Historically, Switzerland has mainly been used as a location where multinational enterprises where centralizing risks and functions in order to attribute high profit margins. This was the case because of the internationally comparatively low tax rates, in particular for companies enjoying special tax regimes, and the taxpayer-friendly approach taken by the tax authorities.
Although Switzerland is still an attractive jurisdiction from a tax perspective, federal and cantonal tax authorities more and more take a strict approach and multinational enterprises are more exposed than before to audits and litigation. The main areas where this trend has been observed are offshore structures used in a group context, transfer pricing and withholding tax.
Under Swiss tax law, there is no specific regulation such as controlled foreign corporations, look-through provisions, subject to tax conditions or similar tax provisions for offshore companies except for the general anti-avoidance principle. As a rule, offshore companies and branches are recognised for tax purposes and their assets and income are segregated from those of their shareholders or head office. It is thus acceptable that Swiss-based companies undertake some activities (for example, financing, IP holding) through subsidiaries, sister companies or branches in offshore jurisdictions.
However, offshore structures may be challenged by the Swiss tax authorities in the following situations:
- The offshore company is deemed to have its place of effective management in Switzerland.
- The offshore company has a permanent establishment in Switzerland through which a substantial part of the business activities is conducted.
- The offshore branch of a Swiss company does not have the adequate substance to be recognised for tax purposes.
- The transactions between the offshore company and Swiss group companies do not comply with the arm's-length principle (transfer pricing issues, discussed later in this article).
Effective management in Switzerland
Under Swiss tax laws, a company is subject to unlimited tax liability when it has its seat or its effective management in Switzerland. In a case ruled in 2003 (Federal Tribunal, December 4 2003, 2A.321/2003), the Swiss Supreme Court considered that a trading company, whose statutory seat was in the British Virgin Islands, had its effective management in Switzerland at the seat of a company with which it had a service agreement and was thus subject to unlimited tax liability in Switzerland.
Pursuant to this decision, the Federal Tax Administration as well as the cantonal tax authorities, took a stricter approach towards offshore companies and conducted some audits. In 2011, a decision of a Swiss inferior court (Administrative Court of the canton of Zug, July 21 2011) confirmed the 2003 ruling of the Swiss Supreme Court. The court had to rule on Swiss tax residency of an investment company registered in the Channel Islands. The company was advised by a Swiss-based investment advisory company which was controlled by the same Swiss individual as the offshore company. It had its own office premises and local employees in Jersey, where meetings and formal decision-making of the board of directors took generally place. The court considered in the first place that the Swiss advisory company had a key role in the whole structure as it materially decided on the investments of the offshore company. Further, the court followed the decision of the Swiss Supreme Court mentioned above and considered that the day-to-day activities of the offshore company included mainly investment research and analysis, documentation of investment ideas, and taking of investment decisions. These activities having all been carried out in Switzerland, the court concluded that the effective place of management was in Switzerland.
Permanent establishment in Switzerland
Under Swiss tax law, a foreign company is subject to limited tax liability when it has a permanent establishment in Switzerland. Only the income derived from the permanent establishment is subject to tax in Switzerland. In the particular context of offshore companies, there is an old case in which the Swiss Supreme Court ruled that a Bermuda company had a permanent establishment at the seat of its managing company in Zurich (Federal Tribunal, February 5 1982, ATF 108 Ib 44).
Although there have not been published court cases of this nature recently, the tax authorities are occasionally following this approach in the context of tax audits.
Offshore branch of a Swiss company
Under Swiss law, foreign permanent establishments of Swiss companies are exempt from Swiss income taxes. Some Swiss companies are thus creating offshore branches to undertake certain activities and a benefit from this unilateral exemption.
In a case ruled in 2012, the Swiss Supreme Court dealt with the situation of a Swiss company with offices and four part-time employees in the Cayman Islands. The purpose of the company was to render mostly financing services to other group companies resident in Switzerland. The financing activities were organised through the offices and employees in the Cayman Islands. Since no tax treaty exists between Switzerland and the Cayman Islands, the court based its decision solely on internal Swiss federal tax law. The Supreme Court stated that the same notion of permanent establishment applies for foreign entities having a permanent establishment in Switzerland and Swiss companies having a permanent establishment outside of Switzerland. However, it ruled that somewhat higher requirements can be imposed on permanent establishments abroad than on permanent establishments in Switzerland because of the risk of double non-taxation. In case of doubt, activities abroad should thus generally be submitted to tax liability in Switzerland. In the present case, the Supreme Court refused to recognise the existence of a permanent establishment in the Cayman Islands, considering that the activities of the company in the relevant tax periods consisted in granting loans to companies of the Swiss group. The court added that it was not clear what the Cayman Islands organisation contributed to the creation of value. In conclusion, the court considered the activities taking place in the Cayman Islands to be insufficient and therefore rejected their qualification as foreign permanent establishment.
As a result, the existence of substance and functions sufficient to support the profit allocated to a permanent establishment is an important issue in Switzerland, as elsewhere.
If transactions between foreign companies and Swiss companies do not respect the arm's-length standard, transfer pricing issues may arise and the Swiss tax authorities may adjust the taxable income of group companies based in Switzerland for income tax and levy withholding tax on the deemed dividend. Switzerland does not have specific transfer pricing regulations. However, the cantonal tax administrations typically follow the OECD's guidelines on transfer pricing.
Although transfer pricing issues can arise in relation to transactions with entities in other treaty countries, including high-tax jurisdictions, the Swiss tax authorities tend to focus their audits on transactions with group entities based in offshore jurisdictions. In a case ruled in 2014, a Swiss inferior court (Administrative Court of the canton of Geneva, April 1 2014, ATA/203/2014) considered that a bank had not been adequately remunerated for services performed in favour of offshore companies and assessed penalties in addition to subsequent tax assessments. The case is now pending in front of the Swiss Supreme Court.
Switzerland levies a 35% withholding tax on dividends. Relief from the tax on the basis of a tax treaty or domestic law can be granted at source for direct dividends paid to significant shareholders. By contrast, a strict refund system is applied for portfolio dividends and both domestic and foreign investors must file reclaims to obtain the refund of the tax they suffered on dividends.
Withholding tax refund requests have been at the heart of much litigation because of perceived dividend stripping transactions. The Federal Tax Administration first challenged Swiss banks holding long positions on Swiss stocks over dividend dates and hedging their position with derivatives, such as futures or total return swaps. It also investigated reclaims lodged by foreign banks based in treaty countries which had substantial refund requests resulting from delta one trading strategies involving derivatives or securities lending transactions. The argument from the Federal Tax Administration is that these transactions are abusive and that the claimants do not have beneficial ownership over the dividends.
On March 12 2012 (case A-6537/2010), the Federal Administrative Court ruled in favour of a Danish bank, which had hedged its exposure with total return swaps, in the first litigated case. This decision was confirmed in another case ruled on July 23 2012 (case A-1246/2011) and that involved another Danish bank which had used futures as hedge. However, the court took a different approach in a case of March 13 2013 (case A-4794/2012) in relation to a reclaim made by a domestic bank and denied the beneficial ownership of the bank, which had purchased shares from the same counterparty to which it had sold futures. All these cases are now pending in front of the Supreme Court. The first case has now been pending for two years, an unusually long delay. The decision is expected soon and will have a significant financial impact since many similar cases are pending following audits.
Lenz & Staehelin