Benedikt Maurenbrecher, Dieter Grünblatt and Stefan Kramer of Homburger discuss the Swiss taxation system’s impact on the issuance of covered bonds at an international level

According to the European Covered Bond Council's definition, covered bonds are secured debt instruments which meet three criteria. First, the issuer or the guarantor of the debt instrument is a prudentially regulated credit institute (a bank). Second, the debt instruments are secured by a cover pool of mortgage loans (property as collateral) or public-sector debt to which investors have a preferential claim in the event of default. Third, the bank has a continuing obligation to provide a sufficient amount of assets to the cover pool in order to be able to satisfy the claims of the covered bond investors, and compliance with such obligation is subject to supervision by a public authority or independent third party. In Switzerland, there are two different legal concepts which correspond to this definition.

Structure Of Swiss Pfandbriefe

Swiss Pfandbriefe

On the one hand, in 1931, the Swiss legislator created the Swiss Pfandbrief system by enacting the Federal Pfandbrief Act (Pfandbriefgesetz, or PfG), complemented by a respective ordinance (Pfandbriefverordnung, or PfV). The PfG provides for explicit regulations regarding all key elements of the Pfandbrief system, such as the institutions authorised to issue instruments under the PfG, the structure and valuation of the cover pool, and certain insolvency-related issues. Accordingly, the instruments issued in accordance with the PfG – the Swiss Pfandbriefe – could be qualified as statutory covered bonds. The term Pfandbriefe is, however, widely recognised and protected by law and it is rather unusual to use the term covered bonds when describing the Swiss Pfandbriefe. According to the PfG, only two institutions are authorised to issue Pfandbriefe in Switzerland, namely the Pfandbriefzentrale der schweizerischen Kantonalbanken (PBZ), a vehicle issuing Pfandbriefe for the Swiss cantonal banks and the Pfandbriefbank schweizerischer Hypothekarinstitute (PBB), a vehicle issuing Pfandbriefe for all other Swiss banks. Both institutions are supervised by the Swiss Financial Market Supervisory Authority (Finma). The issuance of Swiss Pfandbriefe aims at financing the mortgage business of the member banks. PBZ and PBB use the proceeds from the issuance of Pfandbriefe to grant loans to their member banks, which allow the member banks to enter into long-term mortgage loan agreements with real-estate owners.

Structured covered bonds

Under Swiss law, on the other hand, the concept of freedom of contract allows an issuer to structure a covered bond programme based on contractual agreements with investors and other persons or institutions to be involved in the transactions. Instruments issued under such contractual agreements qualify as structured covered bonds. The avenue of structured covered bonds has only recently been explored in Switzerland, when first UBS (in 2009) and then Credit Suisse (in 2010) established their respective covered bond programmes. The key elements of covered bond structures are as follows: the Swiss bank, acting through a non-Swiss branch, issues covered bonds as direct, unconditional and unsubordinated obligations of the issuer. The obligations of the issuer under the covered bonds benefit from a guarantee issued by a subsidiary of the issuer (mortgage SPV) under a so-called guarantee mandate agreement in favour of the holders of covered bonds, represented by the bond trustee. Under the guarantee mandate agreement, all liabilities, costs and expenses incurred by the guarantor under or in connection with the guarantee will have to be reimbursed (or pre-funded accordingly), by the issuer. As security for the relevant reimbursement and pre-funding claims of the guarantor, the Swiss bank transfers a pool of mortgage loans, together with the related mortgage security, to the mortgage SPV. Accordingly, if the issuer defaulted under the covered bonds and the guarantee was to be drawn, the mortgage SPV could claim for coverage by the issuer under the guarantee mandate agreement. Failure by the issuer to pre-fund the payments lowered under the guarantee would allow the mortgage SPV to enforce in the cover pool and to use the proceeds to satisfy its payment obligations under the guarantee.

The cover assets mainly consist of Swiss mortgage loans granted by the issuing bank to Swiss domestic individuals and the respective mortgage certificates securing such loans. Additionally, cash and other qualifying substitute assets may be part of the cover pool. The structure of Swiss structured covered bonds is unique. It is to some extent driven by the Swiss tax law considerations, as well as legal, regulatory, and insolvency law considerations.

Swiss versus international capital markets

Under taxation legislation, interest paid on covered bonds by a Swiss issuer may be subject to Swiss withholding tax. While Swiss investors are used to Swiss withholding tax, experience shows that there is only a limited market outside Switzerland for debt instruments subject to the tax. Covered bonds issued to investors outside Switzerland must therefore be issued under a structure which allows the issuer to make interest payments on covered bonds free of Swiss withholding tax.

If covered bonds are secured by a mortgage over real property situated in Switzerland, an additional Swiss federal, cantonal, and communal income tax applies, but only if the interest payment is made to a beneficiary outside Switzerland. Therefore, identical to the situation in respect of Swiss withholding tax, it is important that interest payments on covered bonds issued to investors outside Switzerland should be possible without such taxes being applicable.

The Swiss withholding tax and the special income tax bifurcate the market for covered bonds. Swiss Pfandbriefe issued by PBB and PBZ are subject to Swiss withholding tax and, potentially, the special income tax. They therefore mainly attract Swiss retail and institutional investors. The structure of covered bonds issued by Swiss banks allows them to make interest payments in respect of the covered bonds without deduction for Swiss withholding tax and special income taxes. They therefore appeal primarily to an institutional investor base outside of Switzerland.

Swiss Covered Bond Structure

Withholding tax rules

Under Swiss withholding tax legislation, interest paid by a Swiss issuer other than a bank is not in principle subject to Swiss withholding tax (35%), unless the debt instrument under which interest is paid is classified as a bond or debenture. The two vehicles issuing Swiss Pfandbriefe do not classify as banks for Swiss withholding tax purposes and can therefore issue covered bonds or covered debt instruments under these rules.

The rules say that where a debt instrument issued by an issuer in Switzerland other than a bank can be held under its terms at any time by more than 10 creditors that are not banks, the instrument will be characterised as a bond and Swiss withholding tax will apply to the entire amount for the entire term of the instrument. Accordingly, if PBB or PBZ privately place Swiss Pfandbriefe, which under their terms cannot be held by more than 10 investors, who are not banks, interest paid in respect of such Swiss Pfandbriefe is not subject to the tax. Swiss Pfandbriefe are, however, usually issued without transfer restrictions, and may therefore be held by more than 10 investors, who are not banks. They therefore usually classify as bonds subject to Swiss withholding tax, and only exceptionally as non-taxable instruments.

Swiss withholding tax is also triggered if the issuer in Switzerland other than a bank has more than an aggregate of 20 lenders under any kind of debt instrument (including private placements, syndicated loans and, subject to certain exemptions, intragroup loans, however not debt instruments classified as bonds). In such a case, the aggregate of such debt instruments is reclassified as a debenture for Swiss withholding tax purposes and Swiss withholding tax will apply on interest payable under such debt instruments from the date of reclassification. Accordingly, if PBB and PBS privately place Swiss Pfandbriefe, they must ensure that their aggregate number of investors who are not banks does not exceed 20, to avoid Swiss withholding tax becoming applicable.

Under the Swiss withholding tax legislation, where a debt instrument is issued by a Swiss bank acting through its head office in Switzerland, interest paid under the instrument is generally subject to 35% withholding tax, irrespective of the number of holders of the instrument. An exemption only applies if the bond is structured like a loan and is held by another bank (interbank exemption). Lacking any meaningful exemption, covered bonds issued through the head office in Switzerland are generally restricted to the Swiss market.

However, where a bond is issued by a foreign branch of a Swiss bank, interest payments in respect of the bond can be made without deduction for Swiss withholding tax, provided, however, that the proceeds from the issuance of the bonds is received and, so long as the bond is outstanding, used outside Switzerland. Further, debt issuances by a Swiss bank through a foreign branch are permissible only if the branch effectively conducts banking activities in its jurisdiction with its own infrastructure and staff as its principal business purpose, and constitutes a permanent establishment situated and effectively managed outside Switzerland. This branch exemption is restricted to banks only. Other issuers, for instance insurance companies, who also provide mortgage loans, are not permitted to issue bonds through foreign branches without deduction for Swiss withholding tax.

The covered bonds issued by the Swiss banks under the covered bond structures outlined above classify as foreign covered bonds not subject to Swiss withholding tax only for so long as they use the proceeds outside Switzerland. Swiss withholding tax therefore puts covered bonds in terms of use of proceeds at a disadvantage to Swiss Pfandbriefe, while it puts Swiss Pfandbriefe at a disadvantage in terms of the available markets. Banks in Switzerland without foreign branches are fundamentally in the same situation as the two vehicles issuing Swiss Pfandbriefe (they are essentially limited to the Swiss capital markets). As two big banks have been made to change their group structure in response to Swiss regulatory requirements addressing the too-big-to-fail (TBTF) issue, the covered bond structure will no longer be used for new issuances. This is because wholly-owned subsidiaries, established as new Swiss banking entities and which hold mortgage loans, are trapped by the non-use of proceeds restriction.

Special income source taxes

Where the cover pool includes mortgage loans, a special income tax levied at source must also be considered. Recipients outside Switzerland of interest paid on a loan secured by a mortgage over real property situated in Switzerland are subject to a special income tax levied at the federal, cantonal and communal levels. The tax applies in principle in addition to the Swiss withholding tax. The tax must be deducted by the borrower from the interest payment and be remitted to the respective Swiss tax authorities. The tax rates range between 13% and 33% depending on the canton and commune where the real property is located.

Many of Switzerland's double taxation treaties, including those with the UK, US, Luxembourg, Germany and France, allocate the right to tax fully the country where the beneficial recipient of the interest payment is resident. If a treaty applies, Switzerland reduces the tax at source to nil. However, for such reduction to apply, the debt instrument must be restricted to permit persons in a treaty country only to be a lender under the instrument.

Swiss Pfandbriefe do legally benefit from security over real property in Switzerland, making the tax in principle applicable. The covered bonds issued under the structures outlined above by Swiss banks do not benefit legally from security over real property. The purpose of the mortgage SPV is restricted to holding the cover pool and providing the guarantee in favour of the holders of covered bonds and benefits from limited recourse and non-petition provisions; therefore, tax authorities could be of the view that, under the doctrine of substance over form, the position of a holder of covered bonds is no different from that of a person legally benefiting from security over real property in Switzerland. It must therefore be ensured that any such re-classification risk is excluded. This is achieved by insisting that all competent tax authorities (all 26 cantons and the federation) confirm in tax rulings that the guarantee of the mortgage SPV does not constitute a security over real property in Switzerland for the purposes of the special income tax.

Use of repack structure?

For a number of debt issuances, the Swiss tax authorities have permitted Swiss issuers to access international debt markets free of withholding tax. They have allowed this through the use of a structure under which the issuer resident in Switzerland issues loan notes which it sells to a foreign multi-issuance vehicle (MPV), typically resident in Ireland, under a purchase agreement for a purchase price equal to the issue price, less costs. The MPV simultaneously issues secured notes, which are secured by the claims under the loan notes (security), which it sells under a syndication agreements to the arrangers for a purchase price equal to the issuance price for the secured notes (the same as for the loan notes) less costs. The arrangers place the secured notes with investors outside Switzerland (having purchased the notes in the earlier book-building). The performance of the secured notes is linked to the loan notes. Therefore, the MPV will make payments under the secured notes only to the extent it receives payment under the loan notes from the Swiss issuer or from the enforcement of the security. The loan notes are restricted in terms of transferability, such that the Swiss issuer is at all times in a position to comply with the Swiss withholding tax rules. This allows a Swiss non-bank issuer to have up to 10 or 20 non-bank creditors as lenders without triggering withholding tax on a particular debt issuance, its financial debt in aggregate. Therefore, under such structure, proceeds can be used in Switzerland without Swiss withholding tax.

The structure as described only works smoothly if the loan notes are not subject to Swiss withholding tax. Swiss banks therefore cannot in principle rely on the structure, except if an entity in Switzerland is interposed and a tax refund mechanism employed allowing the intermediate entity to obtain a refund of the Swiss withholding tax, to be withheld by the Swiss bank on interest payments to the intermediate entity in respect of proceeds on-lent. This is a difficult task to achieve and untested so far.

A silver lining?

Investors resident in Switzerland are used to the Swiss withholding tax. The special Swiss income tax on mortgage loans does not apply to Swiss investors, and as the Swiss Pfandbriefe show, there is a Swiss domestic market for covered bonds subject to withholding tax.

Experience shows that bonds subject to withholding tax do not normally find sufficient demand in international markets. In placing covered bonds internationally, Swiss banks are generally liable to Swiss withholding tax on interest paid: this remains a significant obstacle. Under the existing law, this has only been achieved subject to the restrictions that the covered bonds are issued by a Swiss bank, acting through a foreign branch; the issuance proceeds are not to be used by the Swiss bank in Switzerland and the provision of a guarantee covered by mortgage loans is not considered security over real estate in favour of the holders of the covered bonds.

A silver lining presented itself in the draft legislation issued by the Swiss Federal Council on December 17 2014, which signalled flexibility for future issuances. The draft legislation proposed to replace the existing system requiring the issuer resident in Switzerland to withhold Swiss withholding tax on interest payments by a paying agent system. Under such system, paying agents in Switzerland would have been required to deduct Swiss withholding tax at a rate of 35% on any payment of interest on any bond (not only on bonds issued by issuers resident in Switzerland) to a beneficiary resident in Switzerland (subject to certain exceptions). The international disadvantage of Swiss withholding tax imposed on the issuer would have fallen away. However, the proposed law has been repealed recently for technical and political reasons. There is, therefore, no easy mid-term solution available to Swiss issuers for issuing covered bonds internationally. Whether more flexibility could be achieved by using a repacking vehicle remains to be seen.

Repack Structure


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Dieter Grünblatt

About the author

Dieter Grünblatt focuses on the tax structuring of national and international capital market transactions, collective investment schemes, real-estate investments, structured financial instruments, private equity and fund management structures. He designs acquisitions and reorganisations and advises on employee stock option plans, pension plans and social security taxes and VAT. Grünblatt regularly contributes to publications on tax-related topics.

Grünblatt joined Homburger in 1997 and has been a partner since 2005. He graduated from the University of Basel School of Law in 1989. He holds a doctorate (Dr iur) in law from the University of Basel (1994) and an LLM from New York University, where he completed postgraduate studies with a focus on corporate finance and corporate tax law in autumn 1997. He was admitted to the Baselland Bar in 1996 and to the New York Bar in 1998. He has been a certified tax expert since 2000.


Benedikt Maurenbrecher

About the author

Benedikt Maurenbrecher's practice focuses on banking, finance and capital markets. He is experienced in a broad range of transactions, notably in the areas of equity capital markets, secured and unsecured lending, covered bonds, securitisation and derivatives. He is an authorised issuers' representative at the SIX Swiss Exchange. Maurenbrecher also advises on domestic and cross-border aspects of banking, securities and investment fund regulation, and regularly represents market participants in related regulatory proceedings and civil litigation. He is a member of the banking committee and the securities committee of the International Bar Association, and heads the banking committee's sub-committee on opinions in legal transactions.


Stefan Kramer

About the author

Stefan Kramer's practice focuses on capital markets and banking law. He regularly advises on asset-based financings (covered bonds and securitisations), banking regulation (including regulatory capital transactions) and derivatives markets regulations. Other areas of work include insolvency law and financial markets infrastructures. He has written various books and articles on financial services regulation and is a co-editor of the Commentary on the Swiss Banking Act. Kramer is admitted to the Swiss bar, holds a doctorate from the University of Zurich (2005) and an LLM from Harvard Law School (2010).