On 28 October 2015, the Swiss federal supreme court issued the written judgements on the two landmark decisions on beneficial ownership of two Danish banks decided on 5 May 2015 (see our Tax flash dated 6 May 2015). The two Danish banks held fully hedged Swiss equities positions and claimed a refund of Swiss withholding tax on dividends received thereon. According to the Swiss federal supreme court, the two banks were not entitled to such a refund since they did not qualify as beneficial owners of the dividends received.
1. Executive summary
In its decisions the federal supreme court set some general applicable principles on beneficial ownership of dividend income from Swiss equities. Holding a fully hedged position in Swiss equities over the dividend record date can, depending on the contractual obligations and relationship between the parties, be harmful for the qualification as beneficial owner, with the consequence that the refund of the Swiss withholding tax is denied or an already made refund claimed back.
2. General remarks on the double tax treaty between Switzerland and Denmark
In its judgements, the Swiss federal supreme court first elaborated that irrespective of an explicit statement in the applicable double tax treaty (DTT) between Denmark and Switzerland the concept of beneficial ownership is inherent and applicable. The question about the relationship between the concept of beneficial ownership and the concept of treaty abuse was not answered. Further, it was not analyzed if the concept of beneficial ownership also serves as instrument against treaty abuse. For future cases concerning similar topics, this questions could be of importance.
The Swiss federal supreme court stated that as a general rule the beneficial owner of dividend income is the person who can fully dispose of the dividends, i.e. can fully use and benefit from it without any legal, contractual or factual limitation. Such a factual limitation is given if the following characteristics exists (concept of interdependence):
(i) the realization of the (dividend) income depends on the duty to forward this (dividend) income (first dependency); and
(ii) the duty to forward this (dividend) income depends on the realization of this (dividend) income (second dependency).
Under a substance over form approach it can be summarized that a person does not qualify as beneficial owner if the dividend payments do not remain with the recipient of such payments as a result of the recipient being obliged to forward the dividend payments from a legal or economic perspective. By contrast, the beneficial ownership should, in principle, not be questioned if the engrossed (dividend) income is forwarded without any native or causal connection to the realization of such (dividend) income.
3. Total return swap case
3.1 Beneficial ownership
The Danish bank sold total return swaps (TRS) based on Swiss equities to known clients in Germany, the United Kingdom, the United States of America, the Netherlands and France. The TRS were structured in a way that the bank had to pay the whole (positive) share price performance and dividend income to the counterparty on the maturity date. In return, the bank received from the counterparty a variable interest payment based on LIBOR plus a fixed margin. From an economic perspective, the bank had as a result of selling the TRS a (synthetic) short position in the underlying equities. The bank fully hedged this short position by buying the underlying shares (physical long position) at the time of selling the TRS. The federal supreme court assumed that the interest payments received under the TRS were used for the debt financed purchase of the underlying shares. Irrespective of an explicit legal or factual duty, the federal supreme court came to the conclusion that due to the economic circumstances in the case at hand the duty to forward the dividend income depended on the realization of this income (second dependency mentioned above).
As a result of the full hedge and the described economic situation, the Danish bank had almost no risk to bear. The federal supreme court ruled that under these conditions it was sufficient for the bank to only be reimbursed by a small margin and a LIBOR interest component. The federal supreme court concluded that the bank was almost forced to hedge the TRS. From a civil law perspective there was no legal duty to forward the engrossed dividend payments. The bank was only obliged to forward an amount equal to the dividend payments. Considering the TRS agreements and the to be forwarded amounts, there was, however, not only a remote or loose connection. The amounts were equal to the dividend payments on the underlying equities and were named as such in the respective TRS agreements. As conclusion, the federal supreme court ruled that the contractual obligation to forward the engrossed dividend payments was linked to the realization of the dividend income in such a way that a real duty to forward the dividend income had to be assumed. Therewith, not only the second dependency, but also the first dependency mentioned above, the dependency of the realization of the dividend income on the duty to forward this dividend income, was given.
Based on the above said, the federal supreme court ruled in a 4 to 1 vote that the bank could not be regarded as beneficial owner.
3.2 Claim back of already paid out Swiss withholding tax
For the year 2006, the Swiss federal tax administration (SFTA) refunded CHF 37.9m in Swiss withholding tax (WHT) to the Danish bank. The SFTA informed the bank in 2010 that this refund was unjustified and claimed a repayment of the said amount. The bank argued that there was no legal basis for such a claim back and therefore, denied the repayment.
The federal supreme court ruled that there was no formal decision of the SFTA on the refund of the WHT and, according to the applicable legal ordinance on the DTT between Denmark and Switzerland, such a decision was required. Lack of such a decision, the federal supreme court ruled that the legal basis for a claim back was the civil law instrument of unjustified enrichment.
A controversial discussion was held on the duration of the statute of limitation. Based on the civil law, the statute of limitation is one year. The federal supreme court ruled that with regard to WHT it is justified to use the statute of limitation of the Swiss withholding tax act of three years. Since the SFTA informed the Danish bank in 2009 by letter that it was of the opinion that the WHT refunds were not justified, the statute of limitation period was interrupted. As a consequence, the WHT refunds granted had to be repaid by the bank with an applicable default interest of 5% p.a., starting at the date of the first reclaim of the SFTA for the respective WHT refund.
4. Futures case
Another Danish bank (different from the Danish bank in the TRS case) bought in February 2007 shares of companies listed in the Swiss Market Index (SMI) in the amount of CHF 3.745bn (physical long position). At the same day, the bank sold SMI Index Futures (futures contracts) in the same notional amount and with a maturity date of mid-March 2007 to persons neither domiciled in Denmark nor in Switzerland (synthetic short position). At the maturity date of the futures contracts, the bank rolled the futures position by selling futures with a maturity date of mid-June. At the maturity date in mid-June, the bank sold the underlying shares in the Swiss companies listed in the SMI and closed the futures contracts. During the term of the transaction, the bank engrossed various dividend payments on which a WHT refund was claimed. On the whole transaction, a percentage of approximately 6.6% of the gross dividend or 0.08% of the whole transaction amount remained with the bank. The federal supreme court ruled that the fact that not the full dividend income was forwarded does not exclude a harmful forwarding of dividend income.
With regard to the financing of the transaction, the parent company of the Danish bank, a Swedish company, provided the required funds. The federal supreme court raised the question if under these circumstances the Danish company was able to act independently. The DTT with Sweden foresees a residual withholding tax of 15% which can be credited against the due taxes in the other contracting state. Additionally, the Danish bank confirmed during the proceeding that the effective refinancing costs have been lower than declared against the SFTA. Consequently, the federal supreme court assumed that the difference between the declared and effective financing costs was used to transfer part of the engrossed dividend to the parent company in Sweden.
The federal supreme court raised the question if in addition to the forwarding of the proceeds by the internal financing structures also (dividend) proceeds could have been forwarded by determining the purchase and sales prices of the shares. The bank used two different brokers and exchanges, one for each transaction leg (futures and shares) to perform the mentioned trades. In February 2007 the bank sold futures contracts through one broker in the amount of CHF 3.7bn which was approximately 130% of the normal daily average trading volume. The mere transaction volume and the fact that the usage of different brokers and exchanges does not exclude an agreement between the involved parties lead the federal supreme court to the conclusion that all the involved parties had known each other (circularity of transactions, pre-arranged transactions). Further, at least one broker acted as principal and not as broker and booked the trade in its own books before selling the securities to further parties domiciled in Sweden, the United States of America and the Netherlands (all with a residual withholding tax of 15%). The broker was domiciled in UK, which has also a residual withholding tax of 15%. The federal supreme court came to the decision that the agreed transaction qualifies as scheme.
Based on the above, the federal supreme court came in a 3 to 2 voting to the decision that the bank did, based on the deal structuring, forward the vast majority of the (dividend) income by the financing costs and the price structuring at purchase and sale of the shares. Therewith, the first dependency, the dependency of the realization of the (dividend) income on the duty to forward this (dividend) income, was met.
According to the federal supreme court also the second dependency was met since the duty to forward the proceeds was limited to the effective engrossed proceeds.
In view of the supreme court decisions of 5 May 2015, it will be difficult for financial institutions with pending withholding tax refund claims associated with supposed dividend arbitrage transactions to receive such refunds.