Income Tax – Deductibility of interest payment under Section 14(1)(a) of the Income Tax Act

In 2017, the Singapore High Court had an opportunity to look into the proper construction of the statutory provision under Section 14(1)(a) of the Income Tax Act (“ITA“), which stipulates the following:

“14.—(1) For the purpose of ascertaining the income of any person from any source chargeable with tax under this Act (referred to in this Part as the income), there shall be deducted all outgoings and expenses wholly and exclusively incurred during that period by that person in the production of the income, including –

(a)    except as provided in this section –

(i)    any sum payable by way of interest; …
(ii)   …

upon any money borrowed by that person where the Comptroller is satisfied that such sum is payable on capital employed in acquiring the income”

In BML v.  Comptroller of Income Tax [2017] SGHC 118, the High Court has to address the question whether the appellant is entitled to claim the interest paid on the shareholder bonds as a  deduction in Years of Assessment 2005 to 2009 under Section 14(1)(a) of the ITA.  By way of background, this decision arose from an appeal against the ITBR’s decision in GBK v. Comptroller of Income Tax [2016] SGITBR 3.

Facts of the case

In BML case, the appellant owns and operates a mall, and is owned by two shareholders – A and B, both hold 50% each of the equity interest in the appellant.  In Oct 2004,  the appellant entered into a facility agreement with a special purpose company for the appellant to borrow a sum of $520m.  The loan was made in consideration of periodic interest payments and was secured by a fixed charge over a set of accounts to be opened and maintained by the appellant and an assignment of the rights to the tenancy agreements and rental income of the appellant.  This $520m was based on the full market value of the Mall. $170m of the $520m was used by the appellant to refinance its borrowings and the balance of $350m was lent to the shareholders as interest-bearing loans.

This meant that the appellant was unable to declare dividends that it might have done but for its having to repay the loan. The shareholders then decided to convert their equity holding in the appellant into a debt-based investment. This would allow them to earn a return in the form of interest since they would not be getting dividends.  In order to achieve this, the shareholders resolved to reduce the share capital of the company at an extraordinary general meeting on 26 November 2004. This was done by capitalizing $325.3m from the appellant, paying it up in full ordinary shares and issuing it to the shareholders in equal proportions, and reducing the appellant’s capital by a sum of $333m from $335.5m, to $2,5m.  This capital reduction was approved by Justice V K Rajah on 2 December 2004. Upon the capital reduction, a debt of $333m became due and payable to the shareholders. Instead of returning cash to the shareholders, the appellant issued fixed-rate subordinated bonds for an aggregate amount of $333m, and the shareholders each subscribed for 50% of the issue (“the shareholder bonds”).

High Court decision

  1. The High Court upheld the principle established in previous cases on the test in Section 14(1)(a) of the ITA, ie, whether there is a direct link between the money borrowed and the income produced, has to be real, tangible, precise, and factual, and this requires the consideration of a number of factors, which includes but is not limited to whether the original source of income (to which capital was originally employed towards) can be said to be the same source as the income against which a deduction is now sought.

2.  The High Court had also considered the following factors:

  • Whether the money borrowed had an observable effect on income produced
  • The purpose for which the money was borrowed
  • Whether it was necessary to borrow the money

3. The High Court dismissed the appeal because the appellant faced a few problems in establishing a direct link between the shareholder bonds and the Mall’s rental income.

a.   The Mall was already under the appellant’s ownership and was generating rental income prior to the bond issue. The bond issue neither changed the ownership status nor the rental income.

b.    The appellant’s shareholders admitted that the bond issue was part of their plan to restructure their capital holding in the firm. It was not due to any financing needs or the desire to generate more rental income.

Therefore, the High Court agreed that the Comptroller had exercised his discretion correctly by taking these factors into account and denying the deduction of interest expenses on the shareholder bonds as against the Mall’s rental income.

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