India Strengthens Tax Treaty With Sri Lanka to Close Loopholes and Prevent Abuse

India has moved to tighten its longstanding tax treaty with Sri Lanka by introducing a new anti-abuse provision aimed at preventing so-called "treaty shopping" — a practice where individuals or companies exploit bilateral tax agreements to avoid paying taxes in either country.

What Is Treaty Shopping and Why Does It Matter?

Treaty shopping occurs when a party that is not entitled to the benefits of a tax treaty between two countries structures its affairs — often through shell companies or indirect arrangements — in order to unlawfully claim those benefits. This can result in significant revenue losses for both governments and creates an uneven playing field for legitimate businesses.

The amendment to the India-Sri Lanka Double Taxation Avoidance Agreement (DTAA) introduces what tax experts refer to as a Principal Purpose Test (PPT) or similar anti-avoidance rule, which allows tax authorities to deny treaty benefits if it is determined that obtaining those benefits was one of the principal purposes of a given transaction or arrangement.

A Significant Step in Bilateral Tax Cooperation

The move aligns India's treaty framework with Sri Lanka with international standards set by the Organisation for Economic Co-operation and Development (OECD) under its Base Erosion and Profit Shifting (BEPS) project. Many of India's other bilateral tax treaties have already been updated through a multilateral instrument to include such safeguards.

For Sri Lanka, which has been working to strengthen its fiscal framework and attract genuine foreign investment, the change signals a commitment to greater tax transparency and cooperation with its largest regional neighbour.

Implications for Businesses and Investors

The tightening of the treaty is expected to have practical implications for businesses operating between the two countries. Key points of concern for investors and tax professionals include:

• Transactions structured primarily to access favourable withholding tax rates may now face greater scrutiny from revenue authorities on both sides.
• Companies routing investments through third-country entities to benefit from the treaty could find such arrangements challenged or disallowed.
• Legitimate cross-border businesses with genuine commercial substance are unlikely to be adversely affected by the new rule.

Broader Context

India and Sri Lanka share deep economic ties, and bilateral trade and investment flows have grown steadily in recent years. Tax certainty is a critical factor for businesses operating across the Palk Strait, and clarity on treaty entitlements will be closely watched by the Sri Lankan business community and foreign investors alike.

Tax practitioners in Colombo have advised businesses with cross-border structures involving India to review their arrangements in light of the updated treaty provisions to ensure compliance and avoid unexpected tax liabilities.

The amendment reflects a global trend towards stricter enforcement of tax rules, with governments increasingly unwilling to allow technical loopholes to erode national tax bases. For Sri Lanka, which continues to navigate a period of economic recovery, securing its fair share of tax revenues from cross-border transactions is more important than ever.