Nation should allow interest deduction for share investments with economic substance
By CHRIS WOO AND LIM CHIN CHIN 19 February 2010
The last few months have seen significant changes to regional tax rules as tax authorities in several countries have started to focus on the use of special purpose vehicles (SPVs) or holding companies as a means of trying to secure tax efficiencies through the use of double taxation agreements (‘treaties’).
It is common to set up these SPVs in tax efficient jurisdictions, such as Singapore, given its business friendly environment and extensive tax treaty network. Generally, Singapore’s treaties are relied upon to allow the investor to enjoy preferential withholding tax rates and sometimes exemption from taxes on gains from the disposal of shares.
Jurisdictions such as India, China and Indonesia levy taxes where investments in companies incorporated or resident there are sold by non-resident investors. It is not uncommon to have investments in these countries held by a Singapore SPV. The idea is to avoid local capital gains tax by selling the SPV rather than the shares in the local company.
Developments in the region
As with the scepticism that is being applied to the hedge fund and banking industry as a result of Madoff and hollow bond debacles, SPVs that appear to exist for no other reason than to secure tax benefits or get around local rules are beginning to be put under the microscope. This may be due to the economic crisis and the drop in public coffers, although it is felt that the sophistication required to identify abuse has been gradually increasing anyway. Undoubtedly however, the recent troubles have helped focus attention.
Three examples of the approach that is now taken to holding vehicles were demonstrated in cases in India, China and Australia, where the tax authorities effectively brushed the SPVs aside and claimed that the disposal which took place higher up on the ownership chain was ineffective for avoiding local capital gains tax.
Apart from the scrutiny that such investment holding structures are being subjected to, more domestic rules have been tightened recently to make it more difficult to claim treaty benefits. In October last year for example, the Chinese tax authorities issued guidelines for the determination of beneficial ownership for the purpose of claiming tax treaty benefits in respect of lower withholding taxes. In less than a month, this move was emulated by the Indonesian tax authorities.
The tax authorities’ aim is to curb the misuse of any tax treaty. Greater emphasis has therefore been placed on determining the rationale for the holding company being located in a particular jurisdiction, given the ultimate beneficial ownership of the investment.
The key point to be drawn from the new approach and related regulation is the relevance of economic substance where treaty benefits are sought. The investor with substantive business activities in the country of residence of the SPV is less likely to be regarded as a conduit company than if there are no related party activities going on around it at all. Essentially, the tax authorities’ aim is to ensure that the recipient of the income is the genuine owner of it and not merely an agent or conduit which is established to avoid, reduce or shift the incidence of tax on profits. Singapore has already shown its support to curb treaty abuse in a general context with its amendments to domestic law for the implementation of internationally agreed standards for the effective exchange of information through tax treaties.
Singapore can help investors set up holding companies here by encouraging a move away from the traditional holding company that merely holds shares and has no employees or other income. The potential benefits to Singapore of holding companies which need, as a prerequisite, to have activities associated with them, are bringing into the country new income streams, increased economic activity, more jobs and enhanced skills. While this may help address the regional development referred to earlier, additional incentives will be required. This can be achieved with no tax erosion of Singapore’s tax base.
Interest and borrowing costs for investment in shares remain a bugbear for many investors. Under current tax legislation in Singapore, interest paid on debt taken out by a Singapore acquirer to finance the acquisition of assets or businesses that generate taxable income is tax deductible. However, where the money is borrowed to acquire shares of companies that house those assets or businesses, the interest expense will generally not be tax deductible. This is because the returns from the share investments will generally be exempt from tax in the investor’s hands, tax having been paid at the level of the acquired company. This creates an unfair and unnecessary distortion in the market, given that in substance, the two transactions are the same.
Interest costs incurred on an investment in shares could be allowed as a deductible tax expense where the acquisition is accompanied by new economic substance in the acquiring entity or in the company acquired. In order to qualify for the tax deduction, and this may include the ability to transfer the excess interest expense incurred by the acquirer against the profits of the company acquired, certain conditions would need to be met. This could include additional and substantive business activities, minimum business spending and a minimum number of employees based in Singapore.
Such conditions should not be as demanding as those relating to current tax incentives that offer reduced corporate tax rates. In a situation where a group of companies which has foreign subsidiaries or affiliates is acquired, it may be possible to restructure operations that would cause the Singapore company to derive and repatriate greater profits. This would result in greater value-added activities employed in Singapore. Without the reorganisation, these income streams would not have been moved to Singapore in the first place.
For further value to Singapore, the deduction might only be allowed for interest paid to Singapore-based banks. This would provide additional support to the banking industry in Singapore.
Both investors and Singapore stand to gain
In the light of the regional developments highlighted earlier, the creation of greater economic substance in the manner described would serve an investor on a two-fold basis.
Allowing interest expense deductions levels the playing field to accommodate investors who may be unwilling or unable to conclude an asset deal and therefore secure tax deductions from their borrowing costs. The non-deductibility of interest costs can have a significant impact on the economics of a deal, and render many of them unappealing. Singapore is therefore potentially losing out on investors who would otherwise be prepared to invest in the country. By offering tax deductions for the interest expense, Singapore gives nothing away in these cases.
Insistence on economic substance would also put the Singapore acquiring company beyond any challenge of treaty shopping where it will hold regional investments.
Encouraging mergers and acquisitions activity in Singapore can provide other benefits. Other sectors such as property and retail could benefit from the increased economic activity. The value of Singapore companies would be enhanced, resulting in higher transfer values and stamp collections in due course.
Another sweetener that could be added would be for Singapore to have more transparent rules on the taxation of gains on the disposal of shares. If investors had greater certainty that a Singapore holding company that makes gains from the disposal of its investments is not subject to tax in Singapore, there would be an even greater incentive for coupling the creation of economic substance in Singapore and the use of a Singapore company for acquisitions or investments in the region. It is recognised that an attempt has been made at clarifying the rules for capital gains made by qualifying investment holding companies, however it is felt that these are rather limp and restrictive.
We have witnessed a continuous review of tax rules and strategies taken by the authorities to address abusive use of tax treaties. This development places greater emphasis on careful tax planning, particularly in relation to the holding company’s location. Given this and the potential benefits outlined above, it is timely for Singapore to undertake a reform of the interest deduction rules to enable Singapore to obtain a greater slice of the M&A and regional investment pie.
Chris Woo is a Partner, M&A Tax and Lim Chin Chin is a Senior Consultant, M&A Tax with PricewaterhouseCoopers Services LLP Singapore
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Stricter tax regimes can benefit Singapore
Nation should allow interest deduction for share investments with economic substance
By CHRIS WOO AND LIM CHIN CHIN
19 February 2010
The last few months have seen significant changes to regional tax rules as tax authorities in several countries have started to focus on the use of special purpose vehicles (SPVs) or holding companies as a means of trying to secure tax efficiencies through the use of double taxation agreements (‘treaties’).
It is common to set up these SPVs in tax efficient jurisdictions, such as Singapore, given its business friendly environment and extensive tax treaty network. Generally, Singapore’s treaties are relied upon to allow the investor to enjoy preferential withholding tax rates and sometimes exemption from taxes on gains from the disposal of shares.
Jurisdictions such as India, China and Indonesia levy taxes where investments in companies incorporated or resident there are sold by non-resident investors. It is not uncommon to have investments in these countries held by a Singapore SPV. The idea is to avoid local capital gains tax by selling the SPV rather than the shares in the local company.
Developments in the region
As with the scepticism that is being applied to the hedge fund and banking industry as a result of Madoff and hollow bond debacles, SPVs that appear to exist for no other reason than to secure tax benefits or get around local rules are beginning to be put under the microscope. This may be due to the economic crisis and the drop in public coffers, although it is felt that the sophistication required to identify abuse has been gradually increasing anyway. Undoubtedly however, the recent troubles have helped focus attention.
Three examples of the approach that is now taken to holding vehicles were demonstrated in cases in India, China and Australia, where the tax authorities effectively brushed the SPVs aside and claimed that the disposal which took place higher up on the ownership chain was ineffective for avoiding local capital gains tax.
Apart from the scrutiny that such investment holding structures are being subjected to, more domestic rules have been tightened recently to make it more difficult to claim treaty benefits. In October last year for example, the Chinese tax authorities issued guidelines for the determination of beneficial ownership for the purpose of claiming tax treaty benefits in respect of lower withholding taxes. In less than a month, this move was emulated by the Indonesian tax authorities.
The tax authorities’ aim is to curb the misuse of any tax treaty. Greater emphasis has therefore been placed on determining the rationale for the holding company being located in a particular jurisdiction, given the ultimate beneficial ownership of the investment.
The key point to be drawn from the new approach and related regulation is the relevance of economic substance where treaty benefits are sought. The investor with substantive business activities in the country of residence of the SPV is less likely to be regarded as a conduit company than if there are no related party activities going on around it at all. Essentially, the tax authorities’ aim is to ensure that the recipient of the income is the genuine owner of it and not merely an agent or conduit which is established to avoid, reduce or shift the incidence of tax on profits. Singapore has already shown its support to curb treaty abuse in a general context with its amendments to domestic law for the implementation of internationally agreed standards for the effective exchange of information through tax treaties.
How can Singapore benefit?
Singapore can help investors set up holding companies here by encouraging a move away from the traditional holding company that merely holds shares and has no employees or other income. The potential benefits to Singapore of holding companies which need, as a prerequisite, to have activities associated with them, are bringing into the country new income streams, increased economic activity, more jobs and enhanced skills. While this may help address the regional development referred to earlier, additional incentives will be required. This can be achieved with no tax erosion of Singapore’s tax base.
Interest and borrowing costs for investment in shares remain a bugbear for many investors. Under current tax legislation in Singapore, interest paid on debt taken out by a Singapore acquirer to finance the acquisition of assets or businesses that generate taxable income is tax deductible. However, where the money is borrowed to acquire shares of companies that house those assets or businesses, the interest expense will generally not be tax deductible. This is because the returns from the share investments will generally be exempt from tax in the investor’s hands, tax having been paid at the level of the acquired company. This creates an unfair and unnecessary distortion in the market, given that in substance, the two transactions are the same.
Interest costs incurred on an investment in shares could be allowed as a deductible tax expense where the acquisition is accompanied by new economic substance in the acquiring entity or in the company acquired. In order to qualify for the tax deduction, and this may include the ability to transfer the excess interest expense incurred by the acquirer against the profits of the company acquired, certain conditions would need to be met. This could include additional and substantive business activities, minimum business spending and a minimum number of employees based in Singapore.
Such conditions should not be as demanding as those relating to current tax incentives that offer reduced corporate tax rates. In a situation where a group of companies which has foreign subsidiaries or affiliates is acquired, it may be possible to restructure operations that would cause the Singapore company to derive and repatriate greater profits. This would result in greater value-added activities employed in Singapore. Without the reorganisation, these income streams would not have been moved to Singapore in the first place.
For further value to Singapore, the deduction might only be allowed for interest paid to Singapore-based banks. This would provide additional support to the banking industry in Singapore.
Both investors and Singapore stand to gain
In the light of the regional developments highlighted earlier, the creation of greater economic substance in the manner described would serve an investor on a two-fold basis.
Allowing interest expense deductions levels the playing field to accommodate investors who may be unwilling or unable to conclude an asset deal and therefore secure tax deductions from their borrowing costs. The non-deductibility of interest costs can have a significant impact on the economics of a deal, and render many of them unappealing. Singapore is therefore potentially losing out on investors who would otherwise be prepared to invest in the country. By offering tax deductions for the interest expense, Singapore gives nothing away in these cases.
Insistence on economic substance would also put the Singapore acquiring company beyond any challenge of treaty shopping where it will hold regional investments.
Encouraging mergers and acquisitions activity in Singapore can provide other benefits. Other sectors such as property and retail could benefit from the increased economic activity. The value of Singapore companies would be enhanced, resulting in higher transfer values and stamp collections in due course.
What else could be done?
Another sweetener that could be added would be for Singapore to have more transparent rules on the taxation of gains on the disposal of shares. If investors had greater certainty that a Singapore holding company that makes gains from the disposal of its investments is not subject to tax in Singapore, there would be an even greater incentive for coupling the creation of economic substance in Singapore and the use of a Singapore company for acquisitions or investments in the region. It is recognised that an attempt has been made at clarifying the rules for capital gains made by qualifying investment holding companies, however it is felt that these are rather limp and restrictive.
We have witnessed a continuous review of tax rules and strategies taken by the authorities to address abusive use of tax treaties. This development places greater emphasis on careful tax planning, particularly in relation to the holding company’s location. Given this and the potential benefits outlined above, it is timely for Singapore to undertake a reform of the interest deduction rules to enable Singapore to obtain a greater slice of the M&A and regional investment pie.
Chris Woo is a Partner, M&A Tax and Lim Chin Chin is a Senior Consultant, M&A Tax with PricewaterhouseCoopers Services LLP Singapore
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