Taxation of compensation payments from share certificates

1. Introduction

On 3 October 2017, the Swiss Federal Tax Administration (FTA) published the updated Circular Letter No. 15 (Bonds and derivative financial instruments as subject to direct federal tax, withholding tax and stamp duties). It replaces Circular No. 15 dated 7 February 2007.

The updated circular in particular reflects the changes in legislation since the last publication, such as the capital contribution principle. Annex III, which has also been revised, now contains the following new clarification in connection with traditional index and basket certificates on shares: "Any compensation payments constitute taxable investment income pursuant to Article 20 paragraph 1 letter a of the Federal Act on Direct Federal Tax (DBG), irrespective of whether the distributions of the underlying shares are normal dividends, repayments of par value or repayments of reserves from capital contributions. This assessment cannot be followed, as will be shown below.

This issue is particularly relevant in today's low interest rate environment, as taxes can significantly reduce the net return on a financial investment. Therefore, it is not only for retail investors, for whom the absolute tax amounts should normally be relatively low, that the lowest possible tax burden is of interest. But also for issuers, for whom tax uncertainties and double taxation have a negative impact on the attractiveness of their products.

This paper focuses on the income tax treatment of income from investments in classical index and basket certificates from equities. The focus is on the view of the investor resident in Switzerland who holds the products as part of her private assets.

2. definition and terminology

2.1 Structured products

There is no legal definition of the term structured products. Due to the innovative capacity of the financial sector and the constant changes in the financial markets, a legal definition of structured products was deliberately omitted.01 According to FINMA, structured products are "investments in the form of a bond or debt instrument in which a cash instrument (e.g. a fixed-income security) is firmly linked to one or more derivative financial instruments to form a legal and economic unit. The derivative financial instruments refer to underlying assets (e.g. shares, bonds, interest, exchange rates, alternative investments).02 In fact, the payout profile of most structured products can be replicated (replicated) by combining other investment vehicles.03 However, structured products without a recognisable structure are also possible.

As mentioned in FINMA's definition, a structured product constitutes a debt instrument (innominate contract) from a legal perspective. It is securitised as a security.04 The investor acts as creditor, while the issuer assumes the role of debtor. The issuer risk must therefore be taken into account when investing. Structured products are inseparable from a legal perspective. This distinguishes them from other financial instruments, such as warrant bonds, where the subscription right is securitised in separate warrants and can be separated from the bond and sold, bought or claimed separately.05

In Switzerland, structured products are also referred to as derivative products. The FTA uses the term combined products.06 Structuring is the process of constructing structured products using the various building blocks.07 The value of the product is generally derived from an underlying variable.08 The term derivative products therefore seems obvious. However, the legislator uses the term structured products in various enactments of financial market legislation,09 although without defining it. Nor has uniform terminology become established in teaching.10

The Swiss Structured Products Association (SSPA) divides structured products into five categories on the basis of the repayment profile (payoff): capital protection products, yield enhancement products, participation products, investment products with reference debtors and leveraged products.11

2.2 Participation products

The index and basket certificates discussed here belong to the category of participation products.

Participation products offer investors the opportunity to participate in the performance of an underlying instrument.12 Individual underlyings as well as combinations of different underlyings, e.g. stock indices or baskets, are possible. A single transaction can thus cover entire sectors, regions or themes and offer the opportunity to invest in markets that are difficult to access (e.g. emerging markets or commodities). These products have neither a cap nor unconditional capital protection. Conditional capital protection or disproportionate profit sharing are possible.13 There is the risk of a total loss.

3. principles for the taxation of structured products

In Switzerland, there is no specific legislation on the taxation of structured products. This must therefore be carried out on the basis of the classification in the existing tax law.

3.1 Elemental view versus product view

3.1.1Principles

As explained above under 2.1, a structured product constitutes an innominate contract between the investor and the issuer. The investor does not invest directly in the individual components which would be necessary to replicate the structured product. From an economic point of view, however, both investment variants lead to the same result, i.e. the same payout amount.14 The question therefore arises as to whether these should also lead to the same tax consequences and therefore the element approach (breakdown method, bifurcation approach) should be applied. In other words, it is checked whether the product can be broken down into its components and taxed accordingly. Alternatively, the integration approach would tax the product as a whole, i.e. on the basis of all its properties.

In Swiss literature15 and jurisdiction16 it is undisputed that for the purposes of income tax (as well as withholding tax), structured products should be taxed transparently, i.e. separately according to their building blocks. The aim of this separation is to be able to distinguish between taxable securities income and tax-free capital gains in accordance with the Swiss tax system.17

Nevertheless, practice and literature leave it largely unfounded, which is why the breakdown of structured products according to the income or capital gains and losses resulting from the building blocks is permissible. In Andri Mengiardi's view, the principle of equal treatment (Art. 8 of the Swiss Federal Constitution, BV) and the principle of uniformity (Art. 127 para. 2 BV) speak in favour of applying the elementary approach. A different assessment would tax the small investor, who without structured products has hardly any opportunity to invest in certain financial products or markets, differently than the large investor, who may have the opportunity to replicate the corresponding payout profile by means of direct investments in the corresponding building blocks.18

3.1.2Practice of the FTA

For the FTA, combined products consist of a combination of different financial instruments; usually a bond with one or more options or conversion rights.19 For the purposes of income tax and withholding tax, the FTA distinguishes between transparent products (application of the element approach) and non-transparent products (application of the product approach). "A product is considered transparent if, alternatively, a) the components underlying the instrument are separable at the time of issue and are actually traded separately, b) the issuer of the product presents the various components separately in the term sheet in terms of value by means of a financial mathematical calculation and the verification of this calculation by the FTA has shown the accuracy of this presentation, or c) the various components of the product can be subsequently analytically traced by the FTA and their value calculated.20 This possibility of determining the breakdown of the bond component and the value inflow from the derivative using financial mathematics eliminates the requirement that the components must also be issued and traded separately. This variant of the breakdown method was developed by the FTA in cooperation with the SBA and is therefore widely accepted in practice by issuers and the (cantonal) tax authorities.21

3.2 Income tax

Since Swiss tax law does not contain any standards for the taxation of income from structured products, the individual income components must be allocated to the existing rules on income from capital assets by applying the elementary approach.

For income tax purposes, income from structured products must therefore be allocated to the income types interest from credit balances (Art. 20 para. 1 lit. a and b DBG), dividend-like remuneration (Art. 20 para. 1 lit. c DBG) or capital gains (Art. 16 para. 3 DBG). If an income cannot be divided, e.g. because it cannot be broken down, it remains taxable as income from movable assets on the basis of the general clause in Art. 16 para. 1 DBG or Art. 20 para. 1 Ingress DBG.22

3.2.1 Interest from credit balances (Art. 20 para. 1 lit. a and b DBG)

The taxation of interest income and interest expenses is probably regulated in most national tax laws. However, this does not mean that each national tax law also defines the concept of interest. For example, Swiss income tax law does not provide a legal definition of interest.23 According to Ernst Känzig, from a tax point of view, interest is those payments made by the debtor to the creditor which do not lead to the repayment of the capital debt, but which settle the granting of the use of the capital.24

Interest from credit balances of all kinds constitutes taxable investment income pursuant to Art. 20 para. 1 lit. a DBG. A credit balance is any claim of the taxpayer against a third party for payment of a certain amount of money.25 It can be concluded from this element of the specific amount of money that the repayment of the credit must be risk-free for the investor. The term credit balance also includes (bond) bonds.

The withholding tax and stamp duty bond concept26 has taken over the direct federal tax.27 Periodic interest or in the form of one-off payments (issue discount or redemption premium) constitutes taxable investment income for all forms of bonds in accordance with Art. 20 para. 1 lit. a DBG. They are taxed according to the general principle of maturity. The exception is accrued interest for bonds without predominantly one-off interest. This represents accrued but not yet due interest for the period from the maturity date of the last coupon redeemed until the sale of the bond. For the seller, it is a tax-free capital gain.28

In order for a structured product to contain a bond component (investment component) from an income tax perspective, the bond component must correspond to the executed credit concept. This is not the case with stock certificates.29 Income earned from this is therefore not taxable as interest from credit balances pursuant to Art. 20 para. 1 lit. a DBG.

3.2.2 Dividend-like remuneration (Art. 20 para. 1 lit. c DBG)

Certain index and basket certificates on equities (equity certificates) provide for additional payments to the investor in addition to the repayment depending on the performance of the index or basket. These compensatory payments are (partial) substitutes for dividends which the investor misses in comparison to a direct investment and may be paid periodically or as a one-time compensation.30 The question arises as to whether these dividend-like remunerations are to be treated as investment income (dividends, profit shares, liquidation surpluses and pecuniary advantages from investments of all kinds) within the meaning of Art. 20 para. 1 lit. c DBG.

The qualification as investment income is based on the fact that, due to the principles of equal treatment and uniformity enshrined in the Federal Constitution, investors in structured products and investors with direct investments in the individual components should be taxed as equally as possible. The element approach should consequently also be applied to the equity component. For Andri Mengiardi, the nature of the compensation payment also implies that it is "compensation that replaces the original dividend".31 pointed out that the income tax qualification of this compensation payment should correspond to that of the original compensation.32

This is contradicted by the fact that, due to the formalised concept of income in the area of investment income, such income can only exist if the recipient of the payment is a shareholder in the distributing company. Rather, in Jonas Misteli's opinion, the receipt of dividends passed on constitutes interest from credit balances.33 The FTA also appears to be of this opinion, as it taxes the compensation payments - albeit without stating a reason - as investment income based on Art. 20 (1) (a) DBG.34

For taxation as interest from credit balances, however, the necessary investment component is missing in the case of compensation payments from share certificates.35 Overall, Andri Mengiardi is therefore to be approved. There are more convincing reasons for qualifying dividend-like remuneration from derivative products as investment income within the meaning of Art. 20 (1) c DBG.36

3.2.3 Capital gains (Article 16 (3) DBG)

Tax-exempt capital gains pursuant to Art. 16 (3) DBG are capital gains (difference between the proceeds of the sale and the lower acquisition cost) that are realized on the sale of private assets. The concept of assets is very broad and must be understood from an economic perspective. A "sale" is therefore not only the legal transfer of assets, but also any kind of disposal transaction in which the assets are completely or partially removed from the taxpayer's sphere of assets.37

In practice, the qualification of gains from derivatives as capital gains or losses as capital losses is38, Teaching39 and jurisdiction40 agreed.41 This also applies to the option premium which the writer (seller) of the option receives.42 For Markus Reich, the profits or losses from a structured product are also considered capital gains or capital losses as long as this product lacks at least the investment component (capital guarantee).43 According to the view held here, income from structured products constitutes capital gains if changes in the underlying have at least as strong an impact on the payout amount of the structured product as would be the case with a direct investment. This means if the leverage is 1 (so-called delta-1 products).44 In the case of a direct investment in the Underlying, a realised gain or loss in value also represents a capital gain or loss. It makes sense to focus on the fluctuation intensity: the relationship between the investment amount and the payout amount is the most important aspect of a financial investment.45 The FTA has waived a definition of capital gains for financial assets. In practice, however, it appears to apply the same considerations. This can be seen, for example, in the qualification of gains and losses on traditional index and basket certificates on equities based on the underlying as capital gains or capital losses.46

Income from classic index and basket certificates on equities that does not represent compensation payments is thus considered capital gains or capital losses.

4. taxation of income from index and basket certificates on shares

4.1 Practice of the FTA

Participation products are treated as yield enhancement products for tax purposes, which is why reference is made to the relevant explanations.47 The index and basket certificates are an exception to this rule. In economic terms, such certificates correspond to an investment in the underlying.

In the case of index and basket certificates on shares, a distinction is made between classic and dynamic index and basket certificates. In the case of classic equity certificates, the composition of the underlying remains unchanged during the entire term.48 The dynamic equity certificates are additionally divided into passively and actively managed ones. A passively managed share certificate is one in which the shares included in the index or basket are selected during the term of the certificate according to objective criteria defined in advance. If the issuer or a third party has (subjective) decision-making powers with regard to the composition of the index or basket, on the other hand, an actively managed certificate exists.49

The gains and losses achieved with traditional or passively managed dynamic equity certificates, which are based on the changes in value of the underlying instruments, are regarded for tax purposes as capital gains or capital losses. If the issuer of a classic equity certificate promises the investor additional benefits over and above the performance of the underlying instrument, these are compensation payments to compensate for the investor's loss of income compared to a direct investment. According to the practice of the FTA, these compensatory payments are subject to income tax within the meaning of Article 20(1)(a) DBG. This applies regardless of whether the distributions of the underlying shares are normal dividends, par value repayments or repayments of reserves from capital contributions. Gains and losses achieved with traditional or passively managed dynamic equity certificates that do not constitute compensatory payments qualify as capital gains or capital losses.

Actively managed index and basket certificates on equities are considered instruments of collective investment schemes. The same applies to index and basket certificates on equities without a fixed term if they do not grant the investor an annual right of termination, as well as to index and basket certificates on distributing or accumulating collective investment schemes.50

4.2 Assessment of the income tax assessment of compensation payments

As explained above, compensation payments from traditional and passively managed dynamic equity certificates are to be qualified as dividend-like remuneration pursuant to Art. 20(1)(c) DBG and not as interest from credit balances pursuant to Art. 20(1)(a) DBG.51 According to Art. 20 para. 3 DBG, the repayment of capital contributions is treated in the same way as par value repayments, i.e. free of income tax. In terms of the tax system, the capital contribution principle is a more precise definition of the concept of investment income anchored in Art. 20 para. 1 lit. c DBG.52 The applicability of Art. 20 para. 3 DBG must therefore be assessed according to the concept of investment income as defined in Art. 20 para. 1 lit. c DBG.53 Against this background, the consistent application of the element approach does not justify the taxation of compensation payments resulting from repayments of par value or repayments of reserves from capital contributions of the shares underlying the structured product.

5. conclusion

Provided that the issuer or distributor of affected certificates provides the FTA with all information necessary to divide the compensation payments into substitute payments for dividends, nominal value repayments or repayment of capital contributions, only compensation payments for lost dividends should be subject to income tax according to the view taken here.54 There is no apparent reason why the income tax assessment of share certificates should deviate from the principle of elementary consideration.