India Sri Lanka tax treaty changes introduce a new anti-abuse test that could affect cross-border investors, holding firms and businesses.
The India Sri Lanka tax treaty now contains a stronger anti-abuse rule that could reshape how companies structure investments and transactions between the two countries.
India’s Ministry of Finance notified the protocol amending the bilateral Double Taxation Avoidance Agreement, or DTAA, after both countries completed their required legal procedures.
The protocol entered into force on June 19, 2026. In India, its provisions will apply to income arising from the 2027-28 financial year onwards.
The amendment introduces a Principal Purpose Test, commonly called the PPT. It allows tax authorities to deny treaty benefits when obtaining that benefit formed one of the principal purposes of a transaction or arrangement.
However, the test does not automatically reject every transaction that produces a tax advantage. Authorities must also consider whether granting the benefit remains consistent with the purpose of the relevant treaty provision.
The change does not create a new tax or directly alter the treaty’s existing tax rates. Instead, it adds a broad anti-avoidance test to determine who may claim those rates and exemptions.
India Sri Lanka Tax Treaty Targets Artificial Structures
Double taxation treaties generally protect businesses and investors from paying tax twice on the same income.
They may also reduce withholding taxes on dividends, interest, royalties and certain other cross-border payments. In some circumstances, they determine which country may tax business profits or capital gains.
The new rule focuses on arrangements designed mainly to obtain these treaty advantages.
For example, a company may face questions if it routes an Indian investment through a Sri Lankan entity that has little commercial activity, few employees and no meaningful decision-making role.
Authorities could examine whether that entity performs a genuine business function or merely exists to access favourable treaty treatment.
The same concern could arise where a group creates a holding company shortly before selling an investment, receiving dividends or restructuring an intercompany loan.
Still, the existence of a tax benefit alone would not necessarily invalidate the arrangement. The authorities would need to assess all relevant facts and circumstances.
This makes documentation increasingly important. Companies may need to demonstrate why they selected a particular ownership, financing or operating structure.
Commercial reasons could include access to customers, regional management needs, skilled employees, logistics, regulation, financing requirements or long-term expansion plans.
Which Sri Lankan Businesses Could Face Scrutiny?
The amendment could affect Sri Lankan companies receiving income from India and Indian-controlled businesses operating through Sri Lanka.
Businesses most likely to require a review include cross-border holding companies, investment vehicles, financial service providers and groups with related-party lending arrangements.
Companies receiving royalties, technical service fees, interest or dividends from India could also face closer examination when claiming reduced treaty rates.
Sri Lankan firms with subsidiaries, branches, joint ventures or long-term contracts in India may need to assess whether their ownership and payment arrangements have sufficient commercial substance.
The protocol could also affect corporate reorganisations. Transactions involving share transfers, intellectual property, debt restructuring or changes in group ownership may attract attention when treaty savings form a significant part of the arrangement.
However, the amendment does not mean that every Sri Lankan company operating in India will lose its benefits.
Businesses with genuine operations, real management functions and clear commercial objectives should remain capable of claiming treaty protection. Nevertheless, they may need stronger evidence to support their position.
Companies should therefore review board records, contracts, staffing arrangements, office facilities and decision-making procedures. These records could help establish that an entity performs a genuine economic role.
Existing Structures May Need Review
The Principal Purpose Test is broad because it examines purpose rather than relying only on technical ownership requirements.
A transaction may comply with the literal wording of the treaty but still fail the PPT if authorities conclude that treaty access formed one of its principal objectives.
As a result, businesses cannot rely entirely on certificates of tax residence or formal incorporation documents.
Tax authorities may examine who controls the entity, where executives make decisions, whether the company assumes genuine risks and whether its income matches its actual activities.
Existing cross-border structures should therefore undergo a detailed review before the new provisions begin applying to income in India.
A review does not automatically require restructuring. In some cases, businesses may only need clearer documentation of their commercial purpose and operating substance.
In others, companies may find that an intermediate entity no longer serves a convincing non-tax function.
Restructuring solely because of the new rule could create additional risks. Authorities may examine the timing and purpose of any changes, particularly when they occur shortly before a major payment or disposal.
Companies should obtain professional tax and legal advice before altering existing arrangements.
Implications for Indian Investment in Sri Lanka
India remains an important source of trade, tourism, financing and investment for Sri Lanka.
The revised treaty could encourage Indian investors to place greater emphasis on direct ownership and commercially substantial structures.
Indian groups investing through Sri Lankan companies may need to establish why those companies exist and what operational responsibilities they perform.
This could raise compliance costs, particularly for smaller businesses that lack extensive tax departments. Investors may need additional legal opinions, transfer-pricing reviews and supporting records.
However, stronger anti-abuse rules could also improve confidence in legitimate cross-border investment by separating genuine commercial activity from artificial treaty-shopping arrangements.
The revised preamble makes clear that the treaty aims to prevent double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance.
The change aligns the agreement with international measures developed to combat base erosion and profit shifting.
How Will the Principal Purpose Test Work?
The central question will be whether obtaining a treaty benefit was one of the principal purposes of an arrangement.
That wording is wider than a test that asks whether tax avoidance was the sole or dominant purpose.
Authorities may infer purpose from the structure, timing, documentation and economic outcome of a transaction.
They may also compare the arrangement with alternatives that would have produced a similar commercial result without the same treaty advantage.
However, the treaty provides an important qualification. Authorities should not deny the benefit when granting it would remain consistent with the object and purpose of the relevant provisions.
That safeguard may protect genuine investors, but its application will depend on individual facts.
Businesses could face uncertainty until tax authorities, tribunals and courts develop clearer interpretations through assessments and decisions.
Consistent administration will therefore matter. An overly aggressive approach could delay transactions and discourage investment, while weak enforcement could allow artificial arrangements to continue.
The new India Sri Lanka tax treaty framework sends a clear warning to companies relying on technical structures without strong commercial foundations.
For legitimate investors, the immediate priority is not panic but preparation. Businesses should review their arrangements, preserve evidence of commercial purpose and ensure that their legal structure reflects their actual economic activity.
