Swiss Supreme Court clarifies beneficial ownership in derivative transactions

A Danish credit institute filed claims for the refund of Swiss withholding tax levied on interest payments received on Swiss government bonds. Further to a review of the refund claim by the Swiss federal tax authority it was ascertained that Swiss government bonds were held as part of a cross currency swap transaction. Under the cross currency swap, the Danish claimant committed to swap a fixed interest rate matching the coupon of the CHF-denominated Swiss government bonds against a floating interest rate in USD. To purchase the Swiss government bonds, the claimant had to previously convert USD into CHF and entered into a cross currency swap to mitigate its FX exposure until maturity of the bonds. Both the purchase of the Swiss government bonds as well the cross currency swap, although concluded as separate transactions, were facilitated by a third-party bank acting as broker. The term of the cross currency swap matched the remaining time to maturity of the Swiss government bonds and the swapped fixed rate also matched the coupon rate of the Swiss government bonds.

The Swiss Administrative Court had previously judged that the transactions under scrutiny led to the transfer of the beneficial ownership on the interest income subject to Swiss withholding tax from the claimant to the counterparty of the cross currency swap. Hence the lower court denied beneficial ownership and upheld the SFTA’s view (see our blog post here). The decision of the Swiss Administrative Court has now been overturned by the Swiss Supreme Court.

Beneficial ownership

In a first step, the Federal Supreme Court examined whether the complainant (the Danish credit institute) was the beneficial owner of the interest income paid on the Swiss government bonds. In doing so, the court made clear that the previous practice of the so-called double interdependency test was obsolete and that only the second element of the test has to be considered. This means that beneficial ownership should only be denied if a person is obliged to transfer income subject to Swiss withholding tax to the counterparty of a derivative due to i) a contractual or legal obligation that was in place at the moment of payment and ii) such obligation to forward the income is dependent on the generation of such income. A harmful forwarding of income would only occur if the payment would depend on the fact that the payor effectively generates the income.

The court then explained that in the case at hand the Danish credit institute would have been obliged to make a payment to the counterparty of the cross currency swaps, even if the Swiss Confederation would not have honoured its interest payment obligations. To the extent that the Danish credit institute bore this investment-specific default and credit risk, the transfer of other risk elements such as FX risks or interest rate change risks do not qualify as harmful transfer of risk. In the specific case, beneficial ownership was retained even if a default risk of the Swiss Confederation was deemed as remote.

In the decision, the court also clearly stated that a harmful transfer of beneficial ownership must be analysed on a derivative instrument-specific basis. It notably mentioned that other swap arrangements previously reviewed by the Federal Supreme Court (i.e. total return swaps and similar transactions such as securities lending) would still be harmful from a beneficial ownership perspective, because the transfer of income from the recipient to the counterparty of the derivative was dependent on the effective receipt of such income or dependent on the effectively received amount of Swiss withholding tax refund.

The court then also stated that in the event that beneficial ownership would be given under a specific derivative transaction under the new definition, the entitlement to an effective refund would still need to be reviewed also from a treaty abuse perspective.

If beneficial ownership is established, the Swiss WHT reclaim must also be assessed from a treaty abuse perspective. The court reiterated that, unlike the burden of proof regarding beneficial ownership, the burden of proof for treaty abuse would be with the SFTA. The Federal Supreme Court did not decide whether failing to cooperate with the SFTA forfeits the refund claim by analogy to Swiss WHT Law (Art. 48 para. 2 VStG) but mentioned that notably with regard to subjective elements, the burden of proof can be lower as the relevant facts and circumstances of the transaction are known to the counterparties of the derivative only.

Under Swiss domestic law, tax avoidance is generally assumed by the tax authorities if the following criteria are met cumulatively:

• The taxpayer’s structure or arrangement is unusual, inappropriate or inadequate regarding its economic purpose (objective element).
• The structure or arrangement is deemed to be chosen to save taxes, which would have been due under appropriate circumstances (subjective element).
• The structure or arrangement would lead to significant tax savings if it were accepted by the tax authority.

As in the case at hand, beneficial ownership was given, however the presence of treaty abuse was not assessed, and the Federal Supreme Court rejected the lower court’s decision. The lower court was charged with the task to verify if tax avoidance was given in the case at hand.

• The Swiss Supreme Court has refined the definition of beneficial ownership on income subject to Swiss withholding tax, which is subject to derivative transactions. Beneficial ownership is assumed if the recipient of income would have had a contractual obligation to transfer the income under a derivative instrument even if it would not have generated such income subject to Swiss withholding tax from the underlying.
• The court also made clear that other derivative arrangements where the contractual obligation to transfer income subject to Swiss withholding tax to a counterparty of a derivative instrument would depend on the effective generation of such income (i.e. payment only in case income is generated from the underlying) do still lead to the denial of beneficial ownership.
• In case beneficial ownership is given, the rightfulness of a Swiss withholding tax claim must be analysed from a treaty abuse perspective by applying the domestic Swiss anti-avoidance rules. This concept is not new and is long-standing practice of the Swiss courts. It will be interesting to see how the Swiss Administrative Court will assess the current case from a treaty abuse perspective, notably if it can be argued that cross currency swaps are a usual arrangement from a finance and treasury perspective.
• Whilst the SFTA bears the burden of proof for treaty abuse, the Swiss Supreme Court stated that the taxpayer must cooperate in the refund procedure and disclose relevant information. This is notably required as gathering of all relevant underlying facts of highly complex financial transactions is empirically difficult for parties not involved in the transaction, such as the assessing tax authority. Hence, a lower burden of proof may apply to the assessment of the subjective criteria of tax avoidance and may be given if under consideration of all circumstances including the claimant’s (non-)cooperation makes a tax motivation of the transaction seem as predominantly likely.
• It remains to be seen how the SFTA and the Federal Administrative Court will interpret treaty abuse in connection with derivative transactions. Hopefully, this process will not take a further ten years as was the case for the clarification of the notion of beneficial ownership.