By Yip Yoke Har, Tax Partner and Janine Kwan, Tax Manager at PwC Services LLP
In the Singapore Budget 2012, the Minister for Finance announced that he would introduce a safe harbour rule to provide certainty of non-taxation treatment to gains made by a divesting company that has held at least 20% equity in an investee company for at least 24 months. However, in details released in a e-Tax Guide on 30 May 2012, insurance companies were specifically excluded from this certainty of non-taxation rule. Why is this so?
Capital gains are not taxable
It is often said: “Singapore does not tax capital gains. It only taxes income or revenue gains.” However, in reality, it is not always clear if a gain realised on a sale of investment will indeed be excluded from Singapore tax. The onus is always on the taxpayers to demonstrate to the satisfaction of the Inland Revenue Authority of Singapore (IRAS) that their gains are capital in nature, or risk paying Singapore tax on such gains.
At present, as there are no comprehensive legislative provisions or guidelines, taxpayers have to rely on the so called “badges of trade” established under common law to contest that their gains are in fact capital in nature. This requires a consideration of the particular facts and circumstances of the investment, including the length of period of ownership, motive of acquisition, means of financing the acquisition, circumstances leading to the disposal and frequency of similar transactions. This examination is a subjective exercise and often results in lengthy disputes between the taxpayer and the IRAS.
More complex for insurers
Where insurance companies are concerned, the issue is more complex. As the investment activity of an insurer is normally part and parcel of its business, most investments of an insurer would be regarded as revenue assets and realised gains thereon treated as taxable in nature. However, it does not then follow that insurers cannot hold assets on capital account. Like other taxpayers, insurers can and do sometimes hold investments not to support this insurance business but for long term strategic purposes. And the sale of such investments should be regarded as capital in nature.
This view, however, is not shared by the IRAS and the battle of “capital vs revenue” for insurers is rendered more complex by the IRAS’s view that section 26 of the Income Tax Act (ITA) brings all investment gains of an insurer to tax.
In this connection, it is worth noting that this IRAS’ position was recently rejected by the Income Tax Board of Review (ITBR) in a decision handed down on 20 June 2012 in the case U Limited v The Comptroller of Income Tax  MSTC 50-010.
U Limited case
U Limited was a general insurer and formerly part of the O group of companies. It held certain share investments in ABC, Q Ltd and XY Ltd, together referred to as “the Shares”. Other companies in the O group also held investments in ABC, Q Ltd and XY Ltd. Pursuant to a takeover of ABC by DEF, U Limited sold the Shares to DEF.
U Limited contended that the gains it made from the disposal of the Shares were capital in nature as it had acquired them to preserve the corporate structure of the O Group and to promote the long term strategic interest of itself and of the O group. Based on the so called badges of trade, the gains arising from the sale of the Shares were capital gains and not taxable.
The IRAS however took the view that the gains were revenue in nature and thus taxable. The IRAS contended that there is a “mini regime” for the taxation of insurance companies set out in section 26 of the ITA that made it clear that any profits or gains realised from the sale of investments by an insurance company was liable to tax. In view of this, even if the Shares were purchased for corporate preservation purposes, the gains would still be taxable. In addition, the IRAS contended that the badges of trade were not relevant.
A win for the taxpayer
In the decision released, the ITBR decided in favour of the taxpayer. It stated that, on a balance of probabilities, U Limited had not engaged in any trade or business in the transaction of the Shares. Therefore, the profits from the sale of the Shares should be treated as capital gains and not taxable.
The ITBR held that the provisions in section 26 of the ITA do not do away with the need to distinguish between trading profits and capital gains arising from the disposal of shares by insurance companies and, like any other taxpayer, an insurance company can hold shares as capital assets. Therefore, it was held that in the context of an insurance business, it is still necessary to ascertain if the disposal of the investment arose in the course of a trade or from the realisation of a capital asset, by reference to the badges of trade.
Insurers may take heart at this decision, which precludes the IRAS from taxing their gains unless an examination of the relevant facts points towards the gains being derived in the course of their trade or business.
However, this merely allows an insurance company to contend that a disposal gain is capital in nature. It does not do away with the uncertainty of the eventual tax position of the gain when an insurer exits a long term strategic investment. In this regard, the Singapore tax implications of gains on disposal of equity investments for insurance companies are just as murky and complex as ever, particularly as insurers are still specifically excluded from the certainty of non-taxation rule (the Rule).
Certainty of non-taxation rule
The Rule was announced in Budget 2012 and further details were released by the IRAS in its e-Tax Guide dated 30 May 2012.
Under the Rule, gains derived by a divesting company from its disposal of ordinary shares in an investee company will not be taxable if, immediately prior to the date of the share disposal, the divesting company held at least 20% of the ordinary shares in the investee company for a continuous period of at least 24 months.
The Rule is applicable to divestments made between 1 June 2012 and 31 May 2017. It will be reviewed at the end of this five year period.
The Rule is not applicable to insurers
When the Rule was first announced, insurers were hopeful that it would mean an end to the uncertainty currently affecting many of them. Unfortunately, this is not to be.
In the e-Tax Guide of 30 May 2012, insurance companies were specifically excluded from benefiting from the Rule. This seems rather unfair particularly when no other financial institution (e.g. banks or private equity funds) were excluded. It was a disappointing development as it undermines Singapore’s ambitions to be a regional hub for insurance businesses, but one which reflects the current position adopted by the IRAS in the case of U Limited.
Although it is still early days, given the potential tax revenues at stake, and the fact that the IRAS has not proposed to change its guidance on the Rule, it would not be at all surprising if the IRAS appeals against the ITBR’s decision in U Limited.
This would be unfortunate as the lack of certainty surrounding the “capital vs revenue” issue has been affecting Singapore’s attractiveness and competitiveness as a regional headquarter and regional holding company location for multinational insurance groups.
What should be done instead?
For a start, insurers should not be excluded from the certainty of taxation rule. The conditions for tax exemption requires a divesting company to own an equity interest of at least 20% for at least 24 months before it would qualify for the Rule and enjoy certainty of non-taxation. A 20% interest is sizable and surely large enough to indicate a strategic hold. That size of investment would not be one that an insurer would ordinarily hold to support its insurance business.
Insurance businesses are extremely mobile and global. Given Singapore’s goal to position itself as a leading commercial hub for the insurance industry, the exclusion of insurance companies from the Rule seems to be a real missed opportunity.
Of course, there is also an issue with the five year applicable period of the Rule (it expires on 31 May 2017 and will be reviewed again then). Five years is rather short for long term planning purposes.
It is not too late though to change the rules. What we need from the authorities is the courage to take that step in the right direction.