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The substance-based approach in Swiss income tax law

The term “substance” in the tax practice can have very different meanings. Peter Brülisauer of Deloitte discusses how it is of fundamental importance for the purposes of a substance-based analysis.

There is no definition of the term "substance" in Swiss private law or tax law. In economic terms, the issue of substance is above all associated with the concepts of value added, processes, functions, people, assets, risks, etc. For tax purposes, the concept of substance is most often brought up in connection with the terms operationally justified, caused by operations, domicile, right of use, misuse, etc. These lists show that the concept of substance has many different interpretations and is, therefore, to be understood in a relative sense. This means that the concept of substance takes on a different meaning and content depending on whether it is being used in reference to the real, financial or digital economy. As such, industry-specific considerations are of fundamental importance for the purposes of a substance-based analysis.

The relative nature of the concept of substance also makes it clear that a substance-based approach for the purposes of tax law can also be associated with significant potential for conflict. At an international level, classification conflicts are more or less inevitable because at least two different tax jurisdictions are involved that can/will represent different perspectives on legislation and the application of the law. One specific example of this are the diverging perspectives of the industrialised and emerging economies – especially the BRIC countries (Brazil, Russia, India and China). While the industrialised economies prioritise education and, therefore, intangible assets, the emerging economies pay more attention to the factor of practical labour and, therefore, tangible assets.

These differing viewpoints can become particularly relevant in connection with contract research and development (R&D). BRIC countries often call into question whether local functions and risks are actually being controlled from other countries, or whether local R&D companies can be classified as risk-free, routine service providers. In practice, this can lead to the BRIC countries either demanding very high mark-ups for the purpose of profit allocation, or seeking to deny the recognition of intangible substance in other countries. That being said, it is certainly understandable that the physically locatable factors, such as number of local persons, local turnover and local taxes paid, will also be necessary to report in the future as part of country-by-country reporting (CbCR). These CbCR reports will be used as a starting point for the purposes of a plausibility test. Finally, another important consideration in this respect is that Article 21 (1) of the OECD Model Tax Convention specifies a comprehensive residence-based principle, while Article 21 (3) of the UN Model Tax Convention contains a comprehensive source-based principle that, in practice, is often linked with a limited force of attraction of the permanent establishment.

Principle of separation v the fiscal look-through approach

The principle of separation, i.e. separate taxation of corporation and owner, constitutes one of the fundamental structural principles in Swiss tax law. The principle of separation has a veiling effect in that the profit generated by the corporation is allocable to it for taxation purposes, and cannot be taxed as profit or income of the investors. Swiss legislation governing the taxation of profits – in contrast to VAT law – does not contain provisions on the taxation of groups. Moreover, Swiss tax law does not prescribe any explicit rules for controlled foreign corporations comparable to those in other countries, e.g. Australia, Germany, France, UK, Italy, Japan and the US. In Switzerland, however, an extensive range of tools have been developed in connection with the interpretation of tax law concepts linked to economic fact patterns in order to enable the assessment of cross-border cases by reference to substance-based criteria. Table 1 presents an overview of the main correction mechanisms applied in practice.

To conclude, it should be noted that the fiscal look-through mechanism can be applied irrespectively of whether Switzerland is the state of residence (outbound case), or the source state (inbound case). The doctrines of tax avoidance and abuse of law are outlined hereafter. These institutions are increasingly understood in legislative and judicial practice as the interpretation process integral to the substance-based approach.

 Table 1: Overview of fiscal look-through and defensive mechanisms in Swiss tax law
ActionAbuse of lawTax avoidanceManagement in SwitzerlandPermanent establishment in SwitzerlandTransfer price (TP) adjustmentNo relief on dividends
Legal basis practice • Article 8 and 9 of the Federal Constitution-
• Economic interpretation
• Interpretation-
• Economic interpretation
• Article 20 of the Federal Law on the Harmonisation of Direct Taxation of Cantons and Municipalities (StHG)
• Article 50 of the Federal Act on Direct Federal Taxation (DBG) and Article 9 of the Federal Law on Withholding Tax (VStG)
• Article 21 of the StHG
• Article 51 of the DBG
• Article 24 of the StHG
• Article 58 of the DBG-
• Article 21 of the VStG
• Article 70 of the DBG and circular No. 27 of the Federal Tax Administration
Tax consequencesAdjustment of applicable law or refusal to apply applicable lawAdjustment of formal to economic fact pattern and respective taxationFiscal link on grounds of unlimited tax liability in SwitzerlandFiscal link on grounds of limited tax liability in SwitzerlandTP adjustment by classifying transaction as hidden profit distribution or equity contributionRefusal to grant relief on dividends for tax-deductible transactions abroad
Interpretation process in substance-based approach

Tax avoidance v abuse of law

According to the opinion of the Swiss Federal Supreme Court, tax avoidance is committed if:

  1. The legal structure chosen by the parties is unusual (insolite), improper or outlandish and, in any case, appears entirely inappropriate for the economic circumstances;
  2. It can be assumed that the chosen legal structure was abusively elected for the sole purpose of saving taxes that would have been owed in normal circumstances; and
  3. The chosen procedure would in fact result in a substantial tax saving if the tax authorities were to accept it.

It is evident from this description that a substance-based approach is only to be taken in the context of tax avoidance in extreme exceptional cases. The avoidance corrective serves as an emergency mechanism that should only be triggered if a qualified unjust interpretation occurs that the legislator could not have possibly intended. However, it should be noted that with the advancement of the teleological interpretation, tax avoidance has largely lost its previously great practical significance and is increasingly replaced in practice by a regulatory correction in response to a breach of the prohibition on abuse of law and/or arbitrary action.

An abuse of law, respectively an arbitrary application of the law, is committed when the decision:

  1. Is premised on an actual situation that is clearly inconsistent with reality;
  2. grossly infringes on a rule or an undisputed legal doctrine; or
  3. Compliant application of law objectionably runs counter to a sense of justice.

In contrast to tax avoidance, which takes the fact pattern as its starting point (instead of the legally realised fact pattern), a fictitious (objectively justifiable) fact pattern is supposed and tax is levied thereon. Application of the prohibition on abuse of law and arbitrary action prevents gross infringements of the equal-treatment principle by imposing a replacement regulation, with ultimately the same consequence (as a rule). It is, therefore, of no consequence whether one modifies applicable legislation, so that it fits the fact pattern, or one modifies the fact pattern that it can be subsumed under applicable legislation.

Finally, it must be stressed that a correction of the fact pattern or a regulatory correction in the context of tax avoidance or abuse of law cannot be entirely replaced by an extensive teleological interpretation to the taxpayer's detriment. Semantic boundaries have to be imposed on the economic perspective and the process of interpretation cannot be permitted to become a game without limits. This means that laws cannot be ignored and they must be interpreted. Indeed, there are regulations under tax law, which for good reason – especially on account of legal certainty considerations – are open to avoidance or abuse of law. Furthermore, taxpayers could likewise conceivably appeal to an extensive interpretation as to the teleological intent of a regulation. This can be illustrated by examining the topic of reductions of tax at source. Both in accordance with Article 21 (2) of the Swiss Withholding Tax Act and by virtue of Article 10 (1) and (2) of the OECD Model Tax Convention that state that reductions of tax at source are denied in the event of misuse. If this issue was not (or no longer) instigated by the misuse leading to the denial of a reduction of tax at source, but rather by the profit allocation among the actual beneficial owners, the beneficial owner could also in other cases appeal in his favour on the grounds of the deviation of the economic assessment of the transaction flows from the structure under private law, which can constitute an infringement of the good faith requirement of the prohibition on contradictory behaviour.

Substance test v tax rate test

The substance test can be understood as an extension of the institution of operational business rationale within the meaning of Article 58 (1) b of the Direct Federal Tax Act, when read in conjunction with Article 59. An expense is generally considered operationally justified if it has operational causes or is entrepreneurially motivated. Consequently, only expenses that serve a business purpose qualify as tax-deductible, i.e. if there is a factual relationship between the expense and the business operations of the company performing the transaction. There is no dispute in Switzerland that the concept of "operationally justified", which was further specified in practice in connection with hidden profit distributions, has assumed the function of an arm's length comparison. Against this background – and more recently in light of BEPS – it can be expected that the assessment of operational justification will no longer be conducted from the perspective of the entity performing the transaction. Instead, an aggregate perspective will increasingly be taken in future and substance-based considerations with regard to the recipient of the transaction will be factored into the assessment. This means that if the source state is of the opinion that a sufficient amount of substance is not allocable to the recipient state, the source state can argue that the operational justification requirement is not satisfied – and thus deny tax-deductibility – for the expenses charged to the recipient state. In addition, the source state – to the extent that it levies tax at source on the expenses charged – can deny the recipient use of the otherwise applicable double tax treaties (DTAs).

Owing to the fact that the verification of substance in the recipient state by the source state can entail considerable effort, many countries in practice (e.g. France and Austria) increasingly conduct a tax rate test. Thus, if the statutory tax rate in the recipient state falls short of a certain threshold (e.g. 10%), or if the tax rate gap between the source and recipient states exceeds a certain amount, the source state can deny the tax-deductibility of expenses even if they are operationally justified. An even more severe legislation has been introduced in France, where a higher rate of tax at source is levied on expenses charged to non-cooperating countries, especially those that do not take part in information exchange arrangements. Even if such procedures are defensible on the grounds of practicability and procedural efficiency, taxpaying companies – particularly also in light of BEPS – must be granted the opportunity to demonstrate that a relevant amount of substance is allocable to the recipient state. Such proof of substance can be simplified, for instance, by working with catalogues, so that the activities under review (in the source and/or recipient state) are either listed in an "active or positive catalogue" that is not harmful or not listed in a "passive or negative catalogue" that is harmful.

From a tax system perspective, refusal to grant tax-deductibility in the source state and the taxation of the same transaction in the recipient state constitutes economic double taxation. Further, the undifferentiated refusal to grant tax-deductibility of expenses that are operationally justified – by reference to the fact that profit determination falls exclusively within the scope of unilateral law – or the undifferentiated levy of tax at source can infringe on the fundamental principles of international tax law, particularly given that such procedures ultimately annul the scope of application of the otherwise applicable DTA without a qualified substance-based justification or can result in a breach of anti-discrimination rules.

Peter Brülisauer

Partner, International Tax
Deloitte

Tel: +41 58 279 7290
pbruelisauer@deloitte.ch

Peter Brülisauer is tax partner at Deloitte in Switzerland. He has extensive experience in advising multinational companies on tax matters. This includes corporate restructuring, acquisition, finance restructuring, IP and R&D planning, cross-border tax planning, tax effective supply chain management, as well as function and risk allocation within multinational groups. He also specialises in permanent establishment (PE) planning and profit attribution between PEs.

Peter is lecturer in national and international taxation at the University of St. Gallen and a frequent speaker at tax conferences. He has a PhD in law from the University of St. Gallen and is a Swiss Certified Tax Expert.


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