Harshavardhana Datar – [2026] 187 taxmann.com 398 (Article)
1. The Principal Purpose Test (PPT) is one of the most significant modern tools used in international taxation to combat tax evasion and treaty shopping. Introduced primarily through the OECD’s Base Erosion and Profit Shifting (BEPS) Action 6 and incorporated into Double Taxation Avoidance Agreements (DTAAs) via the Multilateral Instrument (MLI), it completely changed how tax treaties are interpreted.
2. Its main goal is to deny treaty benefits (such as lower withholding taxes on dividends, interest, or royalties) if it is reasonable to conclude that obtaining that tax benefit was one of the principal purposes of the arrangement or transaction.
3. The Two-Pronged Test:
To apply the PPT, tax authorities generally look at two criteria:
A. The Objective Test (The “One of the Principal Purposes” standard): Would a reasonable person, looking at all relevant facts and circumstances, conclude that obtaining a treaty benefit was one of the principal purposes of the arrangement or transaction? (Note: It doesn’t have to be the sole purpose, just a major one).
B. The Subjective/Exception Test: Can the taxpayer prove that granting the treaty benefit in these circumstances aligns with the object and purpose of the relevant provisions of the DTAA? If yes, the benefit is granted despite the tax motive.
4. Before going into the debate. One must keep basic things in sight, like DTAA, which are agreements between sovereign states. Constitutional provisions have enabled the state to enter and to implement. However, these agreements cannot affect the rights of citizens of India, unless a law is passed by parliament to that effect. In other words, Fundamental or Constitutional Rights of citizens of India are subject to reasonable restrictions that are imposed by laws. Laws are made by parliament, and agreements are something less than the law, even if ratified by parliament later. So, these agreements are never at par with laws passed by parliament. Even if there are statutory enabling in section 90(2) in Income Tax 1961, it has been made subject to 90(2A). Both subsections have to be read in harmony. Similar enactments can be seen in Section 159 of the Income Tax Act 2025, too.
5. So, the rules of interpretation of statutes cannot be applied to them. Interpretation of them must be contextual, purposive, ambulatory and in good faith. The selective application of words, applying dictionary meaning to the words in treaties, is not permitted. Even the literal interpretation rule has to be adjusted for the context. Test of substance over the form has to be applied everywhere, whether expressly mentioned or not. The rule of special provisions overrides general provisions cannot be applied, especially if it makes some other clauses redundant or goes against the substance test. This part is going to be the most important foundation of this discussion. This is arising from judgment in Union of India v. Azadi Bachao Andolan [2003] 132 Taxman 373/263 ITR 706 (SC).
6. It is necessary to refer to the principles of good faith interpretation. Article 31 of the Vienna Convention of Law on Treaties (VCLT) is not textually binding as such, as India is not a signatory to VCLT, but the state has accepted Article 31 of VCLT as codification of customary law. It can be taken as a broad guideline as to what could be an appropriate manner of interpreting a treaty in the Indian context. This is arising from cases like Ram Jethmalani v. Union of India [2011] 12 taxmann.com 27/200 Taxman 171/339 ITR 107 (SC) or Assessing Officer (International Taxation) v. Nestle SA [2023] 155 taxmann.com 384/296 Taxman 580/458 ITR 756 (SC). Once we concede to good faith rules, everything changes. It is said via Multilateral Instrument (MLI), that a treaty is a living instrument meant to eliminate double taxation without creating opportunities for non-taxation through tax evasion or avoidance, but the same can be said to be inherently present even before the advent of the MLI era as a corollary of good faith rules under VCLT.
7. By applying the PPT concept, treaty shopping can be negated. Limitation of Benefit clause (LOB), if present textually, can also be used for this, but LOB is a definitive test. PPT is a tentative/subjective test. In other words, both are not mutually exclusive. Both can be used to deny DTAA benefits. In a real-life scenario, either one can be invoked to deny the treaty benefits, even if the other is complied with. PPT allows application to each case based on the facts. LOB gives a strict set of conditions, and once the assessee complies with them, it is difficult for the revenue to overturn them, but on the other hand, PPT is always open to interpretation on both sides. When the LOB is complied with, revenue can invoke General Anti-Avoidance Rules (GAAR) to remove the application of DTAA. In some cases, wherein the LOB clause is not textually mentioned in the relevant DTAA, the substance test or beneficial ownership test can still be applied, especially when we agree that the DTAA has to be interpreted purposively and in good faith.
8. Substance Test or PPT or Good Faith Interpretation rule in VCLT, all operate in systemic harmony to form a reinforced, multi-layered defence against treaty abuse, but they are not inherently or doctrinally the same, at least for academic purposes. In fact, when one of them is invoked or mentioned in some administrative, adjudicatory or judicial order, the application of the other has to be read in and should not be treated as an exclusion of the other.
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