Switzerland: Swiss withholding tax reform: move to a paying agent system?
Switzerland is generally an attractive business location from a tax perspective, however not when it comes to interest withholding tax on notes and bonds. The Swiss 35% withholding tax on interest payment is imposed not only on notes and bonds issued by Swiss borrowers, but can also, in certain circumstances, apply to notes and bonds issued by foreign group companies guaranteed by Swiss group companies.
In practice, the latter can generally be managed in case of upstream guarantees and – after a recent change in the withholding tax ordinance and the practice of the Swiss Federal Tax Administration – also in case of downstream guarantees by Swiss headquartered groups. However, notes by a Swiss issuer cannot be issued without triggering Swiss withholding tax on interest. The regime does not allow for a reduction / exemption of the 35% withholding tax at source. Swiss investors may normally either set off the withholding tax liability against their ordinary tax liability or request a refund. The position of international investors depends on the provisions of the applicable double tax treaty. Most of the Swiss double tax treaties provide for a full refund of the withholding tax on interest. However, the administrative procedure and costs for the refund process, as well as the liquidity disadvantage make Swiss bonds less interesting even for investors entitled to a full refund of the withholding tax, not to mention foreign and institutional investors.
This regime has long been criticised by Swiss multinationals, in particular because of the implementation of specific – temporary - withholding tax exemptions for bonds (CoCos/Tier 1 notes) issued by Swiss banks. The request to change the withholding tax regime was also clearly supported by the Swiss banks. In response to this critique, in June 2019, the Swiss Federal Council decided to resume the suspended reform of the Swiss withholding tax. The new proposal was published and submitted to the legislative consultation procedure by the Swiss Federal Council on April 3. The consultation procedure runs until July 10.
The main concept of the reform is that the withholding tax will no longer be deducted and paid by the borrower making the interest payment and instead by the paying agent of the investor, for example, a bank holding notes in depository accounts. No changes to the dividend withholding tax regime are contemplated. The 35% dividend withholding tax still has to be paid by the distributing Swiss entity (with the possibility to benefit from a reduction or exemption at source for distributions to significant Swiss or foreign corporate shareholders, the latter based on a double tax treaty).
Paying agent withholding tax regime
The basic principle of the new regime is as follows: a Swiss-based paying agent will be responsible for withholding and transferring to the tax authorities the withholding tax on interest payments made to individuals based in Switzerland.
The proposal suggests two essential changes to the scope of the withholding tax. First, only interest income of individuals based in Switzerland is subject to Swiss withholding tax. No withholding tax is due on payments to foreign-based investors (corporate or individual) and Swiss-based corporate investors. Secondly, the Swiss withholding tax will newly apply to domestic and foreign bonds and notes likewise, irrespective of whether such foreign bonds and notes are guaranteed by a Swiss parent or not.
The tax is due and must be deducted only by Switzerland-based paying agents. The reason for this rule is that the withholding tax in principle does not have a fiscal purpose and, instead, should provide an additional guarantee that Swiss residents comply with their ordinary income tax obligations. Hence, the full refund rights of Swiss residents, provided they declare the underlying income. The position is, of course, different in respect of foreign investors, who may not be entitled to a full refund. With the new proposal, the non-fiscal purpose of the Swiss withholding tax, at least in respect of interest payments, will remain in the foreground. In respect of the bonds/notes held with a non-Swiss based paying agents, it is assumed that the international automatic exchange of information on financial accounts (based on the multilateral convention on mutual administrative assistance in tax matters) would have sufficient preventive effect on possible tax evasion.
Typically, Switzerland-based financial institutions holding notes in depository accounts would qualify as paying agents. However, Switzerland-based issuers (provided no financial institution holds the notes), Switzerland-based portfolio managers, trustees and other Switzerland-based payors may also qualify as a paying agent.
In most cases, a paying agent acting for the holder of notes/bonds - i.e. as a rule a financial institution holding notes in depository accounts for its client - will qualify as a taxable person and will be obliged to withhold the tax. An exception to this rule applies in case of substitute payments (see below).
Trustee as a paying agent
The reform proposal explicitly indicates that a trustee would qualify as a paying agent. Therefore, payments made by issuers, banking institutions and other paying agents to a trustee are not subject to the Swiss withholding tax. Instead, the trustee as a paying agent becomes a taxable person and has to withhold and transfer the tax, provided it transfers, refunds, credits or pays out interest income to an individual based in Switzerland. The trustee must also withhold and pay the Swiss withholding tax in case interest income is transferred to the trust, and, although not distributed, is subject to income tax for a Swiss-resident settlor or beneficiary. This could be the case, for example, for the settlor of a revocable trust.
Investment funds and indirect interest income
Under the current regime, Swiss withholding tax is due only in respect of certain Swiss investment funds and some foreign funds; normally foreign contractual investment funds with fund management in Switzerland.
Under the new proposal, the regime for investment funds will become more complicated. First, income from all types of domestic investment funds will be subject to Swiss withholding tax. Excluded are capital gains and income from real estate (also excluded under the present regime) and interest income in accordance with a paying agent regime (i.e. provided that the paying agent is a taxable person and the income is paid to corporate or foreign investors). Secondly, indirect interest income received through domestic or foreign investment funds will also be subject to Swiss withholding tax, provided that such income is paid through a Switzerland-based paying agent to an individual based in Switzerland.
Further, the reform proposal requests that the indirect interest income subject to the withholding tax from structured products and investment funds is separately identified in order to enable the paying agent to deduct the withholding tax based on the residence of the investor. If the necessary identification data on the fund or structured product is not available, the full amount of income will be subject to Swiss withholding tax. The same rules apply to accumulated profits in case of accumulation funds. In this case, the withholding tax must be paid by a paying agent, even in the absence of the corresponding cash flow to the paying agent.
The scope of the Swiss withholding tax will further be extended to include the substitute payments, i.e. payments that replicate capital assets subject to Swiss withholding tax, provided that the income is paid through a Switzerland-based paying agent. This concerns, for example, payments under securities lending and repo transactions, which replicate interest payments or Swiss-source dividends. Withholding tax on substitute payments for Swiss-source dividends under a security lending is already currently paid, however, based on practice applied by Swiss financial institutions. This practice will be implemented in the Withholding Tax Act in course of the reform. Substitute payments will be subject to the paying-agent regime. However, substitute payments, which replicate Swiss-source dividends cannot profit from the usual exemption, i.e. payments to foreign and corporate investors remain subject to Swiss withholding tax.
Further, as an exception to the general rule, the paying agent of the debtor and not the holder qualifies as a taxable person in case of substitute payments.
Voluntary application of the paying agent regime
For Switzerland-based issuers of notes and collective investment schemes, the change to a paying agent-based regime is voluntary. These parties can choose whether they will continue to apply the currently existing debtor-based regime or will switch to the paying agent regime. No such choice is provided to foreign issuers, foreign collective investment schemes or in respect of structured products and substitute payment – in all these cases the application of the paying agent regime is mandatory.
Position of the paying agents
One of the more problematic provisions of the reform is the position of the paying agents. Under the new regime, the paying agent becomes a taxpayer and bears the ultimate liability, including criminal liability, for the correct withholding and transfer of the withholding tax. The issuer, on the other hand, is discharged from any liability in the event of non-compliance. In that respect, the new paying agent regime is fundamentally different from the existing arrangements where a paying agent, normally an agent of an issuer, performs withholding and reporting under a service agreement.
The reform seeks to alleviate the position of the paying agent with a number of measures. First of all, the paying agent will only be subject to criminal liability in case of non-compliance for intentional violations. Under the normal rules, taxpayers are subject to criminal liability also in case of negligent violations. This relief seeks to address in the first instance the situation of incorrect interpretation of law or facts, e.g. when a paying agent erroneously determines that a particular product or payment is not subject to the withholding tax. This, however, does not release the paying agent from its obligation to deliver the withholding tax due.
Further, the proposal provides for a time-limited compensation to the paying agents at the cost of the federal budget. For a certain period, which is yet to be determined, after the new law comes into force, paying agents will be entitled to retain a portion of the withholding tax as a compensation for the implementation costs of the regime. The exact percentage of such compensation is yet to be determined.
After the expiry of this grace period, paying agents will be expected to shift the costs to the clients or carry them themselves.
Over the past few years, there have been movements towards the liberalisation of the Swiss interest withholding tax regime. For example, in 2019 the Swiss Federal Tax Administration introduced a new beneficial practice on the use of proceeds in Switzerland with respect to foreign bonds, guaranteed by a Swiss parent company. This was already a move in the right direction and facilitated to a certain extent the external financing for Swiss headquartered groups. However, the long discussed abolition of the Swiss withholding tax on interest with respect to foreign or Swiss corporate lenders/noteholders and change to a paying agent system for Swiss individuals is still required to enable Swiss companies to directly issue notes through Swiss vehicles. The April 2020 proposal tries to find a viable solution, and, if introduced, it will become more attractive for Swiss companies to raise financing out of Switzerland.
Nevertheless, the reform also contain a number of issues, which need to be fixed or clarified. For example, the funding of withholding tax in case of accumulating funds and in case of trusts may be practically problematic, especially taking into account that Swiss withholding tax amounts to 35%. The rules in respect of liability of the paying agents and the provisions concerning indirect interest income, structured products and foreign investment funds should definitely be discussed in the current consultation process and be subject to further clarifications – hopefully without jeopardising the long-awaited reform project itself, but by finding viable and practical compromises and solutions for the involved stakeholders.
Susanne Schreiber and Elena Kumashova