Update

Swiss Corporate Tax Reform III: how Switzerland will remain attractive


On 5 June 2015, the Swiss Federal Council published Corporate Tax Reform III for debate in parliament. The legislation is designed to boost trust in Switzerland and strengthen its position as a tax domicile. If parliament reinstates the notional interest deduction, Switzerland will be able to retain its place among the most attractive locations for doing business.

Armin Marti

Armin Marti

Partner, Tax and Legal Services

Reform project: background and current status

In 2007 a dispute arose between Switzerland and the EU concerning specific cantonal corporate tax regimes. The EU Commission alleged that tax regimes in Switzerland – particularly cantonal arrangements for holding companies, so-called mixed companies and auxiliary companies – violated the 1972 free trade agreement. Switzerland disputed these accusations. Subsequently the EU Commission was charged by member states to initiate negotiations with Switzerland on the adoption of the EU Code of Conduct for business taxation. Switzerland initially responded with preliminary talks prior to embarking on dialogue. The EU increased the pressure, calling for sanctions if no concrete progress was made by mid-2013. In autumn 2012 the Swiss Federal Council issued an official mandate for negotiations to settle the tax dispute, and formed a project organisation to formulate Corporate Tax Reform III (CTR III). In 2013 the CTR III steering committee published its first interim report. At the same time, in February 2013, the OECD launched its 15-point action plan (see Figure 2) to prevent base erosion and profit shifting (BEPS) at multinational companies. As part of Action 5, ‘Counter harmful tax practices more effectively, taking into account transparency and substance’, investigations into harmful tax regimes and practices in OECD countries commenced. According to the OECD’s assessment, five special tax regimes in Switzerland are distorting international competition:

Cantonal taxation of

  1. holding companies
  2. mixed companies
  3. auxiliary companies

and direct federal taxation of

  1. principal companies
  2. Swiss finance branches.

On 1 July 2014, the bilateral tax dispute with the EU Commission was settled with the publication of a joint declaration of intent. Switzerland undertook to abolish the special tax regimes within the framework of CTR III. In return the EU promised to lift measures taken in various countries (including Italy) against companies benefiting from Swiss tax regimes. Added to this, Switzerland undertook to align any new tax-related measures to OECD standards and actively cooperate with the OECD in the development of international tax standards.

On the basis of a follow-up report published by the CTR III steering committee in December 2013 and the formal positions of the cantons submitted in response to this report, at the end of October 2014 the Federal Council published a consultation draft containing various reforms. The consultation ran until the end of January 2015. Based on the results of this consultation, at the beginning of April 2015 the Federal Council published its parameters for the reform and commissioned the drafting of the dispatch to amend the relevant legislation, the Federal Act on the Harmonisation of the Direct Taxes of Cantons and Municipalities (StHG). This package of reforms was published on 5 June 2015, and parliamentary debate will start this summer. The centre-right parties, at least, believe the reform is urgent. Even so, given that the legislation is subject to a referendum, it may not enter into force until 2017 or 2018. Not only that, but the cantons will be granted an additional two-year grace period to make the necessary amendments to their tax legislation, with cantonal referenda necessary in some cases. This means that the rules contained in CTR III are unlikely to become effective at cantonal level before 2019 or 2020.

Important reform for Switzerland

CTR III will represent a major reworking of corporate tax law in Switzerland. The special tax regimes that are to be abolished have been a magnet for international business over the last thirty years, and alongside other locational advantages have helped drive the country’s economic development and prosperity.

Since the announcement that tax regimes for multinational companies were to be abandoned – exacerbated by uncertainty on how corporate tax rules will develop in the future – there has been a significant decline in companies moving to Switzerland from abroad. Other factors are also contributing to this trend, including the political debate on limiting the influx of foreign labour, the comparatively high costs in Switzerland, and the strength of the Swiss franc.

The abolition of special tax regimes in Switzerland will affect numerous Swiss-based companies with very mobile international activities. These privileged companies account for almost 50% of the Confederation’s revenues from direct federal tax. Add cantonal and municipal taxes to the equation, and more than CHF n sp;5 billion are at stake. Switzerland would be hard hit if the companies affected moved away. It is therefore vital for the abolition of the old tax regimes under CTR III to be accompanied by new, attractive taxation measures – measures that will not only have to preserve this country’s competitiveness, but also be internationally acceptable and affordable for Switzerland. The abolition of existing tax regimes entails clear risks. Despite this, Switzerland must view the reform as an opportunity that has to be seized.

Figure 1: Overview of CTR III reforms
Sustainable effects for Switzerland High competitivenessAttractive jobsInternational acceptanceLegal certainty & security of investmentEconomic benefit for everyone Abolition of privileged cantonal tax regimes,principal taxation, Swiss finance branch regime and adaptationof intercantonal reallocation of revenues CTR III Private capital gains tax Tax loss carry forwards Participation relief Lump sum tax credit for branches Partial taxation of private dividends Issuance stamp tax Cantonal licence boxon patent income R&D – Input incentive Step-up of hidden reserves ? Cantonal corporate incometax reduction Notional interest deduction Adaptation of cantonal capital tax Other measures 1 2 3 4 5 6 7
View figure
  • 1. Cantonal licence box on patent income

    Used to tax income from the exploitation of patents and similar intellectual property rights more favourably.

  • 2. R&D – input incentive

    In addition, cantons can also introduce a special deduction for R&D expenses.

  • 3. Notional interest deduction

    This measure aims at a partial equalisation of the tax treatment of equity and debt financing. It thereby incentivises self-financing, counteracts excessive indebtedness and stimulates investments. The Swiss Federal Council has removed this measure from the reform package. In our opinion, it should be reintroduced in the course of the parliamentary debate.

  • 4. Step-up of hidden reserves

    Previously non-taxable hidden reserves which are realised within five years of the reform entering into force will be taxed at a special low rate.

  • 5. Cantonal corporate income tax reduction

    The cantons will reduce their tax rates for all companies and thus maintain their attractiveness as locations. The federal government will assist the cantons with an annual contribution of over CHF 1 billion.

  • 6. Adaptation of cantonal capital tax

    In order to keep the capital tax burden low without granting tax privileges to particular companies, the cantons will be able to reduce taxable equity for ownership rights, patents and comparable rights.

  • 7. Other measures

    In response to justified criticism, the Swiss Federal Council has proposed to only keep the abolition of the issuance stamp tax and the standardisation of partial taxation on private dividend income in the reform package. In addition, foreign tax credit relief is to be extended to Swiss branches.

The reforms in detail

The impact of the various reforms will vary from company to company in Switzerland. For example the implications for organisations that qualify for a patent box will differ from those for entities that currently benefit from a cantonal tax regime. Below the reforms are explained in more detail. They are ordered by significance in terms of Switzerland’s attractiveness as a location for businesses.

1. Temporary regulations on the treatment of hidden reserves and goodwill (‘step-up’)

At present there is no nationwide corporate tax legislation in Switzerland comprehensively governing transitions from one system of taxation to another. This includes entry into or exit from tax liability on changes of location, transitions from tax exemption to ordinary taxation, or other transitions between privileged and ordinary tax status. CTR III aims to introduce explicit, uniform rules governing such cases across Switzerland.

Of particular interest in practical terms will be the rules governing the abolition of present tax regimes. The consultation draft contained proposals for allowing a so-called step-up. In the meantime a technical working party, including representatives of businesses, consultancies, the academic community and the tax authorities, has refined these proposals. In particular the reworked solution eliminates the undesired effects the consultation draft’s proposal would have led to in terms of recognising deferred taxes.

The new proposal is based on the constitutional imperative of mitigating the fiscal shock for companies that have so far been privileged. To this end the law on fiscal harmonisation will contain the following procedure:

  1. Hidden reserves and goodwill will be valued at the time of the reform. The tax administration will issue a contestable declaratory assessment defining the maximum amount that would previously have remained tax-free upon disposal.
  2. For the first five years,1 taxable net profit will be split in two for the purposes of the annual assessment. The first part will be subject to ordinary taxation, while the second part – the share of hidden reserves and goodwill realised in the year in question, subject to the above maximum – will be taxable at cantonal level at a separate low rate.

On the one hand this rule will mean that the entire net profit will be taxable in the future. On the other hand the actual amount of tax will depend on the separate low tax rate set by each canton and the amount of goodwill carried forward, which was previously tax-free. This will enable the tax burden for companies that have hitherto enjoyed privileged tax status to be kept low – only slightly higher than previously – for a maximum of five years.

2. Introduction of a cantonal patent box and additional R&D input deductions

In the future there are to be patent boxes enabling a discount of up to 90% on cantonal and municipal taxation of income from patents and comparable qualifying intellectual property rights.

In line with the OECD standard, Switzerland has to adopt the so-called modified nexus approach. This means that the reductions in taxes on patent box income will be limited to the proportion of domestic R&D costs - plus an uplift of a maximum of 30% - compared with total R&D expenditures including R&D work sub-contracted abroad and depreciation of acquired technology. This means that patent box income − for example income from patents − from work contracted abroad by a Swiss company will not be privileged, even if the costs of this work were borne in Switzerland. Unfortunately this will limit the income privileged under the patent box and reduces the potential tax relief for companies taking advantage of Swiss patent boxes. However, the modified nexus approach equally limits patent box solutions in other countries besides Switzerland.

In view of these limitations, the idea is that the cantons will now be able to grant a special deduction for research and development costs via so-called R&D super-deduction. The actual design of these additional deductions for R&D, and their extent, will be up to the cantons to define.

The system of cantonal patent boxes and R&D input deductions is aimed at making Switzerland an even more attractive location for innovation. These tax measures are an appropriate way of mitigating the costs of locating innovation activities in Switzerland, which are high by international standards.

3. Notional interest deduction granted on surplus equity

This measure, already implemented in other jurisdictions, is intended to preserve Switzerland’s attractiveness as a location for group financing and treasury functions. It will serve as a replacement for the existing privileged tax treatment of financing activities at Swiss finance branches and holding companies. In conjunction with the transition to the paying agent principle for withholding tax and the possible abolition of issuance stamp tax on equity capital, the deduction would consolidate Switzerland’s position as a location for capital market financing and international corporate finance.

The deduction, which aims to equate equity and debt financing for tax purposes, would apply to the so-called surplus equity (the equity exceeding the security equity defined for tax purposes). This would help counteract excessive corporate indebtedness, stimulate investment and provide an incentive for companies to rely more on their own resources. At the same time, the notional interest deduction would also work in favour of other core group functions such as treasury, regional or global head office and management functions, and procurement. This would encourage the creation of highly qualified jobs in Switzerland, which in turn would stimulate local demand.

Unfortunately the Federal Council has removed this measure from the reform package in conjunction with also dropping the idea of introducing a private capital gains tax. From our point of view it is key in terms of Swiss competitiveness for the notional interest deduction to be re-adopted in the parliamentary process.

4. Reduction in cantonal corporate income tax rates

This reform supplements those already described. Tax disadvantages arising from the abolition of current tax regimes would force companies with mobile activities to avoid Switzerland as a location or even leave the country. This would result in substantial tax losses for the cantons. A general reduction in corporate income tax rates should prevent this from happening.

Some cantons have announced reductions in cantonal tax rates. They include Geneva (rate down to 13%), Vaud (13.7%) and Zug (12%). Other cantons are non-committal or are waiting to see what happens in surrounding cantons. In the light of the OECD’s BEPS action plan, in the longer term international tax competition is likely to take place more within the framework of general corporate income tax rates. Given the fact that cantonal finances are comparatively robust, Switzerland is acting from a position of strength in this respect. Levels in the most attractive cantons are already comparable with or only slightly higher than low-tax Ireland with its corporate income tax rate of 12.5%.

5. Other measures

The consultation draft proposed a number of further individual measures. While some of these were worthy of support from a taxation point of view, they would not have had any additional benefits in terms of Switzerland’s business attractiveness. Critical feedback from the consultation has promped the Federal Council to streamline the reform package. It has removed proposals to amend the participation relief and loss carryforward regulations and introduce a private capital gains tax. However, the following measures remain:

  1. Adjustments to cantonal capital tax: These adjustments make sense, and will offset the lower tax rates for companies benefiting from tax regimes even after the abolition of these regimes.
  2. The abolition of issuance stamp tax on equity capital: While this move is justifiable, it is less urgent than the measures outlined above. In terms of minimising the loss of tax revenues, the abolition of issuance stamp duty should be postponed in favour of the notional interest deduction on surplus equity.
  3. The standardisation of partial taxation of private dividend income:
    This measure is irrelevant in terms of Switzerland’s attractiveness. However, if corporate income tax rates really are reduced in individual cantons, it does make sense to reduce the partial taxation (income tax) of dividend income by way of compensation. According to the Federal Council, the partial taxation rate is to be standardised at 70% across Switzerland, subject to a minimum holding of 10% (the same as previously).
  4. Extension of lump sum tax credit to Swiss branches: The extension of the lump sum tax credit for foreign withholding tax to Swiss branches of foreign companies had been requested in a parliamentary motion. The Federal Council has supported this request. This measure, though, is of minor relevance, and should be included separately in a more fundamental reform of the Swiss lump sum tax credit mechanism, which should be aligned to the realities of CTR III in any case.

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Armin Marti

Armin Marti

Partner, Tax and Legal Services

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Figure 2: The 15-point OECD Action Plan on Base Erosion and Profit Shifting
  1. Address the tax challenges of the digital economy
  2. Neutralise the effects of hybrid mismatch arrangements
  3. Strengthen controlled foreign company (CFC) rules
  4. Limit base erosion via interest deductions and other financial payments
  5. Counter harmful tax practices more effectively, taking into account transparency and substance
  6. Prevent treaty abuse
  7. Prevent the artificial avoidance of permanent establishment (PE) status
  8. Assure that transfer pricing outcomes are in line with value creation – intangibles
  9. Assure that transfer pricing outcomes are in line with value creation – risks and capital
  10. Assure that transfer pricing outcomes are in line with value creation – other high risk transactions
  11. Establish methodologies to collect and analyse data on BEPS and the actions to address it
  12. Require taxpayers to disclose their aggressive tax planning arrangements
  13. Guidance on the implementation of transfer pricing documentation and country-by-country reporting
  14. Make treaty-related dispute resolution mechanisms more effective under the mutual agreement procedure and arbitration
  15. Develop a multilateral instrument to enable the implementation of BEPS-related measures

Summary

Dating back more than thirty years, the current rules on corporate taxation – particularly the tax regimes that are due to be abolished – have been a major factor in Switzerland’s success. Plans to do away with these rules have created a great deal of legal uncertainty, raising the question of how competitive Switzerland will remain in terms of attracting international businesses.

This uncertainty came to an end when the CTR III reform package was released for parliamentary debate on 5 June 2015. Provided that parliament re-adopts the notional interest deduction, the package will contain the reform elements necessary to ensure Switzerland remains among the most attractive tax jurisdictions for corporations.

Given that Swiss public finances are in relatively good shape by international standards and that the will exists on the part of parliamentarians and the general public to adopt and implement CTR III, Switzerland will be able to preserve its reputation as a reliable, long-term, business-friendly location and an attractive tax jurisdiction for international companies. The new corporate tax legislation will help ensure the continuing success of the Swiss model in the coming decades.

  1. The draft bill forsees only a five year limitation whereas the technical workgroup had suggested a ten year limitation.