Deductibility of interest expenses on occasion of capital restructuring

Capital restructuring is a corporate operation that involves changing the mixture of debt and equity in a company’s capital structure. It includes measures like capital restructuring through repurchase tender offer, open market offer, securitization. Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming them into a security. In this article, we would be discussing the deductibility of interest expenses arising out of one such securitization transaction. The root of this issue lies in the recent case of GBK v The Comptroller of Income Tax [2016] SGITBR 3. 

#Singapore taxation

In this case, question arose in front of the Singapore Income Tax Board of Review (“ITBR”). The question was whether the interest expense on the Shareholder Bonds (“Interest Expense”) was deductible for the purpose of Section 14(1)(a) of the Income Tax Act, Chapter 134 of Singapore (“ITA”)1. 

Parties to the case:

Here the taxpayer is GBK who owns and operates a mall. In October 2004, GBK had entered into a securitisation transaction by assigning its rights to the mall’s rental income, to a special purpose vehicle (“SPV”), as security for a S$520 million loan from the SPV (the “Securitisation”).

Subsequently, in December 2004, the shareholders of GBK (the “Shareholders”) restructured their equity holding in GBK to a debt-based investment by reducing GBK’s share capital (“CapitalReduction”), and subscribed for fixed rate subordinated bonds (“Shareholder Bonds”) issued by GBK.

Contention of the case:

The issue was whether the interest expense on the Shareholder Bonds (“Interest Expense”) was deductible for the purpose of Section 14(1)(a) of the Income Tax Act, Chapter 134 of Singapore (“ITA”)1. For the Interest Expense to be deductible, GBK had to show that there was a “direct link” between the incurring of the Interest Expense and the acquiring of the rental income by GBK.

Case Proceedings:

GBK had taken up the capital restructuring exercise due to various reasons like:

1. the abolition of the imputation system and the transition to the one tier
tax system of taxing profits;

2. it was commercially more expedient for the Shareholders to earn interest (in place of dividend) because interest is paid in priority to dividends and is subject to fewer restrictions (unlike dividends, interest need not be paid from profits); and

3.the Shareholder Bonds could subsequently be transferred or assigned for value, if necessary.

The issuance of the Shareholder Bonds, interest on which was sought to be deducted, were the consequences of an exercise by GBK in reorganising its capital structure solely for better profit extraction by the Shareholders.

ITBR was of the view that:

(a) there was no objective evidence to establish the fact that the issuance of the Shareholder Bonds had provided the mall with a greater capacity to generate more rental income; and

(b) it was clear from the evidence that the mall’s rental income was derived by GBK independent of the issuing of the Shareholder Bonds. The Securitisation and the Capital Reduction had no impact on the generation of rental income from the mall.

A “direct link” has to be something “real, tangible, precise and factual”. The “direct link” requirement for the purpose of Section 14(1)(a) of the ITA requires one to determine whether GBK was employing a particular capital to derive a particular income. Accordingly, the ITBR held that a “direct link” was absent in the present case – the Shareholder Bonds had nothing to do with the derivation of rental income from the mall, and were issued for reasons completely distinct from the continued earnings of the mall’s rental income. Hence, the Interest Expense were not deductible in the case.

The ITBR also explained that in the present case, there was no “substituted financing”, which otherwise could have justified deductibility. The debt represented by the Shareholder Bonds was not a “substitute” for any type of financing. For all intent and purposes, the case involved a restructuring of GBK’s capital profile from equity to debt (rather than substituting of one form of debt or financing with another). The Shareholder Bonds did not replace an original loan but were issued as the second phase of the GBK’s capital restructuring from equity to debt.
On a related note, the Comptroller had allowed the deductibility of the interest payable to SPV under the Securitisation loan as there was a direct link between the Securitisation loan and rental income derived.


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