The principle of tax-free private capital gains
Capital gains realised through a disposal of shares held for private investment purposes by Swiss resident individuals are generally exempt from Swiss income taxes. In certain circumstances, such capital gains are assimilated to dividends, salary or compensation payments for the renouncing of a right, in which case they become subject to income tax.
Swiss tax law follows a substance-over-form approach. This being the case, the Swiss income tax consequences depend on the economical nature of the payment for the shares and in many cases it does not suffice to argue that the payment in question was formally made as a result of a share purchase agreement in order for the capital to be tax-exempt.
Given the importance of the distinction between tax-free capital gains and taxable income, a strong court and administrative practice has developed. This article gives a broad overview of the most relevant factors that may lead to a requalification of a capital gain as taxable income upon the sale of privately held shares, and provides ideas on how to prevent such requalification.
The factors potentially leading to a requalification of capital gains can be grouped in two categories: 1) employment-related requalification (where the seller is or was an employee of the company whose shares are sold); and, 2) shareholding-related requalification.
Sales price as compensation for employment activity
In cases where the total compensation paid to the seller under an employment contract was considerably lower than the market standard for a comparable position, tax administrations tend to requalify part of the sales price into taxable employment income. This is particularly true if the seller's total compensation was lowered in the year preceding the sale.
Similarly, a variable sale-price payment after the transaction (earnout) which depends on the seller continuing to work for the target company for a specific period of time risks being requalified in part or in full as taxable employment income.
In order to prevent such requalification, the compensation for the employment activity of a seller should correspond to the market standard and should not be lowered in view of the sale transaction. In addition, earnout payments should not be linked to employment-related factors, such as continued employment with the target company, but rather they should be linked purely to objective profitability, growth or similar targets.
Management incentive plans
Gains from the disposal of employment stock awarded under a management incentive plan may be requalified in part or in full as taxable employment income if the purchase price paid by the employee was below market value or if the employee did not have the ordinary dividend and voting rights of a shareholder.
If a tax-free capital gain on the sale of shares is the desired outcome, we recommend applying a third-party purchase price for the shares and granting full ownership rights to the employee.
Often, share purchase agreements with sellers having a great network of contacts and solid know-how in the respective market come with non-competition clauses. Tax administrations tend to qualify part of the sales price as compensation for agreeing to the non-competition clause.
We therefore recommend agreeing on non-competition clauses in a shareholders' agreement or an employment contract, rather than in the share purchase agreement.
Dividends/indirect partial liquidation
If cash in the target company is distributed to the buyer to pay the purchase price to the seller (and certain additional conditions defined in the law are met), tax administrations may qualify part of the purchase price as a dividend payment to the seller, rather than as a tax-free capital gain (so-called indirect partial liquidation).
If the purchase price is partly to be financed with funds in the target company, we recommend that the seller asks for an indemnity in the share purchase agreement for any tax consequences arising from the use of the target company's cash by the buyer to pay the purchase price. From a buyer's perspective, we recommend carefully structuring the financing of the purchase price to avoid any liability under the indemnity granted to the seller.
Professional securities dealer/shares held for business purposes
If the seller frequently trades with securities (professional securities dealer) or holds the shares for business purposes, the shares may be qualified as commercial assets, the sale of which is subject to income taxes.
In cases where the seller frequently trades with securities or runs a business in an industry similar to that of the target company, measures should be taken to prevent a qualification of the shares as commercial assets. Depending on the case at hand, potential solutions may be restructuring the business or stopping the trade activities well in advance of the sale.
The above is only a brief summary of the tax aspects to be considered by individuals when selling their shares in a company. It is important to carefully analyse the facts before entering into the transaction to ensure that a supposed capital gain is recognised as such by the tax authorities; filing an advance tax ruling may provide both clarity on this question and certainty of the transaction for the benefit of the seller and the buyer.
|Christoph Suter||Markus Mühlemann|
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