Direct Tax Alert:  CBDT circular provides guidance on application of Principal Purpose Test including prospective applicability 

BACKGROUND

The objective of Principal Purpose Test (PPT) is to prevent treaty abuse. It is one of the minimum standards to be implemented by the countries participating in the Base Erosion and Shifting Profits (BEPS) Inclusive Framework. Under the PPT, a taxpayer can be denied Double Taxation Avoidance Agreement (DTAA) benefit where it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining the DTAA benefit was one of the principal purposes of an arrangement/ transaction entered or undertaken. However, if it is established that granting such benefit is in accordance with the object and purpose of the DTAA, the benefit cannot be denied.

Recently, the Central Board of Direct Taxes (CBDT) has issued a circular1  to provide guidance on application of PPT under India’s DTAA. We, at BDO in India, have analysed and summarised the key aspects of the said circular and provided our comments on its impact hereunder:

  •  Date of applicability of PPT:
The PPT provisions shall apply prospectively as follows:

For India, the date of entry into force of MLI is 1 October 2019. The date of entry into force for the contracting jurisdiction will be ascertained using OECD’s MLI database.    
  • Grandfathering provisions under specific DTAAs:

India has made certain treaty-specific bilateral commitments in the form of grandfathering2  provisions, the object and purpose of which is not intended to interact with PPT provisions. Therefore, for the following treaties, grandfathering provisions shall remain outside the purview of the PPT provision and shall be governed by the specific provisions of the respective DTAA:

- India-Cyprus DTAA;
- India-Mauritius DTAA; and
- India-Singapore DTAA. 
 
  • Additional sources of guidance for application of PPT:

The application of PPT is expected to be a context-specific, fact-based exercise, to be carried out on a case-by-case basis, keeping in view the objective facts and findings. Tax authorities may refer to the following sources for guidance:

  • BEPS Action Plan 6 Final Report, subject to India’s reservations,
  • Articles 1 and 29 of the UN Model Tax Convention, subject to India’s reservations.

 

BDO in India Comments

The CBDT’s clarification regarding prospective applicability of PPT is a welcome move. The clarifications under this Circular will provide guidance to taxpayers and reduce potential disputes arising from application of the PPT provisions.
Separately, it is pertinent to note that last year on 7 March 2024, India had signed a protocol with Mauritius to insert PPT in India-Mauritius DTAA. While this protocol is yet to be notified, the clarification given by this circular on non-applicability of PPT to grandfathering provision under India’s DTAA is a relief for taxpayers. Further, since PPT is now part of majority of India’s DTAAs, it would be imperative for the taxpayers to evaluate its impact considering the guidance provided.

 1 Circular No. 01/2025 dated 21 January 2025
 2 Grandfathering provision under the India-Mauritius DTAA provide that gains derived from certain investments acquired before 1 April 2017 shall not be taxable in India.