With a view to curb tax avoidance across various developed and developing countries, OECD Action Plan 15 provided for development of a Multilateral Instrument (‘MLI’) to counter abuse of Tax treaties or Tax treaty network for gaining tax advantages. Under the MLI provisions, Article 7 (which deals with prevention of treaty abuse and is applicable as a minimum standard) prescribes Principal Purpose Test (‘PPT’) as one of the measures to prevent treaty abuse. While India has opted for the PPT rule under MLI, it has also implemented General Anti-Avoidance Rules (‘GAAR’) under its domestic law for countering tax abuse, which also provided for Principal Purpose Test (‘PPT’).

In this regard, Kinjesh Thakkar (Head – Corporate Tax & Transfer Pricing at Linde Engineering India) provides a lucid analysis of Interplay between PPT under MLI and GAAR. The author highlights that the approaches in application of Principal Purpose Test under MLI and GAAR are divergent and states that while GAAR adopts the narrow approach (i.e., main/principal purpose is to obtain tax benefit), MLI adopts the intermediate approach (i.e., one of the main/principal purposes is to obtain tax benefit), thus, creating confusion. The author explains that domestic law is the prime source of charge on tax as well as characterization of transaction or arrangement, “Thus, it is reasonable to conclude that PPT under MLI shall not displace GAAR”. Similarly, the author explains that based on commentary in OECD and Vienna convention, PPT is also not displaceable and therefore, both should co-exist. Highlighting that even O­ECD commentary on Model Tax Convention provides that in case there is conflict in result of GAAR and MLI, the provisions of tax treaties are intended to prevail, the author opines that “...broader definition under PPT rule of MLI shall achieve more desirable result which is in line with purposive interpretation when applied to GAAR provision.”

“Interplay between PPT under MLI and GAAR”

Interplay between PPT as per Multilateral Instrument and GAAR

Introduction

Bilateral Tax treaties negotiated between countries have defined taxing rights between treaty partners. However, there remains certain differences in treaties due to various reasons including the same being negotiated over different periods in time. Such difference in treaty network of a country with other country, different treaty provisions between bilateral tax treaty partners and differences in domestic Income Tax law of multiple countries have created opportunities for taxpayer to legally shift profit from one jurisdiction to another, thereby diverting the right of tax artificially to some other country than the country which should be eligible for. This is commonly referred as Base Erosion and profit Shifting (‘BEPS’).

Such tax avoidance has huge concern globally across various developed and developing countries. To address the same OECD Action Plan 6 provided for developing a Multilateral Instrument (‘MLI’) to counter abuse of Tax treaties or Tax treaty network for gaining tax advantages. MLI provides for Minimum Standard i.e.  to adopt Article 6 and Article 7 of the convention for countering treaty abuse. Amongst Article 7 one of the measures to prevent treaty abuse is Principal Purpose Test (‘PPT’).

India has adopted PPT rule under MLI which has also been adopted by more than 70 countries to make it effective. Similarly, India has also implemented General Anti-Avoidance Rules (‘GAAR’) under its domestic law for countering tax abuse which also provided for Principal Purpose Test (‘PPT’).

Principal Purpose Test under MLI and GAAR

As per Article 7 of MLI, PPT reads as 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”

Thus, the PPT rule provides for denial of treaty benefits when one of the principal purposes is to obtain tax benefit.

Domestic law of India provides for application of GAAR to Impermissible Avoidance Arrangement (‘IAA’). To determine an arrangement as Impermissible Avoidance, section 96 of Indian Income Tax Act provides for PPT rule. The same is read as under:

“An impermissible avoidance arrangement means an arrangement, the main purpose of which is to obtain a tax benefit”

Thus, GAAR applies when main purposes is to obtain tax benefit.

Approaches on application of PPT

Normally three approaches surround PPT rule,

1. Narrow – Main/principal purpose is to obtain tax benefit

2. Intermediate – One of the main/principal purposes is to obtain tax benefit

3. Broad – One of the purposes is to obtain tax benefit

Referring to provisions in second part above, it is very clear that MLI and Indian Income Tax Law are divergent in approach of PPT rule. GAAR provisions has adopted narrow approach whereas under MLI intermediate approach is adopted. This creates confusion.

Issues requiring consideration

1. The pertinent question that arises is Provision of PPT under MLI should only apply or provision of GAAR should only apply or both can co-exist?

2. What should be the result in case of conflicting result between GAAR and PPT under MLI? Which provision shall prevail?

Interplay between PPT under MLI and GAAR – Analysis & Interpretation

MLI on its own has no existence without charge of tax on income by a country. It is when domestic law of countries charges income tax, Bilateral tax treaties assist in allocating such taxing rights between them. Domestic law is prime source of charge on tax as well as characterization of transaction or arrangement. Thus, it is reasonable to conclude that PPT under MLI shall not displace GAAR. To supplement same, OECD commentary[1] on Model Tax convention also affirms and highlights the role of domestic law in preventing tax abuse as “important”. Thus, PPT alone cannot be applied.

Further, where GAAR cannot be displaced & same being narrow still results in denial of tax benefit, PPT under MLI is redundant. Therefore, in such a scenario, practically, application of GAAR alone is reasonable and sufficient.

However, sometimes GAAR may results in approving tax benefit due to restricted scope, which if broader perspective would have been adopted could have been otherwise. Thus, in such scenario shall PPT as per MLI needs to be applied?

To this it is important to refer intent of parties.  Executive summary of MLI provides for intent of MLI as under (extract):

“…..objective to strengthen the current system by putting an end to BEPS, in part by modifying the

bilateral treaty network.”

Further, intent of introducing GAAR is similar to object as mentioned in report of MLI. Memorandum to Finance Bill,2012, provided as below (extract):

“In an environment of moderate rates of tax, it is necessary that the correct tax base be subject to tax in the face of aggressive tax planning and use of opaque low tax jurisdictions for residence as well as for sourcing capital. Most countries have codified the “substance over form” doctrine in the form of General Anti Avoidance Rule (GAAR).”

Thus, intent of MLI and intent of GAAR is aligned in this respect i.e. to curb BEPS which artificially shifts profits and tax base outside a country. Further, it is important to note that Article 26 of Vienna Convention on the Law of Treaties provides for principle of "pacta sunt servanda" which provides that

“every treaty in force is binding upon the parties to it and must be performed by them in good faith.”

MLI amends the Bilateral tax treaty and therefore, PPT as per MLI should be applied as per principle of Article 26 of Vienna Convention. A material breach of a treaty by one of the parties entitles the other to invoke the breach as a ground for terminating the treaty or suspending its operation in whole or in part as per Article 60 of Vienna Convention. The same is also specifically provided in commentary[2] to OECD model tax convention.

Thus, based on intent, commentary in OECD and Vienna convention, PPT is also not displaceable and therefore, both should co-exist.

The last part of analysis is what if there is conflict in result of GAAR and PPT. OECD commentary[3] on model tax convention provides that where the application of provisions of domestic law and of those of tax treaties produces conflicting results, the provisions of tax treaties are intended to prevail. This is a logical consequence of the principle of "pacta sunt servanda" which is incorporated in Article 26 of the Vienna Convention on the Law of Treaties.

Moreover, where intent is to curb the tax abuse, broader definition under PPT rule of MLI shall achieve more desirable result which is in line with purposive interpretation when applied to GAAR provision.

Conclusion

Internationally, tax avoidance has been recognized as a concern area and several countries across the globe have expressed concern over tax evasion and avoidance. MLI is historic in terms of curbing tax evasion and BEPS. MLI is effective in India with effect from 01 April 2020 and it would be important for government to come out with clarification on the above issue.

Disclaimer

The views expressed in this article are strictly personal views of the author. Neither the views nor the analysis constitutes a legal opinion and are not intended to be an advice. In case of any query, please discuss with your consultant.

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