Principle behind the Principal Purpose Test

Principal Purpose Test (‘PPT’) is a burgeoning mechanism that is conducive in preventing tax treaty abuse, through identification of the actual situs of income and curtailment of revenue leakage. The Central Board of Direct Taxes (‘CBDT’), vide a recent circular¹ provided much-needed guidance and clarity regarding the application of PPT provisions and their interplay with the grandfathering provisions prevailing in certain tax treaties. This article discusses the background of these PPT provisions and the implications of the said Circular.

Introduction

Benjamin Franklin’s timeless observation, “In this world nothing can be said to be certain, except death and taxes” underscores the universal presence of taxation. However, with the advent of globalisation and an increase in international transactions, multinational enterprises are developing sophisticated ways to exploit the inconsistencies in taxation rules. Therefore, to curb tax leakage, the Base Erosion and Profit Shifting (‘BEPS’) Action Plan was formulated. The International Monetary Fund, in its policy report, “Spillovers in International Corporate Taxation”², emphasised that the BEPS Action Plan is “an unprecedented effort to address major avoidance opportunities that arise under current international tax arrangements”.

These Action Plans were initiated by the Organisation for Economic Co-operation and Development (‘OECD’) and were first published in 2013. The OECD and G20 jurisdictions jointly developed and finalised these Action Plans in 2015. There are 15 distinct Action Plans, each targeting a specific aspect of tax avoidance.

The 15^th BEPS Action Plan introduced the use of Multilateral Instruments (‘MLI’) to curb the instances of tax evasion swiftly. These MLIs allow governments of different countries³ to plug the loopholes in the international tax treaties and modify the existing bilateral tax treaties in a synchronised and efficient manner, without the need to renegotiate each treaty bilaterally. Furthermore, the MLIs enable governments to implement agreed minimum standards to counter treaty abuse and thereby strengthen the bilateral treaties. Additionally, the MLIs aim to improve dispute resolution mechanisms while providing flexibility to accommodate specific tax treaty policies.

In addition, and in furtherance of the above, the BEPS Action Plan, inter alia, vide Action Plan 6, deals with the prevention of the grant of benefits of bilateral agreements, in scenarios where it leads to double non-taxation. The BEPS Action Plan 6 recommends a three-fold approach to deal with the situation of treaty abuse, which is discussed in the ensuing pointers:

1. Introduction of Preamble – The purpose of a tax treaty is to avoid double taxation in a legitimate manner, and it should not create opportunities for double non-taxation of income. This common understanding is incorporated as a preamble to the treaty and is considered as a minimum level of protection against treaty abuse.
2. Insertion of purpose-based anti-abuse provision, PPT – The PPT essentially serves as the Treaty-level General Anti-Avoidance Rule (‘GAAR’), under which the treaty benefits may be negated in case it is established that the purpose of the transaction or arrangement is to only avoid taxes.
3. Insertion of an objective anti-abuse rule named as “Simplified Limitation of Benefits (‘simplified LOB’)” – It defines a normative criteria and attributes to analyse whether the income recipient shall be eligible for treaty benefit.

Given the fact that prevention of treaty abuse is a critical agenda and is of utmost importance, it must be dealt with sternly. Therefore, for this purpose, MLI provides the insertion of PPT and Preamble as the minimum standard measures. However, in certain cases, countries may adopt PPT supplemented with either a simplified LOB or detailed LOB clause or detailed LOB provision, supplemented by a mutually negotiated mechanism to deal with conduit arrangements.

India’s Position

Amongst other countries, India has also modified⁴ the Treaties through MLIs. In this regard, India adopted PPT supplemented with a simplified LOB clause (i.e., PPT, being a minimum standard, shall apply to all covered tax agreements, and simplified LOB shall apply depending upon the matching position adopted by the other country).

Article 7 of the MLI provides for the PPT provision. The said Article 7 is similar to Article 29(9) of the OECD Model Tax Convention. The excerpt of Article 7 is reproduced hereunder:

“Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.”

(Emphasis Supplied)

Evaluation of PPT Provisions

At the outset, it may be noted that PPT is required to be evaluated qua transaction and stream of income and not qua the entity seeking tax benefit. Further, a single arrangement may lead to the generation of more than one stream of income, and each such stream will have to be evaluated for the application of PPT. For instance, a Luxembourg Entity holds debentures in India and earns interest on such debentures. Further, the interest on such debentures qualifies for the concessional tax rate of five percent, prescribed vide Section 194LC of the Income-tax Act, 1961 (‘the Act’). As per the provisions of Section 90(2) of the Act, the provisions of the Act shall apply to the extent they are more beneficial to the assessee, in comparison to the tax avoidance agreements. Given that the said interest income is taxable at the rate of ten percent as per Article 11 of the India-Luxembourg Treaty, therefore, in terms of Section 90(2) of the Act, the taxpayer may opt for taxation of such interest in accordance with the provisions of the Act. However, in case such debentures are being transferred, then in such a scenario, the taxpayer may opt for taxation in accordance with the Treaty provisions, whereby the capital gains, if any, on such transfer, may be liable to be taxed in Luxembourg.

In the above example, the PPT will not be required to be evaluated in relation to taxation of interest income earned on the debentures held (although the same may be subject to GAAR provisions); however, the capital gains arising in relation to the same source, i.e. debentures, may fall within the ambit of evaluation of PPT provisions.

Further, for the purpose of interpreting the term “arrangement or transaction”, analogy may be drawn from the OECD Commentary⁵ in relation to Article 29(9). As per the OECD Commentary, “arrangement or transaction” should be interpreted broadly and include any agreement, understanding, scheme, transaction or series of transactions, whether they are legally enforceable.

Two-fold Operation of the PPT Provision

Further, it may be appreciated that PPT primarily consists of two limbs, which are as under:

1. Reasonable Purpose Test
2. Object and Purpose Test

(i) Reasonable Purpose Test

On perusal of the provisions of Article 7, it may be appreciated that the PPT provisions can be triggered at a significantly lower threshold, i.e., PPT limitation arises even in cases where it is “reasonable to conclude” that obtaining a treaty benefit was “one of the principal purposes”. Therefore, even in cases where there is no conclusive proof that obtaining a treaty benefit was one of the purposes of entering into a particular transaction, the said transaction may still fall within the ambit of application of the PPT. However, as per the OECD Commentary, such analysis may require sound judgement. Further, it is also clarified vide OECD Commentary that the tax authorities should not assume the presence of a tax benefit; there should be a reasonable basis to arrive at such a conclusion.

Additionally, the phrase “one of the principal purposes” underscores the fact that a transaction will be considered as tainted, even in cases where the sole or dominant purpose of the transaction was not to obtain treaty benefits and only one of the purposes was to obtain treaty benefits. However, it may be noted that where an arrangement is inextricably linked to a core commercial activity, and its form has not been driven by considerations of obtaining a benefit, it is unlikely that its principal purpose will be to obtain that benefit.

(ii) Object and Purpose Test

The scope of PPT should be determined based on the overall objective and context of the provisions of the covered tax agreement, which inter alia includes cross-border economic development and prevention of tax avoidance and evasion.

Recent Developments with respect to the application of PPT provisions in the Indian Diaspora

PPT is generally incorporated as part of

• MLI; or
• through bilateral negotiations in the DTAA

CBDT vide Circular 01 of 2025, dated 21^st January 2025, has provided certain clarification regarding the applicability of PPT provisions. The said clarifications revolve around:

• Scope of PPT provisions
• Date of applicability of PPT provisions
• Impact of PPT in case of grandfathering provisions

Scope of PPT Provisions

The CBDT has clarified that PPT is intended to ensure that DTAAs apply in accordance with the object and purposes for which they were entered into, i.e., to provide the benefits in respect of bona-fide exchange of goods and services and movement of capital and people. Further, the Circular emphatically provided that determination of whether one of the principal purposes of entering into transaction or arrangement is to obtain tax advantage should be based on objective assessment of the facts and circumstances of the case. The application of PPT provision should be context-specific fact-based exercise.

In this regard, reference may be made to a recent decision of Honourable (‘Hon’ble’) Delhi Income-tax Appellate Tribunal (‘ITAT’) in the case of SC Lowy P.I. (LUX) S.A.R.L., Luxembourg v. ACIT (ITA No.3568/DEL/2023) (30 December 2024), wherein the Hon’ble ITAT, while dealing with the applicability of PPT provisions held that the Tax Authorities should establish that obtaining treaty benefit was one of the principle purposes of the transaction or arrangement and the relevant facts and circumstances should be brought on record to prove that the purpose of arrangements and transactions was only for the purpose of taking treaty benefit.

Given that the PPT provisions are at a nascent stage and have been untried in the legal courts until now, therefore, the aforementioned decision, being one of the first decisions dealing with the evaluation of applicability of PPT provisions, may act as a guiding-light. However, it may be pertinent to note that while ruling in the favour of the taxpayer, the Hon’ble ITAT emphasized on the aspect that the Tax Authorities must bring on record relevant facts to establish that availing treaty benefit was the only purpose of the arrangement. In this regard, it may be interesting to decipher, with the course of time, as to whether the threshold to apply PPT provisions will be graciously extended and only those cases where obtaining treaty benefit was the only purpose shall fall within the purview of PPT provisions or cases where even one of the principal purpose was obtaining treaty benefit shall fall within the ambit of PPT applicability.

Date of Applicability of PPT Provisions

It has been clarified that in cases where PPT has been incorporated through bilateral negotiations in the DTAA, i.e.,

1. In cases where India has entered into DTAAs recently such as India-Hong Kong DTAA, India-Chile DTAA; or
2. In cases where the PPT has been incorporated through the amendment of the Protocol, such as India-China DTAA

the PPT shall apply prospectively from the date of entry into force of the respective DTAA or the amending Protocol, as the case may be.

In cases, where the PPT has been implemented through MLI, the effective date is determined based on the later of the dates of coming into force, of treaty under consideration (‘Relevant Date’). The same may be ascertained through OECD matching database.

For instance, in case of India and Malaysia, the date of entry force is as under:

In the above case, the Relevant Date shall be 01^st June 2021, being the later of the two dates of entry into force. Once the Relevant Date is determined, reference is required to be made to Article 35 which deals with the determination of date of entry into effect, i.e.

Therefore, in the above example of India-Malaysia, with respect to withholding taxes, the MLI will enter into effect for the India-Malaysia DTAA, from India’s perspective from the first taxable period after 01^st June 2021, i.e. from 01^st April 2022. In case of other taxes, the MLI will come into effect from taxable periods beginning on or after the expiration of a period of six calendar months (01^st December 2021), i.e. from 01^st April 2022.

Impact of PPT in case of Grandfathering Provisions

With effect from 01^st April 2017, in order to curb instances of double non-taxation of capital gains income, arising from transfer of shares, India had bilaterally negotiated tax Treaties with Mauritius, Singapore and Cyprus, whereby, the source country was conferred the right to tax the capital gains in relation to shares acquired on or after 01^st April 2017. Further, the securities acquired prior to 01^st April 2017 were grandfathered and the right to tax the capital gains vested with the resident country.

However, given that India-Singapore and India-Cyprus had implemented PPT through the MLIs (India and Mauritius had signed a protocol in March 2024, to amend the India-Mauritius treaty and thereby insert PPT provisions and the said protocol is yet to be entered into force), there always existed ambiguity regarding the applicability of PPT provisions in respect of the grandfathered securities, i.e. whether the test of principal purpose shall apply to such grandfathered securities also. In this regard, the CBDT vide Circular 01 of 2025 has clarified and made it amply clear that the grandfathering provisions prescribed vide the aforementioned Treaties of Mauritius, Singapore and Cyprus, shall remain outside the purview of PPT provisions and would be governed by the specific provisions of the respective DTAA itself.

Further, the Circular categorically provides that such grandfathering provisions shall instead be governed by the specific anti-avoidance provisions prevailing in the DTAA itself. Therefore, in the context of India-Singapore tax treaty, the test prescribed vide Article 24A shall prevail, whereby the capital gains tax exemption in the source country shall be denied in case the entity’s affairs were arranged with the primary purpose to avail treaty benefit, whereas in case of Cyprus and in case of Mauritius, the capital gains tax exemption shall be available in relation to the shares acquired prior to 01^st April 2017, once it is substantiated that the shares were owned by the entity and the said entity held valid Tax Residency Certificate issued by the resident country, in accordance with the legal proposition enunciated in various judicial precedents, in this regard.

Further, in case of the India-Mauritius Treaty, given that the PPT provisions are yet to be entered into force, the transitional relief of 50 percent of the applicable tax, prescribed vide Article 24 of the India-Mauritius Treaty, in relation to the shares acquired after 01^st April 2017 and transferred on or before 31^st March 2019, shall not be impacted by the PPT provisions.

Press Release dated 15^th March 2025

In order to provide further clarity in relation to the aforementioned Circular, a press release dated 15^th March 2025 was also issued whereby the CBDT clarified that the Circular shall be applicable only in relation to the PPT provision of the tax treaties and it does not intend to interact or interfere with:

• Any other treaty provision, including those related to treaty entitlement or denial of treaty benefit, other than PPT (For instance, LOB clause which is part of DTAA’s like Singapore, UK etc still remain applicable)
• Anti-abuse provisions under the Act, such as GAAR and Specific Anti-Abuse Rules (‘SAAR’) and provisions emerging from the judicial interpretation i.e. Judicial Anti-Abuse Rules (‘JAAR’)

Further, the Press Release unequivocally clarified that the Circular shall apply only in relation to those tax treaties where the PPT provisions exists.

Conclusion

With the recent Circular issued by the CBDT in relation to application of PPT provisions, it may be appreciated that Income-tax Department has provided much needed guidance in relation to the applicability of PPT provisions and certainty in relation to taxation mechanism.

The Circular has carved out the way forward for the tax-authorities to apply PPT provisions which shall inter-alia foster an effective approach to plug the cases involving revenue leakage and reduce the cases of double non-taxation of transactions.

Additionally, the Indian payer entities shall also be mindful of applicability of the PPT provisions and should ensure that a particular transaction or arrangement is well tested for the applicability of PPT provisions and as an additional documentary compliance, the Indian payer entities should obtain confirmation from the non-resident payee entities regarding fulfilment of PPT provisions, amongst other modifications prescribed vide MLIs.