[Opinion] Understanding Limitation Of Benefit Rule In DTAA

D.C. Agrawal – [2025] 178 taxmann.com 403 (Article)

1. Introduction

Double Taxation Avoidance Agreements (DTAAs) are fundamental instruments in international tax law, aiming to prevent the same income from being taxed in both the source country and the country of residence. These agreements foster cross-border trade and investment by providing clarity and certainty to taxpayers while ensuring equitable tax allocation between countries. However, over time, tax planners and multinational corporations began exploiting treaty provisions to achieve unintended tax advantages. This phenomenon, known as treaty shopping, led to a significant erosion of tax revenues and raised concerns among governments.

To counter such abuse, the Limitation of Benefit (LOB) Rule was introduced in many DTAAs. The LOB rule serves as a specific anti-abuse mechanism, designed to restrict treaty benefits only to genuine residents of the contracting states who have substantial business operations and economic presence. It ensures that DTAAs are not misused by residents of third countries through artificial structures like shell companies or conduit entities.

The necessity of an LOB clause gained prominence in the wake of landmark cases such as Azadi Bachao Andolan in India, where the Supreme Court upheld the legality of treaty shopping in the absence of specific anti-abuse provisions. Internationally, the OECD and G20’s Base Erosion and Profit Shifting (BEPS) Action Plan 6 recognized treaty abuse as a critical issue, leading to a minimum standard for countries to implement either an LOB rule, a Principal Purpose Test (PPT), or a combination of both. This article examines the LOB rule in a structured manner, tracing its origin, components, interpretations under model conventions, global practices, and its application in India, while also discussing challenges and future prospects.

2. Conceptual Framework

2.1 Treaty Shopping and Treaty Abuse

Treaty shopping refers to the practice of residents of third countries indirectly accessing DTAA benefits by routing transactions through an intermediary jurisdiction that has a favourable tax treaty with the source country. Typical features of treaty shopping include:

i. Creation of conduit entities in jurisdictions with beneficial treaties.
ii. Lack of substantial economic activity in the intermediary jurisdiction.
iii. Artificial ownership structures designed to exploit reduced withholding tax rates or capital gains exemptions.

Transfer of tax benefits back to the ultimate controlling entities located in non-treaty jurisdictions.

Treaty abuse occurs when arrangements, though legally valid, are primarily aimed at securing treaty benefits contrary to the object and purpose of the DTAA. This undermines the mutual reciprocity and balance that treaties seek to achieve.

2.2 Role of LOB Rule

The LOB rule acts as a gatekeeper provision, defining which persons or entities qualify for treaty benefits. It sets out objective criteria such as:

i. Nature of the entity (individuals, governments, listed companies).
ii. Ownership thresholds (e.g., minimum percentage of ownership by residents of the contracting states).
iii. Base erosion tests to ensure income is not siphoned off to non-qualified persons.
iv. Active business or substantial presence tests.
Through these mechanisms, the LOB rule filters out conduit arrangements, ensuring that only bona fide residents engaged in genuine cross-border economic activity benefit from the treaty.

3. Historical Development

3.1 Early U.S. Practice

The United States pioneered the use of detailed LOB clauses, first incorporating them in Article 22 of its Model Tax Convention. U.S. treaties use multiple tests to determine whether a taxpayer is a “qualified person,” such as:

i. Stock Exchange Test – shares must be regularly traded on recognized stock exchanges.
ii. Ownership and Base Erosion Test – more than 50% ownership by residents of contracting states and limits on deductible payments to non-residents.
iii. Active Business Connection Test – requiring substantial business operations in the state of residence.
iv. Competent Authority Relief – discretionary power to grant benefits in deserving cases
This framework influenced later OECD developments and provided a model for other jurisdictions.

3.2 OECD and UN Approaches

Initially, the OECD Model Convention did not contain a specific LOB article. Instead, anti-abuse measures were addressed through commentary on Article 1 and reliance on domestic laws. However, with increasing treaty abuse, the 2017 OECD update introduced Article 29, titled Entitlement to Benefits, incorporating both LOB and PPT provisions. The OECD approach provides flexibility:

i. States may adopt only the PPT (a general anti-abuse rule).
ii. States may adopt a detailed LOB rule.
iii. Or a combination of both, which is now the recommended standard under BEPS Action 6

The UN Model Convention, reflecting the interests of developing countries, also acknowledges treaty shopping concerns and suggests inclusion of LOB or PPT rules, though with more emphasis on source-based taxation.

3.3 BEPS Action Plan 6

BEPS Action Plan 6 explicitly targeted treaty abuse. Its final report laid down a minimum standard, requiring countries to include in their treaties either:

(i) A combined LOB and PPT rule,
(ii) A standalone PPT rule, or
(iii) A detailed LOB rule supplemented by targeted PPT for conduit arrangements

This initiative has driven global convergence towards standardized anti-abuse provisions.

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