Interest deductibility - Direct links & refinancing - BML v CIT [2018] SGCA 53

1. Brief (and partial) summary of facts

In BML, the taxpayer’s assets were a mall and some loans to its two shareholders. It had a share capital of S$10.2m. It sought to capitalize a sum of S$325.3m (comprising S$37m from retained earnings, S$268.3m from its asset revaluation reserve and S$20m from its capital redemption reserve). It thereafter sought to reduce its share capital by S$333m. The debt arising from the capital reduction was left outstanding. It then sought to issue 7.1% “Shareholder Bonds” equally to each of its 50% shareholders to replace the debt arising from the capital reduction.

The issue in the case related to the deductibility of interest on the Shareholder Bonds from YA2005 to YA2009.

2. The test for interest deductibility

Under S14(1)(a) of the Singapore Income Tax Act (Cap. 134) (ITA), interest paid on a loan is deductible if, amongst other things, the Comptroller of Income Tax (CIT) is satisfied that the loan constitutes “capital employed in acquiring the income”.

Traditionally, the phrase is taken to imply a “direct link” requirement, the genesis of which is the CA decision inAndermatt Investments Pte Ltd v CIT [1995] 2 SLR(R) 866. The test was cited with approved by the CA in JD v CIT [2005] SGCA 52 and BFC v CIT [2014] SGCA 39, i.e. in at least 3 decisions of the CA (although the discussions in the latter 2 cases are somewhat cursory).

The taxpayer in BML challenged this frontally.

As the CA interpreted its arguments, it argued:

a.   Interest is deductible so long as it is payable on capital that appears on the same balance sheet as the taxpayer’s income-producing assets (the “representation test”);

b.   That capital is “employed in acquiring the income” if the taxpayer’s income-producing assets are preserved or retained by such capital (the “retention test”).

The CA (not at all surprisingly) rejected the representation test as not comporting with the wording of S14(1)(a) and placing undue reliance on the balance sheet of the taxpayer.

With respect to the retention test, the CA stated that for present purposes, it was not necessary to lay down any general rule as to whether satisfying the retention test would necessarily also satisfy the direct link test – because on the facts, the interest paid in the case would not satisfy the retention test in any event. However, the CA expressed the provisional view that the retention test may be “unjustifiably broad” and may not be consistent with the statutory wording of S14(1)(a).

The CA also found the following factors relevant to the application of the direct link test:

a.   There was no observable change in the taxpayer’s rental or interest income after the issue of the Shareholder Bonds;

b.   The Shareholder Bonds did not lead to the acquisition of any new assets by the taxpayer (nb the CA agreed that “such an acquisition is not a requirement … However, that does not mean this factor is not relevant evidentially …”);

c.    There is no identified causal nexus between the Shareholder Bonds and the taxpayer’s income;

d.   The Shareholder Bonds were not issued for the (subjective) purpose of income-generation. The CA agreed that the direct link test is primarily concerned with an objective state of affairs rather than the taxpayer’s subjective intentions. “However, this is not to say that the purpose of a transaction or the intention of the taxpayer does not have evidential value …”

e.   The Shareholder Bonds “… replaced a debt of the same amount and involved no actual flow of funds. It therefore did not improve the cash flow or liquidity of the …” taxpayer.

3. What is the deductibility of debt-to-debt refinancing?

In BML, the CA suggested that one way of looking at Andermatt was to view the ‘capital’ used to acquire the target company’s shares in that case as the debt to the vendor that arose when the shares were acquired on credit. The overdraft was then taken to refinance the prior debt. The CA said “If so characterized, a causal nexus would exist between the debt and the dividends from the acquired shares”.

So the CA would appear to have potentially accepted deductibility in debt-to-debt refinancing situations. One possible consideration is how far it is necessary to go on to consider whether the refinancing improved the “cash flow or liquidity” of the taxpayer (see above for the factors which the CA cited as being potentially relevant to the application of the ‘direct link’ test). Another possible consideration is whether the refinancing is necessary to prevent the taxpayer’s assets from being sold to repay the earlier debt (see e.g. the treatment by the CA of the case of Yeung v FCT (1988) 88 ATC 4193).

Interestingly, in the High Court in BML, the judge noted that IRAS “… accepts that [deduction in a refinancing case] is not allowed by the statute, because the money borrowed from re-financing would have been used to repay another loan rather than to purchase new assets. But IRAS allows a deduction by way of an “administrative concession” if the re-financing was carried out for genuine commercial reasons. The strict reading of the statute may thus not reflect the full commercial reality as IRAS sees it.”

This is, in my respectful view, rather too charitable to IRAS. The reality is not that IRAS “accepts” that interest on a re-financing loan is not deductible. Rather, it is IRAS itself which is advocating this position, and many practitioners would disagree with it !

IRAS has long taken the position that refinancing technically breaks the causal link required. See https://www.iras.gov.sg/irashome/Businesses/Companies/Working-out-Corporate-Income-Taxes/Business-Expenses/Tax-Treatment-of-Business-Expenses--I---P-/(“Based on a strict interpretation of the governing section, Section 14(1)(a)(i), interest expenses incurred on a loan taken up to re-finance an earlier loan or borrowing is not deductible for tax purposes, as the subsequent loan is taken up to repay an existing one and the interest incurred is therefore not payable on capital employed in acquiring the income”) although there is an administrative concession in place. Technically, IRAS’ position is highly doubtful but the practice of CIT is what it is …

4. What about equity-to-debt refinancing situations?

 Of course if IRAS doesn’t accept the direct link is satisfied in the case of a debt-to-debt refinancing, a fortiori it won’t in the case of equity-to-debt refinancing.

Nonetheless, in Andermatt, the CA did say, expressly, that in the Australian cases of FCT v JD Roberts and Smith (1992) 92 ATC 4380 and Yeung, the “direct link was there”. But this was only obiter dicta.

In BML, the ITBR considered that the case on substituted financing should only apply to debt-to-debt refinancing, although it provided no reasoning and its citation ofYeung shows that its analysis is likely wrong (because in Yeung, the court held that it was immaterial whether the original amount refinanced was debt or partnership capital and in the CA, Yeung was treated as a case where debt refinanced prior partnership capital).

In the High Court in BML, the judge said : “I accept that there may be instances where it can reasonably be said that when loan capital replaces equity capital, there can still be a direct link between the money borrowed and the income, e.g., in Yeung, where the partners were essentially paid back the same amount that they had invested into the business.”

In other words, the judge seems to have accepted that a direct link may exist in an equity-to-debt refinancing case. The judge also noted that in Roberts and Smith, the Court was “… clear that where the new borrowing did not operate as a ‘refund of a pre-existing capital contribution’, deduction of the interest expenses on the new borrowing would not be allowed. Thus, interest on loans to replace partnership capital represented by internally generated goodwill would not be deductible.”

In other words, in an equity-to-debt refinancing situation, the equity refinanced must have been contributed equity used to generate income. Equity arising from profit or revaluation reserves etc. cannot be refinanced into deductible interest.

There was only cursory discussion in the CA as to the case law on substituted financing (e.g. the CA noted that in Roberts and Smith, Hill J treated the decision in Yeung as a case of substituted financing). However, BML is noteworthy in that the CA did place some emphasis on the deference which the court thought should be granted to CIT in relation to the finding of direct nexus having regard to the wording of S14(1)(a). Also the court appears in its treatment of Yeung to have placed some weight to the fact that the assets of the taxpayer would have to be sold, i.e. the financing could be argued to have been necessary for the taxpayer to preserve its assets 

Another interesting and unresolved question is whether deduction in a refinancing case could be denied on the ground that the expense was a dual purpose expense and not “wholly and exclusively” incurred for the relevant tax purpose. This question was specifically left undecided by the CA in Andermatt (because the taxpayer failed the direct link test in any event). In BFC (para 10), the CA stated that “... for an expense to be deductible under the general deduction formula, it must have been ‘wholly and exclusively incurred’ in the production of income. But this requirement does not apply to the specific deductions enumerated in the subsections under S14(1), including 14(1)(a) …” This has to be considered, however, in light of S15(1)(b) of the ITA which forbids deduction of “… any disbursements or expenses not being money wholly and exclusively laid or or expended for the purpose of acquiring the income.”. There may well be a difference between the direct nexus test and a "purpose" test, however. See the discussion of the Hong Kong Zeta Estates case below.

5. Loans taken out to pay dividends?

In Hong Kong, the Court of Final Appeal in Zeta Estates Ltd v CIR [2007] HKLRD 102 allows deduction for interest paid on debts arising from dividends declared but not paid out in cash.

In BML, the CA found that Zeta Estates would not assist the taxpayer as S14(1)(a) of the ITA is different from S16(1)(a) of the HK IRO, which used the phrase “for the purposes of producing such profits” in the deduction section. Additionally, the HK IRO did not provide for the Commissioner’s discretion in assessing the satisfaction of the statutory direct nexus test.

6. Is interest payable on a loan used to acquire an asset which is income-producing still capital in nature?

In BFC, the CA held that interest on a capital loan was always capital in nature, even once the asset acquired by the loan started to produce income. The CA rejected the argument that the character of interest transmutes when the acquired asset starts to produce income, which was accepted by e.g. the Privy Council in Wharf Properties Ltd v CIR [1997] AC 505.

In BML, the CA noted that the interaction between S14(1), 14(1)(a) and 15(1)(c) was an “important but perplexing issue“. The CA expressly noted that there has been some concern about the approach taken in BFC. But as the difficulties did not arise in the case and neither party saw the need to challenge the principles in BFC, the CA proceeded on the principles in BFC for present purposes.

This is indeed a technically vexing question.

On the one hand, the logic of saying that interest transmutes in character once the underlying asset starts to generate income is open to question*, but the difficulty with the argument that S14(1)(a) is a carve out from S15(1)(c) is that this appears to contradict the wording of the ITA which is that S15(1)(c) appears to be an overriding section because it says “Notwithstanding the provisions of this Act”.

The CA in BFC was specifically aware of this wording but nonetheless construed S14(1)(a) as a specific exception 

I used to think the CA’s argument in BFC had no technical basis, and was therefore wrong, and indeed the CA in BFC was not able to explain at all clearly how it overcame the difficulty of the wording, but I perhaps have a (slightly) softer view of the point now.

In any case, it is of note that in BML, the CA has at least recognized the controversy around the point – although it may not arise in all that many cases. The issue may arise in a future case where the issue turns on whether deduction of interest on a capital loan may be claimed under the general wording of S14(1) instead of under the specific interest deduction section of S14(1)(a). In BFC, the CA accepted (rightly) that the general deduction provision of S14(1) was subject to S15(1)(c).

* by contrast, the HCA in Steele’s Case considered that interest was inherently revenue in character.