Supreme Court overthrows the concept of "safe harbor rules".
The Supreme Court has severely limited the scope of application of intercompany financing safe harbor rules.
Background
- Intercompany financing and related permissible interest rates are an evergreen topic in most tax systems. Switzerland is no exception. To reduce uncertainty and to simplify the tax assessment process from an administrative perspective, the Swiss Federal Tax Administration ("SFTA") has been publishing so-called safe harbor interest rates for many years. These are interest rates that are accepted as being at arm's length by the tax authorities without the need for any further proof by the taxpayer.
- Hence, if a Swiss taxpayer wishes to engage in intercompany financing activities but wants to avoid having any burden of proof on their arm's length nature with the tax authorities, the taxpayer will apply the safe harbor rates. These provide for a maximum rate where the Swiss taxpayer is the borrower and a minimum rate where it is the lender.
- In a recent ruling, the Swiss Supreme Court has now severely restricted the applicability of these rates and declared them as only applicable, when the taxpayer applies them. Otherwise, they are not considered binding for the tax authorities.
What has happened
- A Zurich-based company had received a loan from its parent entity. The Zurich entity paid interest of 5%*. Meanwhile the safe harbor rate maximum was 2%*.
- The tax authorities assessed that an arm's length rate would have been even lower, i.e. 1%*. They further postulated that the safe harbor rates are not applicable for cantonal and municipal corporate income taxes.
- Their position was that the resulting deemed dividend (i.e. the add-back to taxable profit from excessive interest paid by the Zurich-based entity) should be 4%, namely the difference between the rate paid (5%) and the determined arm's length rate (1%).
- The company's postulated that the excessive interest should be limited to 3%, namely the difference between the rate paid (5%) and the safe harbor maximum rate.
- The Court has ruled that the safe harbor rates are applicable for cantonal and municipal corporate income taxes, as well as withholding and direct federal tax, thus invalidating that point by the tax authorities, which is to be appreciated. This contributes to the harmonization of the tax treatment across the various tax types and the 26 cantons of Switzerland.
- However, in a rather incomprehensible move, the Court has stated that the safe harbor rates are not applicable in the case at hand and has upheld the tax authorities' position. The justification for this is that if the taxpayer has themselves deviated from the safe harbor rules (in the case at hand by paying an interest rate exceeding the safe harbor maximum rate), then the tax authority is no longer bound by the safe harbor rates either and can determine the arm's length rate by the taking the specifics of the individual case into consideration.
- The result is that the very concept of what "safe harbor" means is hollowed out. A taxpayer can only rely on this concept if they apply the rates. If a taxpayer steps outside the framework, it cannot be foreseen what interest rate the tax authorities would deem to be arm's length in a potential contest. Therefore, legal certainty in this regard suffers and it becomes more difficult to anticipate this issue.
- The tax authorities are not bound to publish the safe harbor rates and do so voluntarily to facilitate the assessment process. In doing so, they however set a standard for a basis of orientation of what an arm's length rate is. Ignoring that standard unless the taxpayer chooses to follow it is arbitrary and violates the constitutional Good-Faith and Equality principles in our view (even though the Court has explicitly denied the violation of both those principles).
- There are other examples where tax law itself sets comparable standards for simplicity reasons (e.g. 5% deduction of administrative costs in case of qualifying participation income for the purpose of calculating the participation exemption). If the taxpayer does not apply the 5% flat-deduction, the Zurich tax authority could not go beyond those 5% (i.e. against the benefit of the taxpayer). In this case, there is explicit wording in the Zurich tax law to prevent this, as the lawmakers at the time foresaw this would violate the Equality principle. It is not apparent why there is a difference to the case at hand, simply because the publication of the safe harbor rates is voluntary, while the mentioned admin-cost-deduction in the context of participation income is legally required.
- The notion that the safe harbor rates – accepted by the SFTA as being "at arm's length" rates – are no longer arm's length unless the taxpayer voluntarily subjects itself to them, is an unwelcome development and a logical error. It is a fundamental pillar of Swiss jurisprudence and the legal system that a person must be able to estimate the cost of wrongdoing. If the estimation of the consequence to wrongdoing becomes blurry, so does the line between right and wrong. The "punishment" for not applying safe harbor rates cannot be uncertainty and facing a risk of interest adjustments beyond the safe harbor rates.
- With this approach, the consequence is that a taxpayer not applying the safe harbor rate and failing to provide appropriate proof for the rates applied may face a worse taxation than if they had applied the arm's length rates proactively. The non-application of the safe harbor rates therefore results in a de-facto punishment via higher taxation. It is meanwhile not a punishable offence to depart from the safe harbor framework and – even if it was – the punishment in Swiss tax law never consists of the tax itself, but – if they were applicable – separate fines for specific actions of wrongdoing. Introducing a quasi-obligation to apply the safe harbor framework through the implicit threat of a higher taxation ex post is clearly not in line with the principles of the Swiss legality principle and it further poses a host of problems in international cases, as the Swiss safe harbor rules are not necessarily compatible with other countries' views on arm's length interest rates.
- Additionally, the non-application of the safe harbor framework contradicts the idea of a simplification of the assessment process. Instead of assessing the deemed dividend as the difference between safe harbor rates and paid rates, the tax authorities will have to determine an actual arm's length rate. This is considerably more effort. It will furthermore be interesting to see if the tax authority is also willing to depart from the simple application of the safe harbor framework, when it is to their disadvantage.
- In an M&A context, this raises additional challenges in the quantification of historical tax risks associated with intercompany financing. If there are risks from i/c financing interest rates not being at arm's length in a due diligence, the concerned entity would not have applied the safe harbor rules (otherwise, there would be no risk). Absent the safe harbor rules as a point of orientation for an arm's length rate, the quantification of the risk is not possible in detail without any detailed TP studies performed.
Originally published by 20 August, 2024
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