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May 30, 2014
Singapore Tax Authority Issues Guidelines for Hybrid Financial Instruments
by Slim Gargouri

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Singapore's Inland Revenue Authority on May 19 published guidelines that establish the income tax treatment of hybrid instruments, including the factors generally used to determine whether they are debt or equity instruments for income tax purposes.
To characterize hybrid instruments such as redeemable preference shares, the comptroller of income tax first examines the legal rights and obligations created by the instrument. A hybrid instrument is generally characterized as equity if the legal terms of the instrument indicate ownership interests in the issuer. If the legal form of a hybrid instrument is not indicative of the legal obligations and rights, the characterization is determined based on facts and circumstances and a combination of the factors listed below.

Nature of interest acquired: The provision of capital resulting in the investor's acquisition of a shareholding and residual interest in the entity that issues the hybrid instrument suggests that the instrument is an equity instrument.

Right to participate in issuer's business: An investor's right to participate in the business operation of the issuer based on the investor's investment in the hybrid instrument suggests that the instrument is an equity instrument.

Voting rights conferred by the instrument: The provision to an investor of voting rights at general meetings implies that the instrument is an equity instrument.

Obligation to repay the principal amount: The presence of a fixed repayment date (in the reasonably foreseeable future) on a hybrid instrument that requires the issuer to unconditionally repay the principal amount on or by that date, regardless of its business performance (that is, whether it derives any profits), suggests that the instrument is a debt instrument. In the absence of a fixed repayment date, the existence of a step-up feature may imply that the issuer has an obligation to repay the principal amount.

In contrast, if the repayment is conditional on the financial well-being of the issuer of the instrument and there is no fixed repayment date or step-up feature in the hybrid instrument, the instrument is probably an equity instrument.

Payout: If there is a non-contingent obligation for an issuer to make a periodic distribution of a predetermined amount to the investor, regardless of the business performance of the issuer, and the distribution is cumulative, the instrument is likely a debt instrument.

However, if the distribution is at the discretion of the issuer or is noncumulative or dependent on the issuer's profits, the instrument is probably an equity instrument.

Investor's right to enforce payment: If an investor has an unconditional right to enforce the payment of a distribution and the repayment of the principal amount, the instrument likely falls under the debt category. Conversely, if the hybrid instrument does not provide the investor with any means to enforce the payment of distributions and the repayment of the principal amount, the instrument is probably an equity instrument.

Classification by other regulatory authority: If any other regulatory authority in Singapore does not regard the hybrid instrument as debt for regulatory purposes, it is likely an equity instrument. For example, a regulatory authority may determine that the issuance of the hybrid instrument would not affect any borrowing limit that may be imposed on the issuer if the regulatory authority regards the instrument as equity.

Ranking for repayment in the event of liquidation or dissolution: If the right of an investor to the repayment of the principal amount is subordinated to that of general creditors or to holders of subordinated debt of the issuer, or the investor is required to bear the current or future losses of the issuer by way of either a write-down of the principal amount of the instrument or a conversion to ordinary shares of the issuer, the instrument probably falls under the equity category.

The presence of any single factor may not suffice to classify a hybrid instrument as either debt or equity; a combination of factors and the facts and circumstances of the case must be taken into account.

If a hybrid instrument is characterized as a debt instrument for tax purposes, the distribution from the issuer to the investor is regarded as interest.

The Singapore-based issuer of such an instrument may be allowed a tax deduction on the interest expense incurred if it meets the conditions set out by local regulations.

The interest income from such an instrument is taxable in the hands of the investor unless it is specifically exempted from tax under Singapore's Income Tax Act (for example, if it is derived by a qualifying nonresident or individual from qualifying debt securities).

If a hybrid instrument issued by a company or real estate investment trust is characterized as an equity instrument for tax purposes, distributions from the issuer to the investor are regarded as either dividends or REIT distributions. The Singapore-based issuer of such instruments will not be entitled to a deduction for distributions paid to investors.

If the dividend is paid by a resident company in Singapore, the dividend is tax exempt in the hands of the investor. Otherwise, dividends received by investors in Singapore will be subject to tax. Nevertheless, the foreign-source dividend may qualify for a tax exemption.

When a hybrid instrument issued by a Singapore-based issuer is treated as a debt instrument, the interest expenses are generally considered incurred by the issuer when its liability to pay the interest to the investor is crystallized. However, if the interest payment is deferred, the issuer's obligation to pay the interest will not be considered as crystallized on the scheduled interest payment date. Similarly, the investor is subject to tax on the interest from the debt instrument when its legal entitlement to the income is crystallized.

Slim Gargouri, chartered accountant, Sfax, Tunisia

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