Tax Treaty Override? A Critical Review of Income-Tax Bill, 2025

Prelude

India’s incumbent direct tax legislation — the Income-tax Act — has been in vogue since 1961 and has suffered numerous amendments over the years during the course of its application. According to the Government, “[a]s a result of these amendments the basic structure of the Income-tax Act, 1961 has been overburdened and language has become complex, increasing cost of compliance for taxpayers and hampering efficiency of direct-tax administration”,¹ which has resulted into the Government introducing the “Income-Tax Bill, 2025” for public consultation with a view to replace the 1961 legislation. Various changes are proposed in the Income-Tax Bill, 2025, a compelling one is the provision dealing with the interface between India’s domestic law and tax treaties. This article attempts to critically examine the contours of the proposed provision from a “treaty override” standpoint.

Setting the context

Tax laws operate on two planes: domestic and international. The first set of laws are within the exclusive and sole remit of the sovereign State which enacts the fiscal statutes within the constitutional confines. The second set of laws owe their origin principally to bilateral or multilateral treaties executed by the sovereign States. These treaties confer various rights to the citizens/residents of the States which are signatory to the treaties. While these treaties provide remedies (such as by way of arbitration, mutual agreement procedure, etc.) to a citizen/resident of the States aggrieved by the actions of other signatory State, pragmatically the enforcement of the treaty rights of such persons is generally subject to the domestic law of the State and the judicial remedies provided therein.

Additionally, depending upon the constitutional scheme,² the extent of application of treaty provisions in the domestic tax laws paradigm is limited; the net result is that the treaties operate to the extent permitted by the domestic law.³ Thus, in the absence of absolute alignment and synchronisation of treaty provisions with the domestic law, gaps remain between the treaty commitments made by the States and the entitlements of their citizens/residents.⁴ Often such gaps are intentional i.e. the domestic law is enacted with an intent to deny benefit of a treaty provision in specified circumstances. Colloquially such a situation is described as treaty override.⁵ For illustration, a view prevails in some quarters that instances of tax avoidance or abuse deserve to be denied treaty benefit.⁶ There are also certain instances wherein the domestic law seeks to override the treaty commitments unilaterally i.e. the treaty commitments are not observed by one of the partner countries by providing to the contrary in its domestic law.⁷ There is a judicial view against such unilateral treaty override by domestic law.⁸ However, such view is not universally shared and the fact remains the domestic laws are increasingly enacting such provisions which unilaterally override tax treaties.

(Limited) applicability of domestic law in interpreting tax treaties

A tax treaty, similar to other international treaties, is an agreement between two sovereigns and, accordingly, must be interpreted in “good faith”.⁹ Thus, a treaty must be given effect on the basis of its own terms without reference to domestic law.¹⁰ This general rule is modified to some extent by the standard practice in bilateral tax treaties. In view of the inherent limitations of scope of such treaties, there are many terms in the tax treaties which cannot be exhaustively defined. Thus, to resolve the issues, the general practice is to provide an omnibus clause which permits recourse to domestic law for interpreting the undefined tax treaty terms, both the commonly referred models i.e. the Organisation for Economic Co-operation and Development (OECD) Model Tax Convention¹¹ and the United Nations (UN) Model Double Taxation Convention, 2017¹² recognise this fact. Most Indian tax treaties also provide similarly, with minor variations in the treaty text.

The scheme of the tax treaty, thus itself provides a via media to refer to the domestic law of the country to appreciate the meaning of the expressions which are employed in the tax treaty but not defined in such a treaty. However, an appreciation of the precise language of the tax treaty is important to decipher the extent to which the domestic law reference is allowed. Let us review a few illustrations to appreciate a nuanced position. The India-Australia Tax Treaty provides that “any term not defined in this agreement shall … have the meaning which it has under the laws of that State from time to time in force relating to the taxes to which this agreement applies”.¹³ Thus, domestic law meaning is allowed but only to the extent the domestic law is “relating to the taxes”. This stipulation is similar to various other treaties, such as India-Finland Tax Treaty,¹⁴ India-United Kingdom Tax Treaty,¹⁵ India-United States Tax Treaty,¹⁶ etc. all of which are consistent to the effect that reference can be made to the domestic laws which relate to the taxes which are covered under the tax treaty. Put simply, an undefined term in the tax treaty in relation to tax in income can be given meaning under the income tax law of the tax treaty partner country.

These treaties have been executed based on the model tax conventions which prevailed earlier. The revised Models, however, permit reference to non-tax domestic law. To exemplify this aspect, it is noteworthy that the current Article 3(2) of the OECD Model Tax Convention on Income and on Capital states as under:¹⁷

As regards the application of the Convention at any time by a contracting State, any term not defined therein shall, unless the context otherwise requires or the competent authorities agree to a different meaning pursuant to the provisions of Article 25, have the meaning that it has at that time under the law of that State for the purposes of the taxes to which the Convention applies, any meaning under the applicable tax laws of that State prevailing over a meaning given to the term under other laws of that State. (emphasis supplied)

From the above provision, it is evident that this provision permits meaning under other laws (i.e. non-tax laws) to be adopted but with a rider that if there are two meanings, then “any meaning under the applicable tax laws of that State (shall be) prevailing over a meaning given to the term under other laws of that State”. This interpretation is confirmed by the Commentary to Article 3(2) of the OECD Model Tax Convention on Income and on Capital, 2017 which confirms recourse to non-tax domestic law.¹⁸ The UN Model Double Taxation Convention, 2017 also provides similarly.¹⁹

The contrast between Indian double tax treaties with the incumbent Model Tax Conventions reveals that, unlike these current Models, the text of the Indian double tax treaties do not permit meaning of an expression prevailing under non-tax laws for the purpose of interpreting the undefined terms of these tax treaties.²⁰ This takes us to a review of the provisions of the Income-tax Act, 1961 in order to appreciate the extent to which it permits reference to domestic law to ascertain the meaning of undefined tax treaty expressions.

Dissecting Section 90 of the Income-tax Act, 1961.

Section 90²¹ of the Income-tax Act, 1961²² is currently the sole depository of the linkage between domestic law and tax treaty framework in India. It permits the taxpayer concerned to choose from the domestic law versus the tax treaty, whichever is more beneficial to the taxpayer,²³ this scheme being inspired by the predecessor enactment i.e. the Income Tax Act, 1922.²⁴

A direct tax treaty override provision is contained in Section 90; it is declared that the General Anti-Avoidance Rule contained in the Income-tax Act, 1961 shall mandatorily apply even if it is not beneficial to a taxpayer eligible for tax treaty benefit.²⁵ In the wake of this provision, it requires analysis whether the Income-tax Act, 1961 also contains indirect tax treaty override provision, say, qua the provision supplying the meaning of the undefined tax treaty expressions.

Before adverting to the Income-tax Act, 1961, it is important to appreciate that the respective tax treaties themselves direct reference to the provisions of the Income-tax Act, 1961 (being the relevant tax law in question) to give meaning to undefined tax treaty expressions. Thus, no specific provision is required in the 1961 to address this eventuality wherein certain tax treaty expressions are left undefined. Having said that, however, the Income-tax Act, 1961 specifically addresses a situation of undefined tax treaty expressions and, instead of the undefined tax treaty expressing finding colour from the relevant provisions of the 1961, stipulates as under:²⁶

90(3). Any term used but not defined in this Act or in the agreement referred to in sub-section (1) shall, unless the context otherwise requires, and is not inconsistent with the provisions of this Act or the agreement, have the same meaning as assigned to it in the notification issued by the Central Government in the Official Gazette in this behalf.

In other words, instead of the Income-tax Act, 1961 being applied to give meaning to an undefined expression in the tax treaty, the Government has been conferred the power to adopt a different meaning for such expression. Furthermore, such meaning will not form part of the Income-tax Act, 1961 (being a meaning ascribed in the notification issued by the Government) and still be applicable to interpret the tax treaty. In other words, the Income-tax Act, 1961 departs from the scheme of interpretation flowing from the tax treaty provision.

As if such an override of the tax treaty was not sufficient, what is overwhelmingly noteworthy is an explanation enacted in the Income-tax Act, 1961 which declares that any such specially notified meaning shall have a retrospective effect i.e. from the date of the tax treaty itself.²⁷ Interestingly, this explanation was also enacted with retrospective effect.²⁸ To put differently, the Income-tax Act, 1961 enables the Government to adopt a different meaning of an undefined term in the tax treaty and, because of its statutorily prescribed retrospectivity (going back up to the inception of the tax treaty concerned) the Government’s notification would effectively cull any pending dispute on the meaning of the expression.

Provision in the proposed Income-Tax Bill, 2025

The Income-Tax Bill, 2025 is proposed to be enacted as the new income tax law which shall replace the incumbent Income-tax Act, 1961. Certain changes are proposed in the new law. The corresponding provision in the Income-Tax Bill, 2025 not just perpetuates the aforesaid provision of the Income-tax Act, 1961 but also goes beyond, perhaps enacting another form of treaty override.

Section 159(7) of the Income-Tax Bill, 2025 corresponds to Section 90 of the Income-tax Act, 1961 which seeks to undertake the exercise of filling in the gaps qua undefined tax treaty expressions. The proposed provision is comprised of three clauses which address various eventualities.²⁹ These can be summarised as under:

(A) If a term is used in a tax treaty and is also defined under the said treaty, then the said term shall have the same meaning as assigned to it in that tax treaty [clause (a)].

(B) If a term used in a tax treaty but is not defined under the said treaty, and, it is defined in the Income-tax Act, 1961 then the said term shall have the same meaning as assigned to it in the Income-tax Act, 1961 [clause (a)].

(C) In the event the situation in (B) applies, and, if the Government of India has given an explanation, then the meaning under the said explanation shall apply. Furthermore, the explanation shall have retrospective effect from the enforcement date of the tax treaty concerned [clause (a)].

(D) If a term is used in a tax treaty but it is neither defined under the said treaty nor it is defined under the Income-tax Act, 1961, and, if the Government of India has issued a notification defining such term, then the meaning under the notification shall apply. Furthermore, the notification shall have retrospective effect from the enforcement date of the tax treaty concerned [clause (b)].

(E) If a term is used in a tax treaty but is neither defined under the said treaty nor defined under the Income-tax Act, 1961, and, if no notification has also been issued by the Government of India, then the meaning to be as assigned to such term shall be such as set out: (i) any Central law “related to taxes”; or (ii) any other Central law, shall apply. Furthermore, such meaning shall have retrospective effect from the enforcement date of the tax treaty concerned [clause (c)].

The above summary clearly reveals how far the Income-Tax Bill, 2025, if enacted, would override the tax treaties because it gives wide powers to the Government to define expressions with retrospective effect.

A critical analysis of the Income-Tax Bill, 2025 proposals

There are many areas of concerns in context of the proposed Income-Tax Bill, 2025 qua tax treaty override. Three main concerns are enlisted below:

(A) The power to give retrospective effect is overwhelmingly exercised in this provision. Virtually each and every limb of this provision carries retrospectivity. The presence of such ominous provision bodes ill qua the tenet of tax certainty which is an avowed tenet of fiscal policy and law, particularly in international tax paradigm.³⁰

(B) Second, while retrospectivity in the Income-tax Act, 1961 may still be legally enacted, retrospectivity in the Income-Tax Bill, 2025 creates a piquant scenario which can be subjected to judicial challenge. This is because all the existing Indian tax treaties came into force after the enactment of the Income-tax Act, 1961. Thus, when the Income-tax Act, 1961 provides that a notification of the Government shall come into force retrospectively from the date of the tax treaty, still such a notification would be effective from a date after the Income-tax Act, 1961 came into force. Such would not be a situation in context of the provision in the Income-Tax Bill, 2025 (in the event it was to become the law). Because all existing tax treaties came into force prior to the Income-Tax Bill, 2025, when an expression under the tax treaty will be retrospectively defined under the Income-Tax Bill, 2025, such an expression will have effect from a date even before the Income-Tax Bill, 2025 was enacted. For illustration, a notification issued under the Income-Tax Bill, 2025 in context of India-Netherlands Tax Treaty will be effective from 1987 i.e. decades before the Income-Tax Bill, 2025 came into law. Retroactivity to such extent may render the provision subject to judicial scrutiny.

(C) Third, the Income-Tax Bill, 2025 effectively modifies most existing tax treaties to adopt the revised OECD Model Tax Convention on Income and on Capital, 2017 without having formally amended these tax treaties. This is because it is under the revised OECD Model Tax Convention on Income and on Capital, 2017 that reference to non-tax domestic law is permitted for treaty interpretation. In fact, the recent tax treaties executed by India permit reference to non-tax domestic law for purpose of interpreting undefined tax treaty terms.³¹ However, by contrast, under most Indian tax treaties executed earlier such reference to non-tax domestic law does not appear to be permitted. Thus, the enactment of the proposed provision in the Income-Tax Bill, 2025 is effectively a unilateral amendment of these Indian tax treaties to align them with the new model, a scenario which can be described as unilateral tax treaty override.

Furthermore, by providing for such unilateral change in the meaning of the tax treaty expressions, perhaps the proposed provision is also travelling in a line opposite to the expectations of the constitutional framers in so far as they envisaged that the Government shall endeavour to “foster respect for international law and treaty obligations”.³²

Having said that, one is not very hopeful of a successful challenge to the validity of the treaty override proposed to be enacted in the Income-Tax Bill, 2025. This is because: (a) the dualist feature under Article 253³³ of the Constitution³⁴ permits enforcement of a treaty only to the extent enacted by the domestic law;³⁵ (b) under the legislative scheme of tax treaties, these treaties have effect because it is so provided in the domestic law;³⁶ and (c) owing to judicial declaration, domestic law practice is considered to override tax treaty interpretation.³⁷

Epilogue

The Income-Tax Bill, 2025 is currently at the stage of parliamentary consideration and can still be worked upon to finesse its application. No doubt the international tax practices and domestic law priorities encompass sufficient latitude to enact domestic laws to override tax treaty commitments. However, comity of nations and regard for bilateral international relations presuppose that the ramifications of such a provision are deeply introspected before its enactment. The proposed provision effectively posits India’s international tax practice in a different paradigm and gives ominously overwhelming leeway for the executive to override tax treaty commitments which does not auger well for the nation which encapsulates constitutionally enjoined rule of law in the actions of the State.