The Swiss Federal Court ruled in favor of the tax authorities on July 17, 2024 in a litigation that frames a Swiss debate over the role of the annual circular on safe harbor interest rates issued by the Swiss Federal Tax Administration. The discussions of this litigation revolve around whether these safe harbor rates are binding on the tax authorities. The Federal Court ruled that if the interest rate charged to a Swiss borrower exceeds the safe harbor, then the tax authority is free to lower the rate to an arm’s length rate even if that rate is below the safe harbor.
The Facts
On December 1, 2013, a Swiss affiliate borrowed 0.5 billion Swiss francs from a foreign parent at a fixed interest rate of 2.5% for a term of just over 5 years. The intercompany agreement also included an overdraft facility with a credit limit up to an additional 0.5 billion Swiss francs at an interest rate of 3%. The safe harbor rates were 2% for 2014 and 1.5% for 2015.
The tax authorities, however, argued that the appropriate interest rate should be only 1.08%. This lower figure was derived as the 0.83% interest rate that the foreign group could borrow at plus a 0.25% margin, which was put forward as the arm’s length rate. The taxpayer protested that it should be able to charge the higher safe harbor rates.
The Direct Federal Tax and the Cantonal and Municipal Taxes of Zurich accepted the tax authority’s position, but the Cantonal Administration Appellate Court of Zurich accepted the assertion that the safe harbor rates were binding on the tax authorities. The Federal Court ruling, however, ruled that the tax authorities could lower the interest rates to arm’s length rates.
Analysis of the Arm’s Length Rate
The Federal Court provided little insights into what an arm’s length interest rate would be, as it only considered the legal issues. A standard model for evaluating whether an intercompany interest rate is arm's-length can be seen to have two components — the intercompany contract and the credit rating of the related party borrower. Properly articulated intercompany contracts stipulate:
The first three items allow the analyst to determine the market interest rate of the corresponding government bond. This intercompany interest rate minus the market interest rate of the corresponding government bond can be seen as the credit spread implied by the intercompany loan contract.
The interest rate on 5-year Swiss government bonds on December 1, 2013 was approximately 0.25%. The following table considers three alternative intercompany interest rates and the implied credit spreads and credit ratings.
Table 1: Three Alternative Intercompany Interest Rates
|
Credit rating |
Interest rate |
Credit spread |
|
BB+ |
2.50% |
2.25% |
|
A+ |
1.08% |
0.83% |
|
AA |
0.83% |
0.58% |
The taxpayer’s 2.5% intercompany company interest rate would be consistent with a 2.25% credit spread. The taxpayer could have defended this rate as arm’s length had it presented a convincing argument that the borrower’s credit rating should be BB+. The tax authorities asserted that the foreign parent corporation could borrow at an interest rate = 0.83%, which would be consistent with a credit spread = 0.58%. Had its group credit rating been AA, this argument would be consistent with market rates.
The tax authority’s ultimate position was that the arm’s length rate should be 1.08%, which is consistent with a credit spread = 0.83%. This position was consistent with an A+ credit rating for the borrowing affiliate. While the Federal Court decision did not discuss the role of implicit support, this lower credit rating is 3 notches below the group credit rating. In other words, the tax authority’s position is consistent with an application of implicit support with the assumption that the Swiss affiliate was a highly strategic entity.
The taxpayer did not appear to have a position on what the appropriate credit rating should be. We can speculate on what a taxpayer analysis might be by assuming that a reasonable analysis of the standalone credit rating was BB+, which would be a defense of the 2.5% intercompany interest rate. If the tax authorities and courts insisted on considerations of implicit support, a taxpayer position that this support should be weak support, then a plausible position might have been that the appropriate credit rating might be BBB, implying a credit spread of 1.5% and an arm’s length interest rate of 1.75%.
Intercompany Loans Denominated in Swiss Francs for 2024
The Swiss Federal Tax Administration set the safe harbor rate for inbound loans during 2024 at 1.75%. For the first eight months of 2024, the interest rates on 5-year and 10-year Swiss government bonds have varied between approximately 0.5% to 1%. Let’s consider an intercompany loan issued on June 1, 2024 that was denominated in Swiss francs for a term of 5 years. On that data, the interest rate on 5-year Swiss government bonds was 1%.
An intercompany interest rate of only 1.75% would imply a credit spread of only 0.75%, which would be consistent with a credit rating for the borrower of AA-. If the appropriate credit rate for the Swiss borrowing affiliate were below AA-, then the arm’s length interest rate would exceed this 1.75% safe harbor rate. For example, let’s assume that the appropriate credit rating was BBB, which would imply a 1.5% credit spread. In this case, the arm’s length interest rate would be 2.5%.
Federal Court, Case No 9C_690/2022.