TAX TRIBUNAL PRONOUNCES INDIA’S FIRST RULING ON PRINCIPAL PURPOSE TEST – RULES IN FAVOUR OF TAXPAYER

Multilateral Instrument (MLI) to implement tax treaty-related measures to prevent Base Erosion and Profit Shifting (BEPS) is a global framework designed to modify and prevent exploitation of tax treaties for tax avoidance purposes. One of the key provisions of the MLI under BEPS Action Plan 6 is the Principal Purpose Test (PPT). It provides that tax treaty benefits will not be granted if it is reasonable to conclude, based on relevant facts and circumstances, that one of the principal purposes of an arrangement or transaction was to obtain those benefits. However, such benefits may be allowed if it is established that granting them aligns with the purpose of the relevant tax treaty provision.? The MLI introduced significant amendments to various tax treaties, including the India-Luxembourg tax treaty, which included a revised preamble and the incorporation of PPT to curtail tax avoidance.?

In this regard, recently, the Delhi Tax Tribunal[1] had the chance to examine treaty benefit entitlement under India-Luxembourg tax treaty. ?We have summarized the key aspects of the said decision along with our comments below:?

Facts of the Case??

The taxpayer, a Category II FPI registered with SEBI (Indian Stock Exchange Regulator), was a Luxembourg-incorporated subsidiary of a Cayman Islands company. It earned income from investments in Indian Alternative Investment Funds (‘AIFs’), securitization trusts, and debt securities issued by Indian companies. Relying on its Luxembourg tax residency certificate (‘TRC’), the taxpayer claimed tax exemptions and reduced rates under the India-Luxembourg Treaty.

Indian tax authorities denied treaty benefits, contending that the taxpayer was established in Luxembourg solely to exploit the tax treaty, given the absence of a treaty between India and Cayman Islands. The tax authorities contended the following:

1. The taxpayer’s structure was designed for treaty shopping and tax avoidance. ?
2. The taxpayer was a conduit entity with the Cayman parent company being the real beneficial owner. ?
3. The TRC alone was insufficient to demonstrate substance and tax residency. ?
4. The taxpayer lacked commercial rationale for its establishment in Luxembourg.

Tribunal’s Decision?

The Tribunal ruled in favor of the taxpayer, holding that the treaty benefits could not be denied based on unsupported claims of treaty abuse. Key observations included:?

A. Validity of TRC: The Tribunal upheld the TRC as a valid and conclusive proof of tax residency. It limited the piercing of the corporate veil of the TRC to extremely narrow circumstances of tax fraud, sham transactions, camouflaging of illegal activities, or a complete absence of economic substance. Further, such charges must meet stringent and onerous standards of proof. ?

B. PPT: The taxpayer satisfied the PPT under the amended preamble and Article 7(1) of the tax treaty, which restricts treaty benefits where arrangements are primarily tax-driven. The Tribunal noted that: ?

• The taxpayer was incorporated in Luxembourg from 2015, well before the Multilateral Instrument (‘MLI’) amendments, and continues to hold several investments till date. ?
• Taxpayer has obtained registration as an FPI with the Indian securities market regulator. ?
• Over 86% of its investments were outside India, indicating a global investment strategy. ?
• The entity filed tax returns, paid taxes in Luxembourg on its worldwide income, and incurred significant operational expenses in the nature of consulting fees, legal and litigation fees, other professional fees apart from other administrative expenses, demonstrating substance.

C. Beneficial Ownership: The Tribunal rejected the tax authority’s assertion that the Cayman parent controlled the taxpayer’s income. Due to lack of evidence of a legal or contractual obligation to pass income to the parent, beneficial ownership benefits were allowed. ?

D. Characterization of Income: ?

• Income from securitization trusts cannot be re-characterized as interest income and was held to be classified as business income and not taxable in India under Article 7 due to the absence of a permanent establishment. ?
• Interest income was taxed at the DTAA’s reduced rate of 10%, rejecting the tax authority’s higher tax rate under domestic law.

The Tribunal’s decision sheds light on master-feeder structures where investor funds are pooled in one jurisdiction, like the Cayman Islands, and invested globally through a feeder fund. Despite the Cayman Islands lacking a tax treaty with India, the ruling highlights the importance of commercial justification for jurisdictional choices in Indian investments. Key factors supporting the taxpayer’s compliance with PPT included the feeder fund’s decade-long existence, globally diversified investments, and significant expenses in its home jurisdiction.??

Under PPT, TRC may no longer be sufficient and corporates may be called upon to provide commercial justification for setting up structures in favorable tax jurisdictions. In the post BEPS world, this decision establishes a significant precedent, providing guidance on structuring cross-border investments in line with anti-abuse provisions.?

[1] SC Lowy P.I. (Lux) SARL vs ACIT (ITA No. 3568/DEL/2023)

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