Singapore Tax Board Rules Against Embedded Derivatives in Tax Rate Dispute

In a notable ruling for Singapore's financial industry, the Income Tax Board of Review recently supported GIR (the appellant) in a complex case about tax deductions for derivative-related losses. Decided on April 29, 2025, the case focused on whether losses from complex financial instruments should be deducted at the standard corporate tax rate of 18% or the reduced Financial Sector Incentive (FSI) rate of 10%.

The Complex Transaction Structure

The dispute stems from transactions in 2008 involving redeemable preference shares (RPS) with embedded derivatives linked to JPY/USD exchange rates. GIR invested US$400 million in RPS that contained foreign exchange binary options based on currency fluctuations. When these shares were redeemed, GIR faced losses of about USD96.3 million and attempted to deduct these losses against income taxed at the standard 18% corporate rate, instead of the 10% concessionary rate typically used for derivative trading under FSI regulations.

The Central Legal Questions

The Board needed to address three key questions: if the transactions involved derivatives under FSI regulations, whether GIR was engaged in "trading in derivatives," and if so, whether the redemption losses resulted from such trading. The Comptroller of Income Tax claimed that the embedded derivatives in the RPS qualified as derivative trading eligible for the 10% concessionary rate. Conversely, GIR argued that the transactions were mainly financing arrangements rather than derivative trading activities.

Board's Analysis on Embedded Derivatives

While the Board recognised that the transactions included embedded derivatives, specifically digital foreign exchange options, it pointed out that FRS 39 accounting standards do not establish the legal definition of "derivatives" under tax law. The Board concluded that the hybrid instruments qualify as derivatives according to the regulation, since the embedded foreign exchange options exhibited key features: their value fluctuated with underlying variables, they required no initial net investment, and they were settled in the future.

The Trading Versus Financing Distinction

Although derivatives were involved in the transactions, the Board concluded that GIR was not engaging in 'trading in derivatives" as defined by regulations. Using the recognised 'badges of trade" criteria, the Board found that these transactions mainly appeared to be short-term financing rather than trading activities. Important considerations included GIR's guaranteed positive returns regardless of currency fluctuations, the return profile being similar to financing (ranging from 1.49% to 3.26% annually), and the unique nature of the transaction, which more closely resembled a loan than speculative trading.

Implications for Singapore's Financial Sector

This ruling clarifies that, under Singapore's FSI scheme, complex financial instruments with embedded derivatives are not automatically eligible for lower tax rates solely due to their complexity. It highlights the importance of substance-over form principles in tax law, where the primary commercial purpose - whether for financing or trading - determines their tax classification. For Singapore's financial sector, this may mean applying more careful structuring of financial products to ensure that tax incentives promote genuine derivative trading activities, rather than financing agreements that mimic derivatives.