Oct 14, 2021

Boon or Bane – The Principal Purpose Test

The multilateral convention to implement tax treaty related measures to prevent base erosion and profit shifting (‘MLI’) has significantly boosted tax administrations’ resistance against tax avoidance and treaty abuse globally. One of the most critical impacts of the MLI on the existing Indian tax treaties is the incorporation of the Principal Purpose Test (‘PPT’). The PPT broadly provides that a benefit under a tax treaty would not be granted, if it is reasonably concluded by the tax authorities that obtaining the benefit was one of the principal purposes of the concerned arrangement/ transaction that resulted directly/ indirectly in that benefit. For MLI and consequently PPT, to have an impact on a tax treaty, reciprocal consent of both the countries is required.

Incidentally, many of India’s tax treaties contain general or special anti-avoidance rules (such as Limitation on benefits (‘LOB’) clause that seeks to deny tax treaty benefits based on an objective criteria). Further, the Indian Income-tax Act, 1961 (“IT Act”) also contains General Anti-Avoidance Rule (‘GAAR’). While GAAR is subject to certain procedural safeguards and provide for certain exemptions, PPT has no such stipulations. Potentially, this could give rise to a situation where a transaction is expressly grand fathered or exempt under GAAR, but is assailed by the tax authorities by invoking PPT. Similar questions may arise on the applicability of PPT, particularly where the taxpayer satisfies the LOB provision under the applicable tax treaty.

Incorporation of PPT, could particularly impact investments from jurisdictions like Singapore, Netherlands, Ireland, UK, Cyprus etc. For example, capital gains upon transfer of Indian company shares by a Dutch entity to another non-resident are not taxable in India as per the India-Netherlands tax treaty. However, post the incorporation of PPT therein, such exemption would need to pass through the subjective hurdle of PPT. Furthermore, PPT becomes significant for all other kinds of income as well, especially royalty and fee for technical services (‘FTS’), which were earlier only subject to the beneficial ownership (‘BO’) test. While the non-satisfaction of the BO test only denies beneficial rate of tax, non-satisfaction of PPT could negate the tax treaty itself, including the narrower definitions of royalty/ FTS.

Given that reciprocal consent to apply MLI and to incorporate PPT is mandatory, many tax treaties such as India – USA, India – Mauritius, India – Germany, India – Hong Kong etc. have remained unaltered in the absence of such consent. Inbound investments from such countries are therefore, as on date, not subjected to any incremental anti-avoidance measure introduced by the MLI, such as PPT.

In our view, PPT is yet another subjective ammunition available to the tax authorities to disregard the form of cross-border arrangements, re-characterise their substance and deny tax treaty benefits, over and above the anti-avoidance rules already contained in Indian tax treaties as well as the IT Act. While the objective behind PPT is laudable, in the present form, without any clear guidance from the Government or Courts on inter-play between PPT, GAAR and LOB, it could, at the minimum, lead to increase in uncertainty and thereby, a rise in tax litigation.




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