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01 September 2006
If an individual shareholder resident in Switzerland sells shares or other forms of equity participation in a business which were the shareholder's private assets (ie, a passive investment) and after the sale the participations become part of the business assets of the purchaser, then the seller may be required to pay income tax on the gain realized from the sale of the participations if assets are thereafter removed from the business.
Such a sale of participations - if the purchase price is fully or partially funded out of assets of the relevant business - is considered an indirect partial liquidation for tax purposes. As a result, a normally tax-free private capital gain is converted into taxable investment income in the hands of the individual shareholder. This is particularly true if the relevant business has distributable reserves and/or hidden reserves.
Supreme Court Decision and Circular Letter 7
In a decision dated June 11 2004 the Supreme Court extended the existing practice of the federal tax authorities with regard to the taxation of an indirect partial liquidation. The Swiss Federal Tax Administration (SFTA) adopted the court's opinion in its Circular Letter 7 concerning the indirect partial liquidation and made its application mandatory for federal taxes. The new practice of the SFTA under the circular letter resulted in the repeal, in most cases, of the five-year restricted period. Further, if the purchase price of the shares is financed with borrowed funds, the restricted period is extended until the purchaser has amortized the debt out of its own earnings. During the restricted period, the acquired business may not pay dividends or otherwise distribute profits to its (new) shareholders.
Adverse Actions by the Purchaser - Current Practice
In order to avoid the adverse tax consequences of the indirect partial liquidation rules, the following actions should not be taken during a period of five years after the purchase of the acquired company:
Hence, all actions which reduce the value of the acquired company during the
five-year restricted period and in any way have the economic effect of financing
the purchase price paid by the purchaser of the acquired company have an adverse
tax consequence. In the case of a merger between the acquirer and the acquired
company, a total liquidation of the acquired company will be deemed to have
occurred, with the consequence that all hidden reserves of the acquired company
will be included in the taxable income of the seller.
In the case of federal income taxes, a distinction is made on the basis of whether the purchase price was paid from the acquirer's own resources or whether funds had to be borrowed for that purpose. In this regard, financing provided to the acquirer by other companies in the corporate group does not lead to an adverse tax consequence, so long as it can be demonstrated that no third-party financing was provided. If third-party financing was used for the payment of the purchase price, then in most cantons the restricted period, which is usually five years, will be extended for an unlimited period of time. During this restricted period, dividend distributions even paid out of future profits will trigger the indirect partial liquidation.
New Federal Law
On June 23 2006 a new federal law was passed. This law governs the taxation, at both federal and cantonal level, of an indirect partial liquidation involving the sale of participations equal to 20% or more of the nominal share capital of the relevant company, and limits the restricted period to a maximum of five years. Moreover, only the assets of the company which are not required for its operations (ie, excess treasury liquidity) and which could have been legally distributed on the date of purchase (ie, distributable reserves) may be included in the taxable income of the seller, provided that the seller knew or should have known that after the sale assets would be withdrawn from the acquired company for the purpose of financing the payment of the purchase price. The new law will become effective on January 1 2007 unless a referendum on the law is called before October 12 2006.
The new law significantly improves the tax position of the seller and the purchaser. The most important change is that under the new law, only assets which were not required for its business operations (ie, excess treasury liquidity) and which were legally distributable (ie, distributable reserves) may be subject to taxation. Distributions of future earnings are not included in the taxable income of the seller. Under the currently applicable administrative tax rules, the merger of the acquired company with the acquiring company causes an indirect total liquidation, with the result that all disclosed and hidden reserves can become subject to taxation. The difference between the purchase price and the par value of the company's share capital is used to determine the amount subject to tax. Whether this administrative practice can still be properly applied in light of the new law is questionable. It is therefore highly recommended that the transaction be discussed with the tax authorities before it is executed.
Before the execution of the purchase agreement, an advance tax ruling should be sought which confirms that if none of the actions by the purchaser with adverse tax consequence described above is taken during the five-year restricted period, no indirect partial liquidation will result. Likewise, the amount of the assets which are not required for its business operations (ie, excess treasury liquidity) and which could have been legally distributed on the date of purchase (ie, distributable reserves) should be determined and confirmed by the tax authorities. If a referendum is not called in respect of the new law governing the indirect partial liquidation, the five-year restricted period will also be applicable at a federal level, even if the purchase price is debt financed.
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