Introduction: A New Chapter in International Taxation
Imagine a multinational company setting up an entity in a tax-friendly jurisdiction, such as Mauritius or Singapore, to take advantage of lower withholding taxes under India’s Double Taxation Avoidance Agreements (DTAAs). While this might have been a widely accepted practice in the past, global tax authorities are tightening the noose on treaty abuse and tax avoidance.
India, in line with the OECD’s Base Erosion and Profit Shifting (BEPS) project, has incorporated the Principal Purpose Test (PPT) into many of its DTAAs to prevent misuse. The PPT is a sweeping anti-abuse provision that allows tax authorities to deny treaty benefits if one of the principal purposes of a transaction is to obtain a tax advantage.
However, uncertainty surrounded the timing of its implementation—should the PPT apply retroactively or only prospectively? In a recent Circular No. 1/2025, the Central Board of Direct Taxes (CBDT) clarified that the PPT will be applied prospectively, providing much-needed relief to investors and businesses operating under India’s tax treaties.
But what does this really mean for companies and investors relying on India’s tax treaties? Let’s break it down.
What Is the Principal Purpose Test (PPT) and Why Does It Matter?
The Principal Purpose Test (PPT) is designed to curb tax treaty abuse. Under the PPT rule:
A tax benefit under a DTAA will be denied if one of the principal purposes of a transaction or arrangement is to obtain a tax advantage—unless the taxpayer can demonstrate that granting the benefit aligns with the object and purpose of the treaty.
This means that even if a company is legally incorporated in a jurisdiction with favorable tax treaties, it must prove that its presence and activities there have genuine commercial substance beyond just tax benefits.
For example:
- If an investment holding company is established in Mauritius solely to avail of capital gains tax exemptions, the Indian tax authorities may now deny treaty benefits under the PPT.
- However, if the company can prove that it has substantial operations, employees, and business activities in Mauritius, it may still qualify for tax treaty benefits.
The introduction of the PPT aligns India with the OECD’s BEPS Action Plan 6, which seeks to prevent tax treaty abuse globally.
CBDT’s Key Clarifications on PPT Application
Recognizing the uncertainty around the PPT’s implementation, the CBDT issued Circular No. 1/2025, clarifying three key aspects:
1. The PPT Will Apply Prospectively, Not Retroactively
One of the biggest concerns among taxpayers was whether the PPT could be applied retrospectively, creating uncertainty for past transactions. The CBDT has now confirmed that:
- For DTAAs where the PPT was introduced through bilateral agreements (e.g., Chile, Hong Kong, Iran), the PPT will apply from the date of entry into force of the treaty or the amending protocol.
- For DTAAs modified by the Multilateral Instrument (MLI) (e.g., India’s treaties with France, Japan, the UK), the PPT will apply from the date the MLI provisions take effect.
For India, the MLI came into force on October 1, 2019, meaning PPT provisions will generally apply from the first day of the subsequent financial year in cases involving withholding taxes.
This prospective application provides greater certainty to investors, as they will not face retrospective tax challenges for past transactions.
2. PPT Will Not Override Grandfathering Provisions in Certain Treaties
The CBDT has also clarified that the PPT will not interfere with existing grandfathering provisions in certain key DTAAs:
- India-Mauritius DTAA (which allows tax benefits for investments made before April 1, 2017)
- India-Singapore DTAA (which follows similar provisions as Mauritius)
- India-Cyprus DTAA
This means that investments covered under these grandfathering provisions will remain protected, even though the PPT has been introduced.
3. Supplementary Guidance for Applying PPT
Since the PPT relies on a subjective assessment of intent, the CBDT has advised tax authorities to refer to supplementary international guidelines, including:
- The OECD BEPS Action 6 Final Report, which provides examples of treaty abuse scenarios.
- The UN Model Tax Convention (2021 update), which includes commentary on how the PPT should be applied.
This ensures that India follows global best practices while interpreting the PPT, reducing the risk of arbitrary application by tax authorities.
What This Means for Businesses and Investors
The prospective application of the PPT and the respect for existing grandfathering provisions provide relief to businesses, but they also come with new compliance challenges.
1. Increased Scrutiny on Treaty-Based Tax Planning
Businesses relying on India’s low-tax treaty jurisdictions (Mauritius, Singapore, Cyprus, Netherlands, etc.) will now face greater scrutiny. Simply registering an entity in a tax-friendly country will no longer guarantee treaty benefits unless the entity has:
- Substantial economic presence (employees, offices, active operations).
- A legitimate business purpose beyond tax savings.
2. Stricter Tax Audits and Documentation Requirements
Tax authorities will now closely examine transactions to determine whether they have a genuine commercial rationale beyond tax benefits. Companies must:
- Maintain strong documentation demonstrating the business purpose of their cross-border structures.
- Be prepared for enhanced transfer pricing scrutiny as part of tax audits.
3. India Aligning with Global Tax Norms
This move is part of India’s broader push to align with global tax practices, particularly OECD’s BEPS framework. Similar measures are being implemented worldwide, with:
- The European Union tightening anti-abuse rules in its DTAAs.
- The US scrutinizing “treaty shopping” structures more aggressively.
Businesses operating internationally must now review their global tax structures to ensure compliance with these evolving norms.
Conclusion: A Clearer, But Stricter Tax Regime Ahead
The CBDT’s new guidance on the PPT is a significant milestone in India’s international tax policy. By confirming its prospective application, it brings much-needed clarity and predictability to cross-border tax planning.
However, this also means that businesses must be more diligent than ever. Treaty-based tax advantages are no longer automatic—they must be supported by genuine commercial substance and strong documentation.
For companies with international structures, the message is clear:
- Reassess your treaty-based tax planning strategies.
- Strengthen compliance and documentation processes.
- Be prepared for increased scrutiny from tax authorities.
India’s tax landscape is evolving—and businesses that adapt proactively will be best positioned to navigate this new era of international taxation.
