Principal Purpose Test

A Category III AIF might set up a foreign structure partly, or even mainly, to reduce its tax bill using a favourable tax treaty. Should that structure automatically get the treaty benefit, no questions asked?

The Principal Purpose Test, or PPT, says no. It comes from the OECD's Multilateral Convention to prevent Base Erosion and Profit Shifting (BEPS), known as the MLI. Under the PPT, tax authorities can deny a tax treaty benefit if one of the principal purposes of an arrangement or transaction was, directly or indirectly, to obtain that tax benefit.

The PPT is not limited to the fund itself. It can also apply to an agent in an offshore jurisdiction who plays a principal role in the fund's investment management activities there — unless that agent qualifies as an independent agent.

An agent is not considered independent if it acts exclusively on behalf of one or more closely related enterprises. In other words, an agent that only ever serves one fund group's interests, rather than a genuine spread of independent clients, does not get the independent-agent carve-out.

Because of the PPT, a Category III AIF's choice of jurisdiction and organisational structure has real tax consequences: if the arrangement looks like it exists mainly to capture a treaty benefit, the benefit can be withdrawn even where the letter of the treaty would otherwise apply.

Illustrative figures — the workbook attaches no numbers to its own PPT discussion. Coromandel Offshore Fund, structured through a jurisdiction with a favourable India tax treaty, earns Rs 40 crore of dividend income from its Indian portfolio companies in a year and claims a reduced treaty withholding rate on that income, on the strength of having held the shares for 14 months.

Coromandel routes its Indian investments through a local agent who works exclusively for Coromandel's fund group and no one else. Under the PPT, tax authorities examine whether obtaining the lower withholding rate on the Rs 40 crore was one of the principal purposes of structuring the investment this way.

Because the agent is not independent — it serves only closely related enterprises within the Coromandel group — the independent-agent exception does not apply. The test's conclusion: authorities can attribute the agent's activities to the fund and deny the treaty benefit on the Rs 40 crore of dividend income, pushing it back to the higher domestic withholding rate.

Contrast this with a fund that uses a genuinely independent local administrator serving dozens of unrelated fund clients: that agent's independence is a real factor weighing against denial of the same treaty benefit.

Chapter 9, section 9.8 (Tax impact on performance of Category III AIF), introduces the PPT as part of the OECD's MLI framework, alongside the independent-agent exception and its exclusive-service test. Expect the PPT tested as a definitional question — what it lets tax authorities do, and the specific test for when an agent fails to count as independent.

• The PPT can deny a treaty benefit if a tax benefit was only "one of the principal purposes" — it does not need to be the sole or main purpose of the arrangement.
• An agent is not independent if it acts exclusively for closely related enterprises — serving only one fund group, even without formal common ownership, can be enough to fail the independence test.
• The PPT comes from the OECD's MLI, a multilateral instrument amending bilateral tax treaties — it is not an Indian-specific rule invented for AIFs.
• Do not confuse the Principal Purpose Test with India's own General Anti-Avoidance Rule (GAAR) — both target arrangements set up mainly for a tax benefit, but the PPT operates specifically through DTAA treaty relief under the OECD's MLI, while GAAR is a domestic Indian tax law tool.