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Principal purpose test under BEPS more stringent than GAAR
In June this year, India signed the Multilateral Convention (MLC) to implement tax treaty-related measures to prevent base erosion and profit shifting under the BEPS project.
Principal purpose test under BEPS more stringent than GAAR

Principal purpose test under BEPS more stringent than GAAR

In June this year, India signed the Multilateral Convention (MLC) to implement tax treaty-related measures to prevent base erosion and profit shifting under the BEPS project. MLC seeks to modify a large number of tax treaties. The modification principally works on a reciprocal basis where countries notify (a) the treaties to which they intend to apply the MLC and (b) the provisions of the MLC, which they intend to apply to inpidual treaties.

The MLC, however, incorporates certain minimum standards, which all signatories must adhere to. One of the minimum standards is to counter treaty abuse and requires countries to implement (a) a principal purpose test (PPT) or (b) a PPT along with a simplified limitation of benefits (LOB) clause or (c) a detailed LOB clause, which can be drafted on a bilateral basis.

Since PPT is the only approach that can satisfy the minimum standard, it is the default option under the MLC.

The PPT provides for denial of treaty benefits if it is reasonable to conclude that obtaining a tax benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it can be established that granting that benefit in these circumstances would be in accordance with the object and purpose of the tax treaty. It is manifest that the provision is extremely broad as well as subjective and can be resorted to by the tax officer based on an opinion that he/she forms, given the factual matrix of a case.

The provisions of the PPT do not appear to be too dissimilar from India's General Anti-Avoidance Rules (GAAR), which came into force this year. However, a careful perusal reveals that GAAR is narrower in scope than the PPT. GAAR gets triggered only where the main purpose of an arrangement is to obtain a tax benefit. GAAR also provides for additional tests prior to treating arrangements as impermissible where the arrangement results in (a) creation of rights or obligations, which are not normally created between persons dealing at arm's length; (b) results in abuse of domestic tax law; (c) lacks commercial substance or (d) lacks a bona fide purpose.

GAAR also incorporates a number of additional safeguards in its application whereby there are two administrative and judicial stages, which must be crossed before an arrangement can be held to be "impermissible". The tax officer will initially make a reference to the principal commissioner who, if satisfied that GAAR is to be invoked, will further refer the matter to an approval panel, which should have as its members a retired High Court judge, a Chief Commissioner of Income-tax and an academic or scholar having special knowledge of tax and related matters.

GAAR has been derided as the "mother of all bombs" and "nuclear option" among other cataclysmic words, but it still incorporates several safeguards as it restrains the tax officer to follow an administrative approval process before treaty benefits can be denied. The same cannot be said of the PPT, though.  

Where the PPT is satisfied, it is extremely likely that GAAR will not apply. However, where GAAR does not apply, treaty benefits can still be denied under the PPT. Taxpayers are now looking at a very real possibility that the authorities may not invoke GAAR but instead, deny treaty benefits resorting to the PPT. Such an action will bypass the safeguards provided by GAAR and put the taxpayers in a substantially uncertain, if not worse, position - the phrase "Out of the frying pan into the fire" is mot juste.

All is not lost, though. In paragraph 15 of the commentary on article "Entitlement to Benefits" in Action 6 of the BEPS project, the Organisation for Economic Co-operation and Development (OECD) has recognised that considering the serious nature of disputes in this area, several countries have general anti-abuse rules in the domestic law, which are subject to approval processes. The commentary suggests that countries may wish to establish a similar form of an administrative process that will ensure that treaty benefits are denied using the PPT test only after approval from senior levels of the administration.

The Indian government should promptly lay out the framework based on which the PPT will be administered before the MLC comes into force. Left unfettered, the subjective nature of the provisions may result in abuse, which will fuel additional uncertainty for the taxpayers in an already uncertain international tax environment worldwide.

(The author is partner, international taxation, Nangia & Co LLP.)

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