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India tax administration issues guidance on application of Principal Purpose Test
- A new tax Circular provides guidance on how Principal Purpose Test provisions apply in the context of India's tax treaties with other countries.
- The Circular is a welcome development as it offers some certainty on tax implications that could affect foreign investors who have invested in India.
Executive summary
On 21 January 2025, India tax administration's Central Board of Direct Taxes (CBDT) issued a Circular1 providing guidance on application of the Principal Purpose Test (PPT) provisions in the context of Indian tax treaties.
Broadly, the Circular clarifies that PPT provisions would apply prospectively from (i) the date of entry into force of the treaty/amending protocol under which the PPT was introduced pursuant to bilateral negotiations; or (ii) the effective date of provisions introducing the PPT into the treaty through the Multilateral Instrument (MLI).
Further, the Circular clarifies that the grandfathering benefit provided in the Capital Gains Article of the Indian tax treaties with Mauritius, Singapore and Cyprus will remain outside the purview of the PPT and instead be governed by specific provisions of the respective tax treaty.
The guidance from CBDT is a welcome development, as it provides certainty on tax implications for foreign investors who have invested in India.
This Alert summarizes key points from the Circular and relevant considerations for taxpayers.
Detailed discussion
Background
As part of the Organization for Economic Co-operation and Development's (OECD's) Base Erosion and Profit Shifting (BEPS) 1.0 project, the PPT was implemented globally through an MLI (which provides a framework for amending tax treaties between countries to incorporate certain minimum standards to combat treaty abuse/ shopping) that various countries, including India, signed in 2017. Further, India ratified the MLI in 2019.
Broadly, the PPT acts as a means for denying treaty benefits if one of the principal purposes of the arrangement or transaction is to obtain the treaty benefit, unless granting the treaty benefit is in accordance with the object and purpose of the tax treaty.
The provisions of the MLI entered into force on different dates for various countries, depending upon the date of ratification. For India, the MLI entered into force on 1 October 2019, being the first day of the month after expiry of the three-month period that followed the date when India ratified the MLI with the OECD (25 June 2019).
Further, once the MLI has come into force, the effective date of the MLI is determined based on the later of the MLI's coming-into-force dates for the respective treaty partners under consideration.
Current development
The CBDT issued a Circular on 21 January 2025 to provide certainty and clarity on how the PPT provisions apply under India's tax treaties.
Prospective application of the PPT
The Circular clarifies that the PPT provision is intended to be applied prospectively — i.e., when the PPT provision is effective in the treaty, as follows:
- For treaties entered into bilaterally, the PPT will apply from the date of entry into force of the respective treaty.
- If the PPT provision is included bilaterally by way of an amending protocol, the PPT will apply from the date of entry into force of the respective amending protocol.
- For treaties that incorporate the PPT pursuant to the MLI, the PPT will apply from the entry-into-effect date of the MLI provisions in the respective treaty.
Interplay of the PPT with grandfathering provisions under specified Indian tax treaties
India's tax treaties with Mauritius, Cyprus and Singapore were amended to give the source country the right to tax capital gains on the sale of shares acquired on or after 1 April 2017. Gains from sale of shares acquired before 1 April 2017 were grandfathered and taxation rights were restricted to the country of residence.
To address ambiguity around how the PPT applies to the grandfathering provisions, the Circular clarifies that, in India's treaties with Mauritius, Singapore and Cyprus, the specific grandfathering bilateral commitment remains outside the purview of the PPT.
The Circular also clarifies that, although the PPT will not be applicable, specific provisions agreed in the respective treaties (e.g., the Limitation of Benefits clause in the India-Singapore tax treaty) will continue to apply.
Impact
The CBDT guidance on application of PPT provisions is a welcome development as it provides some certainty on tax implications for foreign investors who have invested in India. With the MLI now effective among the majority of India's treaty partners, the PPT provisions have already become applicable across a broad spectrum of international tax agreements. This recent guidance from the CBDT should help businesses understand and navigate the impact of the PPT on their cross-border transactions. Thus, affected investors should carefully evaluate the guidance in light of the various transactions they undertake.
Further, the Circular clarifies India's position on granting grandfathered benefits to treaty residents of Mauritius, Singapore and Cyprus.
For additional information concerning this Alert, please contact:
Ernst & Young LLP (India)
- Pranav Sayta, National Leader, ITTS
- Rajendra Nayak, National Leader, International Corporate Advisory
- Uday Pimprikar, National Leader, Indirect Taxes
Ernst & Young LLP (United States), Indian Tax Desk
- Deep Shah, New York
- Chintan Gala, New York
- Arpita Khubani, New York
- Yash M Shah, New York
- Aditya Modani, San Jose
- Pratik B Kamdar, Chicago
Ernst & Young Solutions LLP, Indian Tax Desk, Singapore
- Gaurav Ashar
Ernst & Young LLP (United Kingdom), Indian Tax Desk, London
- Amit B Jain
- Arihant A Jain
Ernst & Young LLP (United States), Asia Pacific Business Group, New York
- Gagan Malik
- Dhara Sampat
Ernst & Young LLP (United States), Asia Pacific Business Group, Chicago
- Pongpat Kitsanayothin
Published by NTD’s Tax Technical Knowledge Services group; Carolyn Wright, legal editor
For a full listing of contacts and email addresses, please click on the Tax News Update: Global Edition (GTNU) version of this Alert.