Swiss withholding tax and pending refund claims: A €2 billion question

It all started in 2005 when a Swiss bank (Bank A) acquired some very large positions in Swiss shares from non-Swiss counterparties a couple of days before the dividend payment. At the same time the Swiss bank entered into a synthetic forward (a call and put arrangement or a 'call put combo') with those same counterparties. Shortly after the dividend payment, the options were exercised and the Swiss bank returned the shares to the non-Swiss counterparties. The transactions generated a withholding tax (WHT) enhancement for the Swiss bank and the non-Swiss counterparties, as the Swiss bank was in a position to obtain a full refund of the 35% WHT on the dividends, whereas the non-Swiss counterparties would only have been entitled to receive 65% or 85% of the gross dividend income (dependent on the treaty position).

The Swiss tax authorities (STA) did not like these transactions considering them to be abusive 'dividend stripping transactions' and denied the refund of WHT on the dividends generated by the underlying Swiss shares.

Further to their discovery of these transactions, the STA began investigating any large claims to WHT refund by Swiss and non-Swiss financial institutions. Over the past six to seven years they have audited virtually all Swiss banks and equity traders and have enquired into virtually all non-Swiss financial institutions with material claims to refund under a treaty. The STA initially focussed on Danish entities but later started to look at entities resident in other jurisdictions that have a treaty with Switzerland. The reason the STA started their cross-border investigations with Danish banks and equity traders was that Danish entities were entitled to a full refund of the WHT on Swiss dividends up to the end of 2010, when the dividend article of the Swiss-Danish treaty was amended.

Some non-Swiss entities have received up to four or five letters from the STA. The first letter typically included the following questions: (1) When did the financial institution buy and sell the Swiss shares which generated a dividend? (2) Who are the counterparties to the trades? (3) Did the financial institution use the shares as a hedge against derivatives? (4) What is the economic rationale of the transactions? and (5) Did the financial institutions forward the dividend income to another party? Sometimes the STA have also raised questions in respect of securities lending and/or repo transactions with Swiss securities over the dividend season. Financial institutions who have responded to these questions have almost never received their WHT refund. Instead they have been sent further, more specific letters requesting additional (and sometimes repetitious) information including (1) the names and addresses of the counterparties, (2) the timing and pricing of the transactions in shares and derivatives, (3) details of the agreements relating to the transactions, (4) a cash flow analysis of the transactions, (5) numerous additional information on the entity, the shareholders and the transaction including accounting information and, last but not least, (6) a confirmation that the transactions are not "dividend stripping transactions". The requests can be longer, with the longest we have seen including a list of 21 questions.

Switzerland applies a strict refund system on dividends from portfolio investments. This means that the holder of Swiss shares receives a cash payment representing 65% of the dividend and, upon filing a claim, a partial or full refund of the 35% WHT. A Swiss corporate shareholder is entitled to a full refund and generally receives a cash payment within a few months of receipt of the dividend if (as is usual) it applies for a refund on instalment basis. A non-Swiss shareholder is normally not entitled to a full relief. Under most Swiss tax treaties the investor can receive a refund of 20% (so that the final WHT is 15%). A non-Swiss shareholder used to expect their money back within nine months of filing the claim, but this is no longer the case.

At the domestic level, the STA have denied WHT refund claims relating to Swiss dividends made by numerous Swiss banks and traders holding long positions on Swiss shares over dividend date and having short exposures to single stock futures and even, recently, SMI futures. They have denied the claims to refund irrespective of whether the banks and the traders entered into these transactions in the course of their ordinary business. The STA argue that Swiss banks and traders holding Swiss stocks, receiving the real dividend and having a short exposure on these shares under a single stock future (including SMI future) or any other delta one (or close to delta one) derivative(s) are not the beneficial owner of the shares and that these transactions are abusive from a domestic WHT perspective.

At the cross-border level, the STA have challenged claims to refund of WHT on Swiss dividends made, among others, by Danish, French, German, Italian, Luxembourg, UK, US financial institutions associated with swaps (irrespective of whether the swap is a price swap or a total return swap), securities lending transactions and single stock forwards and futures with Swiss stocks. As with the claims made at domestic level, the STA consider that the Danish, French, German, Italian, Luxembourg, UK and US entities are not the beneficial owner of the dividend and that the claims to refund are abusive from a Swiss treaty perspective.

The STA believe that certain banks and brokers abused their trust in the past and therefore view their actions regarding dividend stripping transactions as legitimate. It seems that the US Senate report on dividend abuse and their enquiries so far have further convinced them of this.

The STA decided to take the dividend stripping transactions to court.

On March 12 2012, the Federal Administrative Court (that is, the lower court) made its first decision in respect of perceived dividend stripping transactions. The Federal Administrative Court stated that a Danish bank, which held Swiss shares as a hedge for a short swap referring to the shares, can obtain a refund of the WHT under the Swiss-Danish treaty even if the payments under the swap include a large portion of the dividend amount. Specifically, the court confirmed that the Danish bank is the beneficial owner of the dividend income and the transaction (that is, the long position in Swiss shares and the swap) is not abusive within the context of the treaty.

The Federal Administrative Court confirmed this approach on July 23 2012 in the context of a Danish trader holding a long position in Swiss shares as a hedge for a short single stock future and index future referring to the shares. The court emphasised that the Danish entity was the beneficial owner of the Swiss dividends even if the trades had a short maturity (no details have been published as to what is meant by a short maturity) and denied the application of anti-avoidance provisions because the Danish entity had staff and carried out its business in Denmark from its own premises.

However, on March 13 2013, the Federal Administrative Court denied the refund of WHT on dividends to a Swiss bank which, shortly after the announcement of the dividend, acquired a large position in Swiss shares from UK brokers and on the same day entered into a single stock future with the same counterparties (trade settled on Eurex). The Federal Administrative Court concluded that the Swiss bank was not the beneficial owner of the shares and the transactions were considered abusive from a WHT perspective. The Swiss bank was not considered the beneficial owner of the shares, according to domestic WHT legislation, because the counterparties to the futures were the same counterparties to the shares and the transactions did not include any market and/or dividend risk. The claim to refund of WHT was considered abusive because the transactions (1) did not make sense from an economic perspective (the margin on the trade was too small), (2) were unusual as a result of the size and the nature of the counterparties (same counterparties) and (3) appeared only to be motivated by the WHT benefit (that is, 100% relief of WHT versus potentially 85% for the UK brokers, if entitled to).

The STA and the Swiss bank appealed these decisions to the Federal Court (the highest court in Switzerland). The Federal Court should make its decision shortly as the first appeal has been pending for two years and such a delay is extremely unusual in Switzerland. These decisions (especially the decision in respect of the Danish bank) are very significant in financial terms. We estimate that the pending claims to refund of WHT associated with perceived dividend stripping transactions amount to more than €2 billion.

The technical arguments of the STA to deny beneficial ownership at domestic and cross-border level are weak. Swiss tax regulations and the STA's own guidelines explicitly confirm that the holder of Swiss shares and the recipient of the real dividend is the beneficial owner of the shares even if they entered into a forward, a future or a securities lending (or repo) arrangement in respect of the shares. In addition, the Federal Administrative Court positively concluded that a financial institution is the beneficial owner of a Swiss dividend even if it enters into a derivative instrument with another counterparty (and not the same counterparty having sold the shares) and the financial institution makes a payment representative of the dividend under the derivative. This approach is in line with the latest comments on the "OECD Model Tax Convention concerning the meaning of beneficial ownership" discussion draft articles 10, 11, and 12.

The arguments of the STA to justify the application of the anti-avoidance provisions at the domestic level and in connection with Swiss treaty shopping at the cross-border level are also weak. The STA do not distinguish between legitimate commercial dividend transactions (including arbitrage) carried out during and outside the dividend season and perceived dividend stripping transactions such as the 2005 transactions of Bank A. In addition, the STA are seeking to apply the Swiss domestic anti-avoidance provisions in a treaty context where there is no technical basis to do so. Last but not least, the claimants hope that the Swiss Federal Court will also criticise the behaviour of the STA. Indeed, the STA do not have any right to require information from a taxpayer which shows a claim to refund of WHT is not related to perceived dividend stripping transactions. Indeed, the term 'dividend stripping transaction' has never been defined in Swiss tax regulations, the STA have never been able to define it and the STA – and not the taxpayer – have the burden of proof where they allege that a transaction is abusive for Swiss tax purposes.

In the meantime, it is unlikely that Swiss and foreign financial institutions with pending WHT refund claims will receive any refunds of WHT as the STA await the Federal Court decision.

Notwithstanding the large amount at risk, it is to be hoped that the Swiss Federal Court will confirm the first decisions of the Federal Administrative Court and reinforce the reputation of Switzerland and its legal system.

Charles Hermann Partner KPMG AG Tel: +41 58 249 29 82 Fax: +41 58 249 44 19 chermann@kpmg.com www.kpmg.com/ch Charles leads the financial services tax group in Switzerland, which provides tax services exclusively to banks, broker-dealers and asset managers. He has extensive experience in advising Swiss banks and asset managers on a wide range of tax issues. Charles is a frequent speaker at industry seminars on banking and capital markets tax issues. Charles' focus is on international and national corporate tax issues, transaction taxes, stamp taxes and Swiss value added tax issues in the financial service industry as well as addressing international questions relating to Swiss withholding tax, QI, FATCA, Swiss-UK and Swiss-Austrian Rubik agreements and the Swiss-EU agreement regarding the EU-savings directive.