In a recently published (final) decision of December 2015, the administrative court of the Canton of Zurich decided on the arm's length interest rate on up-stream loans granted to a parent company in a cash-pooling system. Although the interest rates on these loans were significantly lower than the yearly safe harbour minimum rates published by the Swiss Federal Tax Administration (SFTA), the court considered the lower interest rates as appropriate, based on specific arm's length evidence produced in the case at hand.
Facts of the case
A Swiss subsidiary of a foreign company had joined the zero balancing euro and Swiss franc (CHF) cash-pooling system of its parent company. By the end of the tax period 2011 it had accumulated a substantial credit balance. During a tax audit conducted by the Zurich tax authorities, the tax inspectors concluded that the interest on the loans granted by the Swiss subsidiary were not at arm's length. The tax authorities therefore increased the taxable profit, qualifying the difference between the actual and the arm's length interest rate as hidden dividend distributions. One of the main reasons for this re-qualification was the (re-)characterisation of the up-stream loans as long-term, rather than short-term, as claimed by the Swiss subsidiary. Consequently, the tax authorities applied the safe harbour rules according to which the minimal rates for euro- and CHF-denominated loans were, respectively, three percent and 2.25% in 2011.
The Swiss subsidiary filed an objection against this tax assessment and the tax appeal court reduced the interest rate on the CHF-denominated loan from 2.25% to 1.5%. This was still higher than the actual interest charged. However, it kept three percent for the euro-denominated loan since no evidence for lower market interest rates was provided. The tax authorities appealed against this decision to the administrative court of the Canton of Zurich.
Considerations of the court
The administrative court of the Canton of Zurich could only determine that the tax appeal court did not exceed its discretionary powers. The court held that the interest rates published by the SFTA in a circular letter represent safe harbour rules, which generally aim at ensuring that the tax authorities apply Swiss tax laws in a consistent manner. However, these circular letters are not binding for courts when assessing an individual case. Thus, the taxpayer has the opportunity to provide the tax authorities with an individual third party test as evidence that differing interest rates are congruent with market conditions. In this context, the court also mentioned that a consistent guideline within a multinational group may still be reasonable and at arm's length, although such guideline does not consider all the peculiarities of the tax laws in the resident states of the subsidiaries. It also confirmed that only the circumstances at the time the financing was granted are determinant for the arm's length terms.
In the case at hand, the Swiss subsidiary explained that the interest charged to its parent for euro- denominated loans were based on the EONIA rate (euro overnight index average) and the CHF-denominated loans on the one (or 12)-month Libor (London interbank offered rate). Furthermore, according to the internal group guidelines, the Swiss subsidiary booked cash-pooling claims as short-term receivables. Despite this explanation the administrative court concluded – in line with the tax appeal court – that the up-stream loans granted to the parent company had a long-term character. It argued that the Swiss subsidiary had increased (rather than decreased) its loans between 2009 and 2011 and that the matching counter positions qualified as short-term liabilities by the Swiss subsidiary were of a rather long-term nature. This was particularly so in relation to various (currency and tax) provisions established in the balance sheet.
Based on the re-qualification of the loans, the administrative court upheld the safe harbour rates for the euro-denominated loans (three percent) as the Swiss subsidiary did not provide substantiated evidence. However, and more importantly, the administrative court, following the reasoning of the tax appeal court, confirmed the interest rate at 1.5% for CHF-denominated loans. It clarified that fair market rates for intra-group loans could not be defined in absolute terms, but rather as a range of rates that appear appropriate for the respective transaction.
What it means for Swiss companies
Generally, intercompany loans (or intra-group financing) need to comply with arm's length terms. Following this decision and the safe harbour rules disclosed by the SFTA, it is advisable to either follow those rules (as safe haven for taxpayers complying with these rates) or to provide for an individual third party test proving that the interest payments on the loans reflect fair market rates. Although this possibility is included in the safe haven interest rate circular by the SFTA, Swiss courts have rarely assessed the application of the third party test in such detail. The case shows further that cash-pooling positions need to be individually evaluated to determine both their short- or long-term nature and adequate interest rates.