23 March 2018
The 2016 Singapore Transfer Pricing Guidelines on related-party loans
The Inland Revenue Authority of Singapore published the 3rd edition of its Transfer Pricing Guidelines on the second working day of the New Year. In this new edition, the IRAS' expectations concerning related-party loans have been slightly elaborated. The guidelines now state that a debtor should apply the arm's-length principle when borrowing from a related party. In other words, a borrower is required to pay a related lender an arm's-length rate of interest. The previous guidelines only mentioned charging arm's-length interest when lending. They did not specifically address borrowing.
'When a taxpayer makes a loan to or becomes a creditor of a related party, it should apply the arm's-length principle and charge the related party for the use of the funds as an arm's-length interest rate.'— Transfer Pricing Guidelines prior to 4 January 2016
'When a taxpayer makes a loan to or becomes a creditor of a related party, it should apply the arm's-length principle and charge the related party for the use of the funds as an arm's-length interest rate. _Similarly, a taxpayer should apply the arm's-length principle when it receives a loan from or becomes a debtor of a related party._' [Emphasis added.]— Transfer Pricing Guidelines from 4 January 2016
It is certainly the case that the arm's-length principle requires interest to be charged at a rate that would be charged between independent parties under similar circumstances. Taxpayers had been told since 2006, when the IRAS issued its first transfer-pricing guidelines, that transactions between related parties had to be carried out on an arm's-length basis. They had been told since 2009, when the IRAS issued specific transfer-pricing guidelines for related-party loans and services, that related-party loan arrangements in particular needed to comply with the arm's-length standard. Indeed, well before this new edition of the guidelines made it explicit, some advisers had been advising that borrowers were required to pay interest to related lenders. In other words, they thought that borrowing at zero interest was problematic under the original guidelines. Borrowers with interest-free loans were accordingly informed that they needed to make alternative arrangements to replace these with interest-bearing financing.
I recall one such piece of advice crossing my desk in October 2011 for a second opinion. The client had been advised to cancel — with retrospective effect to boot — more than US$75 million in 10-year, interest-free, unsecured convertible bonds. The bonds had been issued the previous year with the assistance of the same firm that now believed that the zero coupon created a tax exposure. According to this advice, the transfer pricing guidelines regarding related-party loans meant “there is a risk that the IRAS may deem an arm's length interest charge on the loan to the Bondholders. If that happens, [the borrower] would need to withhold tax at 15% on the interest ‘paid'”.
At the time, we advised, firstly, that the IRAS' concern in practice appeared to be that Singapore companies should receive an arm's-length rate of interest on loans given to related entities abroad. That is to say, the focus was on ensuring that loans receivable earned a commercial rate of interest income. Obviously, combating under-market rates of interest charged by Singapore lenders would increase the amount of tax the IRAS collected.
Secondly, we were not aware at the time of any compliance action aimed at ensuring that Singapore companies should incur interest expenses on loans payable. Such a move would generally have had the opposite and prima facie undesirable effect of reducing the amount of tax payable in Singapore.
Thirdly, it was one thing to say that the guidelines required cross-border loans entered into from 1 January 2011 (the effective date of the original guidance regarding related-party loans and services) to be made on arm's-length terms. However, it seemed that it might be quite another thing to interpret the guidelines as having the effect of requiring existing financial instruments to be cancelled.
The scope of interest withholding tax
Even if our opinion was wrong on all three counts, we believed, above all, that the IRAS could not impute interest to be payable on a loan where there was in fact no interest payable and then collect withholding tax on the deemed interest. Simply put, there surely cannot be any withholding tax when interest is not paid and not payable. Only persons paying and liable to pay interest to a non-resident are obliged to deduct tax at source.
It may be observed that, in certain instances, interest may be exempt from withholding tax. In these cases, the IRAS may nevertheless recover withholding tax if the interest is paid in breach of the conditions governing the exemption. This underlines the fact that withholding tax is wholly dependent on there actually being interest; there is manifestly no power to impute interest withholding tax in the absence of interest.
What, though, does a taxpayer do in the event the IRAS decides that withholding tax is payable?
The lengths people go to to avoid judicial review
Shortly before the new edition of the Transfer Pricing Guidelines appeared, The Straits Times carried a report on Christmas Day of the Jolovan Wham case (Wham Kwok Han Jolovan v Attorney-General  SGHC 324).
The Police had investigated Wham, a self-described general busybody and social worker in connection with an event called Democracy Now! Singapore in Solidarity with Hong Kong. This was a candlelit vigil Wham had organised in Singapore on 1 October 2014 in sympathy with the pro-democracy demonstrations taking place in Hong Kong at the time. It seems there were similar events across the world (see here).
The result of the investigation was that Wham received, in place of prosecution by the Attorney-General, a warning from the Police in the following terms:
2. Our investigations into the case have been completed. After careful consideration of the circumstances of the case and in consultation with the Attorney-General's Chambers, we have decided that a Stern Warning would be administered to you in lieu of prosecution. [Emphasis in the original.]
3. You are hereby warned to refrain from such conduct or any criminal conduct. If you commit any offence in the future, the same leniency may not be shown towards you.”
Wham applied to court for leave to commence judicial review proceedings, believing 'that he had done nothing wrong to warrant a warning and therefore he did not consent to the warning being issued to him'.
The Police commonly give offenders warnings in lieu of prosecution since not every offence merits prosecution. Typically, a warning sets out the individual's name, the offence he is receiving the warning for, and the date and place of the offence. However, such warnings are not provided for by statute, nor are there any published guidelines. If an offender refuses to accept a warning, the charge(s) against him might be prosecuted. In other cases, the Police might regard the offender has having been warned and the matter closed even if he refuses to accept the warning and the implication that an offence was in fact committed.
Wham found himself in the latter situation. When he inquired into the outcome of his case, he was informed that it had been placed on the record that he had been warned and the case closed. Neither the Police nor the Attorney-General replied to his written objections afterwards disputing the warning.
In Public Prosecutor v Siew Boon Loong  SGHC 20, the prosecutor referred to a warning in lieu of prosecution and two previous convictions that the defendant had received as a juvenile as criminal antecedents (although it appears the court only took the convictions but not the warning into consideration).
In Public Prosecutor v WG  SGJC 2, the Juvenile Court, in sentencing the defendant for possession of an offensive weapon, treated him as a repeat offender because he had been warned once before for mischief by fire and on another occasion for inhalant abuse.
In Public Prosecutor v Muhammad Irwan Spykerman  SGDC 122, the court regarded a warning given by the Singapore Boys' Home for theft of chocolate bars and another by the Police for a sexual act against the order of nature as prior offences.
The defendant in Public Prosecutor v Tan Hiang Seng  SGDC 146 was under a casino exclusion order. To evade this restriction, he took his mother's identity card without her permission and used it to continue visiting the casino. When he was caught, he flushed the identity card down the toilet. He received a warning for taking the identity card in the first instance; and was prosecuted for misusing and then destroying it. The court treated the warning as an aggravating factor in sentencing him on the charges.
In short, warnings given in lieu of prosecution for offences are placed on the record. They have been cited in court by prosecutors as prior offences, and the courts have taken note of them in sentencing decisions. Be that as it may, in opposing Wham's application for judicial review, the Attorney-General 'submitted that it would be wrong for a court to take into account a prior warning, whether as an antecedent or not, for the purpose of sentencing and he stressed that the prosecution would not in future mention a prior warning to a court for the purpose of enhancing a sentence'.
In the event, the High Court accepted the Attorney-General's submissions and dismissed Wham's application. The judge held that the warning did not affect Wham's legal rights, interests or liabilities and, as such, it was not susceptible to review by the courts.
Jolovan Wham_'s case is relevant to loan interest and withholding tax because the Attorney-General successfully defended the action by relying on the decision of the Court of Appeal — Singapore's highest court — in _Comptroller of Income Tax v ACC  SGCA 13.
The Comptroller's decisions on withholding tax have no effect
So far as I am aware, the ACC case was the first time that the administration of withholding tax received the scrutiny of the courts. The case had a number of surprising outcomes, to wit, that the Comptroller's decisions regarding withholding tax have no legal effect and the taxpayer who disagrees with the Comptroller's decisions need not pay unless and until the Comptroller brings a successful lawsuit to recover the tax.
The case involved interest rate swaps. The swap counterparties regarded the transaction as a contractual exchange of anticipated cash flows. They were not in a lender-borrower relationship; neither was liable to pay interest as such to the other. ACC accordingly believed that interest withholding tax did not apply. It wrote to the IRAS to confirm that it did not need to deduct tax at source.
Withholding tax applies in Singapore to 'interest… or any other payment in connection with any loan'. The Comptroller was accustomed to interpreting this provision broadly. Specifically, the Comptroller thought that the statute was wide enough to cover the interest rate swaps in question — notwithstanding that there was no loan between the counterparties — because the swaps were a hedge for underlying loans. Far from agreeing with ACC that there was no tax to pay, the Comptroller replied that:
'We have reached determination on your request after due consideration and consultation of the issue raised based on the representations and information furnished. …Our Enforcement Division will be contacting you separately on the recovery of the tax and penalty due… '— Comptroller of Income Tax v ACC  SGCA 13 at .
I have before me just such a letter from the Enforcement Division of the IRAS to a client. It is entitled Section 45 Withholding Tax and it reads:
'I refer to our tax auditor's letter… in demand for the settlement of withholding tax… and late payment penalties…
[Y]ou are required to submit the Form IR37 [withholding tax return] together with the payment aforementioned… Otherwise, further recovery actions may be taken against you, including appointing you® bank to pay the outstanding tax from moneys held by [it] for or due to you.'
The late-payment penalties refer to the fact that a return must be filed and withholding tax paid to the IRAS by the 15th of the second month from the date on which interest is paid to a non-resident. The penalty for missing this deadline is 5% of the tax due. After that, there is an additional penalty of 1% for every completed month that the tax remains unpaid. The late-payment penalties are capped at 20%.
The Enforcement Division's reference to recovery action involving the taxpayer's bank alludes to the Comptroller's power to appoint the bank as the taxpayer's agent and to collect any withholding tax the Comptroller believes is due, by attaching the taxpayer's funds.
In the face of these sanctions, a taxpayer generally may be relied upon to pay the withholding tax demanded by the Comptroller, even if it is dissatisfied with the Comptroller's determination on the merits. ACC was no exception:
'The [company] did not agree with the Comptroller's interpretation… Nevertheless the [company] seemed to treat the [Comptroller's letter] as containing an administrative decision or a determination that, if not quashed by a court order, would result in its having to pay withholding tax and any corresponding penalties… In the course of hearing this appeal, we were informed that the [company] had already paid, under protest, the amount of withholding tax… determined by the Comptroller.'— Comptroller of Income Tax v ACC  SGCA 13 at .
ACC applied to court for leave to apply for judicial review of the Comptroller's 'determination' that interest swaps were subject to deduction of tax at source. The Comptroller opposed this on the grounds that ACC had no locus standi and its application was an abuse of process.
The swap payments, after all, were the income of the foreign counterparty. Withholding was only a process for collecting tax from a taxpayer that was outside the jurisdiction. The payment subject to tax was not ACC's income. ACC was not the taxpayer as such and therefore, so the Comptroller argued, had no standing to ask the court to quash the Comptroller's decision. In other words, ACC had to pay withholding tax to the Comptroller under sanction of penalties and administrative action against its bank accounts with no recourse to the courts since, according to the Comptroller, there was no justiciable issue between him and the company.
Before the Court of Appeal, the IRAS' legal officers said that ACC could have challenged the Comptroller's decision if the Comptroller had sued the company for the tax:
'We asked counsel for the Comptroller whether, if the Comptroller were to commence proceedings [in court] against [ACC]…, the latter would be entitled to dispute its liability to pay the tax demanded. Counsel for the Comptroller conceded that [ACC] might be able to resist the Comptroller's claim on the ground that the Comptroller's determination was wrong in law.'— Comptroller of Income Tax v ACC  SGCA 13 at .
On this basis, the Court of Appeal held that the Comptroller's determination that ACC was to deduct tax from its swap payments had no effect on ACC:
'On the basis of this concession, it was clear to us that the Comptroller's determination… was nothing more than an expression of the Comptroller's opinion. Regardless of whether or not that determination was final from the Comptroller's point of view, it had no actual or ostensible legal effect on the [company]. …It would follow that the [company] could simply have ignored the Comptroller's demand for payment and waited for the Comptroller to commence proceedings against it [in court] to recover the amount which was allegedly payable.'— Comptroller of Income Tax v ACC  SGCA 13 at .
Be that as it may, had ACC not paid the tax, it seems likely that the Enforcement Division would have relied on administrative action first to recover the tax, rather than commence legal proceedings against the company. The Enforcement Division does not as a rule use lawsuits as the primary means of tax collection.
In any case, as the court itself had noted earlier in its judgment, ACC had in fact paid the tax once the Comptroller informed the company that it was liable for withholding tax and penalties and subject to administrative enforcement. It is fair to say that most taxpayers would do so too. The Comptroller's determinations are generally received with a degree of authority.
Even in cases where taxpayers had objections, I would have presumed that withholding tax was paid in the great majority of instances without the Comptroller suing for it. Once the withholding tax was paid and collected, both the taxpayer and the Comptroller would have treated the matter as closed and concluded — until ACC applied for leave to quash the Comptroller's decision. It must have occurred to few taxpayers that they were under no liability to pay any withholding tax whatever directions they received from the Comptroller if they did not agree with those directions. Nevertheless, the Court of Appeal held that:
'[The Income Tax Act] merely states the responsibility of the Comptroller to assess and collect tax… It does not confer any power on the Comptroller to make binding determinations of law concerning the provisions of the ITA in the discharge of this responsibility. Instead, as counsel for the Comptroller conceded, it is the court alone which can make such determinations of law if the Comptroller chooses to bring [a suit for tax]. [Emphases in the original.]
In the circumstances, the legal position of the [company] was really that it was under no liability at all to pay any withholding tax under s 45 of the ITA until a court had decided that it was so liable.'— Comptroller of Income Tax v ACC  SGCA 13 at  and .
For a moment, then, it seemed that the Comptroller would succeed in denying ACC the opportunity of setting aside his determination that interest rate swap payments were subject to withholding tax. However, neither the taxpayer nor the Comptroller had anticipated the court's reasoning. On the contrary, it was common ground between the parties that the Comptroller's determination was significant, had actual as well as legal effect, and that it was not simply to be ignored: ACC wanted the decision quashed, while the Comptroller said the company did not have locus standi before the court and was abusing the process. The Comptroller had not thought to say that his interpretation of the withholding tax provisions was an opinion with no legal effect, or that ACC had been under no liability at all to pay the tax demanded of it.
In the circumstances, the court decided that the case would proceed on the basis that the Comptroller's determination could be reviewed, and remitted the matter to the High Court for a decision on the substantive question:
'The question which we had to decide, therefore, was whether we should… let the appeal proceed on the basis that the parties had agreed that there was a determination by the Comptroller which had some legal effect on the [company].
[W]e decided that, procedurally and substantively, the [company] should be allowed to continue with the present appeal on the basis that the Comptroller's determination… was susceptible to judicial review.'
Subsequently, ACC also succeeded on the substantive issue when the High Court held that interest rate swap payments were not subject to withholding tax because the swap payments were not interest and there was no loan between the counterparties:
'Neither counter-party to a swap transaction makes any loan to the other so as to give rise to an obligation on the part of the other to pay interest.
Instead an interest rate swap agreement is an agreement between two counter-parties to ‘exchange cash flows in the future'… Typically, the quantum of the cash flows is calculated based on a notional principal amount, but it bears emphasising that no such principal amount has been passed under a loan (or other indebtedness) from one counter-party to the other. [Emphasis in the original.]
'In my view, therefore, there being no loan or indebtedness involved in an interest rate swap agreement… [i]nterest rate swap agreements should, ordinarily, fall outside the meaning… of the ITA.'— ACC v Comptroller of Income Tax  SGHC 316 at ,  and .
In summary, the Comptroller, in aiming too low, snatched defeat from the jaws of victory on the procedural question; and then lost again on the substantive issue, but this time because he overreached instead.
Applying the lessons
The injunction that a taxpayer should apply the arm's-length principle when receiving a loan from or becoming a debtor of a related party has the appearance of an empty statement; the borrower/debtor cannot help if it is not charged interest.
If a transfer-pricing adjustment were warranted, it would have to be effected on the lender/creditor in the foreign jurisdiction. It is not at all certain that even an adjustment by the foreign tax authority would induce the lender to actually charge interest. With the corporate income tax rate at 17% and the interest withholding tax rate at 15%, the fact of the matter is that withholding tax is equivalent to income tax only when the lender charges the borrower 7½ times its own interest cost.
Any 'risk' that the IRAS could impute an arm's-length interest charge to the borrower/debtor on an interest-free loan was always fanciful, and it is hard to see that there is any meaningful difference between the previous and current editions of the guidelines in this regard. One of the Enforcement Division's big sticks to back up the Comptroller's withholding tax opinions was the appointment of — or the threat to appoint — the taxpayer's bank as agent for payment of the tax demanded. After ACC, this course of action was manifestly ultra vires because the Comptroller's decisions have no effect and, provided the taxpayer is confident of its own assessment of the merits, it is under no liability at all to pay any withholding tax unless a court decides so.