Treaty Shopping & LOB Clauses: Claiming DTAA Benefits Through Holding Structures

What Is Treaty Shopping and Why Does India Care?

Treaty shopping occurs when a resident of a third country interposes an entity in a treaty jurisdiction solely to access DTAA benefits that would not otherwise be available. A classic example: a UK-based fund sets up a shell company in Mauritius, which then invests in Indian shares. When the Mauritius entity sells those shares, it claims capital gains tax exemption under the India-Mauritius DTAA — a benefit the UK fund could not claim directly under the India-UK treaty.

India has historically been one of the largest victims of treaty shopping. Between 2000 and 2016, Mauritius and Singapore together accounted for over 50% of cumulative FDI inflows into India — a proportion widely attributed to favourable treaty provisions rather than genuine economic activity in those jurisdictions. The revenue leakage prompted India to systematically overhaul its treaty network.

The Three Anti-Abuse Mechanisms in India's Treaty Framework

India now deploys three distinct mechanisms to combat treaty shopping. Understanding how they interact is essential for any foreign investor structuring investments through holding companies.

1. Limitation of Benefits (LOB) Clauses

LOB clauses are specific anti-avoidance provisions embedded in individual DTAAs. They define which residents of the contracting state are entitled to claim treaty benefits, typically requiring the claimant to demonstrate genuine economic substance in the treaty jurisdiction.

2. Principal Purpose Test (PPT) via the MLI

The PPT, introduced through India's ratification of the Multilateral Instrument (MLI) in 2019, applies across all covered tax agreements. It denies treaty benefits if one of the principal purposes of an arrangement is to obtain a treaty benefit, unless granting that benefit would be in accordance with the object and purpose of the relevant DTAA provision.

3. General Anti-Avoidance Rules (GAAR)

GAAR, effective from April 2017, operates under Sections 95 to 102 of the Income Tax Act. Unlike LOB or PPT which are treaty-specific, GAAR is a domestic law provision that can override any treaty benefit if the arrangement is classified as an "impermissible avoidance arrangement."

LOB Clauses in Key Indian DTAAs

Not all Indian DTAAs contain LOB clauses, and those that do vary significantly in their scope and conditions. Here is the current status of LOB provisions in India's most commercially significant treaties:

India-Mauritius DTAA (Article 27A)

The 2016 Protocol fundamentally changed the India-Mauritius treaty. Key provisions:

• Capital gains: India now has the right to tax capital gains on shares acquired on or after April 1, 2017. The earlier full exemption was eliminated
• Grandfathering: Shares acquired before April 1, 2017 remain exempt, subject to the LOB clause
• LOB conditions: To claim grandfathered benefits, the Mauritius entity must not be a "shell or conduit company" and must have total expenditure on operations of at least MUR 1.5 million (approximately INR 27 lakh) in the 12 months preceding the transaction
• Supreme Court clarification (2025): The grandfathering benefit and LOB conditions apply only to direct transfers. Indirect transfers of Indian shares through Mauritius entities fall under the residuary article and do not enjoy LOB or grandfathering protection

India-Singapore DTAA

The December 2016 Protocol to the India-Singapore DTAA mirrored the Mauritius amendments:

• Capital gains on shares acquired on or after April 1, 2017 are taxable in India
• The LOB clause requires the Singapore entity to demonstrate that it is not a shell company and that the arrangement has not been entered into with the primary purpose of obtaining treaty benefits
• Singapore's robust regulatory environment and substance requirements (directors, bank accounts, annual filings) generally make it easier to satisfy LOB conditions compared to Mauritius

India-Cyprus DTAA

India's DTAA with Cyprus was amended in 2016 alongside the Mauritius and Singapore treaties. The revised treaty introduced source-state taxation of capital gains and inserted LOB provisions. Previously, Cyprus was a popular conduit jurisdiction, particularly for European investors routing investments into India.

India-Netherlands DTAA

The India-Netherlands DTAA has become increasingly important as investors shift away from Mauritius and Singapore. The treaty currently provides:

• Capital gains on shares are taxable only in the state of residence (Article 13) — unless the company's assets are predominantly Indian immovable property
• No explicit LOB clause in the current treaty text
• However, the PPT under the MLI now applies to this treaty, requiring the arrangement to have a purpose beyond obtaining treaty benefits

India-France DTAA (2026 Amendment)

In early 2026, India and France signed an amendment protocol specifically targeting profit shifting and treaty shopping. The amendment introduces enhanced anti-avoidance provisions including LOB and PPT clauses aligned with current BEPS standards.

The Principal Purpose Test (PPT): India's CBDT Circular 1/2025

On January 21, 2025, the CBDT issued Circular 1/2025 — the first comprehensive guidance on PPT application in India. Key clarifications:

• Prospective application: The PPT applies from the date of entry into force of the treaty amendment or the effective date of MLI provisions, not retrospectively
• Grandfathering preserved: The grandfathering benefits in the Mauritius, Singapore, and Cyprus treaties remain outside the scope of the PPT. They are governed exclusively by the specific treaty provisions
• Objective assessment: The CBDT confirmed that PPT application requires an objective assessment of facts on a case-by-case basis. Tax authorities must demonstrate that obtaining a treaty benefit was one of the "principal purposes" of the arrangement — not merely an incidental benefit
• BEPS Action 6 guidance: The circular directs tax officers to refer to BEPS Action Plan 6 and the UN Model Tax Convention (2021) when applying the PPT, including India's reservations

GAAR and Its Interaction with Treaty Benefits

India's GAAR provisions under Sections 95 to 102 of the Income Tax Act represent the most powerful anti-abuse tool available to Indian tax authorities.

When GAAR Can Override DTAA Benefits

Section 95 explicitly states that GAAR provisions override the Income Tax Act, including its treaty application provisions under Section 90. This means:

• Even if an arrangement satisfies LOB conditions in a DTAA, GAAR can still deny benefits if the arrangement is an "impermissible avoidance arrangement"
• An arrangement is impermissible under Section 96 if its main purpose is to obtain a tax benefit AND it: (a) creates rights not normally created at arm's length; (b) results in misuse of the Act; (c) lacks commercial substance under Section 97; or (d) is carried out in a manner not ordinarily employed for bona fide purposes

Section 97: Lack of Commercial Substance

An arrangement is deemed to lack commercial substance if:

• The substance or effect differs significantly from its legal form
• It includes round-tripping of funds
• It involves an accommodating party (an entity with no real commercial role)
• The transaction disguises the value, location, source, ownership, or control of funds

GAAR vs. LOB: When Both Apply

The CBDT has clarified that where the LOB provision in a DTAA is sufficient to address the abuse, GAAR will not be invoked. However, since LOB clauses (as specific anti-avoidance rules or SAARs) may not address all forms of abuse, GAAR can be applied even when an LOB clause exists. In practice, this means satisfying the LOB conditions is necessary but may not be sufficient.

Structuring Holding Companies: What Works in 2026

Given the layered anti-abuse framework, foreign investors must ensure their holding structures satisfy all three tests simultaneously. Here is a practical assessment by jurisdiction:

Singapore

Remains viable for holding companies with genuine commercial substance. Key requirements:

• Local directors with decision-making authority
• Staff and physical office presence
• Board meetings conducted in Singapore
• Treasury and management functions genuinely performed locally
• Annual operating expenses proportionate to the scale of operations

Netherlands

Increasingly popular due to the participation exemption and absence of an explicit LOB clause. However:

• The PPT under the MLI now applies — pure holding vehicles with no substance will face scrutiny
• The Netherlands itself has tightened substance requirements under its own domestic law
• The Indian tax authority is closely monitoring the shift from Mauritius/Singapore to Netherlands as a potential new conduit route

UAE

The India-UAE DTAA has been updated with modern anti-abuse provisions. The UAE's introduction of corporate tax in June 2023 and increasing regulatory substance requirements have changed the equation. Genuine operations in the UAE can support treaty claims, but pure holding companies face heightened PPT scrutiny.

Mauritius

Post-2016, Mauritius has largely lost its appeal for new equity investments into India. Capital gains on shares acquired after April 2017 are fully taxable in India. However, the treaty remains relevant for:

• Pre-2017 grandfathered investments (subject to LOB conditions)
• Dividend income (10% withholding rate under the treaty)
• Interest income (reduced withholding tax rates)

Recent Case Law and Regulatory Developments

Supreme Court on Indirect Transfers (2025)

In a landmark ruling, the Supreme Court clarified that Article 13(3A) of the India-Mauritius DTAA — which provides grandfathering and the related LOB clause — applies only to direct transfers of Indian shares. Indirect transfers, where shares of a Mauritius holding company are sold to effectively transfer underlying Indian assets, fall under the residuary Article 13(4) and do not enjoy LOB or grandfathering protection. This decision significantly impacts multi-layered holding structures where the Indian investment is held through an intermediate Mauritius entity.

ITAT on MLI and Notification Requirements (2025)

In a significant tribunal ruling, the ITAT held that MLI provisions adopted in DTAAs are inapplicable without specific notification under Section 90 of the Income Tax Act. This means that for the PPT or other MLI provisions to apply to a specific DTAA, India must issue a notification bringing those provisions into effect for that particular treaty. This procedural requirement has practical implications — investors should verify whether the specific DTAA they rely on has been notified under the MLI before assessing PPT risk.

India-France Protocol (2026)

The India-France DTAA amendment signed in early 2026 represents the latest evolution of India's treaty policy. The protocol introduces modernised anti-avoidance provisions aligned with BEPS 2.0 standards. Key features include enhanced LOB conditions requiring substantial economic activities in France, a codified PPT provision, and provisions specifically addressing digital economy transactions and technical services. This protocol is expected to serve as a template for India's future treaty negotiations and renegotiations.

Structuring Mistakes to Avoid

Based on recent enforcement trends, the following structuring approaches carry elevated risk:

1. Letterbox companies: Entities with no employees, no physical office, and no genuine decision-making activity in the treaty jurisdiction. These fail LOB, PPT, and GAAR tests simultaneously
2. Circular or round-tripping structures: Indian capital routed abroad and reinvested back as FDI through a treaty jurisdiction. Section 97 of the Income Tax Act specifically deems such arrangements to lack commercial substance
3. Treaty shopping through multiple layers: Using multiple intermediate entities to create a chain from the investor's residence country to a treaty-favoured jurisdiction to India. Each additional layer increases scrutiny without proportional benefit
4. Timing-based structures: Establishing a holding entity in a treaty jurisdiction shortly before a planned transaction (e.g., share sale) without pre-existing commercial activity. The temporal proximity signals a principal purpose of obtaining treaty benefits
5. Ignoring domestic substance requirements: Some treaty jurisdictions (Netherlands, Singapore, UAE) have their own domestic substance requirements. Failing to meet the treaty country's local requirements undermines the argument for genuine residence and strengthens the case for GAAR application

Practical Compliance Checklist for Treaty Claims

Before claiming DTAA benefits through a holding structure, ensure the following:

1. Obtain a valid Tax Residency Certificate (TRC): A TRC from the treaty country's tax authority is the primary document proving treaty eligibility. In India, this is mandatory under Section 90(4) of the Income Tax Act
2. File Form 10F: Non-residents must file Form 10F electronically to claim treaty benefits. This form requires details about the claimant's tax status, period of residence, and the nature of income
3. Demonstrate substance: Maintain evidence of local employees, office space, board meeting minutes, and decision-making activity in the treaty jurisdiction
4. Document business purpose: Prepare and maintain contemporaneous documentation explaining the commercial rationale for the holding structure beyond tax optimisation
5. Review LOB conditions: For treaties with explicit LOB clauses, verify compliance with specific expenditure thresholds and shell company tests
6. Assess PPT exposure: Evaluate whether the arrangement could be challenged under the Principal Purpose Test — if treaty benefit is one of the main purposes, ensure the arrangement is still consistent with the treaty's object and purpose
7. Consider GAAR risk: For arrangements that may be viewed as lacking commercial substance, assess the risk of GAAR invocation and consider obtaining an advance ruling

Tax Residency Certificate: The Gateway Document

The Tax Residency Certificate (TRC) is the foundational document for any DTAA claim. Under Section 90(4) of the Income Tax Act, no DTAA benefit can be claimed without a valid TRC issued by the government of the treaty country. Key points for foreign investors:

• The TRC must be obtained for each financial year in which treaty benefits are claimed
• For companies, the TRC must demonstrate that the entity is liable to tax in the treaty country by reason of its domicile, residence, or place of management — not merely registered or incorporated there
• Indian tax authorities may look behind the TRC to examine whether the entity has genuine economic substance, particularly in cases where the treaty country issues TRCs based primarily on incorporation rather than effective management
• The TRC does not guarantee treaty benefits if the arrangement fails the LOB, PPT, or GAAR tests — it is a necessary but not sufficient condition

Key Takeaways

• India's anti-treaty shopping framework now has three overlapping layers — LOB clauses, PPT under the MLI, and GAAR — making pure conduit structures extremely risky
• The CBDT's January 2025 circular confirms PPT applies prospectively and preserves grandfathering in the Mauritius, Singapore, and Cyprus treaties
• Holding structures must demonstrate genuine commercial substance — local staff, decision-making, and operating expenses — to survive scrutiny under all three tests
• The Netherlands has emerged as a preferred jurisdiction post-Mauritius, but the PPT and India's monitoring of this shift require careful substance planning
• Professional advice from a qualified tax advisor with cross-border experience is essential before establishing or modifying any holding structure involving Indian investments