INSIGHT: Swiss Tax Reform and Its Transfer Pricing Implications

On May 19, 2019, the Swiss tax reform (Federal Act on Tax Reform and AVS Financing (TRAF)) was adopted at federal level.

ADOPTION OF THE SWISS TAX REFORM AT FEDERAL LEVEL

By abolishing individual tax privileges, Switzerland secures the international acceptance of its tax system and ensures the long-term attractiveness of Switzerland as a place of choice for multinational companies. Apart from the specific measures discussed in the following, many cantons have also chosen to lower their ordinary profit tax rates. It should be noted that the proposal was only adopted at federal level and in a number of cantons so far.

For example, the electorate of the Canton of Zurich accepted the tax proposal on Sept. 1, 2019, with a 56% majority. Most remaining cantonal votes are expected to take place before the end of this year. It is therefore still possible that other cantons will reject the proposal and that measures that can be introduced by the cantons on a voluntary basis will not be adopted, or that a tax disadvantage compared to another canton could arise. In individual cases a relocation to another canton would therefore make sense. A prompt and detailed examination of the individual measures and the cantonal legislative processes is therefore unavoidable.

In this article, individual specific measures of the TRAF are discussed, particularly from a transfer pricing point of view. It also examines the interplay between international guidelines and Swiss tax law, in particular how the DEMPE concept (development, enhancement, maintenance, protection and exploitation) developed by the Organization for Economic Cooperation and Development (OECD) could be applied to the newly introduced patent box in Switzerland and the R&D super deduction, thus creating international consistency from a tax point of view. The effects of the Swiss tax reform go far beyond national borders and can also be of significance for foreign companies with subsidiaries or permanent establishments in Switzerland.

PATENT BOX AND R&D SUPER DEDUCTION

One of the measures provided by the TRAF is the introduction of a patent box and a R&D super deduction. While the patent box allows for a tax benefit to be derived from the patent’s income, the R&D super deduction makes it possible for R&D-related expenses to be used for tax deductions, provided that the relevant conditions are fulfilled.

Scope of the Patent Box

In order to preserve Switzerland’s attractiveness as a business location, notwithstanding the abolishment of tax privileges that are no longer internationally accepted (e.g. cantonal holding status), Article 24a of the new Tax Harmonization Act offers a privileged taxation of profits from certain intangible assets at cantonal level. In other words, the patent box leads to a reduction of the tax base. The TRAF provides for a mandatory introduction of the patent box in all cantons. However, the cantons have some liberty when it comes to the determination of the amount of reduction that can be applied for.

The list of requirements that need to be fulfilled in order to qualify for the patent box is conclusive. In particular, domestic and foreign patents as well as comparable rights, namely supplementary protection certificates and their renewal and topographies, may be considered for the patent box (Article 24a of the new Tax Harmonization Act). However, other intangibles such as trademarks, design, and trade secrets (know-how) are not covered as they do not enjoy patent protection. Initially it was unclear whether copyright-protected software or non-patented inventions would also qualify for the patent box. However, for practical reasons the Federal Council has decided not to consider this category. Nevertheless, please note that software may exceptionally be covered if it is part of an invention.

Scope of the R&D Super Deduction

When it comes to the application of the R&D super deduction, the term R&D can be interpreted broadly. In general, it covers scientific activities that serve research (basic and applied research) as well as science-based innovation, in other words the development of new products, processes, and services for economy and society through research, in particular applied research, and the exploitation of its results (see Article 2, lit. b of the “Bundesgesetz über die Förderung der Forschung und der Innovation” (FIFG)). It should be noted that R&D activities must physically take place in Switzerland. This also includes contract research by domestic affiliated companies or domestic third parties. These regulations intend to ensure that multinational companies retain or locate their R&D activities in Switzerland also in the future.

Calculation of the Tax Base

The Swiss Tax Harmonization Act permits a maximum tax deduction of 90% on the residual profit from patents, whereby the cantons may decide on a smaller reduction. The residual profit consists of income derived from licenses of qualifying intellectual property rights and the proportionate profit from the sale of products attributable to such qualifying intellectual property rights. Once the residual profit has been determined, it needs to be adjusted by using the so-called modified nexus approach. The residual profit is multiplied by the nexus factor, which represents the ratio of qualifying R&D expenses (i.e. R&D expenditures in Switzerland), to total R&D expenditures (so-called “modified nexus approach”). The legislator intends to ensure that profits from intellectual property rights are taxed in the same country in which the associated R&D expenditure was incurred.

However, it is important to note that upon entry into the patent box, R&D expenditures booked over the last 10 years are subject to ordinary corporate income tax. This means that all expenses for qualifying intellectual property rights and any R&D deductions previously claimed for tax purposes will be allocated to the taxable profit at the time of entry (so-called “entry tax”). This retroactive taxation of relevant R&D expenses applies to the 10 previous tax periods. Depending on the costs for developing a qualifying intellectual property right (as measured by the market value of the intellectual property right), this may constitute a significant tax burden for the company concerned.

In the case of the R&D super deduction, which is intended to actively promote R&D activities in Switzerland, cantons are free to decide whether they wish to allow for an additional deduction in the amount of (maximum) 50% of the accrued R&D expenses.

Considering this, companies are well advised to quantitatively evaluate the potential tax implications before applying the patent box and the R&D super deduction. In particular for the patent box, they should calculate the amount of the entry tax for existing intellectual property and compare this to the tax advantages, which the patent box and R&D super deduction entail.

Interaction With International Transfer Pricing Standards

Originally, the OECD has launched the patent box approach as a possible international standard. By using the modified nexus approach in an OECD-consistent manner, it should be ensured that all requirements with regards to the economic substance according to the OECD are met when applying the patent box regime in Switzerland.

This approach therefore complies with relevant transfer pricing requirements. With reference to the 2017 OECD Transfer Pricing Guidelines, it should be noted that the residual profit from patents and other intellectual property rights is only allocated to the patent holding company and is thus taxable in Switzerland, if the patent holder:

• performs essential functions relating to the development, improvement, maintenance, protection, and exploitation of IP (so-called DEMPE-functions),
• has employed substantial assets, and
• has borne significant associated risks.

A comprehensive DEMPE analysis for the purposes of the patent box is not absolutely necessary from a purely Swiss tax perspective. However, as already mentioned, it is of great importance that the required clarifications and documentation (based on local regulations) in connection with the patent box do not lead to inconsistencies with a DEMPE analysis that was performed at Group level.

In order to ensure a coordinated communication and documentation on a national and international level, the profit to be allocated to Switzerland must first be determined in line with international standards, e.g., generally according to the OECD transfer pricing rules for European purposes. The box profit according to the patent box is then calculated on this basis. It is important to note that the nexus quotient does not provide an answer to the question of what share of the profit is to be allocated to a specific country, i.e. Switzerland. Rather, the answer to this question is based on the DEMPE concept as described above, which ensures arm’s-length profit allocation and arm’s-length remuneration for the contributions of the transaction partners in respect of functions performed, assets employed, and risks assumed. The nexus approach, based on the profit thus allocated to Switzerland, merely answers the question of the amount to be included in the patent box, i.e., benefitting from the tax relief for patents and similar rights. The starting point for the application of the nexus quotient is thus a certain profit that has been allocated to Switzerland in accordance with the relevant local substance (i.e. in particular personnel with relevant know-how, experience and decision-making authority) as well as the relevant DEMPE functions.

From a transfer pricing point of view, it is thus indispensable to check compliance of a patent box application with the overall transfer pricing system maintained and documented (e.g. within the scope of a Master and Local File(s)) by the Group before it is submitted—namely with a view to the relative value contributions based on functions performed, risks assumed, and assets held. For example, the results of a functional and risk analysis and supporting documentation can be used at national level to prove the necessary substance and corresponding profits accruing to Switzerland for qualifying for tax relief through the patent box. This also means that an application for the patent box regime by Group tax departments should be checked for consistency with existing transfer pricing documentation, i.e., a more frequent and detailed communication within the Group will be necessary in the future, especially in the event of changes to the existing structure (restructurings, relocation of functions, etc.). This is particularly important in view of the fact that DEMPE analyses are often very broad, while the scope of the patent box is relatively narrow (i.e. only patentable IP, although there are some exceptions). Hence, it is important to record and document these relations precisely so that the pieces of the puzzle can be combined into a coherent overall picture in the event of a tax audit.

Also, in relation with the R&D super deduction it makes sense to examine international regulations. Documentation of the DEMPE functions as described above, which is indispensable for a comprehensive transfer pricing analysis, generally also covers information on relevant R&D activities, and in particular their allocation within the Group. At a national level, this analysis can in turn be used to substantiate the R&D super deduction in a consistent documentation, e.g., to show that the R&D expenses reported as Swiss costs were actually incurred in Switzerland.

TRANSITIONAL ARRANGEMENT FOR STATUS COMPANIES

In the sense of a smooth transition from the old to the new tax regime, the TRAF provides for a mandatory two-rate model at cantonal level as a transitional arrangement to accompany the abolition of tax privileges. The hidden reserves, including goodwill created under the special tax regimes are thus subject to a separate, lower taxation for a period of five years if they are disclosed after the special status is relinquished. It is at the canton’s discretion to set the level for this special tax rate. It should also be considered that any possible valuation of hidden reserves could also become relevant again in the context of a potential subsequent restructuring and should therefore be examined in detail. Also in this respect, the methods used in a transfer pricing analysis can prove to be useful. In practice, this means that when hidden reserves are disclosed, a valuation can be carried out in the same way as it is carried out in an international context for a transfer of assets (typically based on an income-based method, as e.g., discounted cash flow method).

DEDUCTION FOR SELF-FINANCING (INTEREST-ADJUSTED PROFIT TAX)

As a further measure, the TRAF allows for the deduction of an above-average self-financing of a company (so-called “Notional Interest Deduction” (NID)).

The aim of this special deduction is to treat debt capital and equity equally for tax purposes. This is worthwhile for the following reasons:

1. A company’s funding through equity is thereby promoted and the attractiveness of a canton for group financing companies is maintained; and

2. An excessive corporate indebtedness thus becomes less attractive.

However, this measure is only possible if the effective income tax burden in the cantonal capital is at least 18.03% (so-called high-tax cantons). Therefore, such deduction will presumably only be applied in the Canton of Zurich.

After the tax reform bill was approved at the cantonal vote in Zurich on Sept. 1, this measure will create incentives for multinational companies to locate their group financing entities and associated activities, such as cash pooling or general treasury activities, in the canton of Zurich.

The equity of a legal entity consists of the core capital required by the company in the long-term and the safety equity which is not required by the companies in the long term and could theoretically be replaced by debt capital. From a technical point of view, the safety equity represents the difference between the effectively available equity and the core capital. The interest rate is generally based on the return for 10-year Swiss federal bonds. However, if there are receivables from affiliated companies (e.g. inter-company loans) on the assets side of the balance sheet, the taxpayer has the option of also applying the (usually higher) interest used there, provided the rate is in accordance with the arm’s-length principle. In order to determine the share of such receivables as a percentage of equity, the ratio of the average tax profit values of the receivables from related parties to assets is determined.

Companies wishing to apply this deduction should thus check the interest applied on intra-group receivables by means of a transfer pricing analysis in order to determine whether the interest rates applied adhere to the arm’s-length standard. Such analysis (i.e., the determination of an arm’s-length interest rate to be charged on intercompany loans) needs to be performed for international purposes anyway. This analysis and documentation in accordance with the international OECD standards can be used analogously at the national level and become part of the documentation for the NID application.

SUMMARY AND RECOMMENDATIONS

The measures of the tax reform adopted by the Swiss electorate at federal level on May 19, 2019, reestablishes an internationally recognized tax system in Switzerland that will at the same time guarantee the continued tax attractiveness of Switzerland as a business location. This entails the most in-depth restructuring of corporate tax law in Switzerland in recent decades which will affect virtually all companies. Since these changes will come into force on Jan. 1, 2020, the implementation period is very short. It is thus important to make necessary preparations now in order to preserve opportunities and avoid competitive disadvantages:

• As an application for the patent box triggers the ordinary taxation of R&D expenditures booked over the past 10 years (so-called “entry costs”), this can result in a considerable tax burden. Companies are thus well advised to carry out a quantitative evaluation of the potential tax implications before introducing the patent box and R&D super deduction.
• From a transfer pricing perspective, an analysis and documentation of the economic substance (preferably within the framework of a DEMPE analysis) within the multinational group is well worth the exercise. At an international level, such documentation in the form of master files and local files is required anyway—at a national level, such existing documentation can further be used to justify and support the necessary applications for tax relief in the context of the patent box and R&D super deduction.
• In times of ever-increasing transparency, such an aligned approach also ensures that the applications for these new measures are consistent with the group’s IP strategy and do not merely represent the perspective of the Swiss group company applying for beneficial, IP-related tax measures.
• Transfer pricing analyses can also be helpful for the valuation of hidden reserves as required for the step-up.
• If an interest rate higher than 10-year federal bond rates is to be used for NID purposes, an inter-company receivable on the assets side of the balance sheet is necessary. For this, it must be shown that it satisfies the arm’s-length standard.

Many of the above-mentioned analyses have to be carried out for international (documentation) purposes anyway. Provided that such obligations are adequately met, these can be used for the application for the new measures. Prior to performing additional analyses, it is advisable, as a first step, to obtain an overview of the transfer pricing analyses already available in order to ensure that no inconsistencies arise between the international and national (Swiss) levels.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.

Author Information

Fabian Berr, Nate Zahnd, and Niloufar Najafi are with Ernst & Young LLP in Switzerland.