27 May 2025
In this update:
Partners: Himanshu Sinha and Aditi Goyal, Senior Associate: Aishwarya Palan, Associate: Paras Arora
The Central Board of Direct Taxes (CBDT) has issued a circular1 (Circular) clarifying that the principal purpose test (PPT) is intended to apply prospectively and does not override grandfathering provisions in tax treaties. A subsequent clarification2 specified that the Circular applies only to tax treaties that contain the PPT provision and does not apply to other provisions that examine entitlement or denial of benefits.
Under the PPT, tax treaty benefits are denied if it is ‘reasonable to conclude’, ‘having regard to all facts and circumstances’, that ‘obtaining the benefit was one of the principal purposes of any arrangement or transaction’, and such arrangement or transaction directly or indirectly resulted in that benefit. The expression ‘reasonable to conclude’ is not an objective test. If after an objective analysis of the facts and circumstances, it is reasonable to conclude that one of the principal purposes of the arrangement or transaction was to obtain the benefits of the tax treaty, the PPT provision would be satisfied.
Therefore, to determine if the main purpose of undertaking an arrangement or transaction was to obtain tax benefits, various commercial and economic factors must be examined. As a result, there has been considerable ambiguity surrounding the application of the PPT. The CBDT has clarified the following by the Circular:
The PPT is intended to be applied prospectively. Consequently, where the PPT has been incorporated into a tax treaty through bilateral negotiations, the applicable date will be the date of entry into force of the tax treaty or the amending protocol introducing the PPT.
Where the PPT has been included in a tax treaty through the Multilateral Instrument (MLI), as is the case with most of India’s tax treaties, the date on which the MLI provisions came into force becomes relevant. While the MLI came into force for India on 1 October 2019, determining the date of entry into force of the MLI for the respective tax treaty partner (i.e., the other country) is crucial to assess the applicability of the PPT in that tax treaty. This is because the MLI provisions become effective only after both treaty partners (i.e., India and the other country) have ratified the MLI.
Grandfathering provisions included in specific tax treaties (such as with Cyprus, Mauritius, and Singapore) will operate independently of the PPT and will continue to apply according to their respective original terms.
The application of the PPT will be a fact-specific, case-by-case exercise based on the unique circumstances and findings of each transaction.
The guidance provided in the Circular applies only to tax treaties in which the PPT provision exists and does not impact the applicability of any other treaty provisions or anti-abuse provisions under the domestic law, such as the general anti-abuse rules, specific anti-abuse rules or the judicial anti-abuse rules.
The Circular and its clarifications provide much-needed certainty on the implementation of the PPT. They offer reassurance to foreign investors, particularly those from jurisdictions with lower tax rates, about the government’s commitment to ensure consistency and transparency in tax treaty interpretation. Ultimately, while this move is expected to encourage greater foreign investment into India, its effectiveness will largely depend on consistent and uniform application by lower tax authorities, an essential factor in enhancing India’s credibility as a reliable investment destination.
[1] Circular 01/2025 dated 21 January 2025
[2] Press release dated 15 March 2025
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