26 September 2013

Revenue Law— Income Taxation — Deduction

Facts

The Appellant carries on the business of hospitality, investment holding and property investment. The Appellant also owns and operates a hotel (“the Hotel”). In 1995 and 1996, the Appellant issued bonds (subsequently referred to as “the 1995 Bonds” and “the 1996 Bonds” respectively). Each bond issue was for a five year term with the 1995 Bonds maturing in 2000 and the 1996 Bonds maturing in 2001.

The 1995 Bonds were secured bonds and interest was payable semi-annually in arrears on the principal amount. In addition to interest, discount and redemption premium were also offered to purchasers.  The Appellant presented that the proceeds of the 1995 Bonds were used for (a) the financing of the renovation of the Hotel, (b) the refinancing of the existing borrowings of both the Appellant and its subsidiaries, and (c) as working capital for the day-to-day operations of the Appellant’s business.

The 1996 Bonds were unsecured bonds and interest was payable annually in arrears on the principal. As with the 1995 Bonds, the Appellant offered a discount on the 1996 Bonds. However, no redemption premium was offered for the 1996 Bonds. The proceeds of the 1996 Bonds were used as working capital to finance the day-to-day operations of the Appellant’s business.

The Disputed Tax Treatment 

In assessing the Appellant’s income that was chargeable with tax, the Comptroller of Income Tax (“CIT”) allowed the deduction of interest paid on the 1995 Bonds and the 1996 Bonds. With regard to the 1995 Bonds, the Appellant was able to identify (and the CIT accepted) that part of the net proceeds was used to finance the renovation of the Hotel and the CIT allowed a proportionate deduction for the interest paid on the 1995 Bonds. The Appellant sought a similar deduction relating to the discount and redemption premium incurred in respect of the 1995 Bonds.

As for the balance of the proceeds of the 1995 Bonds and the 1996 Bonds, the CIT regarded this as forming a mixed pool of funds and applied an interest adjustment method known as the Total Assets Method (“the TAM”). In applying the TAM, the CIT only allowed a deduction for interest expenses attributable to income-producing assets. The Appellant thus sought similar deductions based on the TAM for the discounts and redemption premium paid on the 1995 Bonds and the 1996 Bonds.

The Appellant’s claims for the above deductions were disallowed by the CIT on two grounds:

(a)   The discounts and redemption premium did not constitute “interest” and therefore were not deductible under section 14(1)(a) of the Income Tax Act (Cap 134, 2001 Rev Ed)(“the ITA”).

(b)   The discounts and redemption premium were not outgoings and expenses wholly and exclusively incurred in the production of the Appellant’s income chargeable with tax and therefore not deductible under section 14(1) of the ITA.

Dissatisfied with the CIT’s disallowance of its claims, the Appellant appealed to the Income Tax Board of Review (“the ITBR”).

The Decision of the ITBR

The appeal was heard by the ITBR on 25 July 2012 and dismissed in its grounds of decision (“the GD”) dated 14 December 2012. The ITBR held that the discounts and the redemption premium were not deductible for three primary reasons:

(a)   The discounts were not deductible under section 14(1) of the ITA as they only related to the non-receipt of the amount of the discounts. Therefore, they were not “outgoings or expenses” incurred by the Appellant.

(b)   The discounts and redemption premium were not deductible under section 14(1) of the ITA because part of the bond proceeds formed a mixed pool of funds, some of which were not used for income producing purposes. Accordingly, the discount and redemption premium were not wholly and exclusively incurred in the production of the income.

(c)   The discounts and redemption premium were not “interest” within the meaning of the term under section 14(1)(a) of the ITA and therefore did not qualify for deduction under that provision. This was because the discounts and redemption premiums were one-off payments while interest remained payable as long as the bonds remained unredeemed. Furthermore, section 10(1)(d) of the ITA referred distinctly to “interest” and “discount”, thereby importing a difference between the two, even if they were both examples of borrowing costs. In this regard, the 2008 amendments to the ITA which specifically provided for the deduction of discounts and redemption premiums also suggested that such borrowing costs were not interest.

The Appellant appealed to the High Court against the whole of the ITBR’s decision.

Issues

(a)   Whether the discounts and redemption premium constitute “interest” under section 14(1)(a) of the ITA.

(b)   Whether the discounts and redemption premium were outgoings and expenses wholly and exclusively incurred in the production of the Appellant’s income under section 14(1) of the ITA.

(c)   Whether the discounts and redemption premium were capital as opposed to revenue expenses and therefore prohibited from deduction under s 15(1)(c) of the ITA.

Conclusion

The Appellant’s appeal was dismissed.

The key points in arriving at the decision were as follows:

(a)   Were the discounts and redemption premium “interest” under section 14(1)(a) of the ITA?

The Judge noted that section 14(1)(a) of the ITA grants a deduction to sums payable as “interest” upon money borrowed by the taxpayer. However, the term “interest” is not defined by the ITA and its meaning falls to be determined as a matter of statutory interpretation.  There has also been little local authority interpreting the term.

In this regard, case law indicates that interest can be described as the compensation paid to a lender for the use of his money.  Alternatively, from the perspective of the borrower, interest is the consideration paid for the use of the lender’s money. Furthermore, it is said that nomenclature, or the label attached to a payment, does not affect the legal question of whether that payment is or is not interest.  The common law looks at the substance of a transaction and not at its label or form.

While interest, discounts and redemption premiums may be incurred by a borrower as consideration for the use of the lender’s money, the Judge decided that it does not however follow that the discounts and redemption premiums are necessarily interest.

In addition, the Judge held that one must consider the essential characteristics of each of those concepts of “interest”, “discount” and “redemption premium”, in particular, the differences between each concept.  It is only where a payment made by a borrower bears the characteristics of interest, discount or redemption premium that it can be properly called, notwithstanding the label one attaches to that payment. In this regard, the Judge agreed with the CIT’s contention that a fundamental feature of interest is that it accrues with time.

In examining whether true discounts and redemption premiums bear the same features as interest, the Judge relied on the ordinary meaning of these concepts.  He held that a true discount and a true premium, unlike interest, do not bear the feature of accrual with time.

The Judge concluded that the discounts and redemption premium incurred by the Appellant in respect of the 1995 and 1996 Bonds do not constitute “interest” under section 14(1)(a) of the ITA. To count as “interest”, a payment must be consideration paid by the borrower for the use of the lender’s money which bears the fundamental feature of accrual with time. Only then will the payment be interest, notwithstanding the label attached to it. The discounts and redemption premium incurred by the Appellant in respect of the 1995 and 1996 Bonds did not bear this feature. Both the discounts and the redemption premium were one-off obligations, based on a fixed percentage of the principal loan amount. They did not accrue with time, but were ascertainable at the time the bonds were issued.

(b)   Were the discounts and redemption premium outgoings and expenses wholly and exclusively incurred in the production of the Appellant’s income under section 14(1) of the ITA?

The Judge held that the Appellant had, by redeeming the bonds at their full face value, incurred actual outgoings with regard to the discount in Years of Assessment 2001 and 2002.  In addition, the redemption premium paid to the bondholders in Year of Assessment 2001 was an actual outgoing incurred by the Appellant.  As such, it was concluded that the discounts and redemption premium constitute “outgoings and expenses” under section 14(1) of the ITA.

As to whether the expenses were wholly and exclusively incurred in the production of the Appellant’s income, case law indicates that there must be a nexus between the incurring of the discounts and redemption premium and the production of the Appellant’s income.  In addition, section 14(1) of the ITA only grants a deduction to expenditure that is revenue as opposed to capital in nature.  This follows that there is a close nexus between section 14(1) and section 15(1)(c) of ITA. By prohibiting the deduction of capital (as opposed to revenue) expenses, section 15(1)(c) serves to reinforce the requirement under section 14(1) of the ITA that the expenses must be wholly and exclusively incurred in the production of the taxpayer’s income to qualify for deduction under that provision.

(c)   Were the discounts and redemption premium capital expenses and therefore prohibited from deduction under section 15(1)(c) of the ITA?

As regards to the deductibility of interest expenses under section 14(1)(a) of the ITA, case laws indicate that it was necessary to examine the nature of the underlying loan when determining whether interest expenses were in the nature of capital or revenue.

In determining the purpose of the underlying loan, and consequently the nature of the borrowing costs incurred on that loan, the Judge turned to the framework laid down by case law which looked at (i) the purpose of entering into the loan, and (ii) whether there is a sufficient linkage or relationship between the loan and the main transaction or project for which the loan was taken. If, no, or an insufficient, linkage is established, the purpose of the loan must, ex hypothesi, be merely to add to the capital structure of the taxpayer and is therefore capital in nature. If a sufficient linkage is established, one must then ascertain whether the main transaction is of a capital or of a revenue nature. If it is of a capital nature, then (given the linkage to the loan) the loan is also of a capital nature. If, on the other hand, the main transaction is of a revenue nature, then (once again, given the linkage to the loan) the loan is also of a revenue nature.

In this regard, the Judge was satisfied that the Appellant’s submission that 1995 and 1996 Bonds were issued to (i) finance the renovation of the Hotel, (ii) refinance the existing borrowings of the Appellant and its subsidiaries, and (iii) to finance the day-to-day operations of the Appellant’s business. It was also found that a sufficient linkage is established between the 1995 and 1996 Bonds and each of these purposes.

However, on the issue of whether the three uses to which the bond proceeds were intended to be put were themselves capital or revenue in nature:

(i)   The Judge agreed with the CIT’s contention that the expenditure incurred by the Appellant in respect of the hotel refurbishment work was capital in nature.

(ii)   It was held that where a later loan is taken out to refinance an earlier loan, one must first ask whether the earlier loan was capital or revenue in nature. If the earlier loan was revenue in nature, it would follow that the later loan and the borrowing expenses incurred in connection therewith would also be revenue in nature. If on the other hand the earlier loan was capital in nature, one should ask whether the taxpayer was ordinarily engaged in the business of financial operations. If the taxpayer was not, then borrowing expenses incurred on the later loan are likely to be capital expenses and disallowed as a deduction under section 15(1)(c) of the ITA.

In this case, the Appellant failed to adduce evidence revealing the nature of the loans to be refinanced by the 1995 and 1996 Bonds and was not engaged in the business of financial operations. It follows that the refinancing transactions for which the 1995 and 1996 Bonds were issued would have been capital as opposed to revenue in nature. To this extent, it also follows that the 1995 and 1996 Bonds were capital in nature and therefore, disallowed from deduction under section 15(1)(c) of the ITA.

(iii)   It was held that there was no linkage between the 1995 and 1996 Bonds and any specific project or transaction that was clearly revenue in nature. Conversely, it was evident that the bonds were issued for the more general purpose of raising funds for the acquisition of working capital. It follows that insofar as the 1995 and 1996 Bonds were to be put to use as working capital to finance the day-to-day operations of the Appellant’s business. As such, the Judge held that this was a transaction that was capital in nature.

Based on the above, the Judge concluded that the 1995 and 1996 Bonds were capital in nature. Accordingly, the discounts and redemption premium incurred by the Appellant in respect of the 1995 and 1996 Bonds were also capital in nature and therefore, disallowed from deduction under section 15(1)(c) of the ITA.

The above judgement was delivered on 9 September 2013.