BML v Comptroller of Income Tax

• Jurisdiction: Singapore
• Judge: Sundaresh Menon CJ
• Judgment Date: 29 August 2018
• Neutral Citation: [2018] SGCA 53
• Court: Court of Appeal (Singapore)
• Hearing Date: 06 February 2018
• Docket Number: Civil Appeal No 119 of 2017
• Plaintiff Counsel: Ong Sim Ho, Keith Brendan Lam Xun-Yu and Khoo Puay Pin Joanne (Ong Sim Ho)
• Defendant Counsel: Foo Hui Min Felicia, Lim Chun Heng Christopher and Lim Weng Kee David (Inland Revenue Authority of Singapore (Law Division))
• Subject Matter: Revenue Law,Income taxation,Deduction
• Published date: 31 August 2018

Tay Yong Kwang JA (delivering the judgment of the court): Introduction

This appeal deals with the issue of the deductibility of interest paid on bonds issued by a taxpayer to its shareholders in the course of a capital restructuring exercise. The appellant (“the Taxpayer”) is a company which owns and operates a mall in the western region of Singapore (“the Mall”). The Taxpayer’s two shareholder companies (“the Shareholders”) own 50% each of the issued share capital of the Taxpayer. In 2004, the Taxpayer conducted a securitisation exercise (“the Securitisation Exercise”) followed by a capital restructuring exercise which was effected in two steps: (a) a capital reduction exercise (“the Capital Reduction Exercise”) followed by (b) a bond issue to the Shareholders (“the Shareholder Bonds”). This capital restructuring exercise in effect converted the Shareholders’ equity in the Taxpayer into a debt investment.

The issue before us is whether the Shareholder Bonds constitute “capital employed in acquiring the income” of the Taxpayer such that the interest paid on them is deductible under s 14(1)(a) of the Income Tax Act (Cap 134, 2014 Rev Ed) (“ITA”). The Taxpayer argues that the interest expense was deductible because the Shareholder Bonds enabled the Taxpayer to retain the Mall and were represented by the Taxpayer’s income-producing assets. The Comptroller of Income Tax (“the CIT”) disallowed the deduction on the basis that the Taxpayer failed to show a direct link between the Shareholder Bonds and the acquisition of the income against which the deductions were sought.

The background facts The Securitisation Exercise

On 17 September 2004, [WM] Limited (“WM”) was incorporated by the Taxpayer as a special purpose vehicle. Following from this, a number of transactions took place involving WM, its two Shareholders and the Taxpayer. We attach in the Annexures to this judgment two diagrams tendered by the CIT to the Income Tax Board of Review (“ITBR”) to aid in the understanding of the said transactions and the flow of funds resulting from them.

On 27 October 2004, WM raised $520m by a bond issue. Of the $520m raised, the Shareholders subscribed to $205m of subordinated junior bonds.¹ The Shareholders considered it crucial for them to subscribe to these junior bonds because, first, it would have been “practically impossible” to find third party investors willing to subscribe to these bonds at the interest rate of 4.05%, and second, the Shareholders’ subscription would signal confidence in the Mall’s performance to other potential investors.²

Subsequently, WM lent the $520m raised from the bond issue to the Taxpayer under a facility agreement (“the WM Loan”) at an effective interest rate of 3.728% per annum.³ The WM Loan was made in consideration of periodic interest payable by the Taxpayer to WM and was secured by, among other things:⁴ a fixed charge over a set of accounts to be opened and maintained by the Taxpayer, and an assignment of the Taxpayer’s rights over the tenancy agreements and rental income from the Mall.

The amount of the WM Loan, ie, $520m, was in line with the full market value of the Mall, which was valued in 2004 at $525m.⁵ According to the Taxpayer, it chose to assign its rights to the rental income from the Mall as security for the WM Loan so that it could continue to own and operate the Mall, which was at that time its only income-earning asset.⁶

The Taxpayer applied the $520m obtained from the WM Loan in the following manner: $170m was used to refinance pre-existing borrowings; $17m was used as working capital; and $333m was lent to the Shareholders pursuant to loan agreements dated 20 October 2004, under which $166.5m was advanced to each Shareholder on an unsecured basis at an interest rate of 3.78% per annum (“the Shareholder Advances”).⁷ The stated purpose of the Shareholder Advances was to enable the Shareholders to subscribe to the subordinated junior bonds issued by WM⁸ and to allow their use as general working capital.⁹

Following the Securitisation Exercise, the Taxpayer’s primary income-generating assets were (a) the interest income from the Shareholder Advances¹⁰ and (b) the rental income from the Mall. For the financial years ending 31 December 2004 through to 2008, the Taxpayer’s total assets ranged between approximately $889m and $996m. During this period, the Mall was valued at between $525m and $614m while the Shareholder Advances remained at a consistent $333m.¹¹

At the same time, the Taxpayer had to pay WM interest on the WM Loan. CIT allowed the Taxpayer to deduct the full amount of interest expense incurred on the WM Loan under s 14(1)(a) of the ITA.¹²

The capital restructuring exercise

Following the Securitisation Exercise, the Taxpayer engaged in a two-step restructuring of its capital structure, involving first the Capital Reduction Exercise and thereafter the issuance of the Shareholder Bonds.

Prior to 26 November 2004, the Taxpayer had a paid-up share capital of $10.2m.¹³ On 26 November 2004, at an extraordinary general meeting of the Taxpayer, the Shareholders resolved to reduce the share capital of the Taxpayer by the following steps:¹⁴ capitalise a sum of $325.3m (comprising $37m from retained earnings, $268.3m from the asset revaluation reserve and $20m from the capital redemption reserve); and thereafter, reduce its share capital by $333m (from $335.5m to $2.5m) by a return of the sum to the Shareholders in proportion to their shareholding.

On 2 December 2004, the Capital Reduction Exercise was approved by the High Court.¹⁵ This brought about two consequences: (a) the Taxpayer was left with a paid-up share capital of only $2.5m and (b) a debt of $333m became immediately due and payable by the Taxpayer to the Shareholders.

On 15 December 2004,¹⁶ in place of the debt of $333m immediately due to the Shareholders,¹⁷ the Taxpayer decided to issue the Shareholder Bonds, which were fixed rate subordinated bonds for an aggregate amount of $333m. The Shareholder Bonds carried interest of 7.1% per annum and would mature in 2011. Each of the Shareholders subscribed to 50% of the issue.¹⁸ The Shareholder Bonds thus formed part of the Taxpayer’s capital¹⁹ and they apparently allowed the Taxpayer to meet its capital needs after the Capital Reduction Exercise.²⁰ According to the affidavit of a director of the Taxpayer:²¹ 11 The decision to issue the Shareholder Bonds was necessary to complete the restructuring of the Shareholder’s holding in the [Taxpayer] from equity to debt without any disruption of the [Taxpayer’s] ownership of and its business of operating the Mall. … 12 The issuance of the Shareholder Bonds was a practical financing option, absent of which, the [Taxpayer] would have been unable to satisfy its obligations arising as a result of the Capital Reduction Exercise without a sale of the Mall, which was the Company’s only income producing asset, or obtaining alternative finance. Neither of these alternative courses were considered. First, it was the intention of the [Taxpayer] to continue its business of owning and operating the Mall. Second, obtaining new financing from third party banks would likely be too costly as a result of the early securitisation exercise.

Further, the Shareholder Bonds apparently provided comfort to the Taxpayer as there would be no danger of the Shareholders calling on the debt so long as interest on the bond was paid in a timely manner.

Collectively, the Capital Reduction Exercise and the issuance of the Shareholder Bonds gave effect to an equity-to-debt restructuring of the Taxpayer’s capital by replacing the Shareholders’ equity in the company with debt in the Shareholder Bonds.²² This capital restructuring exercise was said to serve two purposes: First, it allowed the Shareholders to earn interest rather than dividends. Unlike dividends, interest payments are independent of the Taxpayer’s ability to service the WM Loan.²³ This restructuring therefore addressed the anticipated problem that the Taxpayer’s ability to pay dividends would be heavily curtailed after the Securitisation Exercise. Further, interest payments also allowed the Shareholders’ return on investment to be exempted from capital maintenance rules imposed by the Companies Act (Cap 19, 2008 Rev Ed).²⁴ Second, it was said that the restructuring of the Shareholders’ investment was “timely” given the transition from an imputation system to a one-tier system of taxing corporate profits.²⁵

The contested Notices of Assessment

Between 2005 and 2009, the Taxpayer paid interest of 7.1% per annum to the Shareholders on the Shareholder Bonds (“the Interest Expense”).

The deductibility of the Interest Expense under s 14(1)(a) of the ITA is the subject of contention here and below. The Taxpayer sought to deduct it from its chargeable income in the Years of Assessment (“YAs”) 2005 to 2009. The CIT disallowed the deductions and issued Notices of Refusal to Amend in respect of each of the Taxpayer’s objections against the five assessments for YAs 2005 to 2009.²⁶

The contested interest expense in each YA is tabulated as follows:²⁷

Year of assessment	Interest Expense in contention (S$)
2005	1,101,181
2006	23,643,000
2007	23,643,000
2008	23,643,000
2009	23,643,000
Total	95,673,181

The decision below Income Tax Board of Review

On 21 November 2013, the Taxpayer filed five Notices of Appeals to the ITBR against the CIT’s decision to disallow the deduction of the Interest Expense.²⁸

On 8 November 2016, the ITBR issued its decision affirming the CIT’s decision (“the ITBR Judgment”).

The ITBR started with the legal premise established by this Court in BFC v Comptroller of Income Tax [2014] 4 SLR 33 (“BFC”) that the Interest Expense would be deductible even if it was capital expenditure falling within s 15(1)(c) of...