CBDT Issues Key Guidance on the Principal Purpose Test Under India’s DTAAs

Introduction

The Central Board of Direct Taxes (‘CBDT’), through a circular[i] dated 21.01.2025, has issued an important clarification on the application of the Principal Purpose Test (‘PPT’) under India’s Double Taxation Avoidance Agreements (‘DTAAs’). Introduced via the Multilateral Instrument (‘MLI’) on 01.10.2019, the PPT aims to curb treaty abuse and prevent tax avoidance by denying treaty benefits where obtaining such benefits was a principal purpose of an arrangement or transaction. The circular provides essential guidance on its application, ensuring consistency and transparency across tax jurisdictions.

Understanding the PPT

The PPT is designed to deny DTAA benefits if it is reasonable to conclude that obtaining such benefits was one of the principal purposes of an arrangement or transaction. However, an exception applies if granting the benefit aligns with the DTAA’s object and purpose. The test requires a holistic analysis of all relevant facts and circumstances, including economic substance, business rationale, and genuine commercial considerations.

The PPT denies treaty benefits when:

• Based on an objective assessment of relevant facts and circumstances, it is reasonable to conclude that one of the principal purposes of the arrangement or transaction was to obtain the treaty benefit, directly or indirectly, and

• The taxpayer does not establish that granting the benefit aligns with the object and purpose of the relevant DTAA provision.

Key Aspects of the Circular

1. Timeframe for Application

The PPT will apply prospectively from the date of entry into force of the relevant DTAA or MLI amendment.

• For bilateral agreements (e.g., Chile, Iran, Hong Kong, China), the PPT applies from the date the DTAA or its amending protocol comes into effect.

• For MLI-covered DTAAs, the PPT applies from the date the MLI provisions take effect for each treaty partner country, whereby:

• For withholding taxes: The PPT applies from the first day of the previous year that begins on or after the latest date on which the MLI enters into force for both contracting jurisdictions.

• For other taxes: The PPT applies from the expiration of 6 months after the latest date on which the MLI enters into force for both contracting jurisdictions.

• India’s MLI Effective Date: The MLI entered into force for India on 01.10.2019. However, the effective date for other treaty partners varies and should be verified in the OECD’s MLI database[ii].

2. Interaction with Grandfathering Provisions

Certain DTAAs contain grandfathering provisions[iii] that preserve pre-existing tax benefits under specific conditions. The circular exempts these provisions from the PPT’s application, meaning they will continue to be governed by their respective DTAA provisions. The following DTAAs contain specific grandfathering provisions:

• India-Cyprus DTAA

• India-Mauritius DTAA

• India-Singapore DTAA

These commitments, as bilaterally agreed, remain unaffected by the PPT. The CBDT has confirmed that such provisions will continue to be governed by the respective DTAAs and will not be overridden by the PPT.

3. Additional/Supplementary Sources of Guidance

To determine whether the PPT applies to a particular case, tax authorities may refer to:

• OECD’s Base Erosion and Profit Shifting (‘BEPS’) Action Plan 6 Final Report[iv], subject to India’s reservations.

• Commentary on as. 1 and 29 of the UN Model Tax Convention (updated in 2021)[v], also subject to India’s reservations.

The application of the PPT requires a fact-intensive, case-specific analysis, considering the transaction’s objectives, underlying facts, and economic substance.

Conclusion

The CBDT’s clarification promotes uniformity in applying the PPT under India’s DTAAs. While the PPT serves as a safeguard against treaty abuse, it also ensures that genuine commercial transactions are duly affected. Taxpayers and financial institutions must carefully assess whether their international transactions comply with PPT requirements. Businesses engaged in cross-border transactions must proactively assess the PPT’s implications and ensure that their structures serve a legitimate commercial purpose beyond tax benefits.

This clarification reduces uncertainty by affirming the prospective application of the PPT and delineating its interaction with grandfathering provisions. This is a positive development for cross-border investors, particularly those relying on tax treaties with Singapore, Mauritius, and Cyprus.

End Notes

[i] Circular No. 01/2025, dated 21.01.2025 – F. No. 500/05/2020/FT&TR-II, Foreign Tax & Tax Research Division-II, CBDT

[ii] OECD’s MLI Database: This is a comprehensive resource that tracks the implementation status of the MLI across jurisdictions, detailing how different countries have adopted and modified their tax treaties to incorporate anti-avoidance measures like the PPT.

[iii] Grandfathering Provisions: In tax treaties, these provisions are clauses that preserve certain pre-existing benefits for transactions or entities that were already in place before a new regulatory change, such as the introduction of the PPT.

[iv] OECD (2015), Preventing the Granting of Treaty Benefits in Inappropriate Circumstances, Action 6 - 2015 Final Report, OECD/G20 Base Erosion and Profit Shifting Project, OECD Publishing, Paris. http://dx.doi.org/10.1787/9789264241695-en

[v] https://financing.desa.un.org/sites/default/files/2023-05/UN%20Model_2021.pdf

Authored by Dhruv Goel at Metalegal Advocates. The views expressed are personal and do not constitute legal opinions.