The Multilateral Instrument or MLI provisions came into force on October 01, 2019. Article 7 of the MLI is a minimum standard on treaty abuse. It corresponds to Article 6 of the Base Erosion Profit Shifting Plan 6 – ‘Preventing the granting of treaty benefits in inappropriate circumstances’, the final report on which recommended the introduction of one of the following three new treaty provisions as a minimum standard to address treaty abuse:

1. The Principal Purpose Test (‘PPT’) only, a general anti-abuse rule based on the principal purpose of the transaction or arrangement;
2. A simplified or a detailed Limitation of Benefit (‘LOB’);
3. A detailed LOB, along with mutually negotiated mechanism to deal with conduit arrangements not already dealt with in tax treaties.

Parties to the treaties have an option to apply the Simplified LOB (‘SLOB’) as a supplement to the PPT by making a notification to that effect. However, the SLOB applies to a Covered Tax Agreement (‘CTA’) only when both treaty partners have chosen to adopt it. In case one treaty partner does not adopt the SLOB, the PPT applies systematically. India, in most of its treaties, has chosen to apply the PPT along with the SLOB; however, most treaty partners have chosen to apply only the PPT. Accordingly, as per the compatibility rules, only the PPT will apply to such tax treaties.

The PPT test requires (a) it should be reasonable to conclude that (b) obtaining the benefit under the CTA is one of the principal purposes of the transaction or arrangement and (iii) granting of the benefit is not in line with the object and purpose of the relevant article the CTA.

India has amended its tax treaties with Mauritius, Singapore, and Cyprus to allocate India the right to tax capital gains arising on the transfer of equity shares acquired after 1 April 2017, and all prior acquisitions were grandfathered for capital gains in India.

With the introduction of PPT in such tax treaties pursuant to the MLI (say in the case of Mauritius), it was not clear if the PPT test will have to be complied with even in the case of grandfathered transaction and this Circular by the Central Board of Direct Taxes (‘CBDT’) is an attempt to resolve the uncertainty and provide clarity on such grandfathered transactions.

Clarification by CBDT

The CBDT vide Circular No. 1/2025 dated January 21, 2025, has issued certain clarifications on applicability of PPT introduced in DTAAs through MLI Convention. The clarifications are summarised hereunder:

1. Period of Applicability of PPT :

It has been clarified that PPT shall apply prospectively. Further, the effective period for applicability of PPT provisions has been summarised below:

2. PPT and Treaty Specified Bilateral Commitments :

With respect to the treaty – specific bilateral commitments in the form of grandfathering provisions in treaties executed by India with Mauritius, Singapore, and Cyprus, it has been expressly clarified that such provisions  are not intended to interact with the PPT and shall remain outside the purview of PPT provisions.

3. Additional Guidance for Applicability of PPT :

CBDT has suggested the following additional/supplementary sources of guidance that can be considered by the Tax Authorities before invoking PPT:

• Final Report on Base Erosion and Profit Shifting (‘BEPS’) Action Plan 6, subject to India’s reservations.
• The Commentary to Articles 1 to 29 of United Nations Model Conventions (updated in 2021) is subject to India’s reservations.

The CBDT has also emphasized that applicability of PPT provisions must be a context-specific and fact-based exercise that must be conducted on a case-by-case basis, considering objective assessment of facts and circumstances.

KNAV Comments

1. The CBDT circular on applicability of PPT is a welcome move reflecting the Government’s commitment to honouring its bilateral commitments under tax treaties with other countries and will certainly boost investor confidence.

2. The clarification regarding prospective applicability of PPT provisions will assist in resolving uncertainties among taxpayers, especially corporate taxpayers, with respect to transfer of shares that have been acquired prior to introduction of grandfathering and PPT provisions in the tax treaties.

3. On the interplay of GAAR with PPT, it must be noted that the GAAR provisions are narrower than the PPT as GAAR applies if the ‘main purpose’ of the arrangement is to obtain a tax benefit. Further, the Income Tax Act (‘Act’) provides that GAAR provisions will not be applicable to investments acquired before 1 April 2017. Accordingly, transfer of shares acquired prior to 1 April 2017, will now be grandfathered both under the Act and the PPT.

4. Impact on India – Mauritius Treaty: The clarification on grandfathered clauses in the treaty being outside the purview of PPT is a welcome clarification, specially in light of the 2024 protocol proposing to incorporate the minimum standards of anti-abuse provisions signed between India and Mauritius dated March 07, 2024 (even though not effective). The language of the 2024 protocol created ambiguity in so far as prospective or retrospective applicability of the PPT was concerned. The current CBDT clarification make it very clear that PPT will not be applicable to grandfathered transactions. A similar position will apply with respect to India’s treaties with Singapore and Cyprus.

5. While the CBDT circular provides sound guidance on applicability of PPT, the taxpayer must bear in mind that Revenue Authorities, in view of past judicial precedents, may still question the transaction in case of a fraud or sham transaction where there is no economic substance, or the transaction is aimed at camouflaging illegality. Accordingly, the test of substance over form may still be relevant while evaluating the granting of treaty benefits. However, the onus to prove that the arrangement is a sham would be on the Revenue Authority.

6. On an overall basis, the clarification will serve to resolve ambiguities arising from diverse interpretations of the applicability of the PPT and avoid potential litigation to this effect.