The 50/50 Practice in Switzerland

For many years, international corporations set up so-called Swiss reinvoicing companies, taking advantage of Switzerland's treaty network and its favorable taxation schemes. Due to their foreign activities (i.e., the fact that the majority of their income was foreign-sourced), they were granted tax privileges on the cantonal/communal level. No taxation privilege, however, was granted on the federal income tax level, with its rate of 8.5% on income after tax.

Such companies were regularly taxed as domiciliary or mixed companies. Domiciliary companies are generally not allowed to be active in Switzerland (i.e., no personnel or offices in Switzerland). Domiciliary companies are fully exempt from cantonal/communal income tax. As a result, the effective income tax burden is 7.8% federal income tax on pre-tax income.

Mixed companies, on the other hand, can have offices and employees in Switzerland. However, the volume of Swiss domestic transactions is limited. In other words, the income must generally be foreign-sourced. The foreign-source income of a mixed company (depending on the canton of residence) is exempt from cantonal/communal income up to a 90% level. As a result, the effective income tax burden, including federal income taxes, is 9–11% on pre-tax income.

In addition to the cantonal/communal privileges, the Swiss Federal Tax Administration (SFTA) has regularly accepted a lump-sum expense deduction on certain business activities (reinvoicing in particular). Such lump-sum expense is known as "50/50 practice." The 50/50 practice is applicable not only for federal income taxes, but also for Swiss withholding taxes on profit distribution (and in some cases for cantonal/communal income taxes as well).

In principal, the 50/50 practice allows 50% of the gross margin to be paid as commission to affiliates or third parties without economic justification. Nevertheless, it is worthwhile mentioning that the SFTA does not consider the 50/50 practice as a tax incentive, but an administrative measure to determine the tax base. Because some terms were rather vague and usually required an advance ruling, the SFTA recently issued a circular to confirm the application of the 50/50 practice. However, it does not want these regulations to be considered safe-haven rules, although, for practical purposes, payments up to 50% of the gross margin (whether justified or not) are treated as deductible expenses. Whether a company is eligible for the 50/50 practice is still subject to negotiations with the SFTA.

How to Benefit from the 50/50 Practice

Bascially, foreign business activities must be in the interest of non-Swiss persons (e.g., companies and individuals). For example, non-Swiss persons must decide crucial business elements (such as products, price, marketing and sales strategies).

Generally, the 50/50 practice will be granted only if the Swiss company does not maintain a substantial infrastructure within Switzerland (such as large premises, significant number of personnel, etc.).

The Swiss company may be owned by Swiss or non-Swiss persons or both.

If the Swiss company pays in excess of 50% of its gross margin, the excess might be considered a constructive dividend paid to the recipient of the remittance. If the 35% Swiss withholding tax cannot be charged to the recipient, the Swiss company must pay a tax-adjusted withholding amount of 53.8% of the constructive dividend to the SFTA.

From the remaining 50% gross profit, only nominal amounts (for bookkeeping, board member fees, audit fees or all Swiss income and capital taxes) may be paid as deductible expenses.

The 50/50 practice may also be used by companies that have, in addition to "privileged" foreign activities, ordinary Swiss business activities. Of course, the 50/50 practice is only applicable to income generated by the company's foreign activities.

Generally, mutual assistance in criminal tax fraud matters is not reduced or limited by application of the 50/50 practice.

Finally, the 50/50 practice is, indeed, only a compromise; companies that do not accept such practice must justify all their expenses to be deductible.

Use of 50/50 Practice for Service and IP Activities

Service companies. In general, the 50/50 practice is also available for service companies. The acceptance of service fees paid requires that:

• The beneficiary must have rendered actual services at arm's length.
• Service fees may be paid only through the official—direct—routing to the beneficiary, and not to any corporation domiciled (or even bank accounts) in tax haven countries.
• If paid to a corporation, the ultimate beneficiary/individual must be disclosed with his residence.
• The service fees received by the Swiss company must be scrutinized as well, to avoid unjustified profit transfers from abroad to Switzerland.

When a Swiss service company has its own personnel and a significant infrastructure in Switzerland, the 50/50 practice does not apply. Such companies will be taxed on a cost-plus 5% method.

IP companies and branches. The SFTA accepts (both for federal income and withholding tax purposes) a lump-sum deduction of up to 80% for payments in connection with intellectual property (IP), including amortization of IP assets. According to a 1998 circular, which relaxed somewhat the stringent 1962 Swiss internal decree against the abuse of double-tax treaties, the old 50% maximum is raised to 80% without being regarded as base erosion, as long as the Swiss company meets an active-company test. Such test requires a profit-oriented operation through a company's own employees, conducted on the company's own premises. However, four double-tax treaties (i.e., with Germany, France, Italy and Belgium) still stipulate that only 50% of treaty-favored gross income may be paid to residents outside Switzerland.

To avoid the crucial issue of Swiss withholding tax on disallowed expenses, which are treated as hidden profit distributions or constructive dividends, the concept of a Swiss Intellectual Property Branch may solve the problem. Profit repatriations from a Swiss branch to its foreign head office are not subject to any Swiss withholding, nor are they eligible for any Swiss treaty benefits. As a result, they do not fall under the Swiss misuse decree or under any tax treaty provisions; thus, the 80% deduction should, in principle, be achievable. Further, provided the country where the head office is located entirely or almost entirely provides a tax exemption to the Swiss branch income, the overall tax burden is highly attractive.

Conclusion

In addition to Switzerland's international business environment and its highly sophisticated labor force, a multinational group may also take advantage of an extended treaty network and very competitive rates of taxation on foreign-sourced income, enhanced by the 50/50 practice and the 80% practice for IP structures, reducing the tax base and consequently the overall tax burden further. Properly structured, the 50/50 practice is an effective measure to ensure a low overall income tax burden or at least a significant income tax deferral.

From Hans-Juerg Schmid, CPA, Head International Tax Group, OBT AG, St. Gallen, Switzerland