The Delhi High Court has ruled that a withholding tax rate of 5 per cent has to be applied when an Indian entity doles out dividends to its shareholder in Netherlands after applying the Most Favoured Nation (MFN) clause in the tax treaty between the two countries.

The High Court's decision assumes significance given that India has reintroduced the classical system of dividend taxation in the hands of shareholders and because the availability of tax treaty benefits based on the MFN clause has been a subject of litigation in the past, said experts.

Companies based in Netherlands and even other European countries such as France, Hungary, Spain, Switzerland and Sweden may be able to claim the benefit of lower withholding tax rates from now on. The decision could also apply to categories other than dividend income such as royalty and fees for technical services.

Two Netherlands companies Concentrix Services Netherlands B. V. and Optum Global Solutions International B. V. --- both tax residents of Netherlands which held 99.99 per cent share in their Indian subsidiaries --- were issued withholding tax certificates of 10 per cent by Indian tax authorities.

Their wholly-owned Indian subsidiaries were required to remit dividends after appropriate withholding of tax.

The taxpayers applied for a lower withholding tax certificate under section 197 of the Income-tax Act, 1961 in accordance with the India-Netherlands Tax Treaty read with the protocol that was appended.

"The taxpayer had placed reliance on the MFN clause and had contended that since India had agreed on a 5 per cent withholding tax rate in its subsequent tax treaties (with Slovenia, Lithuania, and Colombia), the lower rate of 5 per cent should equally apply to India-Netherlands tax treaty as well," said a note co-written by Saurabh Shah, principal, Dhruva Advisors.

The MFN clause of India-Netherlands tax treaty provides that if India enters into a tax treaty with an OECD member country wherein the tax rates on dividends, interest, royalties and technical services agreed to are lower than those agreed to in India-Netherlands tax treaty, then those lower rates would equally apply for the purposes of India-Netherlands tax treaty as well.

"Slovenia, Lithuania and Colombia became members of the OECD after India signed treaties with them. The core issue therefore was whether these countries needed to be members of OECD at the time of signing of their tax treaty for the MFN clause to apply," said Shah.

The High Court observed that MFN clause forms an integral part of a tax treaty and no separate notification is required to make its provisions applicable. The Court held that one of the chief purposes of entering into a tax treaty is the equitable allocation of taxes concerning transactions that are taxable in both the countries. It also pointed out that the rules of interpretation of domestic laws cannot be applied for interpreting international treaties.

"This ruling affirms the principle that the protocol to the India-Netherlands tax treaty formed an integral part of the tax treaty and no separate notification was required to apply its provisions. Further, this ruling has upheld the principle of common interpretation and relying on the decree issued by Netherlands, applied the lower withholding tax rate of 5 per cent to dividends received by Netherlands resident (beneficial owner of such dividend) from an Indian subsidiary company," tax consultancy Deloitte observed in a note.