Reforming Beneficial Taxation in Switzerland

This article was written by Kerstin Heidrich and Stefan Widmer of PrimeTax.

The contemplated Corporate Tax Reform III (CTR III) will be a key element for the attractiveness of Switzerland as a location for multinational enterprises. It will be influenced by the ongoing tax controversy with the EU and the growing concern of the OECD with regard to profit shifting and base erosion, presenting challenging and dynamic circumstances.

The EU-Swiss Tax Controversy and its Impact on the CTR III

Since the early 1990s, numerous multinational enterprises have chosen Switzerland as their EMEA headquarters, trading, R&D, management or financial center, or their regional or even global holding company hub. While low tax rates have certainly been a factor in determining where to centralize these mobile activities within a multinational group, other aspects such as excellent infrastructure, frequent worldwide flight connections, qualified workforce and easily accessible support from competent authorities are other significant factors that position Switzerland as one of the leading locations for housing the worldwide headquarters.

In the past few years, Switzerland has been under increased pressure from the EU, which demands conformity of the Swiss taxation principles with EU standards even though Switzerland is not a member of the EU. The focus of the CTR III, which was initially announced in 2008, aimed at abolishing share issuance tax, improving the mechanism of granting tax exemption for dividend income, and eliminating fiscal obstacles relating to group financing with a view to strengthening Switzerland’s financial center. However, the scope of the CTR III was extended to also include the abolition of the existing cantonal (i.e., state or local) tax regimes and the implementation of new, EU compatible tax regimes, which has resulted in the postponement of the official launch.

Although part of the CTR III (in particular the possibility for group financing free of stamp duties and withholding tax) was implemented separately, the centerpiece of the CTR III was adjusted to focus on safeguarding the attractiveness of Switzerland as a tax location while ensuring the international acceptability of the Swiss corporate tax regimes.

At present, an optimized design of the CTR III with a view to further strengthen Switzerland’s position within the international tax competition and achieving positive economic growth effects is a top priority of the Swiss Federal Council. The Swiss corporate tax regimes, which form the main subject of the tax controversy with the EU, are the beneficial cantonal taxation regimes for holding, administrative and mixed companies, which have encouraged numerous foreign companies to move their mobile corporate activities and shift the respective profits to Switzerland.

Below is a brief overview of the existing Swiss cantonal tax regimes and some background information on why the EU is pushing for their abolition. Should Switzerland not present concrete progress by this summer, the EU threatens with a blacklisting or other (unilateral) steps and measures.

Beneficial Cantonal Tax Regimes under Pressure from the EU:

Holding Company Regime

Swiss legal entities or branches of which the main statutory purpose is the permanent administration of investments and which do not perform any business activities in Switzerland are exempt from corporate income tax at cantonal and municipal level provided their investments or their income from investments amounts to at least two-thirds of the balance sheet total or total income.

As a secondary purpose and if within the limits of the so-called “tax free holding third” additional permitted activities include management services, group financing and reporting, cash pooling, IP exploitation, etc.

A thorn in the EU’s side and the reason why this tax regime is assessed to constitute unlawful state aid is the fact that not only the income from qualifying investments, but also any income from the above secondary activities, is taxed solely at federal level and is subject to an effective tax rate of 7.83%.

Administrative Company Regime

With regard to their income from foreign sources, Swiss legal entities and branches which solely perform administrative activities in Switzerland are subject to cantonal and municipal corporate income tax only for a certain quota of their foreign sourced income. As a result, the taxable basis for cantonal and municipal tax purposes is usually reduced to something between 0% (no own infrastructure and personnel) and 20% (significant administrative activities), and the overall effective tax rate including federal taxes on the net profit from foreign sources amounts to only approximately 8% – 10%.

The EU’s criticism with respect to this regime mainly relates to the unequal treatment of domestic vs. foreign sourced income which is assessed ring-fencing and distorting competition.

Mixed Company Regime

In contrast to administrative companies, the mixed company is allowed to also perform business activities in Switzerland. These activities, however, may only be of a subordinated nature; for example, income and expenses related to business activities in Switzerland must not exceed 20% of both total income and expenses (bi-dimensional approach). Should this requirement be met, the taxable basis for cantonal and municipal tax purposes is reduced to usually between 10% and 20% leading to a combined effective tax rate on the net profit from foreign sources including federal, cantonal and municipal tax of approximately 8.5% - 11%.

This tax regime is applied by most international groups that have established their trading, financing, IP, management, or other group internal services companies in Switzerland, and it is also the regime that is applied for purposes of cantonal and municipal taxation by e.g., regional headquarter companies such as the countless EMEA headquarters of U.S. based groups.

While the official criticism of the EU, equivalent to the administrative companies, relates to the unequal treatment of foreign versus domestic income, the major concern is the fact that by way of establishing such a structure profits in the group’s home country are decreased and shifted to Switzerland.

Substitute Measures to Ensure Sustainable International Tax Attractiveness

Given the ever shorter time available for drafting solutions which could serve as a substitute for the existing cantonal tax regimes and at the same time are tolerable also from a Swiss political and financial budget point of view, the process of developing alternative (EU compatible) tax measures possibly combined with a general reduction of corporate income tax rates is at full speed. Common to all endeavors is the imperative of providing attractive compensatory measures to the directly concerned companies, avoiding the transfer of existing Swiss business activities abroad, and maintaining a top position in international location competition.

Of high importance to companies worldwide, the solutions presented within the scope of the CTR III must aim at offering long-term planning and legal certainty. Given the dynamics of the current international tax environment, legal certainty at this stage means that substitute measures must be in line with the EU’s claim against Switzerland to waive the cantonal tax regimes assessed “selective” and/or “ring fencing”.

Since an actual implementation of any concrete measures prospectively taken by the OECD as a result of the more recent discussions concerning base erosion and profit shifting can neither be assessed in their technicalities nor with respect to timing yet, the in-charge group of experts in Switzerland have mainly discussed taxation models as also offered by a number of EU member states (e.g., Luxembourg, Netherlands, Belgium, United Kingdom, etc.).

Besides a license and interest box regime and a more flexible approach to the general “tax follows accounting” rule when determining the taxable basis, other innovative and completely new solutions are being analyzed to determine if they are compliant with (current) EU rules. To put it bluntly, the new taxation models which shall replace the existing cantonal tax regimes in the future and provide for a sustainably attractive environment for mobile, high value-adding activities such as IP exploitation, group financing, trading, R&D and other central group functions, can be expected to be derived from a “best-of” collection from what is already offered by member states of the EU and further spiced-up with certain beneficial particularities with a view to succeeding in future location competition.

In order to provide for real solutions to the companies already located in Switzerland, the challenge is to create a newly designed taxation system that at least maintains the combined federal, cantonal and municipal effective tax rates currently applicable (i.e., amount to between 8-10% for IP exploitation, 2-4% for group financing, and 9-12% for trading activities).

Expected Timing and Medium-Term Impact

Based on the experience of the two previous corporate tax reforms and due to the direct democracy and federalism in Switzerland, the Corporate Tax Reform III can certainly not be implemented overnight. All potential substitute measures firstly need to be evaluated with respect to their compatibility with EU regulations as well as regarding their consequences on the cantonal financial budgets and any necessary adjustments to the system of financial equalization between the cantons.

Once final measures are designed by the Swiss Federal Council, the political approval process will start and, due to the significance and media presence of the topic, can be expected to culminate in a referendum. If asked for a best estimate on when the CTR III will actually enter into force, the authors would assume 2016 to be a reasonable guess, although this date is rather ambitious. Moreover, even after an implementation of the CTR III into the Federal Law on the Harmonization of Direct Taxes of the Cantons, it can be expected that a transition period will be granted to the cantons to allow for sufficient time to adjust their own tax laws. As a result, the authors expect no material changes to the existing system to incur prior to 2019.

Finally, due to the importance to the economy and labor market of foreign companies in Switzerland, it is evident that Swiss politicians together with tax technical experts will ensure that once the current beneficial cantonal tax regimes are abolished there will be substitute taxation models providing for comparable benefits.