1

European Association of Tax Law Professors (EATLP)

Budapest Congress of 2-5 June 2006

Taxation of Savings Income

Swiss National Report

By

Prof. Dr. Robert Danon[1]

University of Lausanne (HEC)

Baker & McKenzie Geneva

TAble of content

I.Introduction

II.Income from movable capital assets under Swiss domestic tax law and DTCs

A.Swiss domestic withholding tax law

1.Constitutional foundations, nature and features

2.Tax object

B.Swiss domestic income taxes

1.Constitutional foundations

2.Jurisdiction to tax

3.Tax object

4.Taxable event

5.Tax rates

C.Swiss DTCs

III.Savings taxation under the Agreement

A.Constitutional foundations and interpretative issues

B.The retention

1.Nature, scope and basis of assessement of the retention

2.Elimination of double taxation

3.Revenue sharing

C.The voluntary disclosure procedure

IV.Substantive terms

A.Beneficial ownership

1.Under Swiss domestic withholding tax law

a.In general

b.Application to Trusts

2.Under Swiss DTCs

a.In general

b.Application to Trusts

3.Under the Agreement

a.In general

b.Application to Trusts

B.Paying agent

C.Interest

1.Direct interests

a.Under the Agreement

b.Comparative overview: Agreement, Swiss income, withholding taxes and DTCs

2.Indirect interests (investment funds)

a.Distribution

b.Sale, refund or redemption

I.Introduction

The present report discusses the Agreement between the European Community and the Swiss Confederation (hereafter: “the Agreement”) providing for measures equivalent to those laid down in Council Directive 2003/48/EC on taxation of savings income in the form of interest payments (hereafter: “the Directive”) and which entered into force on 1 July 2005[2]. In this respect and in order to keep the report within the scope of the EATLP Congress and within manageable proportions, our analysis will be limited to savings taxation per se. On the other hand, the other areas covered by the Agreement will not be considered in this report[3].

In accordance with the guidelines set forth by the general reporter, we begin by outlining the treatment of income from movable capital assets - in particular interest income – under Swiss domestic tax law and double taxation conventions (hereafter: “DTCs”) (I). We then turn to the core of the report and discuss savings taxation under the Agreement (III), both under the retention (III.B) and the voluntary disclosure procedure (III.C). Finally, important substantive terms of the Agreement (e.g. beneficial ownership, paying agent and interest) are analyzed and compared with similar concepts used by Swiss domestic tax law and DTCs (IV).

II.Income from movable capital assets under Swiss domestic tax law and DTCs

A.Swiss domestic withholding tax law
1.Constitutional foundations, nature and features

The Swiss Confederation levies a 35% withholding tax (“impôt anticipé”, “Verrechnungssteuer”)[4] on certain items of income stemming from movable capital assets (“revenus de capitaux mobiliers”)[5]. In essence, the features of the Swiss withholding tax may be summarized as follows.

First of all, the Swiss withholding tax, which is of direct nature, is a genuine tax at source that designates the Swissdebtor of the income as the taxpayer[6]. Is regarded as “Swiss” for this purpose (i) an individual residing in Switzerland on a long term basis, (ii) enterprises which have their statutory seat (legal entities) in Switzerland or which are registered in the trade register, and (iii) foreign enterprises which are effectively managed from within Switzerland and exercise an activity in this country[7]. On the other hand, income paid by a foreign debtor is outside the scope of the Swiss withholding tax.

Secondly, the tax must be withheld when the income falls due[8], irrespective of the nature (individual or legal entity) and place of residence (Swiss or foreign) of the recipient of the income[9]. In particular, the fact that the recipient resides in a high or low tax jurisdiction is irrelevant.

Thirdly, the purpose of the Swiss withholding tax is twofold. As regards persons liable to Swiss income taxes, the withholding tax is primarily aiming at ensuring compliance with direct tax reporting requirements (“Sicherungszweck”)[10]. Accordingly, persons who were domiciled[11], had their tax residence[12] or statutory seat[13] in Switzerland when the item subject to withholding tax fell due may claim its full reimbursement provided they (i) properly report this item in their tax return[14] and (ii) are the beneficial owner (“droit de jouissance”; “Recht zur Nutzung”)[15] thereof[16]. A reimbursement also comes into play where the income subject to withholding tax is attributable to the Swiss permanent establishment of a foreign enterprise[17]. By contrast, non-residents may not claim the reimbursement of the withholding tax. For these persons, the Swiss withholding tax thus essentially performs a fiscal function (“Fiskalzweck”)[18]. The Swiss withholding tax may however be reduced by Swiss DTCs. As a rule, Switzerland complies with its tax treaty obligations in accordance with the refund procedure. Therefore, in order to obtain the refund of Swiss taxes levied in excess of the appropriate treaty rate, residents (typically individuals) of other contracting States must present a refund claim to the Federal Tax Administration (FTA). This being said, as we shall see, special rules apply to non-residents unit holders participating in a Swiss investment fund.

2.Tax object

The Swiss withholding tax is presently levied on the following Swiss source items of income produced by capital assets:

  1. Interest (paid or capitalized[19]) from bonds (or certificates on bonds baskets[20]) and debentures issued by Swiss debtors and other similar negotiable instruments[21].By contrast, interest paid on a commercial loan (inter company loan) is not subject to withholding tax.

The meaning of bond for tax purposes[22] is broader than at private law[23]. A bond is defined as a written debt instruments relating to fixed amounts issued in a multiple of units for the purpose of collective debt fundraising, providing a collective investment opportunity or consolidation of debt obligations[24]. Further, according to the administrative practice, the total borrowed funds must amount at least to CHF 500’000[25].

The law does not define the term “interest”. The ordinance however stipulates that income from a bond includes any item paid to the creditor on the basis of the debt-claim relationship and not representing a repayment of the principal[26]. More generally, what is an interest payment is determined from the perspective of the debtor (“subjektives Herkunftsprinzip”). Whether the payment is regarded as interest at the level of the creditor is irrelevant (“objektbezogene Betrachtungsweise”)[27].Accordingly, interest includes an original issue discount (OID) on a zero-bond or on a low-interest coupon bond, respectively the payment of a premium by the issuer.[28] By contrast and pursuant to the “subjektives Herkunftsprinzip”,a payment which is not made by the debtor is not treated as interest. For this reason, accrued interests (“intérêts courus, “Marchzinsen”) paid by the acquirer to the seller are not subject to withholding tax[29].

With respect to the treatment of hybrid instruments, it is in essence critical to establish if the product incorporates a bond element. In the affirmative, the tax treatment will depend on whether the product is characterized as “transparent” or “non-transparent”.Broadly speaking, an instrument will be treated as transparent if the various components (typically a bond and an option) of the instrument, as well as the value of these components are clearly ascertained in the issuance prospectus[30]. In such case, withholding tax will only be levied on the interest produced by the bond component. By contrast, if these conditions are not satisfied the hybrid instrument will be characterized as non-transparent which entails that the entire product may be characterized as a bond[31].

Example:

Derivatives with guaranteed capital; non-classical option bonds and convertible bonds, reverse convertibles

This form of instrument typically combines an ordinary bond (or sometimes an OID), guaranteeing the repayment of the initial investment, with an option[32]. If the product is transparent, the Swiss withholding tax will exclusively trigger the bond component i.e. the interest coupon and, upon redemption, the discount issue or the premium paid by the issuer[33]. On the contrary, if the product is non-transparent withholding tax will be levied on all periodical payments stemming from both the interest coupon and the option. Moreover, the difference between the total issue and redemption price of the instrument will be subject to withholding tax[34].

On the other hand and in the absence of a bond component, income derived from futures[35], forwards and options remains outside the scope of the withholding tax. The same holds true as regards an investment in index and certificates of shares[36].

  1. Interest on clients’ deposits with Swiss banks[37]. The notion of “bank” is also construed broadly. It covers obviously institutions which, within the meaning of Swiss banking legislation, offer to receive interest-bearing funds. However, anyone (individual, finance entity etc.) accepting borrowed funds from at least 20 creditors and for a total amount of CHF 500’000 is equally regarded as a bank for Swiss withholding tax purposes. Under certain conditions, however, withholding tax is not levied on interest produced by fiduciary and inter bank deposits. Finally, let us also mention that interest from a nominative savings account and amounting to less than CHF 50 is exempted from withholding tax[38].
  1. Distributions from a Swiss investment fund or from a similar unit of assets[39] (regardless of the underlying source i.e. Swiss or foreign) where the certificates have been issued by a Swiss resident or by a non-resident acting in combination with a Swiss resident.[40] The resident company acting as fund manager and owning the assets in a fiduciary capacity is generally liable to tax.[41]. A distribution consisting in the repayment of the issuance price or in capital gains is however exempt from withholding tax provided such distribution is made by means of a separate coupon[42].

Income derived from a distributing fund ("Ausschüttungsfond") will therefore be subject to withholding tax unless it represents a capital gain. The redemption of the certificate is also treated as a capital gain. Further, the tax-exempt capital gain includes the investor's proportionate share of accrued but undistributed dividend and interest income. Accordingly, an investor who purchases a certificate shortly after the yearly distribution to investors are made and then sells his certificate shortly before the next yearly distribution occurs will benefit from an extended accrual period. Undistributed income which the fund has accrued during that period will be treated as a tax-exempt capital gain[43].

On the other hand, income accumulated and reinvested by a growth fund ("Thesaurierungsfond") is not subject to withholding provided it is booked in a separate account. Rather, the withholding tax will only be levied upon the redemption of the certificate. In such case, the withholding tax will trigger the proportion of the sale price corresponding to the accumulated (potentially taxable) income booked in the separate account[44].

Finally, Swiss investment funds predominantly deriving foreign source income benefit from a special treatment. As indicated, for non-resident certificates holders the Swiss withholding tax thus represents a final burden unless a DTC provides otherwise. Yet, the law stipulates that a distribution stemming from a Swiss investment fund is exempted from withholding tax provided (i) the proportion of foreign source income amounts to 80% and (ii) an affidavit certifying this proportion is filed by the entity acting as fund manager[45](“affidavit investment funds”). As we shall see, this exemption has directly influenced the scope of the Agreement.

  1. Distributions from Swiss corporations or limited liability companies not representing a repayment of the entity’s nominal capital[46].
B.Swiss domestic income taxes
1.Constitutional foundations

The Constitution allows the Swiss Confederation to levy an income tax on the income of individuals and the net profit of legal entities[47]. Federal income tax, which is now assessed on a yearly basis (so-called “postnumerando” system)[48] in accordance with the Federal Direct Tax Law (DTL)[49], is collected by the cantons which are entitled to receive three tenths of its gross yield[50]. By contrast, no federal wealth or capital tax[51] is collected. Further, the Constitution also provides that the Confederation is to set forth the principles governing the harmonization of federal, cantonal income and net wealth taxes[52]. Based on this constitutional mandate, cantonal direct tax legislations have been harmonized on the basis of a Federal law (THL)[53] the content of which is similar (if not identical) to the DTL. The following considerations are therefore based on federal and cantonal harmonized legislations.

2.Jurisdiction to tax

As to jurisdiction tax, Swiss domestic law distinguishes between (i) full (personal) and (ii) limited (economic) affiliation. Are liable to tax pursuant to a personal affiliation and on a worldwide basis[54], individuals having their domicile[55] or tax residence[56] in Switzerland[57]as well as legal entities whose statutory seat or effective place of management is situated therein[58]. By contrast, a tax liability based on economic affiliation exists where business operations are carried out in Switzerland[59]. This is for instance the case if non-residents are partners in an enterprise of Switzerland[60] or maintain a permanent establishment therein[61]. In such case, the tax liability is limited to the elements realized in Switzerland[62].

3.Tax object

The DTL and THL, which define the concept of taxable income in accordance with the net wealth theory (“Reinvermögenzugangstheorie”, “théorie de l’accroissement du patrimoine”)[63], provide that all income received by a taxpayer, whether recurring or non-recurring is subject to income tax[64]. Accordingly, these laws first of all refer to the typical elements which a taxpayer may derive (“Einkünftekatalog”), notably interest income[65] and distributions made by investment funds[66]. Finally, certain specific inflows, which constitute income under the net wealth theory, are expressly excluded from the scope of income tax[67]. Among these exempted items, are in particular capital gains realized upon the disposal of private movable assets forming part of the taxpayer’s private wealth[68]. By contrast, capital gains pertaining to business assets are fully taxable (independent activity characterization)[69].

Critical, therefore, in the field of portfolio income, is the classification as taxable income (interest) or private tax-exempt capital gain. As for withholding tax, this distinction is, as a matter of principle, made on the basis of a subjective criterion (“subjektives Herkunftsprinzip”)[70]. From this perspective, as we have seen, interest may only include what is paid by the debtor. Taxable interest income thus first of all covers interest income from bonds[71] i.e. (i) periodic interest payment, (ii) single interest payment in the form of OID or redemption premium[72]. More generally and unlike for withholding tax purposes, taxable interest income is however not limited to interest from bonds but extends, on the contrary, to any income based on a debt-claim relationship[73].

By contrast, this subjective definition of interest entails that accrued interests which is not paid by the debtor but by the acquirer of the security to the seller is not treated as interest income but rather as a tax-exempt capital gain[74]. Under this principle, therefore, income realized upon the disposal of a bond (forming part of private wealth) prior to maturity is exempted from tax[75].

This being said, an exception to this rule was introduced with respect to discounted or zero-coupon bonds and mixed bonds with predominant[76](or exclusive) single interest payment (“obligations à intérêt unique predominant [OIUP]”). Specifically, the law provides that not only the income derived from the redemption but also that stemming from the disposal of such bonds is regarded as taxable income. Under this regime, which in effect amounts to an exception to the exemption of capital gains and which also departs from withholding tax principles[77], the taxable income is the difference between the acquisition cost and the higher sale proceeds[78].

With respect to distributions from investment funds[79] (including growth funds[80]) the flow-through principle applies. Broadly speaking, the investor is taxable on the income derived by the fund, except capital gains distributed through a separate coupon. Further, an investor who has his certificates redeemed by the management company also realizes a tax-exempt capital gain[81].

The principle of “transparency” or “non-transparency” discussed above in relation to hybrid instruments also applies for income tax purposes. Hence, where the product is transparent (for example derivatives with guaranteed capital, non-classical[82]option bonds and convertible bonds), the income produced by the bond portion is taxable (periodic interest, OID, redemption premium)[83] whereas capital gains pertaining to the derivative portion remain tax-free. By contrast, if the product is non-transparent, the bond characterization applies. In other words, the private investor will be taxed on all amounts received on the due date of periodic interest coupons, options, conversion or exchange rights or on maturity of the instrument in excess over the capital initially invested[84].

Finally, the DTL and THL aim at assessing the taxpayer’s net income on the basis of a series of deductions[85]. With a view to determine the objective ability to pay of the taxpayer (“objektive Leistungsfähigkeit”), these laws in particular provide for deductions that are organically connected to the acquisition of the income during the relevant fiscal period (“déductions organiques”; “Organische Abzüge”)[86]. Among these deductions are for example those related to the management of wealth[87]. For example, a taxpayer owning private movable assets may deduct the expenses stemming from their administration by third parties as well as foreign withholding taxes that are not refundable or creditable[88].

4.Taxable event

The taxable event of income taxes is the so-called principle of realization (“réalisation”;“Realisierung”). Under this concept, an income is realized where it forms part of the taxpayer’s property (“Zuflussprinzip”). As regards private individuals, this is the case either when the taxpayer actually receives the income or when the latter acquires the fixed right (“droit ferme”, “feste Rechtanspruch”) to request its payment (“effective realization”) and may dispose of such right[89]. As regards income stemming from movable capital assets, this is the case where the income falls due within the meaning of civil law.