Tax implications of debt restructuring

Recent clarification by the IRAS on debt forgiven under the SDRP provide clarity for businesses considering debt restructuring.

Background

Based on statistics released by the Ministry of Trade and Industry, the Singapore economy has contracted by 5.4% year-on-year in 2020, bringing about the worst recession in the history of Singapore.

Against this trying economic backdrop brought about by the COVID-19 pandemic, debt restructuring is a common avenue that businesses consider to manage their cashflow and stay afloat.

In most instances, a debt restructuring exercise will involve a certain extent of debt forgiveness. Therefore, it is pertinent for both debtors and lenders to duly consider the possible tax implications associated with debt forgiveness.

Before we discuss the clarification by the Inland Revenue Authority of Singapore (IRAS), we take a brief look at the general tax landscape in Singapore with regard to debt restructuring.

Current tax treatment

From a lender’s perspective, the debt forgiven will mean that the lender will have to recognise a loss in its profit and loss account. Where this loss is considered a business expenses of the lender’s trade or business operations, a tax deduction should be available to the lender.

At times, tax deduction claims may not be that straightforward, particularly if significant amounts are involved and where the debts to be forgiven are between related parties. In such instances, the IRAS may scrutinise the circumstances under which the debts are to be forgiven before allowing the tax deduction claim.

The tax treatment of the debt forgiven in the hands of the debtor can be equally complicated. From a debtor’s perspective, the debt forgiven will likely lead to a corresponding credit or “gain” being recognised in the profit and loss account.

As there are currently no prescribed rules under the Singapore tax legislation, the taxability of such credit or “gain” from the debtor’s perspective can be contentious. To ascertain the appropriate tax treatment on the taxability of the credit or “gain”, guidance is often sought from principles that emerge from relevant case laws.

A relevant consideration is whether the relationship, which has given rise to the debt, is that of a borrower-lender relationship or a debtor-creditor trade relationship. The view is that a forgiveness of debt arising from a borrower-lender relationship will generally be construed as capital in nature, and hence not taxable.

Another area of consideration is the circumstances leading to the debt forgiveness. In British Mexican Petroleum Company Ltd v Jackson (1932) 16 TC 570, the taxpayer’s business was adversely affected by an economic slump. As a result, its trade creditors decided to assist the taxpayer by way of forgiveness of certain amounts due by the taxpayer. It was held in the case that the forgiveness of the trade debts was given with a “distinct purpose”, i.e., to give relief by in effect giving new capital, so that the taxpayer had “the opportunity of entering into a new lease of life”. As such, the forgiveness of the amounts should not constitute part of the taxpayer’s trading profits as it did not arise from the ordinary course of trade or business. Applying these principles, it can therefore be argued that even in the case of trade debts, if the forgiveness is given with the “distinct purpose” to give relief to the debtor (relief from insolvency or to allow debt rehabilitation), the amounts should be considered as capital and thus not taxable.

Therefore, businesses should adequately understand and analyse how the debts arise and the circumstances leading to the debts being forgiven, to determine the taxability of the gains, whether capital or not. For trade debts forgiven, businesses should also consider the deduction claims made on the initial expenses relating to these trade debts as the IRAS may take the position that the expenses are “not incurred” and disallow the tax deductions. In addition, the Goods and Services Tax (GST) aspects should also be taken into account. For example, the requirement to repay the input tax claim to the IRAS if the invoice remains unpaid for more than 12 months from the payment due date.

The SIP and SDRP^[1]

In the context of the above, the IRAS has provided certainty to the tax treatment of debts forgiven under the Simplified Debt Restructuring Programme (SDRP), which is a new and temporary process that is covered under the Simplified Insolvency Programme (SIP) established by the Ministry of Law (MinLaw).

The SIP scheme aims to provide simpler and more cost-efficient proceedings in a more expedient manner to assist qualifying micro and small companies (MSCs) that are winding up or restructuring. As part of the SIP scheme, the SDRP is a temporary and new process adopted for qualifying MSCs that undertake debt restructuring and business rehabilitations.

Amongst the specified conditions, an MSC is defined as a company that has annual sales turnover not exceeding S$10m and is not a foreign company. Other conditions include headcount, number of creditors and quantum of liabilities.

The IRAS has recently clarified that debts that are forgiven (including trade debts and loans) under this scheme will be regarded as capital in nature and hence not subject to Singapore income tax.

Implications and learnings

The position confirmed by the IRAS on debts forgiven (including trade) under SDRP is in line with the case law principles established. From a Singapore corporate income tax perspective, this certainty on the non-taxability of the debts forgiven gives assurance for businesses and relieves them of expending undue resources and time in addressing potential controversy with the IRAS. In addition, the non-taxability of the gains allows any monetary saving to be channelled back to the businesses, enabling the rehabilitation process.

The SIP (including the SDRP) is intended to be a temporary relief measure to support MSCs affected by the COVID-19 pandemic. As such, the SIP (including the SDRP) is currently available only for a very limited application period, from 29 January 2021 to 28 July 2021.

It is also important to highlight that the SDRP is limited to MSCs and is not a broad-based scheme that is available to all businesses. With the widespread economic impact of the pandemic, this means that many businesses, which may face financial difficulties, will have to consider the tax implications that may arise from their debt restructuring exercise.

Another aspect of the tax treatment covered on debt forgiveness under SDRP is that the IRAS only provides certainty on the non-taxability of the debts forgiven from the debtor’s perspective. It is, however, not clear with regards to the IRAS’ treatment on the tax deduction claims made by the debtor relating to initial expenses for trade debts.

In the context of debt restructuring, any unexpected tax payments or protracted tax controversy can be disruptive, derailing cashflow planning or business rehabilitation.

Businesses that are unable to avail themselves of the SDRP should ensure that they have contemporaneous documentation that can defend the tax position taken. For amounts that are significant, businesses may consider an advance ruling submission to the IRAS so that any potential tax costs will be taken into account.

The co-authors of this article are Toh Shuhui, Partner, Tax Services from Ernst & Young Solutions LLP and Ng Zhen Liang, Manager, Corporate Tax Services from EY Corporate Advisors Pte. Ltd.

[1] Further details on the SIP and SDRP can be found on the Ministry of Law website: https://io.mlaw.gov.sg/corporate-insolvency/sip-faq/