In Disclose No. 26 you read about how things would proceed in the wake of voters’ rejection of Corporate Tax Reform III (CTR III) and the cornerstones of the new Tax Proposal 17. In the meantime, the Swiss Federal Council has held the consultation on the draft legislation. This article is designed to bring you up to speed with a summary of the components of the Federal Council’s proposal and an explanation of how it should be fine-tuned to make the overall package even better. Given the major importance of Tax Proposal 17 for Switzerland’s attractiveness as a place to do business, it’s important for the political process to proceed rapidly so that the new legislation can enter into force as planned on 1 January 2020.
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Partner, Leader Corporate Tax Services, PwC Switzerland
Together with EXPERTsuisse we’ve taken a thorough look at Tax Proposal 17. Here’s a summary of our insights:
The fact is that the proposed legislation is of key importance in terms of Switzerland’s status as a place to do business. So the second attempt has to work. Switzerland hasn’t yet been put on the EU’s blacklist of states that are seen as failing to cooperate on tax matters. But the only reason this country isn’t on the list already is the prospect that Tax Proposal 17 will change the current corporate tax rules and abolish the internationally frowned-upon tax regimes. The EU has placed Switzerland on a grey list of countries that have declared a willingness to abolish tax regimes deemed internationally to be harmful – and expects them to act promptly and already take concrete steps in 2018. This is why Tax Proposal 17 must be driven ahead rapidly and can’t be allowed to fail. If it does fail, Switzerland will undoubtedly be put on the blacklist immediately, resulting in painful pan-EU countermeasures for Swiss companies.
This doesn’t rule out the possibility that individual states will take countermeasures in advance, for example the new law introducing a so-called royalty or licence barrier in Germany. Under this regulation, from 2018 licence payments made by German companies will no longer be fully tax-deductible if they are paid, for example, to entities in Switzerland that receive privileged cantonal tax treatment by virtue of being a holding or mixed company. This means Switzerland should progress quickly. We can only hope that the political actors in the legislative process will manage to resolve their differences constructively in the overarching interests of the country.
The measures set down in Tax Proposal 17 (see Figure 1) appear comparable with those contained in the rejected CTR III. But that shouldn’t obscure the fact that the Federal Council has significantly streamlined many points of the draft legislation. Despite this – or maybe because of this – various components are subject to controversial discussions. We believe that with only minor fine-tuning it will be possible to put together a package that is better for Switzerland overall. Below is a short summary of the proposed measures, how they differ from those in CTR III, and how we would recommend tweaking them.
The patent box is designed to provide the kind of fiscal incentives to innovation already in place in many other countries. When it comes to the design of the patent box, Switzerland is to a large extent bound by the international rules set down by the OECD. On the one hand, it should not be made overly difficult from a technical point of view for companies to be admitted to the patent box. On the other hand, the question remains as to whether copyrighted software is to benefit from the more favourable patent box taxation. The Federal Council wants to exclude such software. For practical and administrative simplicity reasons it makes sense to limit availability of patent box relief to demonstrably registered intellectual property rights and income from such rights. Software generally cannot be registered and protected under register law. Not only that, but the inclusion of software was fiercely debated in the context of CTR III. For these reasons the Federal Council has excluded copyright-protected software from the patent box.
It is important to realise that Switzerland will continue to provide a fiscally attractive framework for future innovation, in which software will play an important role. This means that excluding software completely is problematic. A feasible middle way would be to include revenues from the sale of software, as permitted by certain countries competing with Switzerland to host businesses. When considering the political aspect of this issue, it is important to remember that we’re talking privileged status on a cantonal level, which, given the internationally prescribed nexus approach, depends on the extent to which the work to develop patents (and software, as the case may be) takes place in Switzerland. No relief is possible for development activity abroad.
Alongside the patent box regime, to promote innovation, the cantons will be able to introduce a super-deduction for research and development. There will be an additional deduction of up to 50% of actual R&D payroll costs plus a supplement of 35% for other R&D costs. In addition to this, the company will be able to claim a deduction of 40% of the cost of R&D rendered by third parties – but only if this work is carried out in Switzerland.
We believe the deduction for third-party R&D should be extended to R&D done abroad under Swiss control. This would create an incentive for ownership of innovations to remain in Switzerland, regardless of where they were developed. Not only would it extend this country’s innovation leadership, but it would result in increased revenues (and thus increased tax revenues) from the exploitation of innovative new developments in Switzerland.
Hidden reserves and gains that can be realised tax-free under a current tax regime should also be given privileged tax treatment for a transitional period after the abolition of the regimes to avoid a fiscal shock. In practice, many cantons currently allow the tax-free step-up of hidden reserves in the tax balance sheet when regime taxation ceases to apply or a company leaves the regime. The company can then depreciate the stepped-up hidden reserves tax-effectively. However, the maximum possible annual relief is to be limited (see “Limit on overall tax relief”).
The solution applied in current practice will be replaced by a separate tax at a special rate, with the cantons taxing hidden reserves that were previously tax-free at a reduced rate. This separate rate solution, however, is limited to five years after Tax Proposal 17 enters into force. What is different now is that the cantons can introduce it ahead of time. Companies can determine whether hidden reserves are to be treated in accordance with existing cantonal practice or the arrangements under the new law by choosing the moment they transfer from the current tax regime to regular taxation.
There is particular need for additional amendments for companies that presently claim Swiss Finance Branch status. Given they lack hidden reserves on their financing assets, neither the step-up nor taxation at the special rate come into play. Here, too, we believe a transitional solution in the form of grandfathering and/or a succession solution (see “What's missing: deduction for secure financing”) should be introduced.
Tax Proposal 17 reduces the limit on overall tax relief from 80% to 70%. This ensures that at least 30% of profits can be taxed at the cantonal level even if the deductions for the patent box, R&D and step-up depreciation are higher. As a consequence of this increase in minimum taxable profit to 30%, all companies currently under a privileged regime will pay somewhat higher taxes than they do now once Tax Proposal 17 has entered into force.
Under the current proposal, deductions exceeding the 30% minimum taxation limit would be forfeited. Here it would be more appropriate if it were possible to carry forward these excess deductions to subsequent periods.
Compared to CTR III, Tax Proposal 17 will only allow cantons to grant relief on capital tax if this applies to participations and patents. Tax Proposal 17 no longer extends relief on capital tax to loans, even though this point was not criticised in CTR III. To avoid an unnecessary additional burden in the form of capital tax, we believe the option of also granting relief on capital tax on loans should be re-adopted by Tax Proposal 17.
Partial taxation is designed to relieve the income tax burden on dividends paid to private persons, mitigate economic double taxation and make tax on corporate profits less dependent on legal form, regardless of whether they were generated by a partnership or an incorporated company. Now this partial taxation is to be limited to 30% at both federal and cantonal level. This means that 70% of dividends will still be subject to income tax.
On a cantonal level there are major differences between corporate and personal income tax rates. A fixed 70% rule will therefore never fit all cases. While a politically motivated increase in partial taxation from 50% to 70% at the federal level seems tolerable, this would create major distortions for private entrepreneurs in some cantons. For this reason the partial taxation proposal has been heavily criticised. The principle of legal-entity-neutral taxation, on the other hand, should as such be agreeable.
A better solution would be not to dictate a fixed partial taxation percentage to the cantons, but instead to only oblige them to set their percentage for partial taxation at such a level which ensures legal-entity-neutrality of business profit taxation at cantonal level as much as possible.
There is agreement that the Confederation will have to help solve the problems arising from the abolition of cantonal tax regimes. After all, the Confederation profits from full federal tax on these entities. There is likely to be further intense debate on how much to increase the cantons’ share of federal tax revenues to ensure the Confederation makes an appropriate contribution. The cantons have already rejected the Federal Council’s proposal to raise the share from 17% to 20.5% and demand a larger increase to 21.2%, as foreseen in CTR III. The cantons want to make it easier for themselves to fund the reduction in general corporate income tax rates.
This reform component was called for from the left side of the political spectrum. It has nothing to do with solving the problems emerging from the abolition of the existing corporate tax regimes. It is inappropriate and should be removed from the draft.
CTR III provided for a so-called notional interest deduction (NID) at both federal and cantonal level. This deduction has been completely eliminated from the draft legislation. We believe it shouldn’t be. Instead, the NID should be included again in Tax Proposal 17 as under the new title “deduction for secure financing”, at least as a voluntary measure for the cantons. After all, the EU is currently discussing the introduction of a similar measure.
A deduction for secure financing would enable cantons such as Zurich to prevent a great deal of financing activity from leaving the canton (and Switzerland). PwC together with the Zurich Chamber of Commerce performed a survey among companies based in the canton of Zurich on this matter. The study shows beyond doubt that the availability of a deduction for secure financing is a crucial factor in decisions on where to locate group financing activities. Companies would withdraw most of these activities if the tax burden were to rise above 10%. This target burden is significantly higher than the present 2% to 3%. In other words, introducing a deduction for secure financing would generate additional tax revenues of around CHF 250 million from companies in Canton Zurich alone, and would prevent businesses from moving away, with the resulting loss of jobs. When interest rates are increasing, the mechanism is designed in a manner to ensure that only companies with solid equity financing could claim the deduction. This would reduce the currently existing undesirable fiscal incentive in favour of debt financing - in other words the measure would help make companies more resistant to crisis.