The Swiss Federal Council proposes the abolition of withholding tax on bond interest in its dispatch. The proposed abolition will make it easier for companies to issue their bonds from Switzerland. There is also a chance that intra-group financing activities will increase in Switzerland.

By Stefan Oesterhelt / Philippe Gobet (Reference: CapLaw-2021-35)

1) Introduction

Under current law, Switzerland levies a withholding tax of 35% on interest payments on bonds (Art. 4(1)(a) Federal Withholding Tax Act [“WTA“]) and on bank deposits (Art. 4(1)(d) WTA). In contrast, no withholding tax is levied on interest on individual loans. 

The withholding tax on interest makes domestic bonds unattractive for most investors, even if they are entitled to a full refund of the tax. This is problematic for the Swiss debt capital market. In order to avoid the withholding tax, Swiss group of companies today predominantly issue their bonds through a foreign group companies.

In its dispatch, the Federal Council therefore proposes to abolish the withholding tax on bond interest without replacement. This is the consequence of the mixed reactions to the consultation on the Federal Council’s proposal of 3 April 2020 to introduce a paying agent tax system on bond interest (see Stefan Oesterhelt, Federal Council proposal of 3 April 2020 to strengthen the Swiss capital market, CapLaw 2020-41). Although the need for action to strengthen the Swiss debt capital market was generally acknowledged, the paying agent tax system was widely considered too complicated.

The proposed abolition of withholding tax on bond interest makes it easier for companies to issue their bonds from Switzerland, not only for domestic but also for foreign groups. There is also a chance that intra-group financing activities will increase in Switzerland.

Trading in bonds is subject to a transfer stamp duty of 0.15% (domestic bonds) or 0.3% (foreign bonds) if a domestic securities dealer is involved in the transaction as a party or intermediary. In its dispatch of 15 April 2021, the Federal Council proposes to also abolish the transfer stamp duty on domestic bonds without replacement. 

The reform leads to estimated revenue shortfalls of just under CHF 200 million per year. If interest rates rise, the revenue shortfall will increase accordingly. However, if the reform achieves to spur domestic capital market and group financing activities, it might have an attractive cost-benefit ratio in the long term.

2) Initial situation and history of origins

The imposition of withholding tax on bond interest makes domestic bonds unattractive for investors domiciled abroad. For this reason, domestic groups of companies issue their bonds predominantly through foreign group companies. If guaranteed by the domestic group parent company, the bonds essentially have the same credit rating as if issued directly by the parent. According to the practice of the Swiss Federal Tax Administration (FTA) of 5 February 2019, the proceeds from such foreign issues may only be on-lent to domestic group companies up to the amount of the equity of the foreign companies (see Stefan Oesterhelt, Swiss Debt Capital Markets: More Flexibility under New Swiss Withholding Tax Rules, CapLaw 2019-44).

Under current law, the only exceptions from withholding tax are regulatory bonds issued by banks (Too-big-to-fail (“TBTF“) Instruments). Contingent Convertibles (CoCos) and Write-off Bonds have been exempt from withholding tax since 1 March 2012 pursuant to Art. 5(1)(g) WTA. Bail-in Bonds (Total loss-absorbing capacity (TLAC) Bonds) have been exempt from withholding tax since 1 January 2017 pursuant to Art. 5(1)(l) WTA. Both exemptions are limited in time and thus regularly subject to renewal by the Swiss parliament.

The proposed abolition of withholding tax on bond interest puts an end to the Federal Council’s long-standing plans to introduce a paying agent tax system. The first such proposal was already launched in 2010 (for an overview of the 2010 proposal of the Federal Council see Dieter Grünblatt and Stefan Oesterhelt, Welcomed Fundamental Changes in Taxation of Debt Instruments Ahead, CapLaw 2011-42). The next attempt was the proposal of the Federal Council of 17 December 2014 following the proposal of the Brunetti expert group (for an overview of the 2014 proposal see Stefan Oesterhelt, Withholding Tax on Interest to be Replaced by Paying Agent Tax System, CapLaw 2015-5). The third proposal to introduce a paying agent tax was launched by the Federal Council on 3 April 2020 (see Stefan Oesterhelt, Federal Council proposal of 3 April 2020 to strengthen the Swiss capital market, CapLaw-2020-41).

3) The Proposal of the Federal Council 

a) Proposed legislative changes

The Federal Council is now proposing to completely abolish withholding tax on bond interest. The withholding tax will thus only be retained on interest on customer deposits with banks and insurance companies (Art. 4(1)(a) WTA), dividend income (Art. 4(1)(b) WTA) and income from collective investment schemes (Art. 4(1)(c) WTA). In addition, Art. 4(1)(d) WTA creates a proper legal basis for the levying of withholding tax on manufactured payments for income pursuant to Art. 4(1)(a)-(c) WTA. This affects securities lending in particular (see Section III.E. below).

In addition, the Federal Council also proposes to abolish the transfer stamp duty on domestic bonds. Bonds issued by a foreign company, however, will continue to be subject to the 0.3% transfer stamp duty. The latter also applies to bonds issued by a foreign group company of a Swiss group of companies. This creates a tax incentive to issue bonds domestically in the future.

b) Implications for bonds

Following the abolition of withholding tax on bond interest, domestic groups will probably start issuing their bonds through a domestic group company. However, this will likely not be the group parent company holding the subsidiaries as this would lead to a participation exemption leakage and thus indirect taxation of dividend income.

Example: The listed company of a domestic group (HoldCo) issues bonds in the amount of CHF 2 billion and pays interest of CHF 80 million per year. HoldCo receives dividends of CHF 500 million per year from its subsidiaries. Under the system applied by Switzerland, dividend income is only indirectly exempt. Accordingly, financing expenses (CHF 80 million) must be deducted when calculating the net investment income and the participation exemption is only granted to the extent of 84% (= CHF 420 million / CHF 500 million). Consequently, dividend income in the amount of CHF 80 million is subject to ordinary taxation, which leads to double taxation of dividend income due to the participation exemption leakage. If, on the other hand, the bonds were issued by a subsidiary (without dividend income), such subsidiary could claim a participation exemption of 100% and the dividends would not be taxed.

In order to prevent participation exemption leakage, bonds will probably be issued from a domestic subsidiary that has no dividend income. The situation is only different for banks issuing TBTF Instruments. For regulatory reasons, TBTF Instruments have to be issued by the parent company. The legislator has addressed the participation exemption leakage arising of this requirement with the provision of Art. 70(6) of the Federal Act on Direct Federal Taxes (“DBG”) (applicable since 1 January 2019). Pursuant to this provision, financing expenses in relation to TBTF Instruments are disregarded for purposes of the participation exemption. 

In the Federal Council’s view, these special rules for TBTF Instruments are constitutional. Nevertheless, in the medium to long term, it aims for a similar participation exemption system for all type of companies.

c) Effects on syndicated loan agreements

The abolition of withholding tax on bond interest has implications not only for the debt capital market but also for loan agreements. The term “bond” in the withholding tax law is extremely broad. A financing is considered a “bond” (Anleihensobligation) subject to withholding tax if it is syndicated to more than 10 non-bank creditors (so-called 10 non-bank rule). If a domestic debtor has more than 20 non-bank creditors from liabilities denominated in a fixed amount, this further constitutes a debenture (Kassenobligation) subject to withholding tax (so-called 20 non-bank rule).

To ensure that interest on credit agreements is not subject to withholding tax, syndications are typically limited to a maximum of 10 non-banks (10 non-bank rule). In addition, domestic debtors must regularly undertake not to have more than 20 non-bank creditors (20 non-bank rule). These restrictions in credit agreements with domestic debtors will cease to apply with the abolition of withholding tax on bond interest. 

Having said this, withholding tax on loans secured by domestic real estate is not abolished. Therefore, syndication must be limited to lenders entitled under the provisions of a double taxation treaty to receive interest payments without a tax deduction (so-called Treaty Lenders) whenever a loan is secured by domestic real estate.

d) Customer credit

The withholding tax on interest income from the credit balances of individuals resident in Switzerland at banks as well as at insurance companies is retained. Since banks and insurance companies already pay withholding tax on interest from customer deposits, this does not involve any significant increase in complexity. Under the proposed legislation, withholding tax will only be withheld on interest payments to individuals resident in Switzerland. Interest payments to all other investors are exempt from withholding tax. 

The scope of application of the withholding tax levied on customer balances will be limited to banks and insurance companies and is thus significantly restricted compared to the current situation. Accordingly, the previously applicable 100 non-bank rule, according to which a domestic debtor is always considered a “bank” for withholding tax purposes if having more than 100 non-bank creditors, will be abolished.

e) Securities lending and borrowing

In the case of securities lending and borrowing, the lender transfers to the borrower the legal ownership of a security (e.g. a share). However, the economic entitlement (beneficial ownership) over the income of the security (e.g. the dividends) remains with the lender. If a dividend subject to withholding tax is due during the loan period, the dividend (so-called original dividend) flows to the current owner of the security (i.e. the borrower). The latter is entitled to a refund of the withholding tax deducted. The borrower must compensate the lender for the lost dividend. This compensation is referred to as a manufactured dividend (Ersatzzahlung). 

Technically, this is done in such a way that the lender’s bank invoices the borrower’s bank for the manufactured dividend. According to the current practice, the lender’s bank invoices 100% of the proceeds to the borrower. It also pays withholding tax to the tax authorities on the manufactured dividend. The borrower is credited with a manufactured dividend amounting to 65% of the original investment income and is in principle entitled to a refund of the withholding tax.

The current practice in connection with manufactured dividends is based on the principle of multiple withholding tax payments (i.e. on the original dividend and the manufactured dividend) and multiple refunds of withholding tax (i.e. on the original dividend and the manufactured dividend, respectively). This prevents a single levy of withholding tax (on the original dividend) being followed by multiple refunds (on the original dividend and the manufactured dividend). 

In its decision of 21 November 2017 (2C_123/2016), the Federal Supreme Court decided that although the previous practice led to an appropriate result, there was no sufficient legal basis for levying withholding tax on the manufactured dividend. This led to uncertainties and risks for the industry and the tax authorities. As a response to this decision of the Federal Supreme Court, the Federal Council proposes to provide for a proper legal basis regarding the withholding tax treatment of manufactured dividends. Under the new proposed legislation, withholding tax is to be levied not only on the original dividend, but on the manufactured dividend too.

f) Cum-Ex transactions

The levying of withholding tax on manufactured dividends affects not only securities lending, but also cum-ex transactions of listed shares. According to industry practice, the transfer of listed shares does not take place until two days (T+2) after the sale. The dividend is credited to the party that has legal ownership of the shares at the due date. Between the sale and the transfer, legal ownership remains with the seller. Settlement takes place almost exclusively via the Central Securities Depository (CSD) or its affiliated banks.

If a dividend becomes due between the sale and the transfer, it is generally credited to the seller. The latter is not the person entitled to the income (time interval between the date of sale and the date of transfer). In such cases, the CSD or its affiliated banks will rescind the proceeds of the seller and credit them to the buyer. This results in both parties to the contract having a receipt with the outcome that a withholding tax refund can be claimed twice. According to the current practice, a second withholding tax therefore is levied by the CSD or its affiliated banks.

This practice is also problematic in light of the Federal Supreme Court’s decision of 21 November 2017 (2C_123/2016). The proposed amendment creates a legal basis for the levying of withholding tax which is intended to exclude multiple reclaims of withholding tax.

g) Collective investment vehicles

Income from domestic collective investment vehicles (such as contractual mutual funds, SICAVs or LPs for collective investment) remains subject to withholding tax. The only exceptions are income attributable to direct real estate holdings, capital gains and distributions of capital contribution reserves, provided that these are distributed via a separate coupon. 

The Federal Council refrained from an exemption for income attributable to bond interest. Consequently, indirect investments in Swiss bonds via a collective investment scheme are subject to withholding tax while direct investments are not. With respect to TBTF Instruments held by collective investment schemes, this will result in an extension of the withholding tax.

Since the distribution of interest income from Swiss bonds by domestic collective investment vehicles is subject to income tax for domestic individuals, there is some logic in refraining from an exemption for income attributable to bond interest. On the other hand, it increases the fiscal disadvantage of domestic collective investment vehicles against foreign collective investment vehicles (e.g. a distribution of a Luxembourg fund attributable to interest from Swiss bonds will not be subject to withholding tax, while such distribution will be subject to withholding tax if the fund was domiciled in Switzerland).

h) Structured products

The interest component of domestically issued structured products (e.g. reverse convertibles) is currently subject to withholding tax. With the proposed abolition of withholding tax on bond interest, withholding tax on the interest component of structured products will also cease to apply. This will facilitate the issuance of structured products with an interest component (e.g. reverse convertibles) from within Switzerland. However, fund-like structured products are still subject to withholding tax, which is why such products may continue to be issued from abroad. 

i) Transfer stamp duty on foreign bonds

Bonds issued abroad continue to be subject to the 0.3% transfer stamp duty if a domestic securities dealer is involved in the transaction as a party or intermediary. The distinction between “bonds” (subject to transfer stamp duty) and “single loans” (not subject to transfer stamp duty) will be made, as today, by applying the so-called 10/20 non-bank rules (see Section III.C above).

A bond issued abroad retains the qualification as a “foreign bond” even if such bond will be “on-shored” by way of a change of issuer. Conversely, a bond issued in Switzerland becomes a foreign bond after a change of debtor to a foreign country.

4) Tax at source on claims of a foreign creditor secured by domestic real estate

No legislative change is proposed with respect to the tax at source on bonds and loans of foreign resident creditors secured by domestic real estate. The interest of such bonds or loans is still subject to a withholding tax of 13% to 33% in the canton where the respective property is located (see in detail Stefan Oesterhelt and Maurus Winzap, Quellensteuern auf hypothekarisch gesicherten Kreditverträgen, FStR 2008, 28 ff.). 

Since the tax at source on mortgage-backed claims may only be levied outside the scope of the withholding tax, the scope of the tax at source will naturally become larger with the abolition of withholding tax on interest payments. This is particularly problematic if the abolition of withholding tax were to affect not only bonds issued after the entry into force of the withholding tax reform, but (as currently envisaged; see Section III.V below) all interest payments. This would, for example, affect covered bonds issued by a resident and secured by domestic mortgages which are subject to withholding tax.

5) Entry into force expected on 1 January 2024

The reform could be debated by Swiss Federal Parliament at the end of 2021 at the earliest. It is expected that the abolition of withholding tax will enter into force the earliest on 1 January 2024 (if accepted by the Swiss Federal Parliament).

The transitional provision provides that withholding tax will no longer be levied on interest from the effective date of the new law (i.e. likely as of 1 January 2024). This means that the new provisions will also apply to bonds issued before that date. In order to reduce the fiscal cost arising of the abolition of withholding tax on bond interest, it might be a compromise to limit the scope to bonds issued after that date. This could reduce the costs without having a negative impact on the overall economy. In addition, this could solve the problem of the resurgence of tax at source on mortgage-backed claims of bonds currently subject to withholding tax (e.g. covered bonds).

6) Conclusion

The abolition of withholding tax on bond interest will enable domestic groups to issue bonds domestically in future. This strengthens Switzerland’s position in the international capital market. In addition, it will become more attractive to locate group financing activities of international group of companies in Switzerland. The abolition of withholding tax on bond interest is associated with fiscal costs and is therefore subject to political headwind. However, if the reform achieves to spur capital market and group financing activities, it will likely outweigh the costs in the long term. In addition, the tax costs and associated concerns could also be somewhat mitigated by redrafting the transitional provision and applying it only to bonds issued after entry into force of the proposed withholding tax reform.

Stefan Oesterhelt (stefan.oesterhelt@homburger.ch)
Philippe Gobet (philippe.gobet@homburger.ch)