Taxation of foreign high net worth individuals in Switzerland

Switzerland may still have the reputation for discreet banking, but
funds can no longer take advantage of Swiss banking secrecy laws. Michael
Fischer reports

Switzerland has sometimes been perceived as insular as far as regulation of
its financial system is concerned. That view is in need of revision.

Switzerland has entered into various bilateral agreements with the EU,
recently deciding to extend them to the 10 new accession states by way of
popular vote. They cover a wide area, including in particular free movement
of persons and the taxation of savings income. What is more, international
procedural assistance and effective anti-money laundering regulation have
long been a matter of course. The era in which funds from dubious sources
could too easily benefit from Swiss banking secrecy laws is a thing of the
past.

Residence in Switzerland

EU nationals have the right to take up residence in Switzerland, provided
they are in gainful employment or otherwise able to finance their own living
expenses. Limited quota restrictions still apply to nationals from the EU's
15 states until 2007. More severe restrictions still apply to nationals from
the new accession states, which will gradually decrease until disappearing
altogether in 2014.

Lump sum taxation and estate tax

Foreign nationals taking up residence in Switzerland may apply for taxation
under the lump sum regime, under which tax is levied on the basis of a
predetermined income. A successful application is conditional on the foreign
national taking up primary residence in Switzerland (often entailing a
minimum duration of stay), not having had Swiss residence in the 10 years
preceding relocation to Switzerland and having no gainful activity in
Switzerland. Any gainful activity outside Switzerland is permissible and
some cantons will allow limited activity in Switzerland as a company
administrator.

Under that regime, tax is levied both at cantonal and federal level on the
basis of a predetermined income. This will normally be equivalent to five
times the cost of Swiss accommodation (rent paid or the deemed rental value
of owned accommodation). The amount of tax payable may not be lower than the
tax that would be due by application of the ordinary tax rate to the
taxpayer's Swiss income and any treaty-favoured income.

Disclosure will normally be required merely of the agreed living expenses,
the Swiss income and the foreign income for which treaty relief is claimed.

Estate taxes (inheritance and gift tax) are levied at cantonal level only on
the life or death transfer of assets of a person resident in Switzerland.
Transfers to spouses and to descendants are, with minor exceptions,
generally exempt.

Recognition of trusts

Trusts have long been accepted as a reality by Swiss courts and ratification
by the Hague Convention of trusts is imminent. The taxation of trusts and
their settlors and beneficiaries is still a matter of considerable
uncertainty. Generally, Swiss tax authorities will accept the trust assets
as being excluded from the beneficiary's estate, hence income arising in the
trust will not be taxed. Distributions to an individual subject to ordinary
taxation will normally give rise to income tax, while those to lump sum
taxpayers do not. While it is widely accepted that this uncertainty is in
need of being remedied, it nevertheless affords the cantonal authorities a
fair deal of freedom, not necessarily to the detriment of the taxpayer's
interest.

Taxation of savings income

Earlier this year, the agreement on taxation of savings income between
Switzerland and the EU (savings tax agreement) came into force.

Under its terms, EU residents with assets in Switzerland may choose between
tax retention on interest payments or voluntary declaration of those assets
to the tax authorities of the relevant EU state. Tax is retained on all
interest payments made by a Swiss paying agent to such EU residents at a
rate of 15 per cent until 2008, 20 per cent until 2011 and 35 per cent
thereafter. Thus, Switzerland ensures that the EU directive on the taxation
of savings income cannot be circumvented by the mere parking of assets in
Switzerland and, at the same time, maintains the fiscal banking secrecy.

It is noteworthy that, as part of the savings tax agreement, taxation at
source on payments of dividends, interest and licence fees between
affiliated companies in Switzerland and EU states was abolished (dividends
paid by UK subsidiaries to Swiss holding companies are no longer subject to
UK withholding tax).

International assistance

As in other jurisdictions, Switzerland distinguishes between judicial and
administrative assistance (direct cooperation between administrative
authorities).

As regards judicial assistance, Switzerland adheres to the 1959 European
Convention. The country enacted a federal statute based on which Swiss
judicial authorities may render international assistance in the absence of
any bilateral or other agreement. Accordingly, Switzerland will generally
agree to render judicial assistance provided the usual conditions are met,
including especially the requirement of double criminality and of restricted
specific use of the information requested and transmitted (speciality).
Mutual assistance requests are routed through a federal authority in Berne.

International administrative assistance may only be rendered on the basis of
specific legislation. Currently, specific provisions allow for international
assistance to be rendered by supervisory authorities in the field of
banking, stock exchange, investment funds and money laundering and, in the
near future, auditing (the enactment of new auditing legislation is expected
in 2006).

When approached for international assistance in fiscal matters, Swiss
authorities will generally distinguish between tax evasion (when a tax
return is not submitted or is incomplete), which is sanctioned by a fine at
administrative level, and tax fraud (eg tax evasion by means of falsified
documentation), which is considered a crime that would be prosecuted by the
criminal authorities. In accordance with the above principles, international
assistance may only be rendered in criminal matters - that is, in cases of
tax fraud, but not tax evasion. This also applies under the terms of the
savings tax agreement and double tax agreements concluded with EU member and
other states.

This choice to sanction tax evasion on an administrative level and punish
only tax fraud as a crime may be perceived as odd. A main motive, therefore,
which underlies the entire Swiss tax system is the notion that enforcement
of tax laws is most efficient when applying moderate tax rates and levying
fairly heavy withholding tax on income of assets (currently at a rate of 35
per cent).

Money laundering legislation

In fighting money laundering, Switzerland relies on three main pillars -
namely its Penal Code, the Money Laundering Act (MLA) and, based on long
tradition in the banking industry, self-regulation. In addition, Switzerland
has taken part in, and actively contributed to, various international
initiatives such as the 40 recommendations of the Financial Action Task
Force.

The scope of the MLA is substantial. The MLA applies to all so-called
financial intermediaries (FIs). Next to banks, and insurance and securities
dealers, anybody dealing with third-party assets in their capacity as a
professional, including in particular trust providers and lawyers, qualifies
as an FI. Under penalty of heavy fines, any FI must first identify the
contracting party and establish the identity of the beneficial owner of the
assets beyond any doubt; second, they must report any assets potentially
deriving from criminal activity to the Federal Office for Police's Money
Laundering Reporting Office.

Offshore jurisdictions are commonly associated with lack of taxes, loopholes
in financial supervision and money laundering regulation, and
confidentiality (arguably bordering on a lack of cooperation). While it is
fair, and indeed right, to say that Switzerland may seem attractive to
foreign taxpayers in several respects, it is obvious that Switzerland is not
an offshore financial centre to the extent that the term implies a
fragmentary or inadequate regulatory environment.

Although it would not appear to be a problem for Swiss financial
institutions, awkward issues could arise in other jurisdictions where
clients elect to pay the withholding tax rather than make a declaration to
the tax authorities in the relevant state. Banks could be placed in a
dilemma - would this (perhaps with other factors) tip the balance in favour
of filing a suspicious activity report? Clear guidance will be required from
the relevant regulatory authorities to avoid inconsistency in approach. n
Pressure from the Organisation for Economic Cooperation and Development
(OECD) regarding the application of the EU Savings Directive, and the allied
negotiations between the EU and Switzerland, have created a situation where,
in the OECD's attempt to level the EU tax recovery playing field and to
reduce tax leakage by the use of structures taking advantage of some member
states' tax benefits, tax advantages have been highlighted in states such as
Luxembourg, Ireland, the Netherlands and Denmark.

The regimes have differed. For example, Luxembourg provided a good general
tax-friendly regime, whereby full use could be made of its extensive double
tax treaty network to minimise withholding taxes on payments made from other
member states to Luxembourg, and utilising tax rulings to permit onward
distribution of such receipts at a minimal tax cost. A similar type of
regime applied in the Netherlands, where the use of Dutch companies and
Dutch Antilles holding companies permitted a convenient route for the
transfer of profits out of EU countries at a 4.2 per cent maximum tax rate.

Many of these structures were used for corporate tax planning, but such
structures were also used in significant numbers by private client investors
to mitigate their European tax liabilities, particularly in relation to
royalties and real estate investment. For example, taxation arising from
real estate investment in France and Germany could be reduced significantly
by using the 'double Dutch' route.

The tax authorities in those countries became increasingly concerned at the
loss of tax caused by such arrangements, and the introduction of legislation
and alterations to the double tax treaties reduced the effectiveness of such
structuring - although ever-inventive tax practitioners would usually
discover some new method of mitigation as soon as a particular route was
closed down.

Except for some very specific double tax treaty use, the offshore centres
such as the Isle of Man and the Channel Islands were not particularly
involved in these arrangements other than being, perhaps, the ultimate
recipients of the funds realised. From a UK perspective, because of its
capital gains tax regime, which does not tax non-residents, the use of
onshore European structures was usually not necessary, except where
royalties or similar income arose in the UK.

As a result of the pressure brought by the EU's Code of Conduct Committee to
reduce 'harmful tax practices', the EU Savings Directive countries within
Europe are being forced into reorganising tax regimes that discriminate
between taxpayers. For example, exemptions or reliefs which have a specific
geographical limit, such as the Dublin scheme, are no longer regarded as
appropriate, with the result that Ireland has abolished such special
treatment and in 2002 introduced a general low rate of corporation tax of
12.5 per cent, applicable to all Irish companies. Similarly, Cyprus, which
had an attractive 4.5 per cent tax regime for its offshore companies, has
introduced a general 10 per cent tax rate for companies; but in the case of
Cyprus, it has introduced a number of reliefs and exemptions which reduce
significantly the impact of what might otherwise have been a substantive
increase in the tax liabilities of such companies.

This has been mirrored in the offshore jurisdictions by, for example,
Jersey, Guernsey and the Isle of Man deciding that they will move to a zero
per cent corporate tax regime for all companies so that there is no
differential between tax paid by local companies and tax payable under their
offshore regimes. However, many of the Caribbean jurisdictions remain
undecided as to how to proceed.

Generally, EU countries have been moving towards lower corporate tax, and
the introduction of holding company legislation in a number of
jurisdictions, the UK being a prime example, has increased the
attractiveness of those jurisdictions.

Allied to the above has been the finalisation of the terms on which the EU
Savings Directive will be applied, which has enabled Luxembourg in
particular to retain its bank secrecy rules by imposing a withholding tax of
15 per cent where disclosure of beneficial ownership is not a route that the
customer wishes to take. This provides EU countries with the same
possibility as that which applies to Switzerland, which now governs the
retention or otherwise of the internal EU tax-friendly states.

This has enabled Luxembourg to retain its full complement of tax-efficient
corporate entities, although it has altered some of the exemptions
applicable to 1929 holding companies (Luxembourg companies exempt from all
tax - including withholding taxes - other than capital duty and the annual
'taxe d'abannement') to make them less aggressive. The use of those
companies within the EU can still provide a very attractive route for
minimising tax, and Luxembourg (despite its high costs) has once again
become the principal player in the onshore taxation game.

An example of the increasing low tax competition is the attempt by Denmark
(never a big player in this field) to become more heavily involved as a
tax-efficient jurisdiction. Some years ago, Denmark abolished withholding
tax on distributions from Danish companies. By making use of Denmark's
extensive double tax treaty network, it is possible to transmit funds from
other European jurisdictions through Denmark without suffering any further
tax charge. Very recently, Denmark has legislated to provide that Danish
companies no longer pay capital gains tax on foreign real estate, and in
conjunction with its other benefits (including income tax exemption in such
circumstances) it is moving up the scale of jurisdictions which should be
included in any consideration of tax-efficient structures.

No doubt there will be much debate in the future as to the political
correctness of EU member states seeking to override the spirit of the
principle of an all-equal and transparent EU taxation regime, but it is
clear that there are significant tax advantages still to be obtained from
taking steps to structure trades and investments by the use of entities set
up in carefully chosen EU jurisdictions. Indeed, there is a continuing
thrust by a number of countries to maintain and expand their shares of the
market for such tax-efficient structures, and there will be continuing
opportunities for practitioners and their clients to be creative in their
pursuit of reduced taxation.

Michael Fischer is an associate with Froriep Renggli and Collingwood
Thompson QC is a barrister at Seven Bedford Row

Section: In-Depth Analysis
Date: 7-Nov-2005
Author: Michael Fischer & Collingwood Thompson QC
Source: thelawyer.com