Understanding the Participation Deduction in Switzerland

The participation deduction in Switzerland is a key tax benefit aimed at reducing the impact of multiple layers of taxation on income from significant corporate investments. This article will explore how the participation deduction works, its purpose in preventing double taxation, and the criteria for qualifying participations. Additionally, we’ll illustrate the tax savings it can offer through practical examples and discuss its impact on corporate investment decisions in Switzerland, helping businesses fully utilize this important tax advantage.

What is the participation deduction?

The participation deduction is a tax relief mechanism available to Swiss companies on income derived from substantial participations in other corporate entities, based on articles 69 and 70 of the Swiss Federal Act on Direct Federal Taxation (DBG).

This tax allowance is aimed at mitigating the multiple layers of taxation that can occur when a company receives dividends and capital gains from significant holdings in other companies which are then taxed both at the corporate level and again at the shareholder level.

The participation deduction allows companies to reduce their taxable income by excluding a portion of dividends and capital gains received from qualifying participations. This exclusion is proportional to the net income from these participations relative to the total taxable income, effectively lowering their overall tax burden.

What is the purpose of the participation deduction?

The primary purpose of the participation deduction is to prevent economic double taxation of corporate profits. Without such a mechanism, the same income would be taxed multiple times as it flows from the subsidiary to the parent company and ultimately to the shareholders. By allowing a deduction on dividends and capital gains from substantial holdings, Swiss tax law encourages corporate investment and growth, enhances international competitiveness, and promotes economic stability.

An example of multiple taxation without the participation deduction

Let us explore the importance of the participation deduction in mitigating multiple tax burdens by means of an example which illustrates what would occur in the absence of the deduction:

Suppose there is a Swiss parent company, SwissParentCo, that owns a substantial stake (more than 10%) in another company, SubCo, which is also based in Switzerland.

Step 1: SubCo earns profit

• SubCo, after its operations, earns a profit of CHF 1,000,000.
• SubCo pays corporate tax on this profit. Assuming a total effective corporate tax rate of 20% (varies depending on the canton), SubCo would pay CHF 200,000 in taxes.
• The after-tax profit is now CHF 800,000.

Step 2: SubCo distributes dividends

• SubCo decides to distribute its after-tax profit of CHF 800,000 as dividends to its shareholders, including SwissParentCo.
• Since SwissParentCo holds a 50% stake in SubCo, therefore it receives CHF 400,000 in dividends.

Step 3: Dividends received by SwissParentCo

• Without the participation deduction, SwissParentCo must include the CHF 400,000 in dividends in its taxable income.
• Assuming SwissParentCo faces a similar corporate tax rate of 20%, it would then pay CHF 80,000 in taxes on these dividends.

Step 4: SwissParentCo distributes dividends to its shareholders

• After further internal expenses and investments, assume SwissParentCo distributes CHF 200,000 to its shareholders in turn.
• The portion of these dividends which were originally derived from the dividends received from SubCo has now been taxed twice.

Step 5: Shareholders pay tax on dividends

• The individual shareholders of SwissParentCo then pay income tax on the dividends they receive. Assuming a personal income tax rate of 25%, they would pay CHF 50,000 in taxes on these dividends. This therefore results in a third layer of taxation on the original dividends distributed by SubCo.
• If any of these shareholders are corporate entities or foreign investors, this dividend income might be subjected to further taxation, depending on their respective corporate tax obligations or international tax agreements, potentially leading to a fourth layer of taxation, and so on.

This scenario clearly illustrates how, in the absence of the participation deduction, profits originating from one company can be subjected to multiple layers of taxation as they flow through the corporate chain. This results in significant tax burdens that can discourage investment and corporate expansion due to the inefficient tax leakage at each level.

How does the participation deduction mitigate multiple taxation?

If we consider the same example, we can see the participation deduction prevents this multiple taxation in the following way:

• Instead of paying additional corporate taxation on the dividends it receives from SubCo, SwissParentCo can instead apply the participation deduction, which allows it to reduce its taxable income by the proportion that these dividends make of its total net income (it qualifies due to its significant stake in SubCo).
• This means that the CHF 400,000 received as dividends will not be taxed again at the level of SwissParentCo. This effectively prevents the same money from being taxed multiple times, thus reducing the overall tax burden on the income as it passes through different corporate entities.

The participation deduction thus serves a crucial role in enhancing economic efficiency by mitigating such multiple taxation, fostering a more favorable business environment.

Who qualifies for the participation deduction on investment income?

To qualify for the participation deduction, a company must meet certain criteria related to the type of income received and the nature of its investment in other entities.

What constitutes “investment income” for the purpose of the participation deduction?

Investment income, in the context of the participation deduction, includes both:

• Capital gains arising when participation rights (shares in other companies) are sold at a profit,

• Profit distributions (dividends, benefits in kind, liquidation surpluses) derived from the holding of shares or participation certificates in other companies.

Both types of income must originate from qualifying participations to be eligible for the deduction.

What is a qualifying participation?

A qualifying participation is an investment in another company that meets specific criteria set by Swiss tax law so that the income derived from it can qualify for the participation deduction. Specifically, for a company’s investment to be considered a qualifying participation, it must:

• Be of a certain type
• Meet the minimum holding requirements

These criteria ensure that the participation is substantial enough to warrant the benefits of the participation deduction.

Types of qualifying investments

Income from the following types of investments may qualify for the participation deduction provided the other qualifying criteria are met (i.e., minimum holding requirements):

• Shares and participation certificates in stock corporations (AGs)
• Share capital of a GmbH
• Share certificates of cooperatives
• Profit participation certificates
• Other similar equity instruments

Basically, the primary condition is that these investments must confer significant ownership and control over the issuing company. As such, the following are not considered qualifying investments:

• Bonds
• Loans and advances
• Hybrid financing instruments

Minimum holding requirements

To qualify for the participation deduction, the investment must be considered a “significant participation”. Specifically, it must meet one of the following conditions:

• The participating company must own at least 10% of the equity or voting rights of the other company, or
• The market value of the participation must be at least CHF 1 million
• Participation certificates which give the right to at least 10% of profits also qualify for the participation deduction

Additionally, for income realized from capital gains to qualify for the participation deduction, the selling company must have held the investment for at least one year.

How is the participation deduction calculated?

The participation deduction is calculated according to the ratio of net participation income to the company’s total net income. The taxable income is then reduced by the corresponding percentage.  Additionally, the company can claim a 5% contribution for administrative expenses. Practically, the steps to calculate the participation deduction are as follows:

1. Identify gross income from qualifying participations: This includes all dividends and capital gains from qualifying investments.
2. Deduct related expenses: Expenses directly related to the holding and management of the qualifying participations must be deducted to arrive at the net income.
3. Calculate the deduction: The participation deduction is then proportional to the ratio of net participation income to total taxable income. This effectively reduces the taxable income of the company.
4. Administrative contribution: The company can claim an additional 5% of the gross participation income towards administrative expenses.

Example:

If a Swiss company holds a qualifying participation in another company and receives CHF 500,000 in dividends, with related expenses amounting to CHF 100,000, the net participation income would be CHF 400,000. If the company’s total taxable income is CHF 1,000,000, the participation deduction would be proportional to the ratio of CHF 400,000 to CHF 1,000,000.

This ratio (0.4 or 40%) would then apply to reduce the taxable income from CHF 1,000,000 to CHF 600,000, resulting in significant tax savings for the company.