India, Switzerland and a thorny tax fix

India and Switzerland share a long-standing relationship – their first treaty of friendship was signed in 1948, making Switzerland one of the first countries to recognise India post-independence. Between the 1950s and 1970s, Switzerland emerged as a significant partner for industrial collaboration and investment in India and in the 2000s, both nations deepened their trade and technology collaborations.

Switzerland is one of India’s major trading partners in Europe. The relationship includes trade, investment, science and technology, tourism, cultural exchange, education, and global governance and has evolved into a strategic partnership focusing on economic co-operation and innovation. India and Switzerland entered a treaty on November 2, 1994, aimed at eliminating the risk of double taxation on cross-border income: the Double Taxation Avoidance Agreement (DTAA) which was subsequently amended in 2000 and 2010, with the latter amendment incorporating a Most Favoured Nation (MFN) clause.

The MFN clause guarantees that if either country offers a lower tax rate to a third country that is a member of the Organisation for Economic Co-operation and Development (OECD), the same reduced rate applies to the other country. For instance, if India agrees to a 5% tax rate with another OECD member, Switzerland is entitled to the same rate. Switzerland believes that the clause should automatically apply to countries that became OECD members after 1994. Based on this interpretation, it unilaterally reduced the tax on dividends for Indian firms from 10% to 5%, referencing treaties India signed with Lithuania and Colombia, which joined OECD in 2018 and 2020, respectively.

India maintained that the benefits of the clause are not automatic and require explicit notification under Section 90 of India’s Income Tax Act. Additionally, India argued that the MFN clause applies exclusively to countries that were OECD members in 1994, the year the treaty was signed. Leading Swiss multinational Nestle challenged India’s interpretation in the Delhi High Court. In 2021, the court ruled in favour of Nestle, permitting a reduced 5% tax rate on dividends by invoking the MFN clause, citing India’s treaties with Lithuania and Colombia.

India’s tax authorities appealed the case to the Supreme Court, which in October 2023 rejected the automatic application of the MFN clause, emphasising that explicit notification is necessary. It further limited the applicability of the clause to countries that were OECD members in 1994. This decision dealt a significant setback to Nestle and other Swiss companies operating in India. Viewing India’s stance as a lack of reciprocity, Switzerland announced the suspension of the MFN clause. Effective January 1, 2025, Swiss firms operating in India and Indian firms operating in Switzerland will not benefit from the reduced 5% tax rate on dividends. The tax will revert to the original residual rate of 10%, thereby increasing the burden on cross-border investments. This development will notably impact Indian businesses, particularly in sectors such as IT, pharmaceuticals, and financial services. Swiss companies will also need to account for the higher tax rate when calculating their returns on Indian investments.

The question on investment

The suspension of the MFN clause has come at a critical juncture in Switzerland’s economic relations with India. In March 2024, India signed the Trade and Economic Partnership Agreement (TEPA) with the European Free Trade Association (EFTA) which comprises Switzerland, Norway, Iceland, and Liechtenstein.

The EFTA pledged to “aim to increase” investments into India to $ 100 billion over a 15-year period. This is a binding obligation on EFTA states, with India possessing measures for its enforcement. This obligation is also qualified by India’s obligation to “endeavour to ensure a favourable climate for foreign direct investment, while taking into account the need to identify, assess and mitigate potential risks for security or public order”. Indeed, tax-related incentives (including concessional tax rates) are recognised as a component of investment promotion. Conversely, the absence or revocation of tax incentives may be considered as antithetical to investment promotion by India.

It is also important to note that the investment obligations are in line with efforts to benefit from India’s rapid economic growth. Officials from the Swiss embassy in India have also clarified that Switzerland’s recent decision will not negatively affect the investments from Switzerland into India.

The suspension of the MFN clause marks a pivotal moment in the tax and investment relationship between the two nations. While the decision stems from the Nestle judgement and reflects divergent interpretations of the MFN clause, it underscores the need for clarity and alignment in treaty obligations to maintain investor confidence. With TEPA offering a framework for substantial Swiss investments into India, the suspensions of the MFN clause raise questions about the interplay between tax policy and investment promotion.

(The writer is an entrepreneur and corporate director)