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Executive summary

The Swiss Federal Supreme Court (the Court) has held that a Danish-resident special credit institution (the SCI) was the beneficial owner of interest payments received from Swiss government bonds and therefore, in principle, met the requirements for relief from withholding tax in Switzerland. However, the Court has remanded the question of whether the SCI's withholding tax refund request must be denied as "treaty abuse" in light of the Switzerland-Denmark double tax treaty (DTT CH-DK).

The case has been remanded to the Swiss Federal Administrative Court (SFAC) for supplementary fact-finding and reassessment in connection with the question of tax avoidance in light of the DTT CH-DK.

Detailed discussion

Facts

The Danish SCI had acquired Swiss government bonds and entered into cross-currency rate swaps. Under the swaps, the SCI committed to swapping a fixed Swiss franc (CHF) interest rate matching the coupon of the Swiss government bonds against a floating US-dollar (USD) interest rate. The time to maturity of the swaps matched that of the government bonds.

The SCI timely applied for a full refund of Swiss taxes withheld on interest from the government bonds. The Swiss Federal Tax Administration (SFTA) then requested that the SCI provide additional information and documents. Among other things, the SFTA requested a copy of all contracts related to the swaps, an exact calculation model for the swaps, a step-by-step explanation of the investment process, detailed explanations of the economic reasons for acquiring the government bonds, and the disclosure of counterparties (for the government bonds and the swaps).

The SCI explained the economic reasons for acquiring the bonds by referring to its investment guidelines and its liquidity situation prior to the acquisition. The SCI stated that the bond purchases and swap transactions were traded as a package. To pay for the acquired government bonds, a corresponding USD amount had to be exchanged into CHF, resulting in a currency risk in CHF. The swaps were entered into solely to eliminate this risk (i.e., there was no financing component).

The SFTA fully rejected the refund applications, arguing that the SCI could not be considered the beneficial owner of the bond interest. The SFAC supported this qualification and the resulting rejection in a decision dated 4 September 2023. The Supreme Court rendered its appellate decision on 3 October 2024.

Underlying questions

Foreign-domiciled recipients of Swiss interest payments may, based on an applicable double-tax treaty, reclaim Swiss withholding taxes levied on Swiss interest payments. Under article 11 (1) of the double tax treaty between Switzerland and Denmark (DTT CH-DK) in force at the time of the reclaims, a reclaim of Swiss withholding tax was possible if the beneficial owner of the income was resident in Denmark. Hence, the Court needed to determine whether the SCI could be seen as the beneficial owner of the interest from government bonds and, if so, whether there were any other grounds for rejecting the SCI's refund applications.

Key considerations for the Court

The Court reiterated its jurisprudence on the concept of beneficial ownership. Specifically, the beneficial owner of a dividend or interest payment is defined as the person who may fully benefit from the payment and, consequently, may fully utilize the payment at their discretion. Further, if the recipient is restricted in the use of a dividend or interest payment by either contractual or legal obligations to forward the payment to another person, the original recipient's beneficial ownership is negated.

Forwarding obligations can only be harmful to the recipient's beneficial ownership if the payment to a counterparty depends on the recipient's actually receiving the "withholdable" income. In a 2020 decision (see EY Global Tax Alert, Swiss Federal Supreme Court issues decision on withholding tax reclaims on derivatives and beneficial ownership, dated 7 October 2020), the Court confirmed that only contractual or legal forwarding obligations can impair beneficial ownership; mere factual or economic forwarding obligations cannot. At the same time, the Court noted that the existence of a contractual or legal forwarding obligation can be inferred not only from contract documents but also from circumstances, including any economic and factual incentives or obligations.

In its 2023 decision, the SFAC referred to a factual forwarding obligation, but also inferred the existence of a legal forwarding obligation from the circumstances of the case — particularly the terms of the swaps laid out in the contract documentation. Thus, these considerations are consistent with the Court's jurisprudence.

Note that both the SFAC and the Court found that the contract documents in this case did not obligate the SCI to forward the interest income received from government bonds. The SCI was also obligated to pay its swap counterparties even if it received none, or only part, of the interest from the government bonds it held. The Court held that if the recipient of the interest payment bears at least this investment-specific default or credit risk, the transfer of interest rate, currency or exchange-rate risk and other market risks does not make the payment obligation to a counterparty a harmful forwarding obligation. Based on these considerations, the Court concluded that the SCI was not subject to a harmful forwarding obligation and must therefore be considered the beneficial owner of the interest payments received from government bonds. Consequently, the SCI meets the requirements for relief from withholding tax as outlined in the DTT CH-DK.

However, the payments that the SCI was obligated to make and did make under the swaps were evidently closely related to the government bond interest income, even without the presence of a (harmful) forwarding obligation.

The Court therefore qualified these swap payments as an effective forwarding of bond interest received, including the anticipated withholding tax refunds. Under the Court's analysis, this means that granting treaty benefits in the present case is not consistent with the purpose of the DTT CH-DK.

The Court held that an examination of whether the withholding tax refund must be denied under the title of "treaty abuse" is necessary.

The Court's jurisprudence defines "treaty abuse" as a situation in which (i) the relief provision is used for an improper purpose, particularly by forwarding treaty benefits to non-treaty entitled persons, and (ii) the denial of relief is compatible with the principle of good faith.

The Court examined the facts based on domestic anti-abuse rules — in this case, the Swiss anti-tax avoidance rule. Tax avoidance occurs when: (i) a legal arrangement chosen by the parties appears unusual, inappropriate or peculiar and completely unreasonable given the economic circumstances (so-called "objective element"); (ii) it can also be assumed that the chosen legal arrangement was made abusively solely to save taxes that would be owed under an appropriate arrangement of the circumstances (so-called "subjective element"); and (iii) the chosen approach would actually lead to significant tax savings if accepted by the tax authority (so-called "effective element").

Under the Court's reasoning, tax avoidance can only be affirmed in exceptional cases when the chosen legal arrangement, apart from the tax aspects, lies beyond economic reasonableness; tax avoidance cannot be assumed if reasons other than mere tax savings play a relevant role in the legal arrangement.

In the present case, the Court held that the effective element of tax avoidance is present under the facts at issue — receiving a full refund of withholding tax would qualify as significant tax savings if a full refund would not be granted under a different, "appropriate" legal arrangement.

The SFAC's findings and the records available to the Court contain certain indications that the legal arrangements in this case were unusual and motivated by treaty benefits (i.e., tax savings). However, the SFAC's findings and the records do not allow for a conclusive assessment of whether the legal arrangements in the present case constitute "tax avoidance."

The ruling

The Court granted the appeal, thus overturning the SFAC's 2023 decision. Additionally, the Court has remanded the case to the SFAC for supplementary fact-finding and reassessment in connection with the question of tax avoidance, as described above.

Implications

Although the Court has held in the past that swap or derivative transactions are not generally detrimental to the refund of Swiss withholding tax per se, arrangements involving (contractual) settlement payment obligations have continued to be subject to close scrutiny by the SFTA and, ultimately, the Court. Where a potential withholding tax refund must be forwarded wholly or in part to the claimant's counterparties, it remains highly likely that the claimant's beneficial ownership of the income will be questioned.

It is helpful that in the present case, the Court has made a clear distinction between harmful swaps or derivatives (e.g., the Total Return Swaps assessed in the recent past), and non-harmful swap transactions (e.g., the ones to be assessed here), and at least sees the possibility of affirming the claimant's beneficial ownership in the latter cases.

Nevertheless, the question remains whether the refund application can still be rejected because entering into even a non-harmful swap transaction is considered to be treaty abuse. It remains to be seen what the SFAC's reassessment of the present case will yield. It will be particularly interesting to see whether the SFAC examines whether entering into cross-currency rate swaps in the normal course of business and in line with a claimant's existing investment and risk policies is considered an unusual legal arrangement, rather than qualifying the mere existence of such swaps as "tax avoidance."