In this article, Sim Siew Moon, Senior Partner and Head of Tax and Lee Vin Wee, Tax Partner, discuss the tax implications of interest expenses on business loans, covering deductibility rules, re-financing, borrowing costs, withholding tax, and compliance with the arm’s length principle.

This article was first published in The Business Times on 13 February 2025.

Taking an interest in your own borrowing costs

When businesses take interest-bearing loans – whether for working capital, business expansion or investment – they inevitably incur interest and borrowing costs. What should companies look out for, from an income tax perspective?

In the past months, Singapore has seen a decrease in interest rates based on the three-month Singapore overnight rate average ("Sora"). On Jan 29, the US Federal Reserve held the target federal funds rate, in a pause that breaks its successive cuts since September 2024.

With interest rates peaking in recent years, this Fed pause could finally be an opportune time for businesses to resume projects and expansion plans that have been on hold. But if borrowing for such a purpose, companies should consider these tax aspects.

Deductibility of interest expenses

The deductibility of interest expenses is intrinsically linked to the purpose and usage of the loan.

For example, interest expenses incurred on a loan for manufacturing equipment are tax deductible. But if the loan is for an investment that produces tax-exempt income, then the interest expenses are tax deductible against the tax-exempt income, rather than having an overall tax deduction value. Should the company thus use excess funds for the investment instead?

It is also common for company's loans to be consolidated and commingled into a bank account which might finance both income-producing and non-income producing activities. Without a basis to track the specific use of funds, such common interest expenses will not be tax deductible.

Hence, it is important for companies to be able to identify the purpose and usage of loans, and retain documentation to substantiate claims.

The Inland Revenue Authority of Singapore ("Iras") allows companies to use the total asset method to approximate the interest expense amount attributable to non-income producing assets that is disallowed for tax purposes.

Specifically, the interest expense to be disallowed is the cost of non-income producing assets, divided by the cost of total assets, as at the balance sheet date.

Assets financed by identifiable specific loans are excluded. For such loans, the interest expense incurred is tax deductible against the income produced by the corresponding asset. This is the direct identification method.

Depending on its circumstances, a company may claim a tax deduction on its interest expense under the total asset method, direct identification method, or a combination of the two if it has multiple loans.

Re-financing loans

If a company takes up a re-financing loan solely to repay an existing loan, the interest expenses incurred on the new loan are, strictly speaking, not tax deductible.

However, as an administrative concession, Iras allows interest expenses on re-financing loans to follow the nature of the existing loan if the re-financing is for genuine commercial purposes.

If the existing loan was obtained for the company's trade - for example, for the purchase of stocks in-trade - then the interest expenses incurred from the re-financing loan would be tax deductible.

Conversely, for existing loans taken for non-trade and non-income producing purposes, the interest expenses on the re-financing loan will not be tax deductible.

Likewise, if the previous interest expenses were subject to the total asset method, the same method will be applied.

Other borrowing costs

Other than interest expenses, companies may incur costs such as bank option fees, guarantee fees, interest rate swaps or extension fees when taking up a facility with a bank.

Generally, for a tax deduction to be claimable on such borrowing costs, the costs must be incurred as a substitute for interest expense, or to reduce your interest costs.

The Iras has prescribed a list of deductible borrowing costs to provide certainty to companies. Companies should note that this does not mean that all other borrowing costs are tax deductible.

Withholding tax

What if a company borrows from a foreign lender? Generally, the company would have to withhold tax on the interest expenses incurred on such loans.

If the company fails to withhold tax and account to Iras within the specified period, Iras will impose a penalty. If the lender is a tax resident of a country with which Singapore has an applicable tax treaty, the withholding tax rate may be reduced accordingly, subject to conditions being met.

Arm's length principle

Companies may borrow or lend to related companies. Iras requires any transaction with a related party to be made under comparable conditions and circumstances as a transaction with an independent party, in what is called the arm's length principle.

For domestic related party loans enteted into on or after Jan 1, 2025, Iras requires the arm's length interest rate to be charged based on Iras' indicative margin rate, or determined based on the arm's length principle, depending on the profile of the borrowers and lenders, and quantum of loan amount.

For cross-border related-party loans, companies need to determine the interest rate based on the arm's length principle - unless the loan amount is below S$15 million, in which case companies can apply Iras' indicative margin rate.

If companies do not comply with the arm's length principle, Iras may disallow interest expenses in excess of the arm's length amount for tax deduction, and impose a 5 per cent surcharge on the transfer pricing adjustment.

Interest expenses are a common business expense, and may be a substantial component of total expenses if the company is highly leveraged. Companies need to be aware that there are important tax considerations when taking up a loan and incurring interest expenses.

Early planning and preparation of contemporaneous documentation will help companies to substantiate and ensure that interest expenses incurred are deductible against taxable income, to reduce their tax liabilities.

Sim Stew Moon is Senior Partner, Head of Tax, and Lee Vin Wee is Tax Partner at Baker Tilly Consultancy (Singapore). These views are theirs and do not necessarily reflect the views of the global Baker TiIly organisation or its member firms.