The issue of whether a taxpayer is entitled to tax deductions for the various expenses it incurs has long been a source of debate between taxpayers and the Comptroller of Income Tax. In particular, the deductibility of financing costs such as interest expenses has been the subject of dispute in several cases. We will explore the current position of the law in this area.
The relevant statutory provisions
For a start, section 14(1)(a) of the Income Tax Act (“Act”) is the provision we are concerned with and it provides:
“14. –(1) For the purpose of ascertaining the income of any person for any period from any source chargeable with tax under this Act (referred to in this Part as the income), there shall be deducted all outgoings and expenses wholly and exclusively incurred during that period by that person in the production of the income, including –
(a) except as provided in this section—
(i) any sum payable by way of interest; and
(ii) any sum payable in lieu of interest or for the reduction thereof, as may be prescribed by regulations …
upon any money borrowed by that person where the Comptroller is satisfied that such sum is payable on capital employed in acquiring the income;…” (emphasis added).
Opening words of section 14(1) do not apply to section 14(1)(a)
It has been held by the Court of Appeal in the case of BFC v Comptroller of Income Tax  SGCA 309 (at ) that section 14(1)(a) of the Act is a “stand-alone” provision for the deduction of interest expenses. The opening words of section 14(1) of the Act do not apply nor impose additional requirements for a deduction of interest expense. This means that in order for interest expense to be deducted under section 14(1)(a), it is not necessary that such interest expense must have been “wholly and exclusively incurred” in the production of income.
Next, we turn to section 15(1)(c) of the Act which prohibits deductions of capital expenditure and it provides:
“15. –(1) Notwithstanding the provisions of this Act, for the purpose of ascertaining the income of any person, no deduction shall be allowed in respect of –
(c) any capital withdrawn or any sum employed or intended to be employed as capital except as provided in section 14(1)(h);…”
Section 14(1)(a) is an exception to section 15(1)(c)
It has been clarified by the Court of Appeal in BFC (at ) that section 14(1)(a) of the Act in effect carves out an exception to section 15(1)(c) of the Act. Thus, an interest expense that is held to be a capital expenditure will nevertheless be deductible so long as section 14(1)(a) of the Act is satisfied, i.e. where such interest was payable on “capital employed in acquiring the income”.
Application of the law and a “direct link”
Test of “direct link” between income and loan
When does a loan constitute “capital employed in acquiring the income”? The test is that there must be some “direct link” between the taxpayer’s income and the loan on which interest is incurred (Andermatt Investments Pte Ltd v Comptroller of Income Tax  2 SLR(R) 866 at ). Once this direct link is established, the interest expense is deductible.
Examples of “direct link”
One will then ask, when is there a “direct link” between income and loan? In this article, we look at some cases in various jurisdictions which have found a direct link between income and borrowed capital where borrowed capital was used (i) to replace equity, (ii) to replace retained earnings required by the taxpayer as well as (iii) to retain income-producing assets.
“Direct link” present where loan taken to replace equity
In the Australian case of Yeung v Federal Commissioner of Taxation (1988) 88 ATC 4193, borrowed funds were used to repay capital contributions made by the taxpayers to a partnership by way of advances. The court held that the interest incurred on the borrowed funds was deductible from the assessable income of the partnership. The Singapore Court of Appeal in Andermatt referred to the case of Yeung, and observed that the requisite direct link was present in Yeung, which was really a case of substituted financing.
In determining that the interest in question was deductible, Davies J in Yeung took the view that where equity capital is invested in assets that earn income, and such equity capital is repaid and replaced by loan capital, interest on the loan capital should be deductible. He further held that assets represent the equity and loan capital, and if the assets are used to earn income, then the equity and loan capital which the assets represent must also be devoted to the earning of income.
“Direct link” present where loan taken to replace retained earnings
In the Hong Kong Court of Final Appeal case of Zeta Estates Ltd v Commissioner of Inland Revenue  HKLRD 102, the taxpayer was a real estate developer that had substantial accumulated profits but was highly illiquid. It declared but did not pay dividends. The unpaid dividends were treated as loans from the shareholders to the taxpayer and commercial interest rate was charged. The Hong Kong Court of Final Appeal held that the interest expense was deductible.
“Direct link” where loan taken to retain profit-earning asset
Lord Scott Foscote NPJ (at ) found that as long as the borrowings were required by the business of the company and not surplus to its requirements, the interest payable on the borrowings would be deductible. He approved a statement of Tang JA in the Court below:
“So the question… is under what circumstances would the deduction of interest [payable on a loan taken out in order to pay a dividend] be permitted. I am of the view that under section 16(1)(a), the answer depended on whether the borrowing was necessary for the [purposes of the] business of the taxpayer. In other words, if the retained earnings in respect of which the dividend was declared was surplus to the business requirement of the company and the subsequent borrowing was similarly surplus to the requirement of the company, the interests paid on the borrowing would not be deductible. But if the retained profits were required by the business of the company… interest on shareholder loans made to replace the retained profits would be deductible.”
Lord Scott also stated (at ):
“The question relevant to Zeta’s tax liability and to the deductibility of the interest paid on the borrowings to raise fresh working capital is why the capital was raised. If fresh capital was raised by Zeta in order to retain, or maintain, its profit-earning assets the interest on the borrowings would, in my opinion, in principle be deductible under s. 16(1)(a) whether or not the Commissioner or the Board, or anyone else, approves of the commercial judgment of the directors in deciding to raise the fresh working capital.” (emphasis in original)
“Direct link” where loan taken to retain asset
Similarly, in the New Zealand Court of Appeal case of Public Trustee v Commissioner of Inland Revenue  NZLR 436, the taxpayer (who was the executor of an estate) took a loan to pay death duties such that he could leave the capital assets in the estate to earn income. The issue in Public Trustee was whether the taxpayer could obtain a deduction for interest paid on borrowed money under section 80(1)(h) of the New Zealand Land and Income Tax Act 1923. The said section provides that in calculating the assessable income of any person from any source, no deduction shall be made in respect of interest, except so far as the Commissioner is satisfied that it is payable on capital employed in the production of the assessable income.
The court held that borrowed funds used to retain the possession and use of assets belong to the same category as borrowed funds used to acquire the assets. Just as borrowed money spent in obtaining an asset is capital employed in the production of income, borrowed money spent in retaining such an asset is likewise capital employed in the production of income.
Correct test is whether loan was employed in acquiring income
In summary, in addressing the issue of deductibility of interest expenses, the correct focus must be that of the manner in which the borrowed capital (on which the interest is payable) is employed. The real question to be asked is whether the loan was employed in acquiring the income.
“Direct link” to be established
In answering the question, a “direct link” must be established between the interest expense and the relevant income. Where the link is established, the interest expense is deductible under section 14(1)(a) of the Act. This is regardless of the nature of the interest expense. Some examples of a “direct link” between income and borrowed capital as illustrated in case law are where borrowed capital was used (i) to replace equity, (ii) to replace retained earnings required by the taxpayer as well as (iii) to retain income-producing assets.
No “wholly and exclusively incurred” requirement
Further, given that there is no “wholly and exclusively incurred” requirement in section 14(1)(a) of the Act, any other purpose for the borrowed capital is immaterial in so far as it is determined that a sufficient direct link exists between the borrowed capital and the income.