Reform of the Swiss Federal Withholding Tax System on Interest

Reform of the Swiss Federal Withholding Tax System on Interest

For a number of years, endeavors to reform the Swiss federal withholding tax system with regard to the taxation of interest from collective debt instruments have been going on. The reform is generally aimed at strengthening the Swiss debt capital market. The latest proposals would completely do away with federal withholding tax on bond interest.

Background to the reform – the current withholding tax system

Under the current rules, interest paid or accrued on collective debt instruments – so called “bonds” and “debentures” – issued by Swiss resident issuers, as well as interest arising on deposits with Swiss banks is subject to federal withholding tax at the statutory tax rate of 35%. In contrast, interest paid on private and commercial loans, as well as interest paid on collective debt instruments issued by non-Swiss issuers is generally not subject to Swiss federal withholding tax.

Taxable bond and debenture defined

The notions of “bond and “debenture” for federal withholding tax purposes are quite broad. Generally, taxable “collective debt” instruments are defined as written debt acknowledgments for fixed amounts which are issued in multiple tranches at comparable conditions for the purpose of collective financing, and which allow the investor to evidence, reclaim or transfer its receivable claim.

A debt instrument is qualified as a taxable “bond” if it meets all of the following criteria:

  • The borrower issues written debt acknowledgments over fixed amounts;
  • the debt acknowledgments are based on a single credit arrangement and have identical conditions;
  • the lenders include more than ten non-banks (including certain types of sub-participants), i.e. not including Swiss or foreign banks as defined by the Swiss Federal Banking Act or comparable foreign banking legislation at the place of establishment of the lender; and
  • the aggregate amount borrowed under the arrangement amounts to at least CHF 500’000.

A loan or similar debt instrument is qualified as a taxable “debenture” for federal withholding tax purposes where the following conditions are all met:

  • The borrower issues written debt acknowledgments over fixed amounts;
  • the debt acknowledgments may have variable conditions;
  • the lenders include more than 20 non-banks (as described above); and
  • the total borrowed amount corresponds to at least CHF 500,000.

Taxable Swiss bank deposit defined

Interest paid by Swiss banks as well as Swiss branches of foreign banks acting under a banking license on “customer deposits” is likewise subject to federal withholding tax at the statutory rate of 35%. A taxable “customer deposit” includes debt funds raised by any Swiss resident entity that publicly solicits interest-bearing deposits, or continuously accepts interest-bearing deposits from more than 100 depositors – other than Swiss or foreign banks as defined by the applicable banking legislation – whereby the aggregate amount of the “deposits” amounts to at least CHF 5,000,000.

The federal withholding tax rules exclude Swiss and foreign banks (as described above), as well as any corporate entities under the control or covered by accounting consolidation of the Swiss resident borrower as potentially “harmful” lenders or “depositors that may trigger an interest withholding tax liability for the debt arrangement.

The rather complex definitions of the notions of “bond” and “bank customer deposit” under current withholding tax regulations make it necessary to include fairly restrictive language in syndicated bank loan facilities for Swiss resident borrowers with regard to transfers of any loan portions to “non-bank” investors, to prevent the Swiss borrower from becoming liable for the deduction and payment of interest withholding taxes whenever any of the “non-bank lender” thresholds are exceeded.

Swiss versus non-Swiss issuers/borrowers

Collective debt instruments such as “bonds” or “debentures” as well as “customer deposits” (taking the above-mentioned “non-bank rules” into account) result in a federal interest withholding tax liability where the issuer or borrower is a Swiss resident person or entity. Under certain circumstances, debt formally issued abroad, through a non-Swiss issuer may be deemed to be issued by or on behalf a Swiss resident borrower, and thereby trigger federal interest withholding tax liability. Such will be the case under the following, cumulative conditions:

  • The (actual or deemed, see above) bond/debenture is guaranteed by a direct or indirect Swiss parent company of the foreign issuer (down-stream guarantee);
  • the proceeds from the issuance of the bond/debenture are directly or indirectly on-lent to one or more Swiss affiliates of the foreign issuer; and
  • such on-lending to Swiss affiliates exceeds the sum of (i) the combined accounting equity of all non-Swiss subsidiaries directly or indirectly controlled by the Swiss parent company, plus (ii) the aggregate amount of loans granted by the Swiss parent and its Swiss subsidiaries to its non-Swiss affiliates.

The “debtor system”

Swiss federal withholding tax on dividends and certain types of interest is based on the so-called “debtor system”: The law technically defines the debtor of the taxable payment as the person liable to tax. In particular, where a debt instrument qualifies as a taxable “bond” or “debenture”, the Swiss resident borrower or issuer owes the 35% withholding tax to the Federal Government, irrespective of the nature or fiscal residence of the investor and beneficiary of the interest payment.

At the same time, the Withholding Tax Act requires the debtor to shift the economic burden of the withholding tax to the investor, i.e. the beneficiary of the taxable interest payment. Thus, the debtor is legally required to deduct the applicable withholding tax from the taxable gross payment, and to submit such tax to the Federal Tax Administration. Any private arrangements designed to circumvent the debtor’s duty to impose the withholding tax burden upon the income beneficiary are declared null and void by the Withholding Tax Act.

Functions of the federal withholding tax

The function of the federal withholding depends crucially on whether the investor into a taxable equity or debt instrument is a Swiss or foreign resident for tax purposes:

  • For Swiss resident investors / income beneficiaries, the federal withholding tax essentially fulfills the function of a mere ”safeguarding” tax, designed to ensure full compliance with the investor’s income tax and net worth tax obligations. Swiss resident individuals and corporate entities beneficiaries may fully reclaim the withholding tax, if they duly report the income in their tax return, or in their accounts used for tax purposes (as applicable) and meet some further conditions, such as beneficial ownership of the income and absence of any tax avoidance. Failure to “spontaneously” declare (or report) the income principally leads to a forfeiture of any withholding tax refund claims.
  • For foreign resident investors, the federal withholding tax has a strictly fiscal purpose: Federal withholding tax is principally meant to constitute a final tax burden, with no possibility for a subsequent refund or initial relief at source. Partial or (in some cases) full relief of the federal withholding tax may exclusively be obtained on the basis of international double taxation or similar treaties between Switzerland and the investor’s country of tax residence, to the extent that such treaties limit the authority of Switzerland as a source country to impose withholding taxes.

The 35% federal withholding tax on interest hits all Swiss and foreign resident investors into “collective” debt instruments, including certain types of syndicated loans and revolving debt facilities where the “non-bank rules” are not complied with. This has rendered the issuance of such debt by or through Swiss resident issuers somewhat unattractive, given that the Swiss debtor has to initially deduct the full tax from the taxable interest payment under all circumstances regardless of the nature and tax residence of the investors, without any possibility for a relief at source.

Foreign resident investors need to rely on a double tax treaty to obtain any subsequent refund of the withholding tax from the Federal Tax Administration. In the light of these disadvantages, Swiss based groups tend to carry out their collective debt financing activities outside of Switzerland.

Features of the proposed reform

The proposed partial reform of the Federal Withholding Tax Act with regard to interest withholding tax is aimed at mitigating some of the above-described issues. On 3 April 2020, the Swiss Federal Council published a first reform draft with an explanatory report for public comments. The key element of the draft bill was a removal of the “debtor system” (as far as withholding tax on bond interest is concerned) in favor of a “paying agent” system.

Under the paying agent system, (Swiss) debtors of collective debt financing instruments would make their interest payments gross, without deduction of any withholding tax. The paying agent (usually a bank in Switzerland) would then have to draw a distinction between different categories of investors/interest beneficiaries:

  • Payments/credits of interest to Swiss resident individuals would be charged with a 35% backup withholding tax, which the paying agent would deduct and submit to the Federal Tax Administration.
  • Payments/credits to any other types of investors, including Swiss corporate investors and any foreign resident investors would be exempt from the backup withholding tax.
  • The backup withholding tax liability would be extended to interest payments on collective debt instruments (bonds etc.) issued by non-Swiss issuers, where the interest beneficiary is a Swiss resident individual. Furthermore, the backup withholding tax on interest would be extended to any indirect investments in taxable bond instruments made by Swiss resident individuals (typically via investment funds).

Further elements of the draft reform bill inter alia included:

  • The backup withholding obligation of Swiss paying agents would also be applicable to interest components in structured financial products;
  • A statutory regulation of federal withholding tax on compensation and “replication” payments for taxable dividends and interest (so-called “manufactured” payments) would be introduced (at present, such manufactured payments are only covered by administrative regulations, which in the author’s opinion are lacking statutory basis). Swiss paying agents’ obligation to apply 35% backup withholding tax to compensation payments for Swiss dividends embedded in the return of derivative financial instruments and structured products, as well as in the context of securities lending and repo arrangements would not only apply to payments made to Swiss resident individuals, but rather to dividend compensations made to all types of Swiss and foreign resident beneficiaries;
  • In order to determine the interest components embedded in the returns of Swiss and foreign collective investment schemes (funds), additional detailed reporting requirements would be introduced so as to enable the Swiss paying agent to calculate and deduct proper backup withholding tax in respect of such fund units owned by Swiss resident individuals. As regards foreign investment fund products, a catch-all provision would be introduced to capture the entire return (including underlying Swiss and foreign source dividends and interest, as well as capital gains) as a basis for the backup withholding obligation, unless the foreign fund provides proper reporting to the Swiss paying agent with a breakdown of underlying taxable interest and exempt dividends and gains, respectively;
  • Finally, the draft bill provided for an exemption of the trading Swiss bonds from the federal securities transfer stamp duty, which under current law is levied from “Swiss securities dealers” at a tax rate of (up to) 0.15% of the consideration paid for trades in the secondary market.

Results of the consultation process and latest developments of the proposed reform

The public consultation process has shown that, while most commentators have welcomed the general improvements achieved by the proposed change to a paying agent system in conjunction with the limitation of the exposure to (backup) withholding taxes on interest to Swiss resident individuals.

Especially the banking and investment fund industries have warned against the increased complexities arising from the extension of the backup withholding obligations to non-Swiss debt instruments, and in particular from the extension of such obligations to indirect investments in such (Swiss and foreign) debt instruments.

Considering the overall results of the consultation process, the Swiss Federal Council announced on 11 September 2020 that it would principally go ahead with the withholding tax reform; however, the initially envisaged system of backup withholding on interest arising on Swiss and foreign collective debt instruments (bonds etc.) via paying agents in Switzerland will be dropped in favor of a full exemption of all interest payments arising on Swiss and foreign issued collective debt instruments to any type of investors.

Only interest paid to Swiss resident individuals on Swiss bank deposits would remain subject to federal withholding tax according to the latest announcement by the Federal Council.

The dispatch to the Federal Parliament with the government’s final reform proposal is expected to be issued in the course of the second quarter of 2021. It is expected that the final legislative proposal will still include the abolition of the securities transfer stamp duties on Swiss bonds and similar instruments. To what extent other elements of the initial reform proposal (such as the statutory regulation of the withholding tax treatment of dividend compensations and the like) will be addressed by the final legislative proposal remains to be seen. https://www.reinarz-taxlegal.com

RFF Lawyers is a tax law “boutique” firm in Portugal, specialized in tax and business law, both for corporate and institutional entities and individual clients. Rogério and his team at RFF Lawyers seek to foster lasting relationships - of confidence and trust - and to provide the proper legal solutions meeting the specific needs of each client, whether individual or corporate. 

Rogério Fernandes Ferreira

Rogério Fernandes Ferreira

RFF Lawyers

rfflawyers.com

Peter Reinarz

Peter Reinarz

Reinarz
Beware Tax pitfalls when moving from one country to another

Beware Tax pitfalls when moving from one country to another

Be sure to beware tax pitfalls when moving residence

Swiss Courts ruled that a US citizen living in the UK could not get Swiss dividend tax back. With a judgment rendered on 27 November 2020 (case no. 2C_835/2017), the Swiss Federal Supreme Court (“FSC”) confirmed a decision by the Federal Administrative Court (“FAC”) of 24 August 2017 (decision no. A-1462/2016) concerning a an individual tax residence matter that arose in the context of certain dividend withholding tax (WHT) refund requests, which had been raised by the appellant (Mr. A, a US citizen) pursuant to the USA-Switzerland income tax treaty of 1996 (the “US Treaty”) with regards to Swiss dividends he had derived in the calendar years 2008-2010.

Both Swiss court instances confirmed the decision of the Federal Tax Administration (FTA) to reject the refund request and to claw back a WHT refund that it had already granted to Mr. A on a summary basis, as they concluded in fact that Mr. A failed to meet the tax residence criteria as defined under art. 4 (1)(a) of the US Treaty. The FTA had at some point suggested that Mr. A. should rather seek a partial WHT refund pursuant to the double taxation treaty between Switzerland and the UK (the “UK Treaty”).

However, Mr. A maintained that he held a “resident non-domiciled” tax status in the UK, which would effectively preclude him from benefits under the UK Treaty, as he did not remit the dividends in question to the UK and consequently did not owe any UK taxes thereon.

Facts of the Case

During the relevant periods Mr. A apparently lived in the UK, where he was treated as a UK “resident bot not domiciled” taxpayer. Mr. A held shares in several Swiss companies, from which he received substantial dividends, namely an aggregate amount of CHF 22.75 million in 2008 and 2009 and an amount of CHF 5,872,459 in 2010, all amounts before deduction of 35% WHT. Mr. A filed partial WHT refund requests with the FTA by using the Forms 82I, which is foreseen for Swiss WHT reclaims made by individuals pursuant to art. 10 of the US Treaty.

The reclaimed amounts corresponded to 20% of the gross dividends received. The FTA first satisfied the WHT reclaims for 2008 and 2009 for an aggregate amount of CHF 4.55 million on a summary basis, even though it had already noted that Mr. A had indicated a residential address in the UK. After receipt of Mr. A’s WHT refund request for 2010, the FTA explored further and suggested that Mr. A make a reclaim under the UK Treaty instead.

Upon Mr. A’s explanation that he could not utilize the UK treaty as he was taxed in the UK merely on a remittance basis, and after Mr. A had filed for a further partial WHT refund for the year 2012, this time indicating a residential address in the USA, the FTA finally rejected the open WHT requests and ordered Mr. A to return the already received WHT refund of CHF 4.55 million with 5% interest per annum. The FTA had concluded that Mr. A did not qualify as a US tax resident in the meaning of art. 4 (1) (a) US Treaty.

Under said provision, any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, nationality, [….] is considered a resident of that State. However, the second sentence of subparagraph (a) provides for a special rule pertaining to non-Swiss resident US citizens and non-US national green card holders in the United States: Such persons are considered resident in the United States only “… if such person has a substantial presence, permanent home or habitual abode in the United States”.

Mr. A. had maintained that he had at least a permanent home available to him in the United States, if not also a substantial presence, facts which the FTA had denied, however.

Relevant considerations of the FAC

The key considerations of the FAC focused on whether Mr. A – as a US citizen not resident in Switzerland – met any of the three criteria mentioned in the second sentence of subparagraph a of art 4 (1) US Treaty: having either (i) a substantial presence, (ii) a permanent home, or (iii) habitual abode in the United States. The FAC considered that the notion “substantial presence” derived from US law and referred to the Technical Explanation of the US Treaty by the US Treasury Department and § 7701(b)(3) of the U.S. Internal Revenue Code.

On the other hand, the notions of permanent home and habitual abode are not used by US domestic law; hence in the FAC’s opinion, they should be construed in an autonomous manner. Those two notions re-appear in the tie breaker provision of art. 4 (3) (a) and (c) US Treaty, which is modeled along the OECD Model Tax Treaty.

Remarkably, the FAC considered that the second sentence of art. 4 (1) (a) US Treaty means in fact that a US citizen or green card holder (thereby automatically a US resident for US income tax purposes) who is not also a Swiss tax resident must prove particular ties to the United States in order to qualify as a US resident for purposes of the US Treaty.

The FAC went even as far as questioning whether the criteria of substantial presence, permanent home or habitual abode are really to be construed as strictly alternative criteria, as the literal wording of the provision (expressed by the word “or”) would suggest.

The FAC considered that in light of the tie breaker rule of art. 4 (3) US Treaty that uses similar criteria as well, it is important to stress that art. 4 (1) (a), 2nd sentence in any case requires a strong personal nexus with the United States of such category of US taxpayers in order to qualify as US resident under the US Treaty.

The FAC in that sense rejected a merely literal interpretation of that treaty provision solely based on the word “or”. In the FAC’s opinion, such a literal interpretation would deprive the criterion of “substantial presence” of any meaning; the FAC feels that it was not the intention of the Contracting States to grant access to the tax treaty benefits just to any persons with only minimal ties to a Contracting State.

It appears that the FAC gives the notion of permanent home in art. 4 (1) (a), 2nd sentence the meaning of a mere tie-breaker, which becomes relevant only where the taxpayer is treated as a resident under the domestic laws of two states, namely the United States and a third country (in the case at hand, the UK).

In the case at hand, as Mr. A did not meet the substantial presence test of US income tax law, nor did he have habitual abode in the United States, the FAC concluded in fact that Mr. A. had stronger ties to the UK than to the United States and discarded Mr. A’s argument that he had a permanent home in the United States available to him.

The fact that Mr. A had indicated his UK address on two of his WHT reclaim forms seems to have played a certain role. Furthermore. Mr. A also had a permanent home in the UK where he was active as a trader. Even though Mr. A. had insisted that he also possessed one or more homes in the United States available for his private use, the FAC expressed doubts as to whether Mr. A. used those home permanently. On those grounds the FAC refused to acknowledge that Mr. A met the US residency criteria of the US Treaty.

Moreover, the FAC pointed to a letter by Mr. A’s counsel to the FTA, in which such counsel had indicated that art. 27 (1) of the UK Treaty was applicable to his client. Under that rule, a UK resident who would principally be entitled to a (partial) relief from Swiss WHT pursuant the provisions of the UK-Switzerland treaty. And who is not taxed in the UK, under UK domestic rules, on the full amount of such Swiss revenues, but only on such portion thereof that is received in, or remitted to the UK shall only be entitled to the Swiss tax relief for the fraction received in, or remitted to, the UK.

The FAC stressed that reference to that provision of the UK Treaty implied that Mr. A was in fact a UK tax resident in the meaning of art. 1 and art. 4 of the UK Treaty. The FAC referred to the FSC decision 2C_436/2011 of 13 December 2011, according to which a UK resident taxpayer who is merely taxed on a remittance basis in the UK is principally considered as a UK tax resident under art.1 and art. 4 of the UK Treaty.

The FAC considered that Mr. A. would likely have been able to obtain a partial Swiss WHT refund pursuant to the UK Treaty, had he chosen to remit the relevant dividends to the UK; he should not be allowed to effectively circumvent that remittance requirement for benefits under the UK Treaty by invoking the US Treaty instead. https://www.reinarz-taxlegal.com/

RFF Lawyers is a tax law “boutique” firm in Portugal, specialized in tax and business law, both for corporate and institutional entities and individual clients. Rogério and his team at RFF Lawyers seek to foster lasting relationships - of confidence and trust - and to provide the proper legal solutions meeting the specific needs of each client, whether individual or corporate. 

Rogério Fernandes Ferreira

Rogério Fernandes Ferreira

RFF Lawyers

rfflawyers.com

Peter Reinarz

Peter Reinarz

Reinarz