LOB Rules & DTAA Limitations in India: Ultimate Guide for Residents, RNORs & NRIs

By CA Surekha

Introduction: Understanding DTAA and LOB

Double Taxation Avoidance Agreements (DTAAs) are bilateral treaties aimed at eliminating double taxation, promoting cross-border investment, and clarifying tax rights between source and residence countries.

Limitation of Benefits (LOB) clauses are safeguards against misuse of DTAAs. Their primary objective is:

1. Prevent treaty shopping, where entities with no real connection to the treaty countries claim benefits.

2. Ensure only genuine residents of treaty countries enjoy tax concessions.

3. Align DTAA benefits with economic substance (ownership, business activity, risk-bearing) rather than paper structures.

Key point: LOB does not grant new benefits—it limits treaty benefits to qualified entities or individuals. Failure to satisfy LOB leads to full domestic tax application, often at higher rates.

Legal & Regulatory Framework

LOB clauses are usually part of modern DTAAs (e.g., India-USA, India-Canada, India-UAE). The legal hierarchy is:

1. DTAA Text (Article defining LOB)

2. Indian Income Tax Act, Sections 90, 90A, 195, 94A/B

3. CBDT Notifications & Circulars

4. Judicial Precedents / Advance Rulings

LOB Clause Objectives:

Objective	Legal Reference / Mechanism
Prevent treaty shopping	DTAA Article on LOB
Ensure beneficial ownership	Sec 195(1), 90 IT Act, CBDT Circulars
Ensure economic substance	Active trade/business test, derivative benefit test
Restrict conduit entities	Sec 94B / GAAR rules on excessive interest, passive income
Align with corporate residence	Ownership/base test, public company test

Judicial Insight: Indian authorities consistently apply “substance over form” (e.g., AAR rulings on NRI investments through holding companies, ITAT rulings on beneficial ownership).

Detailed LOB Tests

LOB clauses usually include multiple tests. Understanding each is critical for compliance:

Test	Explanation	Practical Implications
Ownership & Base Test	Majority of shares must be held by residents of treaty country	Shell companies fail; minimum threshold (e.g., 50% or 75%) often required
Active Trade or Business Test	Entity must conduct real business in treaty country	Mere passive investment does not qualify; operational substance must exist
Derivative Benefits Test	Certain related entities may access treaty benefits	Limits cross-border holding chains; prevents indirect treaty shopping
Publicly Traded Test	Entities listed on recognized stock exchanges may automatically qualify	Simplifies compliance for listed corporates; reduces documentation burden
Beneficial Ownership Test	Recipient must be actual owner of income (dividends, interest, royalties)	Indian tax authorities scrutinize intermediaries; must have control and risk over income

Key Analytical Insight:

• Substance over form principle is paramount: Indian authorities examine actual control, risk exposure, and operational presence, not just paperwork.

• Timing matters: LOB compliance is evaluated at the time of income accrual or remittance, not retroactively.

Country-Specific Analysis

LOB implementation varies across treaty partners. Here’s an analytical comparison:

Country	LOB Features	Practical Notes
Canada	Strict; active business requirement; minimum ownership; CFC rules	Passive investors often denied treaty benefit; corporate investors must maintain >50% resident ownership and active trade
UK	Minimal LOB; treaty shopping largely unrestricted	Easier claiming of dividends, interest, royalties; still need beneficial ownership proof
UAE	Recent LOB introduced mainly for passive income	Favorable for holding companies; caution on Indian beneficial ownership rules if routed via UAE SPVs
USA	Detailed; derivative benefits, active business, ownership % thresholds	Publicly traded companies qualify easily; holding company structures need careful analysis

Analytical Insight: The more structured and substance-backed the entity, the higher the likelihood of DTAA benefits. Passive or shell structures are inherently risky under LOB.

Resident / RNOR / NRI Perspective

Status	Eligibility for DTAA Benefits	LOB Considerations	Compliance Cautions
Resident	Full eligibility	Must satisfy all LOB tests	Maintain ownership & activity documentation; submit Form 10F & COC
RNOR	Limited eligibility (income sourced in treaty country)	Active trade/business and beneficial ownership critical	Ensure accurate declaration of status; risk of partial denial
NRI / Non-Resident	Eligible for treaty country income	Beneficial ownership, active business, public company, or derivative benefit test	Submission of COC + Form 10F is mandatory; misrepresentation can trigger penalties

Caution: Even if a treaty appears liberal, Indian tax authorities may deny benefits if substance, ownership, or operational presence is inadequate.

Nitty-Gritty Compliance and Procedural Points

1. Documentation Required:

   • Certificate of Residence (COC) from foreign tax authority

   • Form 10F with ownership, trade, and activity details

   • Proof of beneficial ownership and control

   • Shareholding patterns / incorporation certificates

2. Timing & Transactional Points:

   • Changes in ownership mid-year may reduce eligibility

   • Each income stream (dividend, royalty, interest) evaluated independently

   • TDS withholding should consider DTAA only after documentation submission

3. Interplay with Indian Domestic Law:

   • Sec 195 IT Act: DTAA benefit claim triggers withholding obligation

   • Sec 94A / 94B: Limits on excessive interest or passive income

   • GAAR provisions: Treaty misuse is target for anti-abuse actions

4. Advance Ruling / DRP Mechanism:

   • Sec 245N IT Act allows obtaining pre-transaction clarity

   • Useful for NRIs, RNORs, or complex corporate structures

5. Audit and Risk Considerations:

   • Indian authorities focus on ultimate beneficial owner (UBO), not just immediate shareholder

   • SPVs, holding companies, and passive entities are high-risk

   • Lack of proper documentation often leads to rejection + penalties

Common Pitfalls and Cautions

Pitfall	Explanation	Mitigation
Treaty shopping via SPVs	Entities claiming DTAA benefits without genuine connection	Ensure ownership, trade, risk exposure; document operational presence
Incomplete Form 10F	Missing critical ownership or activity details	Fill meticulously; attach supporting evidence
Mid-year changes	Ownership/activity changes can invalidate benefits	Track and report changes promptly
Indirect ownership	UBO scrutiny may deny benefits	Maintain transparency on ultimate owners
Passive investment	Income via passive instruments often fails LOB	Ensure active trade/business or public company qualification
Misaligned documentation	Discrepancy between foreign filings and Indian filings	Cross-verify before submission; maintain audit trail

Illustrative Examples

1. Canadian dividends to NRI via Canadian SPV

   • SPV owned 70% by foreign non-residents, no active business → LOB fails

   • Remedy: Adjust ownership to >50% Canadian residents and demonstrate operational business

2. UK royalties to RNOR

   • UK LOB minimal; COC + Form 10F submitted → likely eligible

   • Risk: Indian beneficial ownership must be clear; otherwise domestic tax applies

3. UAE rental income via UAE company

   • UAE treaty favorable, but Indian authorities verify beneficial ownership

   • SPV must demonstrate NRI as actual owner; passive conduit structures may fail

Strategic Recommendations

1. Pre-transaction LOB Assessment: Analyze ownership, trade, and residence status before investing.

2. Maintain Comprehensive Documentation: COC, Form 10F, proof of operational substance.

3. Avoid Conduit Structures: Shell companies, SPVs, or nominee arrangements increase risk.

4. Plan Mid-Year Changes Carefully: Ownership or business modifications can affect DTAA benefit.

5. Country-Specific Strategy: Canada strict, UAE liberal, UK moderate; plan accordingly.

6. Advance Ruling for Complex Cases: Sec 245N IT Act requests reduce audit uncertainty.

7. Audit-Ready Recordkeeping: Keep ownership, financial, and operational evidence for at least 6 years.

Key Takeaways

• LOB rules are critical gatekeepers for DTAA benefits.

• Substance > Form: Ownership, activity, and beneficial ownership are scrutinized.

• Country-specific variation matters: Canada vs UAE vs UK differ materially in strictness.

• NRI / RNOR / Resident differences: Each status has unique eligibility and compliance risks.

• Documentation and procedural compliance are as important as structural planning.

• Advance ruling is strategic for uncertain or complex scenarios.

• Non-compliance risks: Full domestic taxation + penalties + interest.