A Danish financial institution ("FinCo") holds CHF 250 million in a bond issued by the Swiss Confederation. The Swiss Federal Administrative Court ("FAC") has now confirmed that FinCo is not entitled to a refund of the 35% withholding tax on the coupons of this bond because it has simultaneously entered into a cross-currency swap with a counterparty in the market.
This decision means that an investor in a Swiss bond (such as FinCo) cannot convert an exposure in Swiss francs into another currency (or equally a fixed interest rate into a floating interest rate), without losing the entire 35% Swiss withholding tax on the interest generated by the bond. The loss of 35% of the interest means that FinCo, like any other domestic or foreign investor, will in the future refrain from investing in Swiss bonds whenever it considers managing currency risk and/or converting fixed interest streams into floating ones. Investors (even small Swiss cantonal banks or pension funds) will therefore think twice about buying Swiss bonds. How could this situation come about and what should be done?
To be or not to be the beneficial owner?
The holder of a Swiss bond can obtain a refund of the 35% withholding tax on the interest if, among other things, it is the beneficial owner of the interest income. Originally, the beneficial owner of an income was the person who had legal control over the security and its income.
Over the last 15 years, the Swiss courts have changed the interpretation of this concept. They have abandoned the legal approach and adopted an economic view of the term beneficial owner. This economic dimension has recently been extended to cover financial flows almost independently of the legal position. Thus, today, any holder of a Swiss share or bond (following the FAC decision) can no longer obtain any refund of the withholding tax and thus receives only 65% of the dividend or coupon if the investor hedges most of the risk of the security with derivatives or, specifically for a bond, a cross-currency swap.
The FAC decision is based on the recent case law of the Federal Supreme Court developed in the context of several perceived "dividend stripping" cases. The FAC looked only at the financial flows and considered that FinCo "transferred" the amount of the coupons on the government bonds to the counterparty of the cross-currency swap. In doing so, the FAC ignored the risks and economic circumstances of the transaction and "forgot" about all of the important differences between bonds and shares.
A bond is a fully substitutable security; a share is not. Unlike a dividend, a coupon on a bond is due and paid on a pro-rated basis and the accrued interest is not subject to withholding tax. A cross-currency and/or interest rate swap changes only the payment streams, whereas a total return swap converts the entire performance of a security. In this respect, the fact that the Swiss government's default risk is virtually zero is irrelevant. This is because the definition of the term ‘beneficial owner’ does not depend on the level of default risk of a bond’s issuer.
Financing costs rise – an example
“Romandie SA" has granted a loan of EUR 50 million to its German subsidiary. The CFO of Romandie SA wishes to refinance this loan and contacts his Swiss bank to obtain EUR 50 million in financing. The financing proposed by the bank is considered as a bond from a withholding tax perspective in certain cases. As a result, Romandie SA has to account for and pay 35% withholding tax on the interest paid to the bank. Based on the FAC decision, the Swiss bank can only receive 65% of the interest paid by Romandie SA if the bank manages its financial risk and enters into a cross-currency swap to convert the EUR flow into CHF. In practice, no one will be able to obtain the 35% withholding tax on the interest of this financing. So, all other things being equal, the Swiss bank will be forced to increase the funding costs by 35% so as to maintain its margin, for the simple reason that the bank is managing its risks and liquidity in a relevant and legitimate way, both from an economic and a regulatory point of view.
We submitted FinCo's case to Bard, Google's artificial intelligence system. Bard confirmed to us that "FinCo is the beneficial owner of the interest from the government bond" even if FinCo had entered into a cross-currency swap. This is because "FinCo keeps control and retains all of its rights; the swap counterparty has no rights to the interest income or the bond." FinCo had to wait over three years for a 45-page decision from the FAC and pay CHF 32,500 in fees to the FAC.
FinCo has lodged an appeal against this decision with the Swiss Federal Supreme Court.