Aditya Narwekar - Partner, Deals, PwC India
Himanshu Aggarwal - Associate Director, Deals, PwC India

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Principal purpose test under MLIs: what it changes for the tax treaties worldwide

Print Document  12 June 2020

The OECD recognised that governments lose substantial corporate tax revenue because of aggressive international tax planning, which artificially shifts profits to locations where they are subject to non-taxation or reduced taxation. In its efforts to end base erosion and profit shifting (BEPS), and tax avoidance strategies that exploit gaps and mismatches in tax rules, the OECD conceptualised and implemented the Multilateral Instrument (MLI), which amends numerous bilateral tax treaties together. Over 90 jurisdictions have signed the multilateral convention to implement tax treaty related measures to prevent BEPS. The MLI offers a solution for governments to plug loopholes in international tax treaties by transposing results from the BEPS project into bilateral tax treaties worldwide, without the need to negotiate each bilateral agreement individually. India deposited its instrument for ratification on 25 June 2019, and the MLI is now effective from 1 April 2020 for its bilateral agreements or Double Taxation Avoidance Agreements (DTAAs) with 23 countries.

The MLI does not work like a protocol amending the treaty, but works alongside the existing treaty provisions by modifying or replacing them. While India embraces this significant change, it is necessary to consider some predominant aspects while transacting with entities in any of these 23 countries in light of the MLI. This includes the anti-treaty abuse related provisions that are agreed 'minimum standards,' i.e., modification of the preamble text of the tax treaties and inclusion of the Principal Purpose Test (PPT).

The first aspect that requires cognisance by the entities is the modification of the preamble text of the tax treaties, which lays out the purpose and object of the MLI. The modified preamble makes it clear that tax treaties are only to be used as a mechanism for eliminating double taxation, not as a means for non-taxation or reduced taxation through tax evasion or avoidance. It also specifically mentions that treaty-shopping arrangements aimed at obtaining reliefs for the indirect benefit of residents of a third jurisdiction shall constitute tax evasion or avoidance. With this as a minimum standard for a preamble, every entity whose income is to be dealt with under the tax treaties will have to apply the provisions of the tax treaties considering this purpose and object. This may result in the questioning and curbing of tax planning measures under the tax treaties, which were legitimate earlier. This has raised concerns on the validity of Indian jurisprudence on treaty shopping, namely, the case of Azadi Bachao Andolan (Union of India v. Azadi Bachao Andolan [2003] 132 Taxman 373 (SC)), which granted treaty benefits subject to satisfaction of conditions under the Indian tax laws and the DTAAs. One major outcome of this case was that tax planning under a tax treaty was not frowned upon and was considered an economic decision taken by an entity. However, it would now be necessary to revisit the principals laid down by the Supreme Court in Azadi Bachao Andolan (supra) considering the preamble text in Article 6 of the MLI.

The second aspect is the inclusion of PPT. This would deny treaty benefits when it is reasonable to conclude that obtaining such tax benefit is one of the principal purposes for entering into a specific transaction or arrangement unless it is established that the benefit obtained is in accordance with the object and purpose of the relevant provisions of the tax treaty. While the PPT has several substantive and interpretive implications, it also raises many procedural questions. Primarily, is the PPT a matter of self-assessment or will its application be at the discretion of the tax authorities? In addition, one needs to consider the burden of proof for PPT and on whom does it fall–tax authorities or taxpayers? These questions have significant ramifications in granting treaty benefits, especially at the time of tax withholding, where the payer may not always know the purpose for which the payee is entering into the transaction and claiming treaty benefits.

Note also the interplay of the General Anti-Avoidance Rule (GAAR) under the Indian domestic tax law and the PPT under MLI. The Indian GAAR triggers when the 'main purpose' is to obtain tax benefit, whereas the tax authorities may invoke PPT when 'one of the principal purposes' is to obtain tax benefit. There is no specific approval required to invoke PPT and there are no thresholds prescribed, unlike the Indian GAAR, which the authorities may invoke only when the tax benefit obtained is more than INR 30m, and it requires the tax officer (TO) to approach the approving panel to obtain necessary directions to invoke GAAR. The PPT requires obtaining tax benefit as one of the principal purposes; thus, it results in subjectivity and higher degree of discretion in the hands of TOs, which may result in exploitation of taxpayers.

If an entity is considering moving its base/ operations from one country to another, tax will always be an inescapable element among all other commercial considerations. How can one substantiate that tax is not one of the principal purposes among other commercial purposes? Can the authorities invoke the PPT clause if an entity merely has a holding entity in another jurisdiction with a beneficial tax treaty with its home jurisdiction and undertakes a transaction? How should one justify that tax considerations do not drive the intent for moving but purely commercial aspects?

For instance, the India-Singapore tax treaty has a limitation of benefits (LoB) clause with regard to capital gains (for shares acquired prior to 1 April 2017), which limits the benefit provided for taxation of capital gains in case LoB conditions are not satisfied. However, the India-Netherlands tax treaty does not have a LoB clause, and hence, a company in the Netherlands may avail the benefits of the tax treaty without complying with any such conditions. After MLI, and because of the insertion of the PPT clause, might the authorities now deny the tax benefit under the India-Singapore tax treaty even after meeting the conditions under the LoB clause? Alternatively, in case of tax treaties without the LoB clause, such as the India-Netherlands tax treaty, what will be the treatment of such treaties in comparison to tax treaties with the LoB clause? In other words, even without the LoB clause, the tax authorities may deny the tax benefits. This will open a plethora of litigations and is prone to misuse by tax authorities applying a disruptive interpretation of the intent.

Under the GAAR, it is possible to prove that a particular transaction is driven by commercial characteristics and the tax benefit is a by-product. However, under the PPT, it becomes extremely difficult to prove that the tax benefits obtained are merely a consequence of the transaction. This is because the ambit of the PPT is much wider than the GAAR. However, if the intent of the transaction is entirely on commercial grounds and is in accordance with the preamble of the tax treaty, then one may take a view, obviously not free from litigation, that PPT should not be invoked in such cases.

Therefore, it is now imperative to document the commercial purpose and rationale behind a transaction appropriately. It would be prudent for companies to maintain robust documentation to safeguard their positions from a withholding tax perspective and avoid consequences under Indian laws. However, this also creates a challenge of obtaining the required documentation from foreign vendors or service providers (especially third parties) to prevent attracting the PPT clause. Additionally, the taxpayer may also consider undertaking preliminary due diligence to determine its withholding tax liability under the tax treaty with regard to the PPT. Note that the tax benefit may not accrue at the time of the transaction and the tax authorities may also question transactions in which the tax benefit may accrue in future. For instance, in case of Indian shares transferred among jurisdictions to avail lower withholding tax rates under the tax treaty, the tax authorities may attempt to question such transactions also, whether any actual tax benefit is accrued or not.

In addition, similar provisions have been introduced in the MLI, some of which are mandatory, and others that are optional, and therefore, would apply if both the signing countries of MLI opt for the same provision. One such instance is for withholding tax on dividend payouts. Under the MLI, a minimum shareholding period has been introduced that must be satisfied, in addition to the existing conditions in tax treaties, which provide for a lower tax rate, if the beneficial owner or the recipient is a resident of the other contracting jurisdiction, owns, holds or controls more than a certain amount of the capital, voting rights or similar ownership interests of the company paying the dividends. These conditions must be met throughout a 365-day period, including the day of payment of dividends, to be eligible for such lower tax rate. However, change in ownership due to a corporate reorganisation, such as a merger or demerger, is not to be considered for the above purpose. Therefore, companies may not be able to take advantage of beneficial tax rates by transferring shares to a favourable jurisdiction to avail a lower withholding tax rate just before the payment of dividends, and they would need to abide by the cooling-off period.

This is also relevant today, because effective 1 April 2020, India has abolished dividend distribution tax and replaced it with the traditional mode of tax collection, i.e., withholding tax. Where a Dutch or a Singapore company receiving dividends is subject to withholding tax in India at a rate of 10% (under the India-Netherlands or under the India-Singapore tax treaty), a similar company in Slovenia is subject to withholding tax at a rate of 5% (under the India-Slovenia tax treaty). Hence, any movement of Indian shares between geographies and subsequent dividend payouts would need to be tested under the MLI provisions also.


After MLI, companies will have to prepare themselves for additional work, such as maintaining and obtaining additional documentation, evaluation of existing structures, and re-examining current tax practices and positions. Owing to the nature of the PPT, it may result in more tax litigation. It is necessary to test the preamble to tax treaties and the PPT in court for further clarity on its practical application. As on date, India"s tax treaties with 23 countries are modified on the lines of the MLI (notably, those with Singapore, Netherlands, Japan, UK and France). More tax treaties will come under its purview, effective 1 April 2021, and subsequently.

Author: Aditya Narwekar - Partner, Deals, PwC India and Himanshu Aggarwal - Associate Director, Deals, PwC India.

The views expressed in this article are personal. The article includes input from Rajath KS – Associate, Deals, PwC India


Disclaimer: The views expressed in this article are personal. The publisher or the author disclaim all, and any liability and responsibility, to any person on any action taken on reliance of it




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