[Suhana is a student at Hidayatullah National Law University.]
The recent decision of Switzerland to suspend the Most Favoured Nation (MFN) clause under its Double Taxation Avoidance Agreement (DTAA) with India, effective from January 1st, 2025 marks a significant new development in the arena of international taxation policy. This decision stems from the Indian Supreme Court's landmark 2023 ruling in the Nestle case, which made it mandatory to serve a notice for application of the MFN clause under the Income Tax Act. The Swiss response shows that reciprocity and mutual understanding regarding treaty terms can be problematic for businesses being confronted with higher tax burdens in both jurisdictions. This development also indicates the many challenges involved in the process of undertaking tax treaties and prompts questions regarding discussions of the future relevance of these tax treaties in promoting cross-border investments.
Understanding the Most Favoured Nation Clause in Tax Treaties
MFN clause is an integral part of most DTAAs to provide treaty partners with a level playing field. Prevention of a discriminatory regime between signatories to treaties with a third country is the main goal of the MFN clause. By guaranteeing that one treaty partner will not be treated less favorably than another, the MFN clause promotes fairness and consistency in tax agreements. This is aimed at offering benefits like lower tax or tax-free when a country offers such opportunities to another nation in the subsequent or parallel treaty.
The MFN clause operates by creating a link between the treaty and the tax provisions granted to third-party nations. If a country enters into a DTAA with another nation that provides more favorable tax terms—such as lower withholding tax rates or exemptions—those terms are extended automatically (or by notification) to the MFN partner as well. This mechanism ensures that no treaty partner is placed at a competitive disadvantage due to less favorable terms in their agreement. However, the application of the MFN clause often depends on specific conditions, such as:
the subsequent treaty being signed with a member of the same economic bloc, and
certain procedural requirements, such as explicit notifications under domestic laws, being fulfilled.
Judgment of the Supreme Court
In several previous rulings, High Courts provided guidance on how the MFN clause should be applied between India and other contracting states. However, the issue became controversial when the Central Board of Direct Taxes issued a circular offering a contradictory view. This led to confusion and different interpretations as to the extent of the claim of the MFN clause. This controversy was set to rest by the Supreme Court of India in the case of Assessing Officer (International Taxation) v. Nestle SA [2023].
The key issues brought before the Supreme Court of India in response to the appeal of the Indian tax authorities were whether a notification subsequent to the existing notification in each of these agreements was necessary for integrating and extending the benefits under the MFN clause to India’s DTAAs with MFN countries, and whether the MFN clause could be applied to countries that were not members of the Organisation for Economic Co-operation and Development (OECD) when their DTAAs with India were signed.
The court held that a fresh notification under Section 90(1) of the Income Tax Act 1961 is mandatory to give effect to any change in the provisions of existing DTAAs or protocols. The court explained that although the Union has exclusive power to negotiate DTAAs, only Parliament can enact these agreements into Indian law. Without such a legislative change, DTAAs do not automatically bind Indian nationals. If a treaty impacts citizens’ rights or modifies Indian law, it requires Parliament’s approval; otherwise, no legislation is needed.
The Supreme Court of India also emphasized that unilateral orders or decrees from other countries should not be relied upon for interpreting DTAAs, as the legal processes in other nations differ significantly from India’s legislative-driven approach. In India, the MFN clause benefits are typically granted only after the issuance of a separate notification under Section 90, and this practice cannot be bypassed.
On the issue of OECD membership, the court ruled that the phrase "is a member" refers to the present status of a country. Therefore, a third country must be an OECD member at the time it signs the DTAA with India in order for earlier DTAA beneficiaries to claim the benefits of the MFN clause.
Switzerland’s Decision to Suspend the MFN Clause
Switzerland’s suspension stems from its frustration with the lack of reciprocity in the application of the MFN clause. Switzerland had extended the MFN benefits to Indian entities without receiving similar treatment for its own firms operating in India. The Nestle SA ruling, which denied the automatic application of the MFN clause, created a divergence in the interpretation of the clause between the two countries. By suspending the MFN clause, Switzerland seeks to ensure that treaty benefits are based on mutual agreement, rather than unilateral extensions.
The decision has broader political and economic implications. From a tax policy perspective, Switzerland’s move allows it to levy taxes on Indian entities at the original DTAA rates, potentially increasing tax revenue. It also signals to other treaty partners that Switzerland values reciprocity and consistency in treaty implementation, although this could deter Indian investment by raising the cost of doing business in Switzerland. The suspension may serve as diplomatic leverage, prompting renegotiations of the India-Switzerland DTAA, particularly regarding the procedural requirements for applying the MFN clause. Additionally, this decision aligns with global trends in tax policy, particularly the OECD’s Base Erosion and Profit Shifting (BEPS) initiative, which emphasizes fairness and mutual recognition in tax treaties.
Overall, while the suspension of the MFN clause introduces complexities for cross-border transactions, it underscores the growing importance of clear, reciprocal treaty terms in international tax relations.
Case Studies of Similar MFN Disputes
The dispute between the Netherlands and India over the MFN clause in their DTAA arose when Dutch entities sought to apply lower withholding tax rates on dividends, referencing India’s treaties with Slovenia and Lithuania, which offered reduced rates. India, however, argued that the MFN clause did not apply automatically and required formal notifications under the Income Tax Act 1961. The outcome mirrored the Nestle SA ruling, where courts emphasized that the MFN clause must be operationalized through specific notifications. This case highlighted the importance of procedural clarity in treaty benefits, particularly when multiple jurisdictions and treaties are involved, ensuring that the terms are clearly understood and followed.
In the Spain v. Colombia dispute, Spanish investors sought to claim benefits under Colombia's investment treaties with other countries, such as lower taxes on dividends and improved arbitration processes, using the MFN clause. Colombia resisted, arguing that the MFN clause was not meant to extend benefits retroactively. However, arbitration tribunals upheld Spain’s claims, broadly interpreting the MFN clause to ensure fair and equitable treatment. This case reinforced the need for precise language in treaties to avoid disputes regarding the retrospective or expanded application of MFN benefits, stressing the importance of clear definitions in treaty drafting.
The France v. Brazil case involved French companies attempting to apply reduced withholding tax rates on royalty payments based on Brazil’s treaties with other nations. Brazilian authorities contested the application of the MFN clause, citing differences in treaty contexts and domestic tax policies. Ultimately, negotiations led to a compromise where reduced rates were granted for future transactions but not retrospectively. This dispute underscored the value of bilateral negotiations and the risks associated with unilateral interpretations of MFN clauses, suggesting that clear, negotiated solutions are often preferable to unilateral actions.
In the Philippines v. Germany case, German investors in the Philippines sought lower withholding tax rates by invoking the MFN clause, citing more favorable terms in the Philippines' treaties with other countries. The Philippines contended that the MFN clause applied only to new treaties and did not extend to renegotiating terms of existing ones. The case was resolved through bilateral consultations, with the Philippines agreeing to a partial reduction in rates. This outcome highlighted the importance of collaborative dialogue between nations, suggesting that open communication can prevent prolonged disputes and foster mutually beneficial solutions.
The relevance of these cases to the India-Switzerland scenario is in the common themes. Like India, countries such as the Philippines and Brazil stress that procedural clarity is needed to avoid unilateral interpretations of the MFN clause. Germany and France explain those cases of MFN-based dispute ended successfully through bilateral negotiation, indicating diplomatic dialogue can create relevant parties acceptable solution for them. More importantly, these cases show how much more relevant there is a need to comply with the global tax standards, in particular the ones that have been pushed through by the OECD, both in terms of minimizing the chance of similar disputes and ensuring harmonization of these across treaties.
Impact on Business and Investment
The suspension of the MFN clause could lead to higher tax bills for businesses spanning both countries. For Indian firms based in Switzerland they'll be burdened with higher withholding tax rates on income like dividends, royalties, and technical fees which may lower net profits and make Switzerland a less desirable destination. At the same time, high tax rates on cross-border income for Swiss companies in India will compromise their competitive status. Swiss financing will also be affected after the announcement of increased tax burdens, this also applies to those sectors in India where Swiss investments are heavily represented such as pharmaceuticals and technology, this also is likely to discourage reinvestment. The indirect tax burden may also dissuade FDI as companies may prefer jurisdictions with more favorable tax terms.
Broader Implication for International Taxation Policy
The suspension of the MFN clause by Switzerland highlights a growing focus on reciprocity in international tax treaties, where countries aim for balanced agreements that ensure mutual benefits rather than one-sided advantages. India’s stance, reflected in the Supreme Court of India’s requirement for explicit notifications to apply MFN benefits, underscores the importance of clarity and reciprocity in treaty provisions. This development could prompt other countries to reassess their treaties with India to ensure fair treatment. The dispute also exposes challenges in harmonizing treaty interpretations, as differing legal frameworks and judicial rulings, such as the Nestle SA case, create ambiguity and compliance burdens. The OECD plays a critical role in shaping global tax norms, with its BEPS framework and Model Tax Conventions promoting fairness and transparency in treaty negotiations. The Multilateral Instrument also offers a potential path for resolving such disputes, emphasizing the need for greater cooperation to balance national priorities with global tax obligations.
Conclusion: The Way Forward
The suspension of the MFN clause in the India-Switzerland DTAA is a significant shift in international tax treaties, with wide-ranging implications for businesses, bilateral relations, and global tax policy. Indian and Swiss firms will face higher tax liabilities, potentially reducing cross-border investments and trade. The Indian Supreme Court’s Nestle SA ruling highlights the importance of clear procedural requirements, shifting treaty dynamics toward a more formalized approach. Switzerland’s decision underscores the need for renegotiations to restore reciprocity in tax benefits.
The growing emphasis on reciprocity in tax treaties calls for consistent application of treaty provisions. Diverging interpretations, like the MFN dispute, create uncertainty and undermine investor confidence. Clear and predictable rules are vital for fostering economic partnerships, and aligning treaties with global frameworks such as the OECD’s BEPS initiative can ensure fairness and coherence in international tax practices.
Moving forward, policymakers must renegotiate treaties to reflect evolving legal and economic contexts, while ensuring procedural transparency to build trust. Businesses need to adapt their tax strategies to mitigate the financial impacts of higher taxes and engage with governments to advocate for supportive tax policies. International organizations should facilitate dialogue between countries to resolve disputes, promote consistent treaty interpretations, and assist in harmonizing tax practices to reduce compliance burdens. The India-Switzerland scenario highlights the importance of balancing national interests with international cooperation for a fair and sustainable global tax environment.
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