What is Principal Purpose Test (PPT)?

How it works

The Principal Purpose Test (PPT) was added to international tax law via Article 7 of the BEPS Multilateral Instrument (MLI), signed by 100+ countries. Its function: deny treaty benefits where obtaining the benefit was one of the principal purposes of an arrangement.

Standard treaty wording (per OECD Model Article 29(9) post-BEPS):

A benefit under this Convention 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 this Convention.

Two thresholds:

1. One of the principal purposes test — much lower than "sole" or "main" purpose. Multiple legitimate purposes can coexist with a tax-benefit purpose; if the tax purpose is principal (not necessarily dominant), PPT can apply.
2. Reasonable to conclude standard — the tax authority needs to demonstrate it is reasonable to conclude tax was a principal purpose, not prove conclusively.

The taxpayer can rebut by showing that the benefit, in the specific circumstances, aligns with the object and purpose of the treaty provision invoked. In practice, this requires demonstrating commercial substance, business rationale, and that the arrangement isn't a mere conduit.

PPT vs. LOB

Many post-2017 treaties combine both — LOB for structural tests and PPT as a backstop. A structure passing LOB can still fail PPT if the principal purpose was tax.

US treaty practice

The US has not signed the MLI. PPT therefore does not automatically apply in US treaties. Instead:

• US treaties continue to use LOB as the primary anti-treaty-shopping device.
• Recent US treaties (post-2016 model) sometimes add a "main purposes" clause that mirrors PPT.
• Domestic US Economic Substance Doctrine (codified §7701(o)) functions as a parallel anti-abuse rule.

For founders structuring through US treaties, LOB is the focus. For founders using EU, UK, or other MLI-covered treaties, PPT can apply.

Examples

• Indian investor inserts Cypriot SPV to access UK-Cyprus 0% interest WHT on UK-source loans. SPV has no employees, no premises, no commercial activity beyond holding the loan note. UK tax authority applies PPT (post-MLI UK-Cyprus treaty): one of the principal purposes was treaty benefit (clear from facts: the SPV exists for nothing else); benefit denied → UK domestic 20% WHT on the interest applies.
• French operating multinational uses Luxembourg holding to manage European subsidiary investments. Luxembourg holding has staff, board meetings in Luxembourg, makes substantive investment decisions. French sub claims France-Luxembourg treaty benefits on dividends paid up. PPT analysis: even though tax efficiency was a factor, the holding has genuine commercial substance and operational role. PPT challenge fails; benefit granted.

Common mistakes

• Treating PPT as identical to LOB. Different tests, different jurisdictions, different burdens. Modern arrangements may need to pass both.
• Underestimating "one of the principal purposes". This is a low bar. Multiple legitimate business reasons for a structure don't immunise it from PPT if a tax-benefit purpose is also principal.
• Skipping the substance and rationale documentation. PPT challenges turn on contemporaneous evidence of commercial substance — board minutes, decisions made locally, employees, premises. Building it after the challenge is too late.
• Assuming US treaties are PPT-free. Most are (US not in MLI), but post-2016 US treaties include similar main-purpose clauses. Plus, the US Economic Substance Doctrine works domestically.