Can Principal Purpose Test and GAAR apply when Specific Anti-Avoidance Provisions are not applied to a covered Tax Agreement?
Executive Abstract & Jurisprudential Scope
“Multilateral Instrument (‘MLI’) is historic in terms of curbing tax evasion. It has been effective in India with effect from 01 April 2020. As per MLI, Principal Purpose Test (‘PPT’) is one of the minimum standards. However, other provisions to implement specific Base Erosion and Profit Shifting (‘BEPS’) measures referred as specific anti-avoidance rules are optional for which countries may not opt in for the same limiting application of MLI. However, analysis is made to understand as to whether PPT being a minimum standard of MLI can apply in absence of such specific anti-avoidance rules for such Covered Tax Agreements (‘CTAs’). Read on…”
1. Introduction: The MLI Architecture & Treaty Abuse Framework
Bilateral Tax treaties define taxing rights between treaty countries. However, based on loopholes in tax treaty network, various arrangements have been devised to avoid fair share of taxes. To address the same, Multilateral Instrument (‘MLI’) provides for Article 6 and Article 7 as minimum standards for countering treaty abuse.
Article 6 of MLI – Purpose of Covered Tax Agreement (‘CTA’)
Article 6 provides text that should be included in the Preamble of Covered Tax Agreements. It states that the jurisdictions intend to avoid creation of opportunities for non-taxation or reduced taxation through tax evasion or avoidance, and through treaty shopping. The preamble text reads as below:
“Intending to eliminate double taxation with respect to the taxes covered by this agreement without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping arrangements aimed at obtaining reliefs provided in this agreement for the indirect benefit of residents of third jurisdictions),” (Emphasis supplied).
Article 7 of MLI – The Principal Purpose Test (‘PPT’)
Another minimum standard, Article 7, introduces the Principal Purpose Test (‘PPT’) to prevent treaty abuse. As per the said rule, treaty benefits are denied when one of the principal purposes is to obtain tax benefit. The bare text of the rule is provided below:
“Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement” (Emphasis supplied).
Apart from above, there are specific anti-avoidance provisions included in CTA like Limitation of Benefit clauses, Minimum Holding period in case of dividend for application of lower tax rate, countering Permanent Establishment avoidance by Splitting up contracts etc. Such provisions for ease of reference are termed as “Specific anti-avoidance rules” (“SAAR”) in CTAs. However, on account of the nature of MLI, countries may opt-in or opt-out of such provisions of MLI which means that it normally applies only if both the contracting jurisdictions accept these specific anti-avoidance rules.
The Core Question: Where a particular CTA is not modified by specific anti-avoidance rules (SAAR), can the PPT rule apply to such transactions or arrangements?
2. Interplay Between PPT and SAAR: Evaluating the Two Competing Views
In this connection, two diametrically opposed views are possible among international tax jurists:
View 1 – Passive Intent
The absence of such rules in a particular CTA indicates the intention of the contracting jurisdictions to grant treaty benefits resulting from transactions.
View 2 – Independent Overriding Application
The absence of this rule in a particular CTA indicates that contracting jurisdictions intend to rely on the PPT rule to challenge these transactions without adopting such detailed, fact-specific, objective limitations.
Whereas View-1 does not require any analysis and is quite clear, analysis of View-2 considering the Commentary to Article 1 of OECD Model Tax Convention (Paragraphs 57 to 65 of OECD Model Tax Convention [2017]), provides that in absence of such specific anti-avoidance rules, PPT is not precluded from its application. This is firmly supported by the following legal grounds:
- Mandatory Preamble Alignment: The minimum standard requires countries to adopt the amended preamble explicitly stating the intention to eliminate double taxation “without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance…”.
- Overriding Non-Obstante Clause: The PPT rule begins with the words “Notwithstanding any provisions of a Covered Tax Agreement…”. This means it has an overriding impact over other provisions of CTA and can operate independently.
- Expansive Scope: Furthermore, the phrase “resulted directly or indirectly in that benefit” in the PPT rule is deliberately not restrictive in nature and is quite broad to cover all transactions without any exclusion.
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Vienna Convention on the Law of Treaties (VCLT): Article 26 of the Vienna Convention on the Law of Treaties provides for the foundational principle of “pacta sunt servanda” which effectively means that:
“Every treaty in force is binding upon the parties and must be performed by them in good faith”.
Hence, based on the above, it would be reasonable to conclude that View-2 is a better and legally sound view.
Practical Demonstration: Article 14 of MLI (Splitting-up of Contracts)
Article 14 of MLI counters contracts that are artificially split-up to avoid Permanent Establishment (PE) in a contracting state. However, Article 14 can be opted out by countries, and many contracting states have done so. However, if a contract is artificially split up, then one of the principal purposes of obtaining tax benefit is satisfied for application of PPT. In such cases, even if specific anti-abuse provisions of Article 14 of MLI are absent in the CTA, PPT being the minimum standard rule, can be applied to counter such treaty abuse.
This effectively means that specific anti-avoidance rules provided in the convention can be looked at as a guiding principle to determine treaty abuse and in the absence of such specific anti-avoidance rules, PPT shall apply.
3. Interplay Between PPT and Domestic GAAR
Commentary to Article 1 of OECD Model Tax Convention (Para 58 [2017]) not only affirms application of PPT in situations where specific anti-avoidance rules are absent, but also provides for possibility of application of General Anti Avoidance Rules (‘GAAR’) under domestic law of countries.
As per the said commentary, taking into account the fact that taxes are ultimately imposed through the provisions of domestic law, as restricted by the provisions of a tax treaty, any abuse of the provisions of a tax treaty could also be characterised as an abuse of the provisions of domestic law under which taxes are levied. Such guidance in commentary can ultimately lead to a conclusion that for these cases, provisions of GAAR as per local laws can apply.
Statutory Dimension of Indian GAAR [Section 96 & Section 98]
Domestic law in India provides for application of GAAR to Impermissible Avoidance Arrangements (‘IAA’). To determine an arrangement as Impermissible Avoidance, Section 96 of the Indian Income Tax Act, 1961 (“the Act”) provides as under:
“An impermissible avoidance arrangement means an arrangement, the main purpose of which is to obtain a tax benefit”.
Thus, GAAR applies to an impermissible avoidance arrangement meaning an arrangement whose main purpose is to obtain tax benefit. As per domestic law, GAAR applies to all domestic as well as international transactions with tax benefit exceeding INR 3 crores. Consequence of application of GAAR is that Tax Authorities can re-characterise, combine, disregard, or reclassify a transaction including reattribution of income as per section 98 of the Act.
| Parameter | Principal Purpose Test (PPT) [Article 7 MLI] | Domestic GAAR [Chapter X-A, Income Tax Act] |
|---|---|---|
| Legal Origin | Bilateral Tax Treaty / Multilateral Instrument (MLI) | Domestic Tax Legislation (Section 95 to 102 of IT Act) |
| Purpose Threshold | “One of the principal purposes” (Lower, broader test) | “The main purpose” (Primary / dominant purpose test) |
| Monetary Threshold | No threshold (Applies to all international transactions) | Tax benefit in aggregate exceeding INR 3 Crores |
| Jurisdictional Reach | Cross-border Covered Tax Agreements (CTAs) | Domestic and cross-border transactions |
| Statutory Consequence | Denial of treaty benefits under the CTA | Re-characterisation, disregarding conduits, combining steps, and reattribution of income (Section 98) |
Most cases may have a specific set of facts where either only PPT or either only GAAR shall apply. However, both apply when there is “a cross border transaction or arrangement wherein the main purpose is to obtain tax benefit exceeding INR 3 crores.”
Harmonious Co-Existence: Why GAAR Cannot Displace PPT and Vice Versa
In such a scenario, it is important to note that GAAR is imposed by domestic tax law which provides for charge of tax. Thus, GAAR is not displaceable which even the Commentary to Article 1 of OECD Model tax convention (Para 58 [2017]) provides to apply. Further, PPT is applicable based on bilateral tax treaties of countries. As per Article 60 of the Vienna Convention on the Law of Treaties, a breach of treaty by one of the parties entitles the other to terminate the tax treaty or suspend its operation either in whole or in part. Thus, GAAR cannot displace PPT which ultimately means both can co-exist.
“Application of PPT shall ensure denial of tax treaty benefits and application of GAAR ensures that Tax Authorities can re-characterise, combine, disregard, or reclassify a transaction including reattribution of income as per section 98 of the Income Tax Act. This ensures appropriate tax revenue is due to the country charging tax on a transaction/arrangement.”
4. Comprehensive Practical Case Study: Conduit Loan & Deemed Dividend
To illustrate the real-world operational interplay of PPT, domestic law, and GAAR, consider the following tripartite transaction structure:
Fact Pattern: The H.Co – S.Co – Financial Institution Arrangement
- Corporate Structure: H.Co, a company incorporated in State H, has a subsidiary in State S namely S.Co.
- Financial Need: H.Co needs funds and S.Co has surplus cash as well as substantial accumulated profits.
- Domestic Tax Rate: Dividend attracts a rate of 20% tax in State S. Domestic law also provides for a rate of 20% on interest income in State S.
- Conduit Arrangement: To avoid dividend distribution taxation, S.Co provides a deposit to a Financial Institution in State X, which in turn provides a loan to H.Co of a similar amount.
- Treaty Position: Interest income from Financial Institution is exempted from tax in State S under the X-S tax treaty.
(State H • Parent)
(State X • Intermediary Conduit)
(State S • Subsidiary with Profits)
Step-by-Step Legal & Tax Determination:
1. Impact of PPT (Denial of Treaty Exemption): Based on PPT, treaty benefits shall not be allowed for the X-S treaty because one of the principal purposes of placing funds with the Financial Institution in State X was to obtain treaty exemption. Thus, interest income shall be taxable in State S at the rate of 20% based on domestic law.
2. Impact of GAAR (Re-characterisation as Deemed Dividend): Further, GAAR shall also apply on the said transaction as the entire arrangement’s main purpose is to obtain tax benefit. If State S would have been India, the entire arrangement avoided deemed dividend or dividend taxation by artificially providing deposit to a Financial Institution which grants the same amount of loan to H.Co. This would have attracted provisions of Section 2(22)(e) of the Income Tax Act of India if a normal loan transaction would have been undertaken.
Cumulative Revenue Assessment: Thus, as per GAAR, the said transaction by S.Co can be re-classified as deemed dividend disregarding Financial Institution of State X. Hence, based on application of GAAR, over and above interest amount, the loan amount shall also be taxable in State S.
Thus, it can be concluded that both GAAR and PPT can co-exist and this gives more means to tax authorities to have a fair share of taxes for their country.
5. Conclusion & Global Tax Outlook
Internationally, tax avoidance has been recognized as a serious concern. MLI is historic in terms of curbing tax evasion and Base Erosion and Profit Shifting (‘BEPS’). MLI is effective in India with effect from 01 April 2020.
The PPT rule is quite broad and can counter all abuses of treaty. Thus, it would be important to consider implications of said rule on any arrangement even if countries have not accepted specific rules of anti-avoidance provided in MLI or GAAR is not part of tax laws.
“Thus, PPT or GAAR does not restrict but supplements specific Anti-avoidance rules to avoid tax abuse.”
Statutory & Commentary Citations
- OECD Model Tax Convention [2017]: Commentary on Article 1, Paragraphs 57 to 65 (Application of PPT in absence of SAAR).
- OECD Model Tax Convention [2017]: Commentary on Article 1, Paragraph 58 (Co-existence of domestic GAAR with tax treaties).
- Vienna Convention on the Law of Treaties (VCLT): Article 26 (Pacta sunt servanda) and Article 60 (Termination or suspension of a treaty as a consequence of its breach).
- Income-tax Act, 1961 (India): Section 96 (Impermissible Avoidance Arrangement), Section 98 (Treatment of IAA), and Section 2(22)(e) (Deemed Dividend).
- Multilateral Convention to Implement Tax Treaty Related Measures (MLI): Article 6 (Purpose of CTA / Preamble) and Article 7 (Principal Purpose Test).