Intra-group debt financing: updated safe haven rates and thin capitalisation rules

Background

The establishment of a legal entity or the expansion of its business requires capital in the form of either debt or equity. A shareholder providing equity capital is generally compensated by dividend payments, which constitute a non-deductible cost for the company. On the recipient level, such dividend income is often exempt or favourably taxed in order to mitigate or avoid double taxation. Conversely, the provision of debt capital leads to interest expenses, which are generally tax-deductible on the company level and taxable in the hands of the payee.

Particularly in cases where the parties involved are related, the financing structure can be freely chosen and the person providing the capital may prefer to provide debt capital instead of equity capital. In cross-border or inter-cantonal situations within Switzerland, where different tax rates apply, it may be beneficial if debt capital is provided by a low-tax group company to a high-tax group company to optimise the group's overall tax position. For instance, if the debtor of the intra-group loans is subject to a corporate income tax rate of 30% and the lender to a rate of 12%, the interest expense may be offset against taxable income at a rate of 30% and the interest income is taxed at 12% in the hands of the lender. In this financing structure, related group companies take advantage of the tax arbitrage and shift profits to the low-tax jurisdiction.

Given this situation, various countries have adopted anti-abuse rules to combat such financing structures and protect their tax base. Switzerland is one of those countries that have enacted tax-driven thin capitalisation rules that limit the debt-to-equity ratio and the interest rate paid on such intra-group loans. In addition, the safe haven interest rates published annually by the SFTA aim to prevent an unjustified erosion of the profit of a Swiss company.

The rest of this article discusses the Swiss safe haven interest rates and the operation of the thin capitalisation rules in Switzerland in respect of intra-group loans granted to Swiss companies.

Overview

In general, debt capital raised by a Swiss company from independent third parties is not restricted and the interest paid therefrom is qualified as a tax-deductible business expense.

On the other hand, interest expenses on intercompany debt are tax-deductible only on the level of a Swiss company provided that:

• the interest rate complies with the safe haven interest rates published annually by the SFTA or evidence is provided that the interest rate is at arm's length; and
• the loan granted by a related party does not qualify as hidden equity (ie, it is in line with the Swiss thin capitalisation rules).

These two sets of rules are outlined below.

Safe haven rates

Overview
The SFTA's annually updated circular letters provide safe haven interest rates for intra-group loans. The applicable rates depend on whether the loans:

• are granted to or from a Swiss company (ie, whether it acts as a creditor or debtor);
• are granted in Swiss francs or in a foreign currency; and
• are secured.

The circular letters prescribe minimum interest rates for loans granted by a Swiss company to its shareholders and/or related parties and maximum interest rates for loans granted by the shareholders and/or related parties to a Swiss company in order to avert an unjustified erosion of the Swiss company's profit. If the safe haven interest rates are met, the SFTA will consider these as being at arm's length without requiring any further evidence.

Intra-group loans in Swiss francs
The minimum interest rates for the year 2022 on loans denominated in Swiss francs and granted by a Swiss resident company to shareholders and/or related parties are generally as follows:

• equity-financed loans – 0.25%; and
• debt-financed loans – actual interest expense plus 0.5%. For debt-financed loans exceeding 10 million Swiss francs, a mark-up of plus 0.25% must be applied on the actual interest rates.

The maximum interest rate for the year 2022 on loans denominated in Swiss francs and granted by shareholders and/or related parties to a Swiss trading or production company is 1%. However, loans of up to 1 million francs granted to a Swiss trading or manufacturing company may bear interest at a rate of up to 3%.

Different interest rates apply to loans secured by real estate and loans granted to Swiss holding and asset management companies.

Intra-group loans in foreign currencies
The safe haven interest rates for loans denominated in foreign currencies are published by the SFTA in a separate circular letter. In contrast to the circular letter for loans denominated in Swiss francs, there is only one safe haven interest rate per currency. Thus, no distinction is made between maximum interest rates (ie, for loans granted by shareholders and/or related parties) and minimum interest rates (ie, for loans granted to shareholders and/or related parties). However, in practice, the published safe haven interest rates for loans denominated in foreign currencies are considered as being minimum interest rates.

For instance, for the year 2022, the minimum interest rates for loans granted to shareholders or related parties denominated in euros or US dollars are as follows:

• equity-financed loans – 0.5% (euros) and 2% (US dollars). However, in all cases at least the safe haven interest rate on loans denominated in Swiss francs (0.25%) applies; and
• debt-financed loans – actual interest expense plus 0.5% with a minimum of 0.5% on loans denominated in euros and 2% on loans denominated in US dollars.

In order to determine the maximum interest rate for loans granted by shareholders and/or related parties, a spread (corresponding to the difference between the minimum and maximum interest rate for loans denominated in Swiss francs) is added to the published safe haven rate. For instance, the spread for loans granted by shareholders or related parties to a Swiss trading or production company is 2.75% (up to 1 million francs) or 0.75% (above 1 million francs) and the maximum interest rate for a respective loan denominated in euros is 3.25% (0.5% minimum interest rate plus spread) and 1.25% (0.5% minimum interest rate plus spread), respectively.

Proof of arm's length
The related parties may deviate from these safe haven rates and the Swiss company may therefore apply higher or lower interest rates to the extent that proof can be provided that the used rates are at arm's length. A loan will be considered as being at arm's length if an independent third party would have granted such a loan under the same conditions.

Thin capitalisation rules

Loans from related parties
If downstream or cross-stream loans are granted to a Swiss company by shareholders and/or related parties, the competent tax authority will wish to make sure that the Swiss company is not thinly capitalised (ie, excessively debt funded) from a tax perspective.

The tax practice regarding thin capitalisation is set out in a circular letter issued by the SFTA on 6 June 1997, which places a limit on the maximum amount of debt granted by related parties on which deductible interest payments are available. According to the circular letter, each asset category of the borrowing Swiss company must be financed by a certain equity portion (ie, the maximum underlying debt for each asset category is determined by a safe harbour debt-to-equity ratio (see table below)). The calculation is based on the fair market values of the underlying assets. For instance, participations in subsidiaries should be equity-financed with at least 30%, which means that debt financing may amount up to 70% of the fair market value of the respective participations.

Table 1: each asset category of the borrowing Swiss company must be financed by a certain equity portion

Third-party loans guaranteed by related parties
As an exception to the above practice, a safe haven debt-to-equity ratio of 6:1 applies to finance companies. Further, a Swiss company that is not in line with the safe haven rules may always prove that a higher debt is still at arm's length.

In general, Swiss thin capitalisation rules apply to related party loans only. Conversely, this means that debt financing of a Swiss company by independent third parties (eg, banks) is not restricted.

However, loans granted by independent third parties which are guaranteed by a shareholder or a related party of a Swiss group company, are treated as loans from related parties under the Swiss thin capitalisation rules.

Tax consequences

If the funding of a Swiss group company is not in compliance with the safe haven interest rates and/or the Swiss thin capitalisation rules and no arm's length proof can be provided, the following tax consequences will arise.

In the event of thin capitalisation, the part of related party debt that exceeds the relevant debt-equity ratios determined in the circular letter will be treated as equity subject to annual capital tax (hidden equity) and must not bear interest. Thus, the interest paid on the respective portion of hidden equity will be requalified as a hidden dividend distribution. Excessive interest payments that are not in line with the safe haven interest rates published by the SFTA are equally treated (ie, are also re-characterised as a hidden dividend distribution). As a result, such interest will be added back to the Swiss company's taxable income, which means that the tax deduction of interest paid on the hidden equity or in excess of the permitted safe haven rate will be disallowed. Additionally, such hidden dividend distributions will be subject to Swiss withholding tax at a rate of 35%.

In general, the Swiss withholding tax will be refundable or creditable in full if the recipient of the hidden dividend distribution is a Swiss tax resident corporate or individual shareholder and certain requirements are met. Even though Swiss withholding tax is generally conceptualised as a final tax burden for beneficiaries who are not Swiss residents for tax purposes, a full or partial refund may be available if the country in which such a beneficiary is resident for tax purposes has entered into a double tax treaty with Switzerland.

In cross-border situations, where the beneficiary of the hidden dividend distribution is a corporate shareholder owning a qualifying participation in the Swiss company of usually 10%, the withholding tax is often reduced to 0%.

Relief at source (rather than a refund procedure) may be available provided that an application for the "notification procedure" has been filed and granted by the SFTA prior to the distribution of the hidden dividend. In this case, the cash outflow in connection with the Swiss withholding tax of 35% could be avoided by a timely notification of the hidden dividend distribution. However, if the lender is a related group company that does not own a qualifying participation in the Swiss company (eg, sister company), the notification procedure cannot be applied and the withholding tax of 35% is typically reduced to 15% only.

If a third-party loan is guaranteed by a related party and thus treated as a related-party loan for the purposes of the Swiss thin capitalisation rules, the Swiss company's direct shareholder will be deemed to be the recipient of a potentially resulting hidden dividend distribution, even though another related party may have guaranteed the loan. This SFTA practice is particularly favourable in a treaty context where a qualifying shareholder often benefits from a full refund of the Swiss withholding tax.

Comment

In order to avoid adverse tax consequences associated with intra-group financing, it is crucial that the funding of a Swiss company by its related parties is in line with:

• the safe haven interest rates published annually by the SFTA; and
• the Swiss thin capitalisation rules.

Exceeding interest rates or debt ratios must comply with the arm's length principle, which needs to be proven by the taxpayer. On the other hand, debt financing of a Swiss company by independent third parties is not restricted unless the respective loans are guaranteed by related parties of the Swiss company.

For further information on this topic please contact Maurus Winzap or Fabienne Limacher at Walder Wyss by telephone (+41 58 658 58 58) or email ([email protected] or [email protected]). The Walder Wyss website can be accessed at www.walderwyss.com.