FAQs on Principal Purpose Test (PPT) and Recent Clarifications by CBDT

1. What is the Principal Purpose Test (PPT)?

The Principal Purpose Test (PPT) is a provision under the Multilateral Instrument (MLI) to prevent treaty abuse and aggressive tax planning practices. It aims to ensure that treaty benefits are granted only when the principal purpose of a transaction or arrangement is genuine and not merely to obtain treaty benefits. The PPT is incorporated into the tax treaties of countries that have adopted the MLI.

2. What does the PPT seek to address?

The PPT is designed to combat "treaty shopping," where taxpayers exploit gaps or mismatches in tax treaties to minimize their tax liabilities. It ensures that taxpayers cannot claim treaty benefits for transactions or arrangements primarily structured to avoid taxes.

3. How does the PPT work in practice?

Under the PPT, treaty benefits (e.g., reduced withholding tax rates, tax exemptions) can be denied if it is reasonable to conclude that obtaining such benefits was one of the principal purposes of an arrangement or transaction. However, this does not apply if granting the benefits aligns with the object and purpose of the relevant treaty provisions.

4. What are the key elements of the PPT analysis?

• Principal Purpose: Assess whether obtaining treaty benefits was one of the primary motivations behind the arrangement or transaction.
• Reasonableness: Evaluate whether it is reasonable to conclude that the arrangement was primarily tax-driven.
• Object and Purpose of Treaty: Determine if granting treaty benefits aligns with the intended purpose of the treaty provisions.

5. How has India implemented the PPT?

India introduced the PPT through the MLI, which modifies its existing tax treaties. The PPT has become effective for India's treaties with other MLI signatories from April 1, 2020, for withholding taxes and from FY 2020-21 for other taxes.

6. What recent clarifications has the CBDT issued regarding the PPT?

The Central Board of Direct Taxes (CBDT) has issued detailed clarifications to address taxpayers' concerns and provide guidance on the application of the PPT. Key highlights include:

• Substance over Form: The CBDT emphasized that the substance of the transaction will take precedence over its form. Arrangements with no substantial economic or commercial purpose, other than obtaining treaty benefits, may fail the PPT.
• Case-by-Case Evaluation: Each case will be evaluated based on its specific facts and circumstances, ensuring a holistic assessment.
• Safe Harbor Guidelines: The CBDT has issued examples of genuine transactions that are unlikely to violate the PPT, such as bona fide business operations, investment activities with economic substance, and arrangements aligned with industry standards.
• Documentation Requirements: Taxpayers must maintain robust documentation to substantiate the commercial rationale behind their transactions or arrangements.
• Interaction with GAAR: The CBDT clarified that the PPT operates alongside the General Anti-Avoidance Rules (GAAR) but does not replace them. The PPT applies at the treaty level, while GAAR applies under domestic law.

7. What are some examples of arrangements that might violate the PPT?

• Establishing a holding company in a low-tax jurisdiction primarily to avail of a reduced withholding tax rate under a treaty.
• Structuring a transaction to shift income to a jurisdiction with favorable treaty benefits without any substantial business activity.
• Using intermediary entities solely for accessing treaty benefits without adding any economic value.

8. How can taxpayers ensure compliance with the PPT?

To comply with the PPT, taxpayers should:

• Ensure that transactions or arrangements have a genuine commercial purpose beyond tax benefits.
• Align their operations with the economic and business realities of the jurisdictions involved.
• Maintain detailed documentation, including contracts, agreements, and business plans, to demonstrate the substance of the arrangement.
• Seek professional advice when engaging in cross-border transactions to evaluate treaty implications and the potential application of the PPT.

9. How does the PPT interact with other provisions of the MLI?

The PPT complements other anti-abuse measures in the MLI, such as the Simplified Limitation on Benefits (SLOB) clause and specific anti-abuse rules. Together, these provisions create a comprehensive framework to prevent treaty abuse.

10. What should taxpayers do in light of the recent CBDT clarifications?

Taxpayers should:

• Review existing arrangements and transactions to identify potential PPT risks.
• Reassess treaty benefits claimed in light of the PPT criteria and CBDT clarifications.
• Strengthen compliance processes to document the commercial rationale for arrangements.
• Engage with tax advisors to proactively address concerns and mitigate risks.

11. What is the impact of the PPT on cross-border investments?

While the PPT may deter aggressive tax planning, it does not hinder genuine cross-border investments. By ensuring that treaty benefits are granted only for bona fide transactions, the PPT promotes fair competition and reduces the risk of tax disputes.

12. What happens if a transaction fails the PPT?

If a transaction fails the PPT, the tax authorities can deny the treaty benefits claimed. In such cases, the taxpayer may be subject to the domestic tax laws of the relevant jurisdiction, including higher withholding taxes or other penalties.

13. How does the PPT align with India's broader tax policy?

The PPT aligns with India's commitment to international tax transparency and its active participation in the OECD's Base Erosion and Profit Shifting (BEPS) initiative. It reflects India's focus on curbing tax avoidance while fostering genuine economic activities.

14. Are there any remedies available to taxpayers if treaty benefits are denied under the PPT?

Yes, taxpayers can:

• Appeal the decision through the dispute resolution mechanisms provided under the treaty or domestic law.
• Access the Mutual Agreement Procedure (MAP) to resolve disputes arising from the application of the PPT.

15. Where can taxpayers find further guidance on the PPT?

Taxpayers can refer to:

• The OECD's commentary on the MLI and PPT provisions.
• CBDT circulars and notifications clarifying the implementation of the PPT in India.
• Professional tax advisors with expertise in international tax laws.

Authored by: CA Rohit Rajendra Sonar, Associate Chartered Accountant (ACA), Proprietor of Rohit R Sonar & Associates