Relocation of business activities abroad: Tax consequences and risks
Businesses nowadays structure their value chain globally. In doing so entire operations, but sometimes only individual functions (sales activities, services provided etc.), can be transferred within a group; often across borders. Such relocations of functions within a group usually occur free of compensation and have so far rarely been taxed. Nevertheless, a cross-border business restructuring can already under the current legislation lead to tax consequences; particularly, if the transferring company is not compensated in line with market conditions.
Tightening of existing practice? However, the draft Federal Act on Tax Proposal 17 proposed by the Federal Council now expressly provides that when functions are transferred abroad, the hidden reserves and the self-created added value of these functions are to be taxed. The Dispatch on Tax Proposal 17 merely refers to a clarification of the existing law. Is that true or could all future cross-border transfers of functions trigger taxation?
Entrepreneurial decisions must be respected... In principle, the tax authorities in Switzerland must respect corporate governance decisions. The tax authorities may not use their own discretionary power to 'ignore' the company management decision. Only if the sole reason for the chosen structure is tax savings are the tax authorities allowed, under certain circumstances, to disregard the chosen action and the resulting new structure when taxing the business. If management decides to transfer parts of the business, assets or functions from Switzerland to another company abroad, generally the tax authorities have to accept the situation.
…but they can have tax consequences Another question is whether the Swiss business needs to be compensated for the restructuring of its operations and how high this compensation should be. In Switzerland, this is based on the arm's length principle. This demands that a service be compensated in the same way as it would be compensated between independent third parties. If this is not the case, the difference between this third party price and the compensation actually received is a so-called payment in kind. This payment in kind would then be taxed as an additional taxable profit for the Swiss business.
The offsetting of the payment in kind thus leads to the taxation of a higher profit at the level of the Swiss company and to the taxation of income/earnings at the level of the recipient in the same way as a dividend payment. In general, additional 35% withholding tax is due on this "dividend distribution" (depending on the double taxation treaty, this can be reclaimed in whole or in part from the receiving company or already reduced at source).
When does a compensation obligation arise? Since business restructurings between independent third parties are rare in practice, transactions between third parties cannot be referred to in determining whether and how to compensate for a business restructuring. The planned restructuring should therefore be subject to a comparability analysis. In doing so, the following will be assessed:
functions, risks, assets before and after the business restructuring;
the commercial reasons and the expected advantages of the business restructuring;
the potential courses of action available to the involved group businesses before the restructuring of the business;
Based on this information, it must be decided whether the restructuring of the business is subject to a compensation obligation.
Four different cases In simplified terms, a distinction must be made between four cases in which an internal group business restructuring leads to an obligation to pay compensation, i.e. the company, which loses the functions, risks and assets must receive compensation for:
transfer of a (partial) operation;
transfer of a tangible or intangible asset, such as machinery, patents, trademarks;
amendment or termination of contracts if compensation would be paid to a third party in similar circumstances;
transfer of a business opportunity (functions and risks) if this business opportunity would be of value to a third party in similar circumstances.
Restrained Practice It can therefore be stated that according to current practice, the transfer of an individual function to a foreign company (e.g. CFO, production employee, etc.) does not in itself constitute a transaction requiring compensation. Only in connection with tangible and intangible assets, business opportunities and risks can an obligation to pay compensation arise. When value chain activities such as research & development, procurement, production or sales are relocated, it must therefore always be carefully checked whether related assets or exploitable business opportunities are transferred and whether the business restructuring leads to contract adjustments requiring compensation.
The amount of the compensation is based on the principle of arm's length settlement. The price to be paid is what independent third parties would pay to each other. If a (partial) operation is transferred, any resulting goodwill must also be taken into account.
Outlook The Council of States discussed Tax Proposal 17 on 7 June and the National Council will deal with it in the autumn session. If the new version of the Federal Act on Tax Proposal 17 is adopted in the current form, it will anchor in the legislation that when functions are transferred abroad their value must be accounted for. Whether this really only represents a clarification of the aforementioned practice or whether even the transfer of individual functions will, trigger tax consequences will only become apparent with time. It is therefore more important than ever to comprehensively examine the tax aspects of business restructuring abroad.
Our tax and insolvency law teams will be happy to answer any further questions you may have on business restructuring.