Tax implications of granting interest-free loans between members of a group

When related parties (e.g. members of a group) transact with one another, the price they set for such transactions is known as a transfer price. Such transactions usually include the transfer of funds or extension of loans within a group of companies, sale and purchase of goods and services, transferring assets, tangibles and intangibles etc.

In principle, transfer prices should be the same as what parties would charge independent, unrelated, third party buyers or pay third party suppliers. In the case of loans, the interest charged by related parties in a group of companies should reflect market conditions as well. In essence, transfer prices among divisions of an enterprise should reflect allocation of resources among such components.

However, transactions within a group often do not reflect market conditions because the prices are controlled and set within a group of companies and not influenced by market mechanisms. Granting an interest-free loan to a related member of in a group is one such example. This creates taxation problems because countries with subsidiaries in one or more countries can simply transfer or “lend” money out to a related company in a jurisdiction with a lower tax rate and reduce taxable profits in the jurisdiction with a higher tax rate, generating tax savings. This is especially pertinent in multinational corporations which use transfer pricing as a profit allocation method.

The arm’s length principle

Therefore, many governments regulate transfer pricing rules. Most countries do this by adopting the “arm’s length principle”, that is, a requirement that transactions with a related party be made under comparable conditions and circumstances as transactions with an independent party. This is an international standard that the OECD has also published guidelines on (OECD Model Tax Convention on Income and Capital; OECD Transfer Pricing Guidelines). This principle is based on the premise that the pricing of transactions between related parties would reflect the true economic value of the contributions made by each party in that transaction because market forces, and not the special relationship between the two parties, drive the terms the conditions agreed in an independent party transaction.

Position in Singapore

Background

For years, Singapore companies were free to extend interest free loans to domestic as well as overseas related companies. However, IRAS eventually issued transfer pricing guidelines for related-party loans and services on 23 Feb 2009. It ended years of public debate and laid to rest the vital issue of whether interest-free loans between related companies can be accepted. The guidelines stipulate that when taxpayers lend to or borrow money from related parties, pricing must now be determined based on the rate of interest that would have been charged between independent parties under similar circumstances. In other words, they should adhere to the arm’s length principle when determining the interest to be charged on such loans.

Section 34D of the Income Tax act stipulates the use of the arm’s length principle for related party transactions. Other provisions like sections 32 and 53 also imply or refer to the concept or use of the principle. IRAs has also noted that the arm’s length principle should be applied on a transaction-by-transaction basis, which suggests that each transaction should be analysed on a stand-alone basis.

The rationale for endorsing this principle is perhaps because Singapore is a tax treaty partner to more than 60 countries wants to ensure compliance with the arms length principle to reduce transfer-pricing adjustments and improve the resolution of transfer-pricing disputes between countries. It also wants to protect and defend its tax base from more aggressive tax jurisdictions. Another consideration for IRAS is that creative tax planning may have led to increase use of tax havens thereby eroding its revenue base.

Tax treatment of loans in Singapore

In Singapore, the tax treatment of loans between related parties differs depending on whether the loan is domestic or cross-border.

There are principally two kinds of loans:

  • a) Related domestic loans (when the lender/borrower in Singapore lends to/borrows from a related party which is also in Singapore)
  • b) Related cross-border loans (when the lender/borrower in Singapore lends to/borrows from a foreign related party)

This diagram illustrates how IRAS applies the arm’s length principle to related party loans depending on whether they are domestic or cross-border:

loan tax

loan tax

From the table, we can clearly see that IRAS agrees to allow interest-free loans to be extended between related domestic companies that are not in the business of lending and borrowing because there is currently already a mechanism in place, known as “interest restriction”, whereby the taxpayer will be disallowed a portion of the interest expense incurred in extending interest-free loans. This cost or expense will be treated as non-deductible tax expenses. Therefore, IRAS is not likely to lose out by allowing interest-free loans between domestic related entities that are not in the business of borrowing and lending.

However, loans between a foreign related entity and a domestic one must strictly comply with the arm’s length principle. S33 of the Income Tax Act also contains general anti-avoidance rules that allows IRAS to disregard or revise any arrangement in order to counteract a tax advantage obtained under an existing arrangement. As a final measure, IRAS has the power to refuse to accept a tax return and assess taxable income based on its judgment.

Additionally, IRAS might review and audit the transfer pricing methods and documentation of selected taxpayers through the Transfer Pricing Consultation (TPC) programme. In this programme, IRAS might request for select taxpayers with substantial cross-border related party transactions and taxpayers who make continued losses to schedule a TPC with IRAS. IRAS will then assess the appropriateness of the taxpayer’s compliance with the arm’s length principles for related party transactions and make adjustments if the profits do not fulfill the arm’s length requirements.

How to calculate arm’s length interest charges?

  • I. Conduct a comparability analysis
  • II. Identify the most appropriate transfer pricing method
  • III. Determine the arm’s length results

I. Step 1: Conduct a comparability analysis

At this step, taxpayers must consider relevant facts and circumstances relating to the loan such as, for instance, the credit standing of the borrower, the nature and purpose of the loan, the security offered by the borrower, market conditions at the time the loan is granted etc. This is to assess the areas and extent of similarities and differences between controlled and uncontrolled transactions.

II. Step 2: Identify the most appropriate transfer pricing method

The guidelines indicate that although taxpayers can used any method to price intercompany loans, the Comparable Uncontrolled Price (CUP) method is the most suitable one for loan transactions.

An illustration of the CUP method, as taken from the guidelines, can be seen below:

arm's length principle

arm’s length principle

Supposing that X is a taxpayer in Singapore not in the business of borrowing and lending and Y is a foreign related party, the internal CUP that X can use to determine an arm’s length interest rate for a loan to Y is, in order of priority:

  • Loan A is the preferred internal CUP as X should charge Y the same interest rate that it charges a third party.
  • Loan B, if Loan A is not available, is the next internal CUP that X can use as X should charge Y the same interest rate that a third party charges Y.
  • Loan C if both Loan A and Loan B are not available and the moneys borrowed by X are on-lent to Y, i.e. X should charge Y the same interest rate that a third party charges X.

III. Step 3: Determine the arm’s length results

Once the appropriate transfer pricing method has been identified, the method is applied on the data of independent party transactions to arrive at the arm’s length result. The base reference rate is usually a publicly available rate such as the Singapore Inter Bank Offered Rate (SIBOR), the London Inter Bank Offered Rate (LIBOR) or prime rates offered by banks.

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For private loans, consider the following:

Sources
Income Tax Act Singapore
IRAS Transfer Pricing Guidelines (Second edition), 6 Jan 2015
http://www.kgtan.com/wp-content/uploads/2011/10/Aug-2011-Issue-7.pdf
http://www.duffandphelps.com/services/tax/Pages/TPTimesArchive.aspx?itemid=33
https://www.kpmg.com/SG/en/IssuesAndInsights/ArticlesPublications/Documents/Tax-MA-Taxation-of-Cross-Border-Mergers-and-Acquisitions.pdf
http://www.agn-ap.org/news/0911singapore.htm
http://www.pwc.com/gx/en/international-transfer-pricing/assets/singapore.pdf
https://www2.deloitte.com/content/dam/Deloitte/global/Documents/Tax/dttl-tax-tpalert-singapore-003-030215.pdf
http://www.cfoinnovation.com/story/9327/transfer-pricing-singapore-penalties-thresholds-and-other-new-requirements
https://home.kpmg.com/content/dam/kpmg/pdf/2012/05/singapore.pdf

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