Income tax treatment of hybrid instruments in Singapore
Banking on Tax, Issue 13
The Inland Revenue Authority of Singapore (IRAS) recently issued guidance on the income tax treatment of hybrid instruments in Singapore.
Prior to this guidance, there have been no specific provisions in the Singapore Income Tax Act (ITA) on the character of hybrid instruments for tax purposes (i.e. whether a hybrid instrument is debt or equity for tax purposes).
The one exception is the 2014 Singapore budget amendment to treat Basel III Additional Tier 1 (AT1) capital instruments (other than shares) issued by specified Singapore-incorporated banks and their holding companies as debt for tax purposes.
IRAS Guide: Income tax treatment of hybrid instruments
Briefly, where the legal form of a hybrid instrument issued by a Singapore-based issuer is not indicative of the legal rights and obligations, IRAS will adopt a ‘combination of factors’ approach to determine the tax treatment of an instrument. Under this approach, the characteristics of a hybrid instrument are examined and considered in entirety.
Factors considered by the IRAS (with the debt/equity inference in parenthesis) include:
- Investor acquires a shareholding and residual interest in the issuer (equity)
- Investor acquires a right to participate in the issuer’s business (equity)
- Instrument confers the investor with voting rights (equity)
- There is a fixed repayment date in a reasonably foreseeable future and repayment is not conditional on business performance of the issuer (debt)
- There is no fixed repayment date, although there is incentive for the issuer to redeem the instrument, such as a step-up feature (debt)
- Distributions are cumulative and payment is not conditional on business performance (debt)
- Investor has an unconditional right to enforce the payment of a distribution and repayment of the principal amount (debt)
- Relevant regulatory authorities in Singapore regard the hybrid instrument as debt (debt)
- The right of the investor to repayment of principal is subordinated to that of the general creditors or to the holder of subordinated debt of the issuer (equity)
- The investor is required to bear current or future losses of the issuer by way of either a write-down of the principal amount of the instrument or conversion to ordinary shares of the issuer (equity).
The Guide does not discuss the weight allocated to each factor, nor the tax treatment of instruments that have already been issued in the Singaporean market (e.g. perpetual securities). However, without the recent budget change to the treatment of AT1 capital issued by a local Singapore bank, such an instrument should be expected to be equity based on the above tests.
To characterise a hybrid instrument issued by a foreign-based issuer, IRAS will examine the above factors. IRAS notes in the Guide that it will also consider the characterisation of the instrument in the country of the foreign issuer and that “the use of this guide may be limited by new forms of hybrid instruments as well as changes in tax treatments adopted by foreign tax jurisdictions which may have an impact on the Singapore income tax consequences”.
In doing so, IRAS is seeking to address potential mismatches in the tax treatment of hybrid instruments across jurisdictions.
The position articulated by IRAS in the Guide is not the law and taxpayers may appeal to the courts if they do not agree with IRAS’ position. For taxpayers that require certainty, an advance ruling may be sought from IRAS.
Income tax treatment of Basel III AT1 instruments
Broadly speaking, AT1 capital instruments, other than shares, issued by specified Singapore banks and their holding companies will be treated as debt for income tax purposes with effect from the 2015 year of assessment (i.e. from 1 January, 2014). Distributions on these instruments will be tax deductible. Tier 2 instruments, other than shares, are currently regarded as debt for tax purposes and will continue to be regarded as debt.
This treatment does not extend to AT1 instruments issued by Singapore branches of foreign banks. These branches are not required to comply with MAS Notice 637, which is issued to banks incorporated in Singapore and sets out directives on their risk-based capital adequacy requirements. As such, hybrid instruments issued by these branches are likely to be subject to the ‘combination of factors’ approach discussed above.
A new section 14X is to be introduced into the ITA (via Income Tax (Amendment) Bill 2014). The proposed section 14X provides for the deduction of expenditure incurred by a person for the purpose of complying with any local or foreign legal or regulatory requirements, if the expenditure is not capital in nature and is incurred for the purpose of any business from which the person’s income is acquired. The new section 14X will apply from the 2014 year of assessment.
This may lead to a scenario where hybrid instruments with materially similar terms and conditions have different tax treatments based on the status of the issuer.