This content is from: Tax Disputes

The MLI wipes out Indian jurisprudence on treaty shopping

Tax professionals in India warn that existing case law on tax treaty use will have almost no influence in a post-MLI world. The preamble to the Multilateral Instrument (MLI) will need to be tested in court.

The preamble of the MLI states that existing tax treaties should not create opportunities for tax avoidance and evasion. This could expose companies to future challenges despite tax avoidance being legal.

“Clearly the winds are against treaty shopping of any kind,” said Haroon Qureshi, vice president of taxes at Genpact.

For several years, the Indian tax community has relied on the Supreme Court judgement of Azadi Bajao Andholan Andholan (Union Of India And Anr vs Azadi Bachao Andolan And Anr), which granted treaty benefits to Mauritian residents.

“It clearly did not frown upon treaty shopping,” said Qureshi. “In a way, it actually condoned treaty shopping as being an economic decision taken by a country.”

However, Qureshi said no company can afford to turn a blind eye to treaty shopping right now. “You have to look at all your royalties and the dividends and interest that you have to pay because this is going to become very important,” he said.

The MLI has created a new minimum standard for tax treaties and this will have consequences for decades to come. The fact that it does not rely on a legalistic standard opens up more problems for businesses.

Paragraph seven of the MLI preamble states that existing agreements for the avoidance of double taxation on income need to be interpreted to “eliminate double taxation with respect to the taxes covered by those agreements without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance”.

The preamble goes on to specify “including through treaty-shopping arrangements aimed at obtaining reliefs provided in those agreements for the indirect benefit of residents of third jurisdictions”.

“It is the first time that tax avoidance, which is legitimate, may get challenged” under the law, said Rakesh Nangia, chairman of Nangia Andersen Consulting. “This is a minimum standard. This is the minimum definition, which has to be in the preamble, which is binding for every company. You cannot enter the MLI without a preamble like this.”

Since the MLI is new, Nangia said no one knows what will happen and there is going to be a lot of debate of this issue of tax avoidance because it gives revenue authorities a lot of power. The courts are going to rely on the intent of a transaction when assessing a case.

Amit Maheshwari, partner at AKM Global, pointed out that the judgment in the Azadi Bachao case said that a preamble holds important value when interpreting a treaty. Hence, the MLI’s preamble will be important in deciding future tax cases.

“Now, with Article 6 of MLI, the preamble itself of the treaty is getting changed. That judgment [Azadi Bachao] may no longer be relevant, particularly because of the preamble,” said Maheshwari.

Qureshi agreed with Maheshwari and said that Article 6 of the MLI is the provision that refers to treaty shopping in a negative way. “That basically overrides everything – all the jurisprudence we had to date,” said Qureshi.

It has taken almost two decades for the jurisprudence in India to settle and confirm that when a taxpayer claims tax treaty benefits, the form of the transaction has paramount importance. This was evident in the Azadi Bajao, Vodafone and Sanofi.

“In all these cases, they are consistent that if you have a valid tax residency certificate, you are eligible for treaty benefits,” said Vikas Aggarwal, head of tax at Home Credit. “But, now, with the MLI, there is going to be a big change [because] there is no grandfathering [in the rules]. There is no clarity.”

According to Maheshwari, even companies with intermediary holding structures relying on the Sanofi case would be exposed. This is despite the court finding that such holding structures could also be a valid commercial entity.

Beneficial ownership to be questioned

The MLI is far from the only change coming to the Indian tax system. The 2020 India budget repealed the dividend distribution tax, and decided to levy tax only on the recipients of dividend income at the applicable rates.

Under these changes, non-resident shareholders will be subject to a 20% dividend income tax, plus applicable surcharges and cess, but would also be able to enjoy beneficial rates where there is an eligible tax treaty.

While the announcement created “a lot of euphoria”, according to Qureshi, and it was good news for foreign investors, the plan does raise the risk of litigation over whether non-residents would be able to enjoy treaty benefits.

“The dividend distribution tax was clear cut - you just pay a 20% tax and move on with life. Now, you pay a lower tax or at least you try to pay a lower tax, but then obviously, every large case is going to be challenged, at least on beneficial ownership,” said Qureshi.

“You will have to prove beneficial ownership and, on top of that, we will now have the MLI and the PPT [principle purpose test],” he added.

According to Qureshi, even without the MLI entering into force, the DDT would raise questions over beneficial ownership. However, with the MLI coming in, there will be questions about the PPT. Nevertheless, he still believes that taxpayers could argue that when all their corporate structures were set up, the dividend was not taxed at the shareholder level at that time.

“So, how could that be really a principal purpose of setting up a structure?” said Qureshi. “There is going to be a lot more litigation than there was in the past.”

Temporary implementation of PPT to cause chaos

The Indian government is applying the PPT clause of the MLI as a temporary measure to prevent treaty abuse.  This is while it enters into bilateral renegotiations for a number of double tax treaties relying on the limitation of benefit (LoB) of simplified LoB (SLoB) clause.

Taxpayers have warned that this will either create more litigation, or lead to a rise in the number of mutual agreement procedures (MAPs).

Vikas Aggarwal stressed that the PPT being used as an interim measure will create a “volatile” situation. This is because the PPT is too subjective.

“We will have to prepare ourselves for a lot more work, in terms of evaluating all structures,” Aggarwal said.

The concern for many taxpayers is how the PPT will interact with the general anti-avoidance rule (GAAR) and how the tax authorities will use the two measures. The GAAR sets a clear threshold before it comes into play, it also includes grandfathering provisions for investments made before April 1 2017. The GAAR is overseen by a panel and this may mean there is some accountability.

By contrast, the PPT has no threshold, no grandfathering and no panel to oversee it. This combines subjectivity with a lack of accountability and a lack of clarity about when the test applies.

“There is a proper process for invoking GAAR,” said Qureshi. “There is an approving panel, a high-powered approving panel I must admit, but there are checks and balances before the GAAR can be invoked. For the PPT, there is actually nothing like that, at least in the Indian context.”

“The PPT is much wider than GAAR,” Qureshi continued. Noting that both the renegotiated Singapore and Mauritius treaties including grandfathering provisions, Qureshi said that taxpayers are “safe” with Mauritius because it is not covered by the MLI. However, Singapore may be a problem because there is no clarity on what happens to the renegotiated agreement.

Although the OECD and UN have issues certain safeguards, Qureshi said India needs a type of “Collegium of Commissioners” who can “look at the issues, which are sought to be re raised under the treaty, and give an approval before the matter actually goes into a big litigation”.

Gupta said that with all this happening, he wonders whether more MAPs will be initiated. “Someone will have to take a call as to whether it could work to one's disadvantage if you really want to invoke MAP in a situation where the treaty benefit is being denied to you because of the PPT,” he said.

Although tax professionals were concerned with the MLI preamble in the context of Indian tax law, the fact that the preamble applies to all signatory countries means there is likely to be widespread impact on future case law. Taxpayers and authorities are unlikely to be able to rely on past cases in a new tax world.

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