The Central Board of Direct Taxes (‘CBDT’), on January 21, 2025, has issued Circular No. 01/2025 (‘Circular’), by way of which it has provided guidance for application of the Principal Purpose Test (‘PPT’) under India’s Double Taxation Avoidance Agreements (‘DTAAs’) with various countries.

Briefly, PPT is an internationally acknowledged tax anti-avoidance measure that was introduced by the Organisation for Economic Development (‘OECD’) as part of its Base Erosion and Profit Shifting (‘BEPS’) project in 2017. The PPT clause allows the Indian-Revenue Authorities (‘IRA’) to deny a benefit availed under a DTAA in respect of any item of income, if it can be reasonably concluded that obtaining such benefit was ‘one of the principal purposes’ of an arrangement or transaction that resulted in such benefit. However, the benefit may not be denied if the assessee is able to establish that the same was aligned with the object and purpose of the relevant provision(s) of the DTAA.

The CBDT has now provided guidance on the following key points in relation to application of PPT under India’s DTAAs:

i.    Prospective Application of PPT

The Circular clarifies that in case of DTAAs where PPT was introduced through bilateral processes (such as with Chile, Hong Kong, China, etc.), PPT applies from the date of enforcement of the DTAA or of the amendment incorporating PPT in the DTAA.

For DTAAs where PPT was introduced through the Multi-lateral Instrument (‘MLI’)^[1], the PPT provision applies as follows:

a. In Case of Taxes Withheld from Payments Made to Non-Residents: The PPT applies to transactions occurring in or after the relevant financial year beginning on or after the date of enforcement of MLI for India (e., October 1, 2019) / other contracting State, whichever is later.

b. For Other Taxes: The PPT applies to transactions occurring in the relevant financial year beginning after six calendar months from the date of enforcement of MLI for India (e., October 1, 2019) / other contracting State, whichever is later.

ii.   Application of PPT in Case of DTAAs with Grandfathering Provision

Significantly, the Circular clarifies that the PPT cannot be applied to deny grandfathering benefits (capital gains exemption from sale of shares acquired prior to April 1, 2017) as provided under India’s DTAAs with Cyprus, Mauritius and Singapore.

iii.  Fact-Specific Examination and Sources of Guidance

The Circular clarifies that application of PPT is a fact-specific exercise which should be carried out on a case-by-case basis. Further, in addition to ‘BEPS Action Plan 6 Final Report’ the IRA may refer to ‘Commentary to Articles 1 and 29 of the UN Model Tax Convention’ (updated in 2021 and subject to India’s reservation) as sources of guidance while applying PPT on a transaction. This underscores the need for careful consideration and ensuring that the PPT is applied fairly.

Key Takeaways

The Circular provides much-awaited clarification and mitigates uncertainty regarding application of PPT. It significantly reassures investors, particularly from Singapore, Mauritius, and Cyprus, that gains arising from shares acquired before April 1, 2017, would be protected from the applicability of PPT.

[1] For India, date of entry into force of the MLI is October 1, 2019.