Paying No Interest On A Related-Party Loan

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 not 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...