The principal purpose test (“PPT”) has been introduced into the Indian double taxation avoidance agreement (“DTAA”) lexicon through the base erosion and profit shifting (“BEPS”) project of the Organisation for Economic Cooperation and Development (“OECD”) to dissuade sophisticated taxpayers from entering into transactions aimed at tax avoidance. The requisite amendments to the DTAAs have been made via multilateral instruments (“MLIs”).
If the tax authorities invoke PPT provisions, they may deny DTAA benefits to the taxpayers if it is reasonable to conclude that obtaining these benefits is one of the main objectives of the transaction. However, if the taxpayer can demonstrate that the decision to structure the investment through a particular jurisdiction is backed by legitimate commercial reasons rather than solely for the purpose of claiming DTAA benefits, then the DTAA benefit may be permissible.
Since the PPT is a new concept, the legal landscape and jurisprudence around its application is still evolving. Consequently, any ambiguity regarding its precise interpretation and scope will get decided in due course.
Against this backdrop, it is an opportune moment to analyse the Hon’ble Delhi Income Tax Appellate Tribunal’s (“ITAT”) recent decision in SC Lowy P.I. (LUX) S.A.R.L. v. ACIT (“SC Lowy case”)[1]. The ITAT interpreted PPT under the India-Luxembourg DTAA, as modified by the MLI.
Factual background
Established in 2015, SC Lowy P.I. (Lux) S.A.R.L. (“SC Lowy”) is a limited liability company, incorporated in Luxembourg. It is also registered as a Category II foreign portfolio investor (“FPI”) with the Securities and Exchange Board of India (“SEBI”) in India. SC Lowy is a wholly-owned subsidiary of a private equity firm based in the Cayman Islands and invests in various Indian debt instruments, including bonds, non-convertible debentures, and pass-through certificates from securitization trusts, etc., in India.
During the relevant year, SC Lowy earned income from its investments in alternate investment funds (“AIFs”), securitization trusts, sale of Indian debentures, etc., in India. It claimed that it is entitled to the following benefits available under the India-Luxembourg DTAA:
- exemption on capital gains from selling securities; and
- liable to pay tax at a reduced 10% on its interest income, since it is the beneficial owner.
However, the learned Assessing Officer (“AO”) did not agree with these claims. According to the AO, SC Lowy merely functioned as a conduit entity with very little genuine economic substance and it was set up in Luxembourg mainly to claim the beneficial rate of tax advantage available under the DTAA, especially since India does not have a tax treaty with the Cayman Islands. The AO denied the benefits under the DTAA by holding that a tax residency certificate (“TRC”) issued by the Luxembourg tax authorities is not sufficient for SC Lowy to get benefits under the India-Luxembourg DTAA without clear evidence of commercial rationale. The AO further stressed that its real owner is its holding company. It was also alleged that SC Lowy is not the beneficial owner of the income generated by it and hence, it is not entitled to the DTAA benefits. The dispute resolution panel (“DRP”) also upheld this decision, which led to SC Lowy challenging the decision before the ITAT.
Decision of the ITAT
The ITAT, however, was of the view that a valid TRC should be regarded as sufficient proof of tax residency and it should enable a taxpayer to claim DTAA benefits. It also held that PPT invocation should be restricted to the rarest of cases involving tax fraud, sham transactions, camouflaging of illegal activities, etc. It further held that the establishment of these charges should satisfy further stringent and onerous standards of proof, through submission of cogent and convincing evidences, but should not be decided based on mere suspicion.
After a thorough factual analysis, the ITAT found that SC Lowy has demonstrated genuine commercial substance in Luxembourg. The company was incorporated in 2015, well before the PPT was introduced. It has a diversified investment portfolio with about 86% of its investments outside India. The ITAT also noted that SC Lowy has paid taxes on its global income in Luxembourg, incurred significant operational expenses, and maintained control over all its investments, thereby establishing its beneficial ownership over such investments. Without concrete evidence from the tax authorities to the contrary, the ITAT determined that SC Lowy had demonstrated that obtaining DTAA benefits was not the primary purpose of investing from Luxembourg. Consequently, PPT should not be invoked to deny DTAA benefits to SC Lowy.
Further clarification on application of PPT
Shortly after the SC Lowy ruling, the Central Board of Direct Taxes (“CBDT”) issued a circular (“Circular”)[2] clarifying the application of PPT in respect of DTAAs executed by India. The Circular reiterated that PPT will be applied only prospectively, from the date the MLI or relevant bilateral DTAA amendment came into force, ensuring no retrospective taxation on past transactions.
The Circular also reconfirms that grandfathering provisions would be available for investments in shares of Indian companies before April 1, 2017, by residents of Mauritius, Singapore, and Cyprus and investments made by them shall continue to be exempt from PPT. However, other income streams, such as interest on non-convertible debentures, are not covered by this exemption and may be subject to PPT. The Circular also encourages the tax authorities to apply PPT contextually through objective, fact-based assessments, and not to disregard commercial rationale without evidence.
Significant Takeaways
The concept of PPT has changed the way income from tax friendly jurisdictions is taxed, by shifting from relying solely on TRC to scrutinising the underlying purpose of investment structures. Effectively, even though foreign investors can rely on TRCs to avail DTAA benefits, they would still be required to factually demonstrate genuine commercial substance to avoid invocation of PPT. This involves creating proper commercial rationale and robust documentation, such as financial records and proof of operational expenses, reasons to move out of home jurisdiction, having control over investible funds and returns thereon to establish beneficial ownership, etc. If the entity invests in multiple jurisdictions, it strengthens the factual matrix.
The SC Lowy case and the subsequent CBDT Circular require the Indian tax authorities to conduct fact-based, context-specific assessments when invoking PPT provisions. This approach gives foreign investors a clearer framework for navigating India’s tax regime and securing DTAA benefits. While these developments may have raised the compliance bar, providing significant clarity and requiring businesses to proactively substantiate their operational substance and investment motives allows businesses to begin their preparations immediately, marking a significant step forward.
It is also pertinent to note that 86% of the total investments made by SC Lowy were outside India and it may not be possible for every investor to emulate such a feat in the coming days. It will be interesting to see how the judiciary interprets these situations. Till such time, one will have to find one’s way in these troubled waters!
[1] S.C. Lowy P.I. (Lux) S.A.R.L. v. ACIT, [TS-972-ITAT-2024(DEL)]
[2] Guidance for Application of the Principal Purpose Test (PPT) under India’s Double Taxation Avoidance Agreements, Circular No. 1/2025 (January 21, 2025).