The answer is simple: Business operations in Switzerland can often benefit from concessionary low income tax rates. Such privileged tax arrangements make Switzerland a very attractive location to assume business functions and risks within internationally operating businesses, thereby attracting significant amounts of overall profits to this country. That is now exactly the point where more detailed transfer pricing analysis and defense documentation is required. Not so much because Switzerland requests adherence to the arm's length principle, but rather to protect the benefit of low taxable income from being attacked by foreign tax authorities.
Now before going into more detail concerning transfer pricing related tax planning structures we should first give an overview of the Swiss transfer pricing rules:
ARM'S LENGTH PRINCIPLE
As stated above, Switzerland has no comprehensive rules regarding transfer pricing. As a basic rule Swiss corporate tax law follows the Swiss commercial law. Nevertheless, in article 58 of the FDTA (Federal Direct Tax Act), the general rule is set forth that expenses must be "commercially justified" in order to be recognised for income tax purposes. Similar provisions are found in all of the 26 cantonal and communal tax laws. From this general rule in Swiss tax law it follows that Swiss taxpayers must adhere to the dealing at arm's length principle.
As a member of the OECD, Switzerland endorses and follows the guidelines and methods set out in the 1995 OECD report entitled "Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations". In the instructions issued on March 4 1997, the Director of the Federal Tax Administration informed the cantonal tax authorities about the contents of the Guidelines on transfer pricing and asked the cantonal tax authorities to observe these guidelines when adjusting profits or when assessing multinational enterprises in their canton.
The burden of proof normally lies with the tax authorities, except when the taxpayer fails to produce the documents required by the tax authorities, and then the burden of proof reverts to the taxpayer. However, the documentation requirements in practice are not stringent.
When called to judge whether a particular transfer price conforms to the arm's length principle, the Swiss tax authorities frequently refer to the "comparable uncontrolled price" method, i.e. they make direct reference to prices in comparable transactions between independent enterprises or between the group and unrelated parties. There are, however, many cases where no useful evidence of uncontrolled transactions is available for a number of reasons. In these instances, the tax authorities preferably apply the "cost-plus" method which, starting from the cost of providing the goods or services, allows the addition of a profit mark-up deemed appropriate in the light of the functions performed and business risks assumed. The resale price method may, however, also be used. Transactional profit methods are less favoured but in practice they can be negotiated with the tax authorities. Actually, discussions with the tax authorities regarding particular tax issues are common and advance rulings can also be obtained in the area of transfer pricing.
While it is in the discretion of each tax inspector to investigate transfer-pricing matters, they normally are not specifically trained in this field. There is no such thing as a transfer pricing specialist team at the Swiss tax administration. There are only two to three people at the Swiss Federal tax administration that have more extensive experience and expertise in international transfer pricing matters. These individuals, however, assume additional responsibilities at the same time as well.
As mentioned above, tax audits in Switzerland, are not typically performed aggressively and the investigation offers possibilities to negotiate and an adjustment is often mutually agreed. In addition, the Swiss authorities would not join with the foreign tax authority to participate in a joint investigation. In case of a tax adjustment no specific transfer pricing penalties exist in Switzerland. Penalties can be levied, though, in case of tax evasion (both intentional and as a result of negligence) according to general provisions in Swiss tax laws. Their amounts are equal to one to three times the additional tax and are not tax deductible.
SPECIFIC TRANSFER PRICING RELATED RULES
Group service entities (September 17, 1997)
The Swiss corporate tax law provides a special rule for service entities. The practice regarding the taxation of group service providers has for a long time followed the circulars issued by the Federal tax administration on June 29, 1959 and June 1, 1960 setting the following principles:
- Group service providers should at least be taxed on the net income that an independent enterprise would have earned in the same circumstances and for the performance of the same services and the applicable method is the cost plus method.
- The minimum profit for income tax purposes should equal 10% on total costs or 1/6 of the salary costs. A new circular letter issued by the Federal tax administration on September 17, 1997 has reduced the minimum amount of taxable income to 5% on total costs or 8.33% on salary costs.
- According to general practice, total costs include all costs including taxes. However, third party costs for services purchased can be excluded from the mark-up computation since the supplier has already included the profit element. They can be on-charged at cost.
Safe haven interest rates (Circular n° 7, 1998-02-02)
Regularly the Federal Tax Administration issues instructions regulating maximum and minimum interest rates on group financing in Swiss Francs set by reference to the prevailing market rates. For example, the applicable interest rates for the tax period 1997/1998 as per the circular dated February 2nd 1998 are as follows:
- Advance to parent or affiliate: Minimum 3% if financed by equity; if financed by debt: actual cost of debt plus a spread of 1/2% on amounts up to SFr. 10 million and 1/4% on amounts exceeding SFr. 10 million.
- Advance from parent or affiliate: Maximum 6% for funds used in an operating business.
For loans in foreign currencies no safe haven interest rates exist but market rates must be used.
Thin capitalisation (Circular n° 6, 1997-06-06)
Certain cantonal tax laws require a specific debt to equity ratio. Swiss Federal tax law contains a general rule stating that a Swiss company's equity capital may be increased by those amounts of debt that economically represent equity. The Federal tax administration has provided their interpretation of this general rule in a circular letter dated June 6, 1997. This circular states that for operational businesses the maximum amount of acceptable debt financing must be determined on the basis of applying specific percentages on the fair market value of different asset categories, e.g:
- Trade and other receivables: 85%
- Inventory: 85%
- Participations: 50%
- Loans: 85%
- Equipment and machines: 50%
- Intangible assets: 70%
- etc
The same circular states that for finance companies the maximum allowable debt generally must amount to 6/7 of total assets.
Interest paid by a Swiss company to group lenders on disallowed debt is added to taxable income. The same applies to interest on third party financing if the shareholder or another related party secures it.
Fiduciary arrangements (notice 1965-05-331, 1967-10)
Recognition of the fiduciary arrangements is regulated as per the instruction S.02.107 issued by the Federal tax authorities in October 1967. Among other conditions the compensation, i.e. commission, rewarding the trustee for his services must be agreed in advance. This commission should be determined in accordance to what is usual among unrelated parties. In particular the extent of services provided by the trustee must be taken into account. In any case, the minimum commission for assets such as securities, participations, receivables or real estate held in trust must be determined based on the value of such assets. It must amount to at least 2%o on the first SFr 10 million, 1.5%o on the second SFr 10 million and 1%o on amounts exceeding SFr 20 million.
If these rules are not observed for Swiss tax purposes the assets held and any proceeds from such assets are attributed to the trustee himself.
Anti-abuse decree (Letter of 1998-10-16 "Massnahmen gegen die ungerechtfertigte Inanspruchnahme von Doppelbesteuerungsabkommen des Bundes)
Tax treaties basically apply only to persons (individuals and corporations) who reside in one or both of the contracting states and who are the beneficial owners of the income to which the treaty applies. In order to prevent non-residents of Switzerland from benefiting from double taxation conventions entered into by the Confederation, Switzerland had enacted certain unilateral measures against treaty abuse. They are set forth in the Decree of the Federal Council dated December 14, 1962 on measures against improper use of tax conventions concluded by Switzerland (the so called "abuse decree" or "Missbrauchsbeschluss"). The abuse decree lists the conditions that must be met by the taxpayer in order to obtain tax relief from withholding taxes by virtue of a Swiss double taxation convention. A circular letter dated December 31, 1962 of the Federal Tax Administration clarified such rules.
The tests of "residence" and "beneficial ownership" are standard requirements applicable to all double taxation conventions that Switzerland has entered into. Residence requires a person to be a bona fide resident. Beneficial ownership requires the claimant to be entitled to the full use and enjoyment of the property giving rise to the relevant income itself. For these purposes, interposed persons such as agents or nominees are disregarded for tax purposes, and are themselves not entitled to treaty relief.
A tax treaty relief claimed by a resident individual, legal entity or partnership is considered abusive if the relief substantially benefits, directly or indirectly, persons not entitled to such treaty relief. The abuse decree and the corresponding circular letter of the Federal tax administration state four specific abuse criteria:
1. interest bearing loans may not exceed six times the Swiss company's net equity,
2. not more than 50% of the income that is subject to withholding tax can be paid, either directly or indirectly, to non-residents of Switzerland, and
3. a minimum of 25% of the income subject to treaty relief in the prior year must be distributed as dividend in the current year.
These domestic anti-abuse provisions have caused some debate over the last couple of years. As a consequence, the Federal tax authorities are now in the process of amending their circular letter dating back from 1962 and replacing it with a new one. A draft of the new circular dated October 16, 1998 has been circulated recently. According to this draft, which should become effective as from 1999 the first requirement, i.e. the debt-equity requirement is abolished and replaced by the general rules as described further above. Furthermore, the second and third restrictive condition above shall be eased in certain cases. In particular, active Swiss companies that do not benefit from a special tax status can pay more than 50% of their treaty protected income to un-related non-Swiss resident recipients provided such payments are commercially justified. In addition such active companies are relieved from the minimum distribution requirement as per condition three above.
Further, publicly quoted Swiss companies or Swiss companies directly held by a Swiss or foreign publicly quoted group would not have to fulfil the above criteria two and three either.
It should be noted, however, irrespective of the above liberalisation in practice of the Swiss domestic anti-abuse decree conditions, the original restrictions of the Swiss anti-abuse decree have been implemented into the text of the tax treaties with Belgium, France, Germany and Italy. With respect to these countries the original restrictions will further apply as long as such treaty provisions are not amended.
THE SECONDARY ADJUSTMENT PITFALL
In case the Swiss tax authorities challenge a transfer price, a profit adjustment will be made. Depending on the tax treaty, the company of the other country has to make a corresponding adjustment, or a mutual agreement procedure between the competent authorities of the two countries may take place. Based on such corresponding adjustment of taxable income the parties may want to proceed also with a so-called secondary adjustment of the entities' cash position.
According to such secondary adjustment the cash position of the two entities involved is adjusted so that it conforms to the situation which would have resulted if the adjusted transfer price had been applied right from the beginning. For example, if a US parent had sold a product to its Swiss affiliate at a price, which is too low, the IRS may adjust the income of the US parent. If Switzerland agrees to a corresponding adjustment, taxable income of the Swiss affiliate would be reduced. As a consequence the US parent may claim a receivable in the amount of the income adjustment (secondary adjustment) against its Swiss affiliate. If the Swiss company proceeds with booking a corresponding payable in its commercial accounts in any year subsequent to the year for which the income tax adjustment is made, this would, according to general practice of the Federal tax authorities, be treated as a distribution subject to 35% Swiss withholding tax (subject to rate reduction under the treaty).
Zurich, December 5, 1998 PricewaterhouseCoopers Armin Marti Partner International Tax and Transfer Pricing
The content of this article is intended to provide a general guideline to the subject matter. Specialist advice should be sought about your specific circumstances.
