The Principal Purpose Test in India's DTAA: CBDT's New Guidance

Introduction: A New Chapter in International Taxation

Take a company that sets up an entity in a low-tax place such as Mauritius or Singapore. It does this to pay less withholding tax under India’s Double Taxation Avoidance Agreements (DTAAs). In the past, many groups treated this as normal. Tax officials now push back on treaty abuse and on tax avoidance.

India has signed up to the OECD’s project on Base Erosion and Profit Shifting (BEPS). As part of that, it has written the Principal Purpose Test (PPT) into many of its DTAAs. The PPT is a broad anti-abuse rule. It lets the tax office deny a treaty benefit if one of the main purposes of a deal was to get a tax advantage.

One question hung over the rule. Does it apply to past deals, or only to new ones? In Circular No. 1/2025, the Central Board of Direct Taxes (CBDT) settled the point. The PPT applies prospectively. That is relief for investors and for businesses that trade under India’s tax treaties.

So what does this mean for a company that relies on India’s tax treaties? Here is the short version.

What Is the Principal Purpose Test (PPT) and Why Does It Matter?

The PPT exists to stop treaty abuse. The rule works like this:

A tax benefit under a DTAA is denied if one of the main purposes of a deal is to get a tax advantage. The taxpayer can still win the point. It must show that the benefit fits the object and purpose of the treaty.

A company may be lawfully set up in a country with a good treaty. That is not enough. It must show that its presence and its work there have real commercial substance, beyond the tax saved.

For example:

• An investment holding company is set up in Mauritius for one reason. It wants the capital gains exemption. The Indian tax office may now deny treaty benefits under the PPT.

• The company can still claim them. It must show real operations, staff and business activity in Mauritius.

The PPT brings India into line with BEPS Action 6. That is the OECD plan to stop treaty abuse worldwide.

CBDT’s Key Clarifications on PPT Application

The PPT’s start date was unclear. The CBDT issued Circular No. 1/2025 to settle that point. It also made two other clarifications:

1. The PPT Will Apply Prospectively, Not Retroactively

Taxpayers worried that the PPT could reach back into past deals. That would leave old transactions exposed. The CBDT has now confirmed the following:

• Where a bilateral agreement introduced the PPT (Chile, Hong Kong, Iran), it applies from the date the treaty or protocol came into force.

• Where the Multilateral Instrument (MLI) changed the treaty (India’s treaties with France, Japan and the UK), it applies from the date the MLI rules take effect.

India’s MLI came into force on October 1, 2019. So the PPT generally applies from the first day of the next financial year, in cases that involve withholding tax.

A prospective start gives investors more certainty. Past deals will not face a retrospective tax claim.

2. PPT Will Not Override Grandfathering Provisions in Certain Treaties

The CBDT has also said that the PPT will not disturb existing grandfathering clauses in some key DTAAs:

• India-Mauritius DTAA, which protects benefits on investments made before April 1, 2017

• India-Singapore DTAA, on terms similar to those for Mauritius

• India-Cyprus DTAA

Investments covered by these clauses stay protected, even though the PPT now applies.

3. Supplementary Guidance for Applying PPT

The PPT turns on intent, and intent is a matter of judgement. The CBDT has told its officers to follow two international texts:

• The OECD BEPS Action 6 Final Report, which gives examples of treaty abuse.

• The UN Model Tax Convention (2021 update), whose commentary explains how to apply the PPT.

This keeps India in step with global practice. It also cuts the risk that the rule is applied at will.

What This Means for Businesses and Investors

A prospective start, and respect for existing grandfathering clauses, is good news for business. It also brings new compliance work.

1. Increased Scrutiny on Treaty-Based Tax Planning

Many groups rely on India’s low-tax treaty partners: Mauritius, Singapore, Cyprus, the Netherlands and others. They will face closer scrutiny. An entity in a low-tax country no longer secures a treaty benefit by itself. The entity needs:

• Real economic presence: staff, offices and live operations.

• A business purpose that stands on its own, beyond the tax saved.

2. Stricter Tax Audits and Documentation Requirements

The tax office will look closely at a deal. It will ask whether the deal had a commercial reason apart from tax. A company must:

• Keep clear records that show why a cross-border structure exists.

• Expect closer transfer pricing scrutiny in a tax audit.

3. India Aligning with Global Tax Norms

India is moving towards global tax practice, and the OECD’s BEPS framework is the model. Other regions are moving too:

• The European Union is tightening anti-abuse rules in its treaties.

• The US is taking a harder line on “treaty shopping” structures.

A group that operates across borders should now review its global structure against these norms.

Conclusion: A Clearer, But Stricter Tax Regime Ahead

The CBDT’s guidance is a milestone in India’s international tax policy. A prospective start gives cross-border planning more clarity and more predictability.

It also raises the bar. A treaty benefit is no longer automatic. It must rest on real commercial substance and on solid records.

For a group with cross-border structures, three things follow:

• Review the treaty-based planning you rely on.

• Strengthen compliance and the records behind it.

• Expect closer scrutiny from the tax office.

India’s tax rules are changing. A group that adapts early will be better placed than one that waits.