Principal Purpose Test (PPT) under India’s DTAA

Principal Purpose Test (PPT) under India’s DTAA

The Principal Purpose Test (PPT) is an anti-abuse provision incorporated into India’s Double Taxation Avoidance Agreements (DTAAs) in line with the OECD’s Base Erosion and Profit Shifting (BEPS) Action Plan 6. The PPT aims to prevent treaty abuse by denying treaty benefits if obtaining such benefits was one of the principal purposes of an arrangement or transaction.  PPT provision in India’s DTAAs is a powerful anti-abuse measure that ensures treaty benefits are only available for genuine commercial transactions. It aligns with global tax transparency efforts and strengthens India’s tax enforcement against treaty abuse.  CBDT Circular No. 01/2025 dated 21.01.2025 was issued in the form of a guidance to provide clarity and certainty on the application of the PPT provision under India’s DTAA.

Key Aspects of Principal Purpose Test under India’s DTAAs:

1. General Anti-Avoidance Rule (GAAR) Alignment : The PPT is consistent with India’s General Anti-Avoidance Rules (GAAR) under the Income Tax Act, 1961, which target impermissible tax avoidance arrangements. It strengthens India’s ability to deny treaty benefits if transactions lack commercial substance.

2. Standard PPT Clause in DTAAs : A typical PPT clause states that treaty benefits will not be granted if it is reasonable to conclude that one of the principal purposes of an arrangement or transaction was to obtain such benefits, unless granting the benefits aligns with the object and purpose of the DTAA.

3. Impact of India’s Multilateral Instrument (MLI) Adoption : India has adopted Article 7 (PPT) of the MLI, which modifies its DTAAs to include the PPT provision. This ensures that India’s tax treaties comply with the minimum standard for preventing treaty abuse under BEPS.

4. Burden of Proof and Subjectivity : The determination of whether an arrangement was primarily tax-motivated involves subjective assessment by tax authorities. The taxpayer must demonstrate that the transaction had genuine commercial reasons beyond tax benefits.

5. The PPT effectively combats treaty shopping, where entities are structured in low-tax jurisdictions solely to access DTAA benefits.
6. Indian tax authorities have increasingly invoked PPT to challenge tax treaty benefits claimed by foreign entities, especially in cases involving capital gains exemptions, royalty, and interest payments.

CBDT clarification on the application of the Principal Purpose Test (PPT) under India’s DTAA ​

The Central Board of Direct Taxes (CBDT) has issued a clarification regarding Circular No. 01/2025, originally released on January 21, 2025, which provides guidance on the application of the Principal Purpose Test (PPT) under India’s Double Taxation Avoidance Agreements (DTAAs).​  Key Clarifications:

1. Scope of Application: The guidance pertains exclusively to Indian DTAAs that incorporate the PPT provision. It does not extend to treaties lacking this specific provision. ​

2. Non-Interference with Other Treaty Provisions: The Circular does not affect other DTAA provisions related to the examination of treaty entitlement or the denial of benefits. Its focus is solely on the PPT. ​

3. Independence from Domestic Anti-Abuse Rules: The guidance does not interact with domestic anti-abuse measures such as the General Anti-Abuse Rule (GAAR), Specific Anti-Abuse Rules (SAAR), or Judicial Anti-Abuse Rules (JAAR). These domestic provisions will continue to operate independently.

4. Reaffirmation of Legal Interpretation: This clarification does not introduce new legal interpretations but reaffirms that the Circular’s guidance is confined to the PPT, leaving other provisions of the Income-tax Act unaffected. ​

5. Grandfathering of Gains : The circular affirms that capital gains from shares acquired before April 1, 2017, under India’s DTAAs with Singapore, Mauritius, and Cyprus, will continue to enjoy treaty benefits without the risk of PPT application. This is consistent with the Protocol amendments to these treaties, which introduced source-based taxation for capital gains on shares acquired on or after April 1, 2017.

6. Investor Reassurance : Foreign investors from these jurisdictions had concerns that Indian tax authorities might apply PPT retrospectively, potentially challenging tax treaty benefits. The clarification ensures that pre-2017 investments remain protected, boosting investor confidence.

7. Limited PPT Application for Post-2017 Gains : For shares acquired on or after April 1, 2017, the PPT could be applied to deny treaty benefits if the principal purpose of structuring the transaction was tax avoidance.

8. Impact on Treaty Shopping Concerns : The circular aligns with India’s commitment to prevent treaty abuse but also acknowledges the importance of tax certainty for genuine investors.

CBDT Circular provides crucial clarity on the Principal Purpose Test (PPT) and reassures investors, especially from Singapore, Mauritius, and Cyprus, regarding the grandfathering provisions for capital gains on shares acquired before April 1, 2017.  This clarification is a positive step toward regulatory certainty, particularly for FPIs and long-term investors who had structured investments before 2017. While India remains committed to BEPS principles, this approach balances anti-abuse measures with investor-friendly policies.