Swiss principal companies have long benefited from the rules of Swiss Federal Tax Administration (SFTA) Circular 8 (2001). On 6 March 2015, the SFTA confirmed in an official letter to the cantonal tax authorities (see enclosure) that it has adopted new interpretations of circular 8 that vary from those the SFTA issued in January 2014. Circular 8 remains applicable for existing and new principal companies, with the following modified interpretations effective as from financial year 2016 for existing and immediate effect for new principal companies.
- Substance: Principal companies applying Circular 8 must prove sufficient substance in Switzerland. Also when a company meets the overall principal company qualification outsourcing of core principal functions now needs to be reviewed as it may result in an adjustment of the principal tax allocation.
- Exclusivity test for limited-risk distributors (LRDs) or commissionaires: LRDs and commissionaires must perform limited-risk distribution ‘exclusively’ for Swiss or other group principals. Exclusivity means that at least 90% of the net profit of the distribution company is derived from LRD activities. There will be an available grace period through the beginning of Corporate Tax Reform III — which is not expected to enter into force until 2018-2020 — for existing distributor companies that do not meet the 90% exclusivity test and cannot be restructured in a timely manner to meet the exclusivity test due to legal and operational constraints.
- Margin test: The principal tax allocation calculation must be adjusted if gross margin/compensation of the LRD or commissionaire exceeds 3%. Companies that cannot meet the 3% gross margin test can use a ‘fall-back’ test that considers the ‘higher costs’ of distributor companies, which now include a 5% mark-up on the higher costs. If the effective LRD remuneration exceeds the new margin test, a respective adjustment to the principal allocation under circular 8 has to be considered.
Modified exclusivity test
Only distribution companies that exclusively or almost exclusively act as LRDs or commissionaires qualify for principal allocation. To meet the test, at least 90% of the net profit of the distribution company must originate from the limited-risk distribution activity for the Swiss or other group principal. This requirement must be met by each distribution company on a stand-alone basis. A ‘short-term’ violation of the 90% rule will not be disqualifying. Based on recent confirmations from the SFTA, the test can be performed on the basis of local GAAP financial statements or management accounts (e.g. IFRS or US GAAP). This test applies to all principal companies that have obtained a new ruling since 2014 or that apply for principal company treatment for the first time.
Existing (pre-2014) principal companies whose distributors do not fully meet the 90% test will be granted a grace period to restructure their distribution companies. The SFTA has confirmed that the exclusivity rule will not be enforced with respect to existing companies when:
- The distribution companies will not meet the 90% test.
- Restructuring under local commercial law cannot be achieved within a reasonable period (i.e., before Corporate Tax Reform III comes into force in 2018-2020).
- The burden of proof lies with the principal companies.
Modified margin test
Distribution margin affects the principal allocation level under Circular 8 as follows:
Maximum compensation for distribution companies will be the higher of 3% of gross revenues or the higher costs of the distribution companies plus a mark-up of 5% on those costs. If a distributor company also performs non-distribution activities, separate divisional accounts must be provided. Based on the SFTA letter, qualifying costs for the mark-up will include the distributor’s ‘own’ operating costs as well as taxes of the qualifying distribution companies. Third-party costs will not qualify for the mark-up.
Observation: In practice, some uncertainty remains regarding which costs are seen as ‘own’ costs versus ‘third-party’ costs. The SFTA indicates that the cantonal tax authorities should give some flexibility to simplify the cost basis identification and act in favor of the tax payer for such assessment of the cost base.
If effective compensation of the distributors exceeds total permissible compensation, the excess compensation must reduce the principal allocation on the principal company’s tax return, although the 50% deduction under the principal allocation rules will apply. As previously announced, the margin test will be applied in average taking into account all qualifying distributors.
The modified rule will take effect for tax year 2016. Rulings concluded since 2014 under the 2014 rules can be amended to include the cost plus test but apply immediately.
Example of the modified margin test:
Consolidated LRD Basis
|Profit before tax
|Profit after tax
Margin Test Calculation
|Effective gross margin:
||(30% of 1’000)
|Permitted gross margin:
||(3% of 1’000)
||(270 operating expenses + 10 taxes)
|Higher costs + 5%:
||(280 * 1.05; assuming all costs qualify as “own” costs)
||(300 effective gross margin ./. 294 higher costs+5%)
Impact on Principal Allocation
|Reduction of principal allocation on principal tax return level:
||(50% of difference)
The head of the SFTA confirmed in a recent meeting that the outsourcing of support or auxiliary functions to shared service centers and similar facilities will not lead to a reduction of the principal profit allocation. (This point was not included in the new letter.) If core principal functions are outsourced, this will still lead to an adjustment of the profit allocation provided overall principal substance in Switzerland is otherwise sufficient. In the case of potential outsourcing of core principal functions, the taxpayer must present its case to the SFTA for resolution.
Existing Swiss principal companies may need to review their positions with respect to the modified interpretation that will take effect in 2016. The SFTA has indicated there will be some leeway during the transition to the new interpretation. Newly established principal companies must take the new interpretations into account immediately.
Switzerland remains an attractive principal location considering its operational business environment. The upcoming Swiss Corporate Tax Reform III is expected to add new measures to maintain the country’s attractiveness.
For a deeper understanding of how these issues might affect your business, please reach out to one of the PwC professionals listed below, or your local Swiss contact: