Transfer pricing: Do Swiss safe harbour interest rates apply to all intra-group loans?

Switzerland does not have explicit transfer pricing rules, but the tax law makes reference to the fact that the OECD transfer pricing guidelines are respected. Though no specific documentation requirements exist, taxpayers may be requested, in the course of a Swiss tax audit, to provide further evidence on any transaction and demonstrate its arm's-length nature based on the Swiss corporate tax law. Transfer prices are, as in any other country, increasingly subject to review as part of any Swiss tax audit.

On intra-group loans a taxpayer needs to demonstrate, on the one side, the credit rating of the borrowing party and on the other side determine an arm's-length interest rate, taking into consideration the terms and maturity of such a loan based on the credit rating identified.

Like any intra-group transaction, intra-group loans in particular with regard to the interest rate applied must be at arm's length. Interest payments which are based on an arm's-length interest rate and whose underlying intra-group loan is accepted as debt for Swiss tax purposes, should generally be considered as an income-tax-deductible business expense.

If the interest rate applied on an intra-group loan is not at arm's length, this may lead to a taxable income adjustment at the level of the lender (if the interest rate applied is below the arm's-length interest rate on intra-group loan receivables) or at the level of the borrower (if the interest rate applied is more than the arm's length interest rate on intra-group loan payables).

And in case the interest rate applied on an intra-group loan is not at arm's length, the difference between the arm's-length interest and the interest effectively charged might be considered as a hidden dividend distribution, which might lead to Swiss withholding tax consequences of up to 53.8% (gross-up of 35%). Depending on the specific facts and circumstances and provided certain criteria are met the withholding tax might, however, be partially or fully reclaimed.

Based on the Swiss tax practice no Swiss issuance stamp tax consequences should arise on intra-group loans involving a Swiss company since hidden capital contributions related to interest payments on intra-group loans (even in case of interest free loans) should not be considered subject to Swiss issuance stamp tax.

To facilitate interest charges between related Swiss companies the Swiss Tax Administration (STA) issues in an annual circular letter so-called safe harbour interest rates for intra-group loans in Swiss francs as well as, in a separate circular letter, safe harbour interest rates for intra-group loans in foreign currencies. These safe harbour interest rates can be considered as maximum allowable (on loans payable) respectively minimum required (on loans receivable) interest rates for intra-group loans which are considered by the STA as arm's-length interest rates.

As per the latest circular letter issued by the STA on February 25 2013 for the year 2013 the maximum allowable interest expense safe harbour rate on Swiss francs intra-group loans payable for an operating company amounts to 3.75%. The same maximum interest rate is also acceptable for euro loans and dollar loans.

For intra-group loans receivable provided to another group company, the minimum required interest income safe harbour rate is 1.5% for Swiss franc loans and 1.75% for euro and dollar loans (if completely equity financed). If debt financed the minimum required interest income safe harbour rate for Swiss franc loans is the cost of the debt plus 0.5% for loans up to Sfr10 million ($10.7 million) and plus 0.25% for loans more than Sfr10 million subject to a minimum rate of 1.5%. If debt financed the minimum required interest income safe harbour rate for euro loans and dollar loans amounts to the cost of the debt plus 0.5% subject to a minimum rate of 1.75%.

The annual circular letter published by the STA about foreign loans explicitly states that the taxpayer may apply a higher interest rate than the safe harbour rate if he can prove that the applied interest rate meets the arm's-length standard. Based on practical experience this practice should also apply for intra-group loans in Swiss francs. This, on the contrary, means that there is generally no legal duty for the taxpayer to apply the published safe harbour rates on intra-group loans. However, applying the above outlined safe harbour rates on intra-group loans, the taxpayer receives certainty that the interest charged by a Swiss company and/or to a Swiss company is accepted by the STA and should generally not lead to adverse Swiss tax consequences (if the Swiss entity is not thinly capitalised and that the finance arrangement is not considered as tax evasive).

From a transfer pricing perspective the interest rates applied for cross-border intra-group loans need to meet the arm's-length consideration at both ends of a financing transaction. The Swiss safe harbour rates neither consider the credit rating of the borrower nor the duration and terms of a loan. Particularly since the recent financial crisis the credit spreads between the different ratings have increased significantly. The financial markets are also far more volatile than in the past, a fact which can hardly be reflected with safe harbour interest rates published annually.

Compared to the past, the gap between the arm's-length interest rates and the safe harbour rates has increased substantially which leads to inappropriate and unjustified results for the taxpayers with intra-group cross-border financing.

Due to this mismatch, applying the Swiss safe harbour interest rates for cross-border intra-group financing transactions would probably result in a classical double taxation case. Such a double taxation might in most instances only be eliminated by initiating a mutual agreement procedure between Switzerland and the other country involved. This is, however, typically a long lasting and costly procedure for the taxpayer.

So, for cross-border intra-group loan agreements between a Swiss company and its foreign related counterparty the application of the safe harbour rates is in most cases, however, not a feasible solution.

For an intra-group loan between two Swiss-based companies the application of the safe harbour interest rates might in most cases still be the most practical approach since the safe harbour rates are accepted by the STA for both the lender as well as the borrower. On the other hand, also in a Swiss-Swiss financing arrangement, a taxpayer may still be able to apply market rates instead of the safe harbour rates in case he is prepared to demonstrate the arm's-length nature of the transaction.

A taxpayer should evaluate the most practical solution considering the specific case. Particularly for an intra-Swiss financing arrangement he has the option of applying the safe harbour interest rates, whereas for cross-border financing transactions the safe harbour rates will often not be a feasible alternative.

To identify an arm's-length interest rate it is important to understand first of all the rationale and the financial status of the borrowing group entity. Based on this knowledge the credit rating, which serves as a basis for the appropriate lending rates for the loan between the related parties, needs to be determined. In the literature two approaches exist on how to determine a credit rating.

The most common approach is the single-entity approach where, based on his financial status, a rating for the borrower is being determined. An alternative approach is to determine the interest rate based on the overall group credit rating. This approach is used less often, particularly since the interest spreads even for minor gaps in the credit rating may already have a significant impact on the arm's-length interest rate. And a third-party lender would not grant a group entity a credit facility based on the overall group credit rating unless the parent company would issue an explicit guarantee.

Credit ratings for individual group entities can be obtained relatively quickly through rating tools offered by all major rating agencies.

Once the rating has been defined, the base interest rate as well as a market-based interest spread reflecting the terms and conditions as well as the rating and the duration of the loan needs to be identified. For documentation purposes it is essential that such rates are documented, for example, based on copies of the screenshots quoted by financial news providers at the time such a loan is granted.

The exercise is more challenging where interest rate spreads for so called non-investment grades (BB- or lower) need to be identified. Such data is not readily available from online financial news portals. In this case it is necessary to resort to financial simulation techniques such as linear extrapolation or a regression analysis to identify reliable market-based interest spreads which withhold the scrutiny of any future tax audit.

Since intra-group loans on a cross-border basis need to meet the arm's-length requirements for both the borrower as well as the lender, the likelihood that either of the two parties resides in a country with explicit transfer pricing documentation requirements is high. For this purpose it is recommended that a proper interest rate report is prepared, covering the business rationale, describing the parties to the agreement and the terms and conditions of the loan.

The report is then expanded with the details of the credit rating as well as with the screenshots of the interest rates / interest rate spreads identified at the moment the loan has been granted. In case any further analysis or extrapolation has been made, then it is essential that such analysis is also comprehensively covered as part of the documentation.

Based on practical experience the STA are familiar with this approach, and on the basis of such supportive transfer pricing documentation, accept cross-border interest payments between related parties, whether outbound or inbound. The STA knows the Swiss safe harbour interest rates have some shortcomings when dealing with cross-border intra-group financing. For this reason they accept the taxpayers granting such loans / financing at actual market conditions if the taxpayer can underpin the arm's-length nature, and in particular the interest rate applied, with proper documentation. It is also possible to confirm the applied approach and the respective Swiss tax consequences in advance with the STA through a binding tax ruling request.

Hans Rudolf Habermacher
		Deloitte, Switzerland Tel: +41 (0)58 279 63 27 Email: hhabermacher@deloitte.ch Hans Rudolf Habermacher has extensive experience in transfer pricing and is the partner leading the Deloitte TP practice in Switzerland. As part of his work he is advising clients among others in the trading and financial sectors.

Diego Weder
		Deloitte, Switzerland Tel: +41 (0)58 279 63 43 Email: dweder@deloitte.ch Diego Weder is a senior manager at Deloitte in Switzerland in the international corporate tax group. He has significant experience in the area of M&A and business reorganisations including establishing tax-efficient finance structures.