Date : 04/11/2023

Relevance: GS Paper 3 – Indian Economy

Keywords:MFN Status, OECD, WTO, World War II

Context-

Tax treaties play a crucial role in international taxation, facilitating cross-border trade and investments by providing clarity on tax obligations between countries. However, these treaties are not static documents; they can be influenced by legislative changes and evolving economic circumstances. Recent observations by the Supreme Court of India shed light on the challenges arising from the changing contours of legislation and economic dynamics in the context of India's tax treaties with countries like France, the Netherlands, and Switzerland.

About 'Most Favoured Nation' Status in World Trade

Overview:

The World Trade Organization (WTO) comprises 164 members who commit to equitable treatment, ensuring mutual benefits through shared advantages such as the lowest tariffs, highest import quotas, and minimal trade barriers for goods and services. This principle of non-discrimination is known as Most Favoured Nation (MFN) treatment.

Historical Origin:

The MFN principle is a fundamental aspect of the multilateral trading system established after World War II.

Exceptions:

While the MFN principle stands, exceptions exist. Members can form bilateral trade agreements, and developed nations can extend special market access to developing countries.

Outside the WTO:

For nations outside the WTO, like Iran, North Korea, Syria, or Belarus (an ally of Russia), WTO members can enforce trade measures without violating global trading regulations.

Suspension of MFN Status:

There is no formal procedure for suspending MFN treatment, and the obligation to inform the WTO about such decisions remains unclear. India suspended Pakistan’s MFN status in 2019 in response to a terrorist attack, despite Pakistan never applying MFN status to India.

Historical Context: India's Tax Treaties

Historically, India's tax treaties, especially with countries like France, the Netherlands, and Switzerland, were designed to attract foreign capital inflows. Prior to 1995, these treaties provided lower tax rates to members of the Organisation for Economic Cooperation and Development (OECD). However, the OECD expanded significantly since then, adding countries like Colombia, Lithuania, and Slovenia, altering the dynamics of India's tax treaties.

Key Points from the Supreme Court's Ruling on Indian Tax Treaties

Ruling Highlights:

The Supreme Court of India has clarified that under Indian Tax Laws, the issuance of a notification is mandatory to enforce any Indian tax treaty or Protocol that modifies its terms. This notification is necessary even if it alters existing provisions of the law. The court emphasised that invoking the beneficial provisions of a tax treaty, especially under the Most Favoured Nation (MFN) clause, requires a specific notification reflecting consequential amendments. Without such a notification, the MFN provisions cannot be applied.

Implications:

This ruling holds significant importance in the interpretation of Indian tax treaties. As the decision comes from the apex court, it stands as the law of the land and is binding on all parties involved. Consequently, it is expected to impact claims made by nonresident taxpayers concerning source taxation of various financial elements like interest, royalties, fees for technical services, and dividends.

Relevance to India's Most Favoured Nation Approach:

The Supreme Court's decision aligns with India's Most Favoured Nation approach, underscoring the importance of specific notifications to implement favourable tax treaty provisions. This ruling provides clarity and sets a precedent for the proper application of Indian tax laws in the context of international treaties.

The Significance of the Most Favoured Nation (MFN) Status in International Trade

Establishing a Rules-Based Framework:

The MFN status serves as a cornerstone of international trade, aiming to replace the inconsistencies and power-driven dynamics of bilateral agreements with a robust rules-based framework. In this system, access to trading rights is not contingent on a nation's economic or political influence. Instead, it ensures that the most favourable trade conditions granted to one country are automatically extended to all participants within the system.

Promoting Free Trade:

The MFN clause plays a pivotal role in boosting international trade by increasing trade creation and reducing trade diversion. It fosters a climate that encourages free trade among nations, allowing goods to flow from the most cost-effective producers to regions with the highest demand without the interference of government regulations.

Equitable Treatment for Disadvantaged Nations:

An essential facet of the MFN clause is its commitment to providing equal treatment to smaller and less influential countries that might typically be overshadowed by major global trade players. This clause empowers these smaller nations to negotiate favourable trade terms that they might not otherwise attain.

Access to Larger Markets:

Through the MFN status, a nation gains access to a more extensive and potentially lucrative market. This expanded market enables a nation's industries to enhance their products, catering to a broader consumer base, thereby contributing to economic growth and development.

Supreme Court's Ruling and Its Implications

The Supreme Court's ruling that a notification is mandatory to invoke MFN provisions reversed investors' tax positions, causing a significant impact. Interestingly, despite low investment flows, these benefits were retained, raising questions about their relevance. Additionally, the absence of explicit notification requirements in some treaties, in contrast to others like the India-Finland treaty, adds complexity to the situation.

Challenges Associated with Most Favoured Nation (MFN) Status

Potential for Dishonest Business Practices:

One of the challenges linked to MFN status involves nations offering financial support to their domestic industries without considering the ethical standards of these businesses. This support can lead to artificially low export prices, resulting in practices like dumping, which may violate WTO rules and regulations.

Uniform Trade Benefits for All Nations:

Another drawback of MFN status is that a nation is obligated to extend the same trade advantages to all members of the MFN agreement or the WTO. This uniform treatment might not always be suitable for individual countries' economic interests.

High Import Taxes Impacting Developing Nations:

Developing nations have reported facing high import taxes, particularly on goods such as textiles, clothing, and fish products. These tariff peaks hinder their ability to compete in the global market, posing a significant challenge to their economic growth.

Specific Challenge in India's Case:

India faces a unique challenge related to the varying treatment of dividends in different treaties. The availability and rates of beneficial treatment for dividends differ across agreements. While some treaties offer more accessible benefits to all investors, others restrict rates, particularly for investments exceeding certain thresholds. The lack of clarity in tax treatment necessitates intervention from the tax department to provide precise guidelines before the application of these provisions.

The Way Forward

1. Embracing Comprehensive Reviews:

Periodic reviews of existing tax treaties are crucial, not just within India but on a global scale. These reviews should be conducted to ensure that treaties remain relevant and effective amidst shifting economic realities and international obligations. Regular assessments can help identify loopholes, ambiguities, and areas needing modification.

2. Enhancing Collaboration:

Collaboration between nations is key to fostering fair and equitable economic relationships globally. Open dialogues and mutual understanding can pave the way for treaties that accommodate the interests of all parties involved. Sharing insights and best practices can lead to more robust agreements, benefiting all stakeholders.

3. Clarity in Interpretation:

Developing nations have reported facing high import taxes, particularly on goods such as textiles, clothing, and fish products. These tariff peaks hinder their ability to compete in the global market, posing a significant challenge to their economic growth.

4. Introducing Flexibility and Adaptability:

Given the dynamic nature of international trade, introducing flexibility and adaptability within treaties is imperative. Provisions that allow for adjustments based on changing economic circumstances can enhance the treaties' resilience. Timely updates and revisions in response to emerging economic challenges can ensure the continued effectiveness of these agreements.

Source- Indian Express