if similar interpretation is followed by other courts, India and other source jurisdictions with identical MFN clauses stand to lose a great deal of tax revenue.
The perils of MFN clauses for lower-income countries
Generally, MFN clauses will not create risks if they are concluded between two equally developed nations, but when the agreement is between countries where one receives more investments from the other than it makes, potential dangers are inevitable.
There will surely be other treaty partners like the Netherlands, who would like to seek similar beneficial treatment of “nil” tax on dividends on their investments in South Africa by applying the existing MFN provisions and referring to treaties like the one with Sweden, where the clause supposedly (as interpreted by the court) applies to both existing and future contracts, and the Kuwait DTAA, which exempts source taxation of dividend income.
In the context of Indian tax treaties, the dangers of MFN clauses have multiplied since the Concentrix judgement. India has a vast treaty network, of which approximately 13 have MFN clauses, and around nine are based on the conditionality of the third state being an OECD member. The High Court of Delhi’s interpretation, that the third country need not be an OECD member on the date of signature of the treaty, will likely lead to treaty partners with higher dividend tax rates trying to import lower rates from the DTAAs with Slovenia, Lithuania, and Colombia, which were not members of the OECD when they signed DTAAs with India, but subsequently became members of the OECD.
Beyond South Africa and India, it is conceivable that global investors might plan their business affairs and locate their holding structures in jurisdictions where they can use MFN clauses to pay substantially lower rates of tax in lower-income countries. However, in present times, this level of international tax planning by multinational companies would not be easy considering the fact that creating any such structure or arrangement will require them to pass the “Form” vs. “Substance” Test and get through domestic anti-abuse rules (such as General Anti-Avoidance Rules) and treaty anti-abuse rules (such as the Limitation on Benefits). Still, aggressive tax planning is an issue that source countries should not miss anticipating.
What can lower-income countries do?
The risk of including MFN clauses in tax treaties may well outweigh their benefits for lower-income countries. Going forward, if at all these provisions are needed, negotiators should take the utmost care in drafting MFN clauses and undertake a thorough impact assessment on their tax treaty networks before adopting them. As the cases above demonstrate, the presence or absence of a single word or phrase in tax treaties, and particularly in sensitive clauses like the MFN which binds future tax policy, can lead to unintended and damaging outcomes.
Will the Multilateral Instrument (MLI) change anything?
As MFN provisions are not standalone treaty articles, the MLI will not have any direct impact on them, apart from the fact that some items of income covered under MFN clauses will be impacted if countries opt for those provisions. However, as far treaty abuse is concerned, the MLI’s new preamble text and Principal Purposes Test will definitely be a major anti-abuse instrument to curb such practices, on top of general anti-tax avoidance rules existing in domestic tax law.
The MLI’s preamble text prescribes the purpose of a tax treaty as: “Intending to eliminate double taxation with respect to the taxes covered by this agreement without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in this agreement for the indirect benefit of residents of third jurisdictions)”, will act as deterrent for tax avoidance practices creating opportunities for “non-taxation” and “reduced taxation” (emphasis added).
Similarly, under the Principal Purposes Test, if the tax department reasonably concludes that obtaining tax benefits was one of principal purposes of restructuring or tax planning, the treaty benefit of lower rate and restricted scope under the MFN provisions can be denied.
The way forward
In the above cases, the detrimental impact of the MFN clauses emerged after changes in domestic law, when the system of dividend taxation was changed from Dividend Distribution Tax to the classical system of dividend taxation. The South African and Indian experiences of issues involving dividend taxation under tax treaties, their interplay with MFN provisions, and the unfavourable interpretations by the Courts is just one example and early indication of how MFN clauses can be hazardous for lower-income counties. While MFN clauses may have been relevant as a negotiating tool in the past, they may no longer be useful for source jurisdictions, as they limit their future tax policy options.
In terms of recommended actions, a comprehensive analysis of all the MFN clauses in tax treaties and examination of their cross-connections and negative spill over effects is urgently needed. In addition, careful analysis of changes to domestic tax laws and their impact on tax treaties is also important. In the long run, lower-income countries should do away with existing MFN clauses altogether by renegotiating the relevant tax treaties.