The Swiss Federal Supreme Court published the written reasons for judgement for the two Swiss withholding tax refund lead cases concerning Danish banks involved in derivative transactions over dividend ex-dates with Swiss equities on 28 October 2015. The two cases were previously discussed in a public hearing at the beginning of May. The Swiss Federal Supreme Court has ruled in favour of the Federal Tax Authority (FTA) in both cases and has overruled the previous decisions taken by the Federal Administrative Court.
The cases under scrutiny
In the first case, a Danish bank entered into several total return swap transactions with counterparties in the EU and the US relating to Swiss equites. To hedge the exposure from the total return swaps, the Danish bank bought the necessary Swiss equities from various parties. Upon the maturity of the total return swaps, the shares were sold to parties other than those from whom the bank had previously sourced the shares. Under the swaps the Danish bank had to pay an amount equivalent to the dividend received to the counterparty.
The second case relates to a Danish subsidiary of a Swedish bank that entered into derivative transactions by selling (OTC) SMI futures through EUREX and a broker, and who had hedged this short position by buying the SMI components from a different platform/broker. Both legs of the transactions were executed on 19 February 2007. Upon the maturity of the SMI futures on 15 March 2007, the derivative position was rolled into further SMI future contracts with an expiry of 15 June 2007. Upon expiry in June, the SMI futures position was closed and the long position in SMI components was also sold.
In both cases, dividends received during the maturity of the trade were subject to 35% Swiss withholding tax for which a full refund was claimed under the former Danish-Swiss double tax treaty (the current amended treaty only provides for a partial refund on portfolio holdings). For both cases, the FTA had denied the refund of Swiss withholding tax and was then overruled in the Federal Administrative Court.
Reasons for judgement of the Swiss Federal Supreme Court
The Swiss Federal Supreme Court analysed whether the notion of beneficial ownership was a requirement for Swiss withholding tax refund under the Danish-Swiss double tax treaty as the Federal Administrative Court did not analyse this notion in its appealed decisions. In application of the Swiss Federal Supreme Court’s practice, the interpretation of double tax treaties has to be based on international law and its inherent practice, in particular on the Vienna Convention on the Law of Treaties and the principle of good faith. In its analysis, the Swiss Federal Supreme Court has ruled that the requirement of beneficial ownership is implicitly demanded for the refund of Swiss withholding tax even if such a definition is not explicitly contained in the wording of the relevant treaty, which is aligned with the domestic interpretation of the two treaty countries in the case at hand.
The Swiss Federal Supreme Court defines beneficial owner as a person who has the power of disposition over the dividend income. This is the case, if and when a person having the beneficial use can utilise the dividend without any legal, contractual or factual obligation leading to a limitation of this right to use. According to the Swiss Federal Supreme Court, an actual limitation of beneficial ownership is a given if the following two conditions are met cumulatively: (i) the achievement of the income is dependent on an obligation to forward such income, and (ii) the obligation to forward the income must depend upon the achievement of that income. The Swiss Federal Supreme court states that such an obligation to forward income may be based on a (direct) legal obligation or on the basis of all the facts and circumstance of the case, i.e. by applying a substance over form approach.
In the swap case and by applying the above definition of beneficial ownership and considering the overall facts and circumstances of the case, the Federal Supreme Court came to the conclusion that the Danish bank had given up its beneficial ownership of the dividend payment when entering into the swap transaction. The main arguments used were:
- The hedging with Swiss equities was carried out immediately after entering into the derivative liability with a full hedge (of dividends and positive price changes of the underlying components)
- By entering into the swap transaction the Danish bank was able to fund the transaction with debt
- The Danish bank did not bear any (meaningful) risks from the transaction and generated only a risk free return amounting to the interest on the swap transaction as the dividends were transferred under the swap agreement to the counterparties.
Against this background the Federal Supreme Court decided that there was a clear interdependence between the purchase of the underlying equities and the derivative, which led to a giving up of beneficial ownership. This ownership was given up at the moment in time where the funds received as dividends were paid out to the counterparty of the swap agreement as there was, in the view of the Swiss Supreme Court, an on-payment obligation under the total return swap agreements entered into by the Danish bank. Further to this obligation, the bank was no longer in a position to freely dispose of the dividend proceeds received and, in addition, entering into the total return swap put the bank in the position of being fully relieved from any risk associated to the underlying long position in Swiss equities.
In the SMI futures case the Federal Supreme Court also argued that beneficial ownership was lacking by relying on the interdependency principle laid out above. However, as the facts and circumstances of the SMI case were clarified in less detail by the FTA, in some instances due to a lack of cooperation from the taxpayer, the judges based their decision on factual indicia as well. Beneficial ownership was denied with the following arguments:
- The large volume of the single transaction (3.7 billion CHF) being substantially more than the ordinary average daily trading volume at the stock exchanges involved, the use of brokers and the limited number of parties involved and the short term of the transaction were used as indicia that the transaction must have been agreed amongst known counterparties and that hence the transaction must have been of a circular nature
- Only a small portion of the dividend income (between 0.04% and 0.06% of the overall transactional volume, respectively between 6.6% and 9% of the dividend income) was retained by the Danish bank. The fact that a portion of the dividend income was retained is not sufficient to prove that no harmful transfer on of dividend income occurred in the case at hand.
- The Swiss Federal Supreme Court challenged the Danish bank’s ability to act independently as the Swedish parent company had fully debt funded the transaction; the court was of the opinion that the interest paid on the funding led to a partial transfer of dividend income to the Swedish parent, which would have benefitted from a less attractive double tax treaty if the latter had held the Swiss equities
- A harmful transfer of dividends occurred via the purchase and sales price of the underlying SMI components where the relevant prices were bilaterally agreed with the broker involved acting as a principal for the Danish bank. As the purchase and sales prices were not set in standardised and anonymous transactions, but rather in a specific, tailor-made single transaction, the Swiss Federal Supreme Court assumed, on the basis of the indicia of the case, that prices were set in order to transfer the dividend income to the broker. The court also concluded that similar agreements must have been in place between the broker and its counterparties originally providing the SMI components to the broker.
- The Danish bank’s refusal to disclose the counterparties of the broker was interpreted by the Swiss Federal Supreme Court as a violation of its information-sharing and cooperation duty even if the foreign country’s legal system does prohibit such a sharing of information. Although the court acknowledged that the Danish bank cannot be requested to infringe foreign law, it must face the legal consequence of such a missed disclosure of useful and reasonable information in the specific case. This because the Swiss Federal Tax Administration had various valid reasons to believe that the transaction was structured as a circular-like transaction between related parties. Because of this specific transaction structure, the Danish bank has an increased duty of disclosure and cannot just rely on the professional secrecy of the broker. The Supreme Court also concluded that the only reason for routing the transactions through a broker and for incurring the additional costs was to avoid the disclosure of the identity of the counterparty.
The majority of the judges of the Swiss Federal Supreme Court concluded that there was sufficient evidence to conclude that the bank had given up the beneficial ownership and had to forward the dividend proceeds, which were partially up-front priced in the sold OTC SMI futures.
Appraisal of the decisions
The Swiss Supreme Court has now issued two guiding decisions with regard to the question of beneficial ownership, which will have an important impact on the numerous other cases which are pending with the Swiss courts and the FTA. Both decisions were based on the notion of beneficial ownership in a double tax treaty environment and the Swiss Federal Supreme Court has clarified its view on how beneficial ownership in the double tax treaty with Denmark shall be defined from a Swiss perspective. Whereas the swap decision is substantially based on this beneficial ownership notion, the SMI futures decision does not seem to follow this notion totally as the Swiss Federal Supreme Court based its decision on conclusive indicia that were not fully evidenced by the FTA and that were not rebutted by the Danish bank.
In particular the following points were not addressed in the two decisions and may lead to a different assessment of an individual case:
- How do “imperfect” hedges, i.e. non delta one, impact the question regarding beneficial ownership?
- If the party holding Swiss equities as a long position is not the beneficial owner of the dividend, who is entitled to a refund (e.g. the counterpart of the derivative)?
- If the long position in Swiss equities is not acquired before the dividend ex-date and is not sold after the dividend season, but hedged as a long term investment, would the court come to a different decision?
The two published decisions made it clear, that each case should still be analysed on the basis of its individual facts and circumstances and that the outcome may vary depending on the basis of the underlying facts and circumstances. The currently defined notion of beneficial ownership in a treaty context needs to be considered for those double tax treaties that do not embed a separate definition of beneficial ownership. Pending claims, as well as new derivative transactions that may give rise to a Swiss withholding tax refund claim, should be carefully evaluated on the basis of the recent decisions of the Swiss Federal Supreme Court.