The Principal Purpose Test & Circular 1 of 2015

At first glance, CBDT Circular 1 of 2025 offers little new information. While it clarifies that the Principal Purpose Test (PPT) will not apply to determine the taxability (under treaties with Mauritius, Singapore, and Cyprus) of gains from investments in Indian companies made before April 1, 2017, the Income Tax Department’s track record with Circular 789 offers little assurance that this will be anything more than symbolic.

Reading between the lines, Circular 1 sets terms of engagement. When it comes to the applying the PPT, context is key. Treaty benefits will not be denied, despite an arrangement or transaction having been entered into with the principal purpose of obtaining those benefits, if it is established that granting the benefit would be in accordance with the “object and purpose” of the treaty.

This is typically found in its preamble. The 2017 Multilateral Instrument preamble insert reads: “Intending to eliminate double taxation… without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance (including through treaty-shopping...).” Thus, determining whether granting benefits aligns with a treaty’s “object and purpose” generally hinges on interpreting this preamble, adjusted for treaty-specific variations.

Circular 1 reflects the government’s interpretation. “The PPT is intended to ensure that DTAAs apply in accordance with the objects and purpose for which they were entered into, i.e. to provide benefits in respect of bona fide exchange of goods and services, and movement of capital and persons.”

This is probably a fair characterization. However, does the government have another view? In explaining why the PPT won’t apply to grandfathered investments, the Circular states: “These commitments, as reflected in the bilaterally agreed object and purpose of such provisions, are not intended to interact with the PPT provision.” Since the preambles to the Dutch and Singapore treaties mirror the MLI’s, this language seems to imply that the government sees the object and purpose of grandfathering provisions as discernible from their very language and existence.

Circular 1 also prescribes what supplementary sources of information the ITD may rely on to determine the appropriate circumstances in which to invoke, and manner in which to apply, the PPT. The Commentary to the OECD Model Tax Convention is conspicuous by its absence.

P.S. Last March, concerns over the impact of a Mauritian treaty protocol introducing the new preamble and the PPT led the ITD to clarify that the protocol had neither been signed nor ratified. Circular 1 hints at forthcoming ratification and notification, and is intended, perhaps, to soothe any resulting jitters.