CBDT: Guidance Note on application of Principal Purpose Test

CBDT on application of Principal Purpose Test under amended tax Treaties

This clarification from the CBDT on the application of the Principal Purpose Test under amended tax treaties provides much-needed relief to foreign investors, especially those relying on the grandfathering provisions of agreements with Mauritius, Cyprus, and Singapore.

Principal Purpose Test (PPT) :

The Principal Purpose Test, part of the OECD’s Multilateral Instrument, is designed to prevent tax avoidance through treaty abuse. It denies treaty benefits if one of the principal purposes of a transaction or arrangement was to gain tax benefits, unless consistent with the treaty’s objectives. 

Guidance Note on application of the Principal Purpose Test under amended tax treaties

• Past Investments Protected Under Grandfathering Provisions:

  • Investments made prior to the implementation of PPT under amended tax treaties, such as those with Mauritius, Cyprus, and Singapore, will continue to benefit from the earlier rules. This means they won’t be scrutinized under the PPT as long as they qualify under the respective grandfathering clauses.
  • This assurance should calm concerns about retrospective application of the PPT on treaty benefits.
  • Investments made under older tax treaties with countries like Mauritius, Cyprus, and Singapore will not be subjected to Past Investments Protected scrutiny. This ensures that past investments benefiting from treaty provisions prior to the introduction of Past Investments Protected are safeguarded.

• PPT Application:

  • The Past Investments Protected Rule, designed to target transactions whose principal purpose is tax avoidance, will only apply to taxable events occurring after the protocol or rule comes into effect (expected from Financial Year 2025-26, starting April 1, 2025).
  • Example: If a transaction happens in 2025 after the amended treaty becomes effective, the PPT may scrutinize whether the transaction was driven purely by tax benefits.
  • Principal Purpose Test is a global standard aimed at preventing tax avoidance. It examines whether a business arrangement was primarily designed to obtain tax benefits without legitimate commercial or economic substance.
  • However, this rule will only apply to transactions post the implementation of amended treaties.

• No Complete Immunity for Pre-2017 Investments:

  • The note does not provide blanket immunity for investments made before 2017. If evidence shows that those investments were structured primarily to exploit treaty benefits without genuine commercial intent, the Past Investments Protected could still apply.

• Investor Confidence:

  • This prospective application aligns with India’s commitment to honoring the grandfathering provisions in its tax treaties.
  • It reassures foreign investors that their historical investments won’t be revisited under the new rules.

• Case-Specific Applications:

  • The Principal Purpose Test application will depend heavily on facts and circumstances. Recent cases, such as one before the Delhi Income Tax Appellate Tribunal regarding the India-Luxembourg Double Taxation Avoidance Agreement, highlight the context-driven nature of such investigations.

Impact- Why It’s Significant:

• Investor Confidence: The clarification underscores India’s commitment to honoring treaty provisions and ensuring that investments benefiting from grandfathering clauses are protected, thereby fostering confidence among foreign investors.
• Clearer Interpretation: Investors now have a better understanding of when Principal Purpose Test may be invoked, reducing uncertainty around its retrospective impact.
• Focus on Genuine Transactions: The Principal Purpose Test is a global standard to curb tax avoidance, but it will target only transactions lacking genuine commercial substance, ensuring that legitimate investments aren’t unfairly impacted.
• Ease for Historical Investments: Investors with holdings routed through tax-friendly jurisdictions like Mauritius can rest assured that benefits claimed earlier won’t be overturned by Principal Purpose Test.
• Focus on Future Compliance: The prospective application emphasizes the importance of structuring future investments with a clear commercial purpose beyond tax benefits.

Takeaways for Investors:

This clarification ensures a fair balance between implementing global tax standards and maintaining investor trust. It’s a significant step in fostering a stable tax environment for foreign investments. Ensure all future investments comply with the Principal Purpose Test rule and have genuine commercial substance. Review pre-2017 investments for any risk exposure under the Principal Purpose Test. Pay close attention to the notification and implementation of the amended tax treaties starting Financial Year 2025-26.

This guidance should help streamline cross-border investment flows while keeping tax compliance in check. If you’re a stakeholder, are you feeling reassured by this move, or does the fact-based scrutiny still seem concerning?

Significant precedent regarding Principal Purpose Test & Tax treaty benefits

The Delhi ITAT’s ruling in SC Lowy P.I. (LUX) S.A.R.L. vs. ACIT marks a significant precedent regarding the Principal Purpose Test & tax treaty benefits. This detailed analysis highlights the growing importance of commercial substance and economic rationale in determining eligibility for tax treaty benefits under the evolving tax landscape in India, particularly with the introduction of the Principal Purpose Test & General Anti-Avoidance Rules.

Tax Residency Certificate: Indian courts and the Central Board of Direct Taxes have consistently upheld that possessing a valid TRC is sufficient proof of residency and eligibility for treaty benefits. However, the tax authorities are increasingly adopting a substance-over-form approach to challenge tax treaty benefits claimed by entities.

Principal Purpose Test Impact: The Principal Purpose Test, introduced via the Multilateral Instrument, allows authorities to deny treaty benefits if a key purpose of a transaction or structure is to obtain those benefits. Taxpayers must now justify their commercial rationale and substance to avoid scrutiny under Principal Purpose Test.

ITAT Ruling on SC Lowy P.I. (LUX) S.A.R.L. vs. ACIT : This ruling emphasizes the importance of:

• Commercial Substance: Demonstrating genuine business activities in the country of residence (e.g., Luxembourg in this case).
• Purpose: Proving that the entity was not set up solely for tax benefits.
• Substantial Operations: Showing operational expenditure and maintaining investments in multiple jurisdictions.

• The ITAT ruling shifts the burden of proof onto the tax authorities, requiring them to produce concrete evidence of treaty abuse.

With Principal Purpose Test  and General Anti-Avoidance Rules being relatively new, this ruling offers clarity and reassurance to taxpayers with genuine business structures. Taxpayers should:

• Ensure their structures have commercial rationale beyond tax savings.
• Maintain robust documentation to demonstrate substance (e.g., expenditures, operations, and investments).
• Be prepared for fact-specific scrutiny of their arrangements.

The ITAT ruling reinforces the principle that economic substance and bona fide business activity outweigh mere formalities. Courts are likely to adopt a nuanced approach, distinguishing between genuine structures and arrangements created solely for treaty shopping.

The taxpayer was held eligible for benefits under the India-Luxembourg Tax Treaty. Specific rulings: Business income from securitization trusts and capital gains on debentures/bonds are exempt. Interest income is taxable at the treaty rate of 10%.

Implications: The ruling is a precedent-setting judgment for cross-border investments, especially in light of evolving tax rules under PPT and General Anti-Avoidance Rules. It offers a roadmap for foreign investors and portfolio entities to navigate the complexities of claiming tax treaty benefits while ensuring compliance with Indian tax laws. For taxpayers with legitimate business models, this judgment is a positive step toward reducing litigation risks.

Income Tax Alert Section 80GGC