On October 26, 2004, the European Union and Switzerland signed the savings tax agreement (the “Agreement”) that will introduce measures equi...

On October 26, 2004, the European Union and Switzerland signed the savings tax agreement (the “Agreement”) that will introduce measures equivalent to the E.U. Savings Tax Directive (the “Directive”) in Switzerland. Generally, these measures will require Switzerland to withhold tax on interest payments made by Swiss “paying agents” to individual E.U. residents.

The Agreement, which has been the result of intense negotiations between the European Union and Switzerland, generally replicates the text of the original Directive with relatively minor changes. The points to note, which include differences relating to the exchange of information and the definition of “paying agent”, are discussed below. The Agreement also incorporates provisions which will enable Switzerland to receive the benefits of the E.U. Parent-Subsidiary Directive(2) and the E.U. Interest and Royalties Directive (3).

It is expected that the Agreement will go into force on 1 July 2005, in conjunction with the entry into force of the Directive within the European Union. However, the Agreement still must be approved by the Swiss parliament, and may still be subject to a popular referendum.

On 19 October 2004, the Swiss Federal Tax Administration (“FTA”) released draft guidelines (“Draft Guidelines”) on the implementation of the Agreement. These guidelines are extensive, and provide welcome guidance on the operative terms of the Agreement, as well as specific direction concerning which types of financial instruments are subject to withholding tax under the Agreement.

II. BACKGROUND

The E.U. Savings Tax Directive was formally adopted by ECOFIN (4) on June 3, 2003, and was originally expected to become effective across the European Union from January 1, 2005. However, this date was conditional on the European Union negotiating and concluding agreements with certain states outside the European Union (Switzerland, Liechtenstein, Monaco, Andorra and San Marino) who must first agree to introduce equivalent measures. In May, the European Union reached a preliminary agreement with Switzerland, and the Agreement between the European Union and Switzerland was formally signed on 26 October 2004 along with the other agreements that are part of the so-called “Bilateral II” agreements package. Now that agreement has been reached with Switzerland, it is expected that the other jurisdictions will follow using the Swiss agreement as a model.

Because of the delay in obtaining agreements with Switzerland and the other jurisdictions, the European Union decided in July 2004 to postpone the effective date of the Directive until 1 July 2005. The Agreement still must be approved by the Swiss parliament. The Agreement has been submitted to the parliament, which will consider it along with the other Bilateral II agreements. It is expected that the Swiss parliament will take action before the end of 2004 on the Bilateral II agreements. Even if approved, however, the Agreement may be subject to a referendum in Switzerland. Accordingly, although the Agreement appears likely to be effective as from 1 July 2005, it is possible that it will not.

III. THE AGREEMENT

The Agreement is in three parts: an Explanatory Memorandum; a Memorandum of Understanding, and the actual text of the Agreement.

1. Explanatory Memorandum
This introductory section summarises the negotiation process between the European Union and Switzerland, as outlined above. Interestingly, and rather surprisingly in view of its prior statements (but not in view of the initial understanding between both parties), the European Union acknowledges a link between the implementation of the Directive and other issues which Switzerland wishes to negotiate with the European Union.

2. Memorandum of Understanding (the “MoU”)
Under the MoU, Switzerland commits to the execution of further agreements with other E.U. Member States for the exchange of information on tax related issues. Until this point, Switzerland has only executed tax-related information exchange agreements with the United States and Germany.

3. The Agreement and Swiss Draft Guidelines on the Agreement

3.1 General Application
The application of the withholding tax regime applicable to Austria, Belgium and Luxembourg is extended by analogy to Switzerland. Under the withholding tax regime, a withholding tax will be imposed on savings interest paid in Switzerland by Swiss “paying agents” to “beneficial owners” who are resident in other E.U. Member States including the states that joined the European Union on 1 May 2004 (5). As discussed below, however, there are numerous exceptions to the application of withholding tax.

Assuming the Agreement will be in force as from 1 July 2005, the percentage withholding tax imposed will increase over time as follows:
– From 1 July 2005 15%
– From 1 July 2008 20%
– From 1 July 2011 35%

3.2 Swiss Anticipatory Tax
The interest payments made on debt obligations issued by debtors who are Swiss residents, or by permanent establishments (6) of nonresidents located in Switzerland, are excluded from the withholding tax requirement of the Agreement as long as a 35 percent anticipatory tax on Swiss source interest is imposed by Switzerland. Should this tax rate fall below 35 percent, for example by virtue of a tax treaty or change in domestic law, the Agreement will apply to the extent that the tax rate has been reduced.

For example, if Switzerland reduces its anticipatory tax rate to 25% in 2008, no additional withholding will be required under the Agreement until 1 July 2011, when the Agreement’s rate increases to 35 percent. At that time, an additional 10 percentage points will need to be withheld from the interest payment.

In addition, if Swiss legislation reduces the scope of its anticipatory tax law on interest payments to individual E.U. residents, any interest payments excluded by the change in law will be subject to withholding tax under the Agreement.

Swiss investment funds that are exempted from Swiss anticipatory tax are also exempt from application of the Agreement’s withholding taxes.

3.3 Disclosure as Alternative to Withhold Tax
An E.U. resident may avoid the application of the withholding tax by choosing instead to authorize the paying agent to report the interest payment to the Member State in which he or she is resident. The authorization applies to all payments to the resident. The information supplied includes the identity and address of the recipient, the account number, the identity of the paying agent, and the amount of interest paid. The paying agent sends the information and authorization to the FTA, which automatically sends it to the Member State concerned within 6 months of the end of the tax year concerned.

3.4 “Beneficial Owners” and Determination of Persons Subject to Withholding Tax
The withholding tax is potentially applicable only to individual persons resident in an E.U. Member State who are “beneficial owners” of the interest.

The definition of “beneficial owner” in the Agreement is basically the same as it appears in the Directive. A “beneficial owner” is any individual who receives an interest payment or any individual for whom an interest payment is secured, unless the individual can provide evidence that the interest payments was not received or secured for his or her own benefit. An individual is not a “beneficial owner” when he or she (1) acts as a paying agent; (2) acts on behalf of a legal person, an investment fund, or a comparable common investment body; or (3) acts on behalf of another individual who is the beneficial owner and who discloses to the paying agent his or her identity and state of residence.

According to the Draft Guidelines, the term “beneficial owner” is construed under Swiss money laundering laws, except that shareholders in a company are not considered to be “beneficial owners” for purposes of the Agreement. The Draft Guidelines also contain additional guidance on what or who is, and is not, a “beneficial owner.”

The Draft Guidelines explicitly provide that legal persons are not to be subject to withholding tax under the Agreement, and provide a list of legal entities in each E.U. Member State. Partnerships are not “legal persons” for this purpose.
The Draft Guidelines also provide:

– In the case of usufructs, the usufruct owner is the “beneficial owner.”
– In the case of a Treuhand, the owner of the assets is the “beneficial owner,” not the Treuhander.
– Commercial partnerships and condominium companies are treated as companies, and thus cannot be “beneficial owners” because they are not individuals.
– Individual partners in non-commercial partnerships, however, can be “beneficial owners.”
– Sole proprietorships are treated as natural persons, and, therefore, can be “beneficial owners.”
– Where there are multiple recipients of an interest payment under a contract, e.g., a joint bank account, the fact that some recipients are not individual E.U. residents does not shield an individual E.U. resident from withholding tax

Moreover, the Draft Guidelines specifically provide that individual residents of Andorra, Liechtenstein, Monaco, and San Marino are not subject to withholding tax, and neither are individual residents of the dependencies of E.U. Member States such as the Netherlands and Great Britain. Interest payments to residents of France’s “Departements Outre Mer,” however, would be potentially subject to withholding tax.

Treatment of Trusts Remains Unknown. The Agreement does not provide any guidance on how a trust should be viewed to determine the “beneficial owner.” The Draft Guidelines mention the problem, but merely state that the issue continues to be under study. Accordingly, the proper treatment of a trust is still unknown.

3.5 Identifying and Documenting the Beneficial Owner
According to the Agreement, the paying agent is required to apply the Swiss money laundering rules to identify the recipient. According to the Draft Guidelines, paying agents generally must obtain only the name and address of the recipient, and confirm his or her identity with a passport or official identity card issued by an E.U. Member State, in order to determine whether withholding tax must be applied under the Agreement to interest payments. The Draft Guidelines say that the fact that the recipient provides a mailing address in a country other than that in his or her passport or identity card does not create an issue concerning the accuracy of the residence claim, and no further inquiry is required in such circumstances. Banks, however, must apply the Swiss “know-your-customer” rules for purposes of making the determination. The Agreement provides that where a person claims not to be a resident of an E.U. Member State or Switzerland, but presents a passport of identity card from an E.U. Member State, the paying agent must obtain a certificate of residence from the country concerned. The Draft Guidelines provide additionally that, in certain specified unusual cases, the person claiming residence must provide a certificate of residence from his or her country of residence.

Paying agents are permitted to rely on the foregoing evidence, unless they have in their possession information to the contrary.

3.6 “Paying Agent”
The paying agent is under the obligation to withhold tax. Accordingly, the definition of the paying agent is crucial.

The definition of “paying agent” is extended by the Agreement to include not only Swiss banks and financial institutions but also Swiss resident individuals, partnerships and “permanent establishments” located in Switzerland. The paying agent definition, according to the Agreement, encompasses any entity that “even occasionally” accepts, holds, invests or transfers assets of third parties, or merely pays or secures interest in the course of its business. The relatively broad definition potentially covers the administration of non-Swiss private investment companies conducted from Switzerland (e.g., a Singapore non-resident company), as well as the administration by trustees of certain trusts from Switzerland.

The Draft Guidelines provide additional guidance in this regard. According to them, the term “paying agent” can include an administrator of mutual funds, asset managers, Treuhanders, insurance companies, attorneys, and notaries. Persons involved in “private transactions,” however, are not “paying agents.”

According to the Draft Guidelines, where there are a number of transactions involving the payment of a particular interest payment, it is only the person who makes the payment to the individual E.U. resident who is a “paying agent” required to perform the duties of a paying agent.

Registration Required. The Draft Guidelines require all paying agents to register with the FTA, and provide information on themselves and their activities. A paying agent must register by the end of the first calendar quarter after it makes the first payment of interest. Banks and securities dealers, however, are deemed to be registered if they are in business prior to 1 July 2005, and therefore do not need to register with the FTA. If a person ceases to act as a paying agent, it must de-register as a paying agent with the FTA.

The Draft Guidelines require the paying agent to (1) identify and document the recipient; (2) determine whether or not any particular payment is an “interest payment” subject to withholding tax under the Agreement; (3) withhold the tax and transfer it to the FTA; and (4) notify the FTA of relevant information.

3.7 “Interest Payment”
Only “interest payments” are potentially subject to withholding. Both the Agreement and the Draft Guidelines provide extensive guidance in this regard. As noted, it is up to the paying agent to make the determination of what constitutes an interest payment.

The definition of “interest payment” as contained in the Agreement is substantially the same as in the Directive. The definition is extremely broad, a point re-emphasized in the Draft Guidelines. Interest includes interest accrued or capitalized when the debt obligation is sold, redeemed, or refund. In addition, interest is covered if it is derived directly from or indirectly through (1) an undertaking for collective investment, wherever domiciled; (2) entities exercising an option pursuant to article 4(3) of the Directive; and (3) Swiss investment funds that are exempted from Swiss anticipatory tax on payments to individuals who are E.U. residents. Moreover, proceeds from the sale, refund, or redemption of shares or units in one of the foregoing entities or undertakings is considered to be interest, if more than 40% (25% after 1 Jan. 2011) of their assets consist of debt obligations.

Under the Agreement, a paying agent may make certain assumptions if it lacks information. First, in the case of interest derived through one of the undertakings or entities mentioned in the previous paragraph, the paying agent must assume that the entire amount is interest if it doesn’t have information concerning the proportion that is interest. Further, on the sale, refund, or redemption of shares or units of such entities, the paying agent must assume that the percentage of debt obligations owned is over 40% (25% after 1 Jan. 2011), in the absence of information to the contrary.

Income relating to undertakings or entities that have invested less than 15 percent of their assets in debt obligations is not considered interest income, however.
The Draft Guidelines repeat the foregoing provisions, but also elaborate. Interest does not include:
– Dividends on shareholdings in companies
– Payouts from insurance policies
– Payments from pension funds
– Any other payments not based upon a lending of funds

Application of these rules to specific types of financial instruments is discussed in the next section.

3.8 Other Provisions of the Agreement
Revenue Sharing. According to the Agreement, withholding taxes collected by Switzerland are allocated 25% to Switzerland and 75% to the E.U. resident’s Member State. This is the same as the revenue sharing provision of the Directive.

Exchange of Information. Switzerland commits to the exchange of information concerning “tax fraud or the like”. The phrase “tax fraud or the like” is to be interpreted by the state which has been requested to provide the information. The Swiss understanding and definition of tax fraud and tax evasion would thus be applied to requests from Member States asking for information from Switzerland. The statute of limitations of the requesting state would govern any request for exchange of information (7).

Interpretation of Agreement. Provisions of double tax treaties which would otherwise obviate the terms of the Agreement are overridden to the extent that they conflict with it. Moreover, according the Draft Guidelines, undefined terms in the Agreement are defined according to Swiss law, unless there is a mutual agreement on another definition between Switzerland and the European Union.

Parent-Subsidiary and Interest and Royalties Directives Extended to Switzerland. The application of the Parent-Subsidiary Directive (taxation of parent companies and their subsidiaries) and the Interest and Royalties Directive (taxation on interest and royalties) is extended to Switzerland. The Parent-Subsidiary Directive will not, however, apply between Switzerland and Spain until a bilateral agreement has been concluded on the exchange of tax-related information between these jurisdictions.

IV. APPLICATION OF AGREEMENT TO FINANCIAL INSTRUMENTS

The Draft Guidelines go into great detail in setting forth the application of the Agreement to financial instruments. They set forth which types of financial instruments generate “interest payments” for purposes of the Agreement.

Standard Derivatives. Under the Draft Guidelines what may be called “standard” derivatives-options, forwards, futures, swaps, and any other similarly-based instruments do not generate income that is considered to be “interest” for purposes of the Agreement.

Structured Financial Products. The Draft Guidelines enumerates a series of types of structured financial products, e.g., asset-protected derivatives, certificates, reverse convertibles, low-exercise price options, securities lending, etc., and describes whether and to what extent each of these produces interest.

However, as noted above, obligations issued by Swiss debtors are generally not subject to withholding tax under the Agreement. Consequently, even financial instruments that otherwise generate interest will not produce interest payments subject to withholding if issued by Swiss issuers, in general.

Helpfully, the Draft Guidelines place this in a table in an appendix, which is reproduced at the end of this article.

A review of the table indicates the following general conclusions
1. Instruments Issued by Swiss Issuers
Income produced by all mentioned types of instruments and investments is not subject to withholding tax under the savings directive, with the following two exceptions:
a)Mutual funds, if it is possible to obtain a bank statement (“Möglichkeit zur Bankenerklärung”), and if more than15% of its assets consist of debt obligations that produce interest.
b)“Bankinterne Sondervermögen mit Bankenerklärung”

2. Instruments Issued by Non-Swiss Issuers
Most listed items are not subject to withholding tax under the Agreement, with the following exceptions:
a)Standard debt-e.g., Treasury Bills, Municipal Bonds, CDs, Commercial Paper, Banker’s Acceptances
b)Bonds (unless “grandfathered” because issued before March 2001)
c)The interest element of repo transactions
d)Hybrid financial instruments-depending upon structure
e)Mutual funds-depending upon structure, and the extent to which invested in debt obligations (i.e., more than 15%/40%-see discussion above).
f)Structured Financial Products-to the extent they produce interest income as set forth in the Draft Guidelines.

Footnotes

1. Council Directive 2003/48/EC of June 3, 2003 on the taxation of savings income in the form of interest payments.
2. Council Directive 90/435/EEC of July 23, 1990 on the common system of taxation applicable in the case of parent companies and subsidiaries of different Member States.
3. Council Directive 2003/49/EC of June 3, 2003 on a common system of taxation applicable to interest and royalty payments made between associated companies of different Member States.
4. The European Council of Economic and Finance Ministers.
5. Cyprus, Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia
6. As defined in the relevant tax treaty.
7. Switzerland commits to entering into bilateral treaties with the Member States to extrapolate and define “or the like” cases. It is particularly interesting that the provisions of the Agreement specifically allow Switzerland to apply its understanding of tax fraud when requested to provide information, and that the statute of limitations of the requesting state will apply. This may indicate that Switzerland wishes to limit any misunderstanding or controversy treaty.