BEPS in the changing Swiss tax landscape
Markus Wyss of KPMG identifies the key issues being raised in discussions around base erosion and profit shifting (BEPS) that will impact Swiss-based or Swiss-headquartered businesses.
The issue of base erosion and profit shifting (BEPS) and the corresponding Comprehensive Action Plan (CAP) of the OECD is a major concern for many tax practitioners in many countries worldwide including Switzerland. The main question to discuss is how will the anticipated results, such as a global template for country-by-country reporting or revised guidelines on intangibles, potentially and ultimately impact taxpayers and tax authorities around the world and how Swiss-based or Swiss-headquartered businesses and the Swiss tax authorities in particular will be impacted. Given the enactment of Corporate Tax Reform III, some of these resultant issues may be mitigated.
Transparency as the crystallisation point for BEPS considerations
The starting point for many BEPS considerations is likely action 13 of the CAP – Re-examine transfer pricing documentation – including through the implementation of country-by-country reporting as proposed in the Discussion Draft on Transfer Pricing Documentation and Country-by-Country Reporting published by the OECD on January 30 2014. The proposed transparency and disclosure is a major step towards a new age in global taxation as it allows tax authorities around the globe to see their actual share in a company's total income and tax payments for the first time, and to compare the returns in their jurisdictions with returns from apparently similar activities in other countries. The requirement to provide such information and a big picture view of profit allocation is likely to give tax authorities a motivation to preliminarily assess potential base erosion and profit shifting. However, the expectation that it is then mainly tax authorities in high tax jurisdictions and main consumer markets that are astonished about the full pattern might be an erroneous belief and the common perception of a country being a tax haven that attracts above-average profits might need some revision.
Swiss concerns on key items of the OECD Action Plan on BEPS
The BEPS report issued in 2013 and the action plan of the OECD responding to the request from the G20 include a total of 15 action items addressing:
The tax challenges of the digital economy (action 1);
The issue of financial transactions with deductions (for example interest) in high tax jurisdictions and profits in low tax jurisdictions or hybrid mismatches (actions 2, 3, 4);
Harmful tax practices, treaty abuse and artificial avoidance of PE status (actions 5, 6, 7);
Transfer pricing and value creation, that is, the shifting of intangibles, the role of risks and capital, and high-risk transactions (actions 8, 9, 10);
Ways to obtain necessary information to address BEPS (actions 11, 12, 13); and (last but not least)
Mechanisms to resolve disputes and controversies (actions 14 and 15).
Out of this list the key items to focus on include the digital economy and intangibles; hybrid mismatch arrangements; harmful preferential regimes; aggressive tax planning, and greater transparency and disclosure.
The overall significance of all action items for Switzerland heavily depends on the commonly held view that Switzerland attracts foreign businesses to erode the tax base in high tax jurisdictions and to shift profit to the presumed tax haven Switzerland. As such, many of the action items may have an impact on Switzerland and the businesses operating out of the country, even if the impact is eventually "only" a significant additional compliance burden. However, the different action items cause different levels of concern for Switzerland and its existing as well as its proposed future tax landscape.
Digital economy and hybrid mismatch likely of less concern
Action items 1 and 2 addressing the challenges of the digital economy as well as hybrid mismatches are not likely to be of any different significance to Swiss-based or Swiss-headquartered businesses or the Swiss tax authorities than they are to other countries because Switzerland is neither a particular host country for digital ventures nor does it actively apply hybrid qualifications.
However, modification to the OECD's permanent establishment definition in light of the digital business that would support the French argument that the existence of consumers within a jurisdiction creates a virtual PE would also affect Swiss digital businesses. And even though such modifications are perceived as being unlikely, intense reviews of the digital business in France in tax audits have already yielded impact on Switzerland since France is an important market for various Swiss industries applying digital marketing and sales.
Measures to counter hybrid mismatch arrangements are primarily of concern to structures applied by US multinationals and arrangements with jurisdictions that apply hybrid qualification of debt and equity for tax purposes. Hosting numerous global or regional hubs of US multinationals and being once in a while counterparty to particular financial structures, Switzerland might experience some changes to how foreign businesses will structure their presence in Switzerland for a regional or global reach.
Harmful preferential regimes and aggressive tax planning as an immediate concern vs treatment of intangibles as a long-term concern
Action items addressing harmful tax practices and aggressive tax planning including base erosion via interest deductions and also artificial avoidance of permanent establishment status (action items 3, 4, 5, 7, and 12) are certainly of immediate and particular concern for Switzerland and Swiss based businesses.
The current Swiss tax privileges, such as the cantonal holding privilege with the cantonal tax exemption for income from qualifying participations (interest and royalties), the domicile company and the mixed company regimes at cantonal level and the principal company regime at federal level as well as Swiss finance branch regimes, are perceived as harmful or somewhat artificial and are commonly seen as motivation for international businesses to erode tax bases and shift profits away from high corporate income taxation. Therefore future counter-measures to be proposed by the OECD and to be eventually implemented by its member states, taking transparency and substance into account, are likely to lead to some remarkable adjustments of an actual allocation of profits to Swiss shelters, in particular those shelters lacking true substance. In any case Switzerland has decided to abolish the above-mentioned tax regimes and to apply only measures in compliance with OECD principles in future.
The discussions about BEPS via interest deductions and other financial transactions but in particular via payments for the use of intangibles granted by its beneficial owner are of immediate but also of long-term concern to Swiss-based businesses and Swiss tax authorities, as indeed they should be in general to everybody. The Swiss concern, prima facie, is with the likely above-average profit allocation to Switzerland by means of interest and royalty payments. A general concern for all is the steeply increasing challenge of the arm's-length principle (ALP).
Debt limitation and interest rate fixation threatening the ALP
The use of debt financing to achieve tax savings, that is the combination of the tax shield as described by Modigliani-Miller in 1958 with tax rate differentials, is a very common and long-lasting instrument for tax planning that is rather commonly applied by many companies. However, the question of how companies finance themselves at arm's-length, (how much debt at what interest rate they would use or get) lacks a definitive answer within a group situation. Thin capitalisation rules on one hand are likely a reasonable substitution for a good arm's-length standard. The artificial limitation of interest rates accepted on intra-group loans far below market rates on the other hand is likely not that reasonable and a threat for the arm's-length principle.
As such, any overly-narrow limitation of international and cross-border group debt financing that does not thoroughly consider the arm's-length principle has already impacted Swiss based intra-group funding and will continue to do so in the future. A future notional interest deduction on equity (NID) as currently proposed as part of the Swiss tax reform to support Swiss financing companies by an internationally competitive taxation should not create particular additional issues in light of BEPS and the CAP.
As stated above, a low tax rate in itself should not lead to requalification of an arrangement or the denial of a transaction, provided all criteria of an acceptable arrangement, such as substance (including management and control by a significant people function) are met.
Privileged taxation of intangible income on the edge of an abyss
Action items 8, 9, and 10 directly relating to transfer pricing address the shifting of intangibles, risks and capital, and high-risk transactions. The shifting of intangibles is already addressed by the revision of chapter VI (intangibles) of the OECD Transfer Pricing Guidelines, which are expected to be finally released before the other two action items (covering hard-to-value intangibles, re-characterisation, and the return to risk and capital) will be discussed. However, all three issues have already posed challenges for the revision of chapter VI and are far from being resolved yet.
One main concern is with the tendency that the OECD draft minimises the importance of contractual risk allocation and the provision of capital. Both elements quite regularly provide a key for the ultimate allocation of significant, if not all, returns from intangibles in an uncontrolled environment, that is, between unrelated parties. Hence the concepts developed in the draft chapter would not seem to work very well if they were applied more widely across all transactions and sectors. And it would therefore likely be hard to defend the recognition of beneficial ownership and hence the right to receive royalty payments if the entity concerned has primarily the capacity to bear the risks related to the development of an intangible and funding it. Whether additional managerial substance and the know-how about market demand and capacity – for example marketing know-how for a particular innovation – would be sufficient to turn the tables is quite questionable and doubts are mentioned widely within the transfer pricing community.
Another main concern is with the discussion of "significant people functions" as a driver of the allocation of profits attributable to intangibles using guidance under Article 7 of the OECD Model Tax Convention for attributing profits to permanent establishments for transfer pricing between associated enterprises. Further concern is created by comments made that the OECD is willing to "stretch" the arm's-length principle for "hard-to-value intangibles" and "high-risk transactions".
But it is the combination of challenging the importance of funding and risk capacity versus the importance of the notion of control (including the significant people function) in relation to the creation of and the right of exploitation of an innovation that concerns taxpayers and practitioners the most.
Today there are quite a lot of intangible assets allocated to Swiss-based companies and these companies probably receive significant royalty payments. Full transparency about the substance of such entities, their income from royalties and the tax paid in Switzerland and in other jurisdictions as country-by-country reporting would provide might be troublesome and require a very good defence of the facts and circumstances. Funding of research and development (R&D) activities and the capacity to bear the risks related to R&D activities even together with the economic substance of entrepreneurial management people that have the ultimate say about the R&D activity and the commercialisation of the R&D results will likely be insufficient defence. The ultimate question to be answered will be "what is a sufficient significant people function at the location of an IP company and what evidence can prove it?"
Switzerland offers highly-educated employees and is traditionally regarded as a good or even very good location for R&D activities, and hence constitutes a good ground for the exploitation of innovation. Swiss federal and cantonal governments are clearly focusing on measures to support R&D activities in Switzerland, including the exploitation of intangibles as results of the R&D activities. The proposition of a preferential taxation of income from innovation such as patents, but also unregistered technology and the like, is therefore a key element of the Swiss corporate income tax reform currently being discussed. Given the discussions and the developments around BEPS and the CAP it becomes clearly evident that Switzerland must define its patent box or innovation box and the criteria for a privileged competitive low taxation with as much diligence and far-sightedness for international acceptance as possible. Otherwise the privileged taxation of income from intangibles as an attractive argument for the location Switzerland will not be sustainable. Other jurisdictions that have already implemented a patent box, including the UK (Patent Box) and the Netherlands (Innovation Box), have faced challenges at various levels.
It is in the vital interest of Switzerland to actively participate in the discussions about BEPS and the action items stipulated to support, with as much certainty as possible, the design of its future tax landscape within the global economy.
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Markus Wyss is a tax and transfer pricing partner with KPMG Switzerland leading the Swiss Global Transfer Pricing Services practice providing high value added transfer pricing consultancy to international business out of Switzerland for state-of-the-art transfer pricing systems and most effective compliance processes.
Markus is providing advice on international corporate tax and transfer pricing including international tax structuring for international clients for more than 15 years. He assists clients in the development of transfer pricing compliance, including documentation processes; in planning of appropriate intercompany pricing including supply chain restructuring and optimisation; in dispute resolutions, including through the use of MAP and APAs; in intangible valuation and management; competitive benchmarking and economic value creation analyses. Markus teaches regularly at the Universities of Zurich and Lausanne as well as at the Federal Institute of Technology (ETH) in Zurich as a visiting scholar on tax and transfer pricing in supply chain management, tax treaty / OECD Model Convention on ALP and MAP/APA.