Withholding tax: Decision on “beneficial ownership” in refunds based on a double tax treaty

Recent decision of the Swiss Federal Supreme Court 

The case (Federal Supreme Court ruling 9C_635/2023) revolved around the refund of Swiss withholding tax on interest from two Swiss federal bonds to a Danish financial institution. The institution had excess liquidity in USD and, as part of its investment strategy, purchased the bonds. To finance the purchase, the amount was converted from USD to CHF, creating a foreign exchange risk in CHF. To mitigate this risk, the institution concluded cross-currency rate swaps with investment banks, aligning the conditions and maturities of the swaps with those of the bonds. The institution applied for a refund of the withholding tax, invoking the Switzerland-Denmark Double Taxation Agreement (DTA CH-DK), which grants Denmark the exclusive right to tax the interest. 

However, the Swiss Federal Tax Administration (SFTA) and the Federal Administrative Court (ruling A-2121/2020) denied the refund claim. Although the institution was domiciled in Denmark, it was not considered the “beneficial owner” of the interest income. The mechanism of the cross-currency rate swaps, according to both authorities, led to a loss of beneficial ownership, thereby disqualifying the institution from the treaty benefits. 

Beneficial ownership criterion is met 

Under the DTA CH-DK, the “effective beneficial ownership” of the underlying interest is a prerequisite for claiming a refund of Swiss withholding tax. A beneficial owner is defined as the party entitled to dispose of the interest and use it without restriction. If the recipient is contractually or legally obliged to pass on the income to an ineligible third party, they lose their beneficial ownership. A payment obligation of the income recipient is considered a harmful forwarding of the income, if the payment (or its amount) depends on whether the recipient receives the income. 

The Swiss Federal Supreme Court concluded that, in this case, the financial institution would have been required to make payments to its counterparties under the cross-currency rate swaps even if the Swiss Confederation had failed to meet its interest obligations on the bonds. By bearing the default risk, the financial institution’s payment obligations under the swaps did not constitute harmful forwarding obligations. This distinction is critical, especially compared to total return swaps and similar transactions, where the recipient’s payment obligations cease when the income subject to withholding tax is not received. 

Potential treaty abuse? 

The Court further clarified that Switzerland is not internationally obligated to grant withholding tax relief automatically, even if the beneficial ownership criterion is met under the treaty. Relief may be denied in cases of treaty abuse. Treaty abuse arises when the treaty benefits are indirectly enjoyed by a party not entitled to them and when, under the principle of good faith, Switzerland would not grant such relief to a domestic taxpayer in a comparable situation. According to Swiss tax law, such relief would typically be denied in case of tax avoidance. Based on domestic law, tax avoidance occurs when: 

1. the chosen legal arrangement is unusual, inappropriate, or peculiar; 
2. it can be assumed that the arrangement was established solely for the purpose of saving tax, and 
3. the chosen arrangement would actually lead to a significant tax saving. 

In the present case, the question of treaty abuse was referred to the Federal Administrative Court for further evaluation. 

Implications for practice 

The Swiss Federal Supreme Court’s ruling is to be welcomed and in particular clarifies that a dividend or interest recipient does not automatically lose the right of use and thus the DTA benefits in the event of swap transactions. It is clear that the right of use and the question of possible treaty abuse are two separate issues that must be assessed independently of each other. In this specific case, it remains to be seen whether the refund will actually be granted, as the Federal Administrative Court still has to examine whether there is an abuse of the agreement. 

Based on the Court’s reasoning, withholding tax refunds on Swiss securities should generally be possible in the future, provided that the recipient in the DTA jurisdiction assumes the corresponding default risk on the securities and that the acquisition of the securities is not purely tax driven. 

For investors in Swiss securities, it is advisable to assess potential tax risks before concluding swap or similar transactions with these securities. The ruling provides important information on the circumstances under which treaty benefits can be denied. 

Article written by André Kuhn, Yann Waeber, Dominique Roggo and Grégory Sarbach