Supreme Court endangers tax-free capital gain
The distinction between “private wealth administration” and “self employment” is crucial for the tax consequences on capital gains realized by Swiss sellers in M&A deals.
Background
- Capital gains realized from the sale of privately held assets (including shares in a company) are generally tax-free for Swiss-resident individual sellers.
- There are various requalification schemes that lead to such capital gain being taxable (e.g. indirect partial liquidation, certain non-competes, earn-out schemes etc.)
- In a new landmark case, the Swiss Supreme Court has refreshed a requalification practice seldom used, the so-called “participation dealer”.
Participation Dealer
- A participation dealer is an individual who sells a participation (generally above 10%). Through significant time, effort, know-how in the industry etc. that the seller invests into the participation, the resulting capital gain is qualified as income from self-employment. The degree of financial risk is also a relevant factor.
- The participation dealer needs to be distinguished from the Swiss professional securities dealer, another scheme which can result in the same outcome (i.e. requalification of tax-free capital gain to taxable self employment income), but whose main “risk factors” are frequent trading and debt financing of traded securities, as well as the use of derivatives. The classic case of the professional securities trader is a savvy stock-exchange investor, making a great number of trades, often with leverage.
- While debt financing is generally also an important factor in the case of a participation dealer, the Supreme Court has specifically stated this is not a necessary condition. In the specific case at hand on which the Court passed its ruling, it remained unclear to what level the taxpayer (seller) had debt-financed the participation he later sold, but it did not matter in any case, given the other factors, the court stated. Hence, the lack of debt financing of one’s participation is not a safe-haven criterion.
- The participation was a mining company and the seller actively courted members of certain African governments in order for the company to obtain mining licenses. The successful outcome of these endeavors led to a higher capital gain upon sale of the participation. It was thereby seen as decisive by the Supreme Court that the seller invested significant amounts of time and took on significant financial risk. The extent of this financial risk was “measured” in the sense that the participation comprised a substantial part of the seller’s wealth.
- Crucially, the seller derived his main income from a 100% regular employment. The existence of this employment relationship (even at 100%) does not exclude the seller being able to devote a significant enough share of his time to the participation dealer activity, according to the Court.
- Further, a business associate of the seller was an expert in mining activities. The fact that this person was also an investor in the target entity sold led the Supreme Court to impute the relevant knowledge of this person to the seller. In other words: The Supreme Court considered the industry knowledge of a co-investor as if it was the relevant seller’s own knowledge, merely because they were jointly investing in the participation they later sold.
Why it matters
- Swiss law is clear in that it exempts private capital gains from any type of income taxation. This is not the result of an oversight of the lawmaker or any loophole, but explicitly provided as a cornerstone of Swiss tax legislation. In other words, this feature of Swiss tax law is explicitly desired by the legislature and legitimized by the sovereign (the people).
- Tax authorities restrict the applicability of this “fundamental right” through the introduction of respective practices, such as the participation dealer. In most cases and where the situation is clear-cut, this is reasonable and prevents abuse. It is necessary for the tax system to function well that the rule has its limits – as with any other fundamental right.
- However, in the case at hand, the Supreme Court has set-up a trap for the de-facto abolishment of a tax-free capital gain, depending on interpretation.
- Any founder, selling their life’s work (i.e. an exit case for any start-up) has usually invested a substantial amount of time in the company he or she sells. This company most often also makes up a substantial portion of their wealth and they have direct knowledge of the relevant industry, which they likely also used to develop the start-up.
- Due to the Supreme Court’s explicit statement that the absence of debt-financing does not exclude the qualification as a participation dealer, nor does the presence of a regular employment relationship, these cannot serve as safe-haven criteria. The result is that the new ruling can – if a tax authority wants to pursue this avenue – serve as a basis for a requalification of a tax-free capital gain into taxable income from self-employment in numerous imaginable exit-cases. The line between a regular exit case and an abuse of the tax-free rule is becoming more and more blurry and legal certainty harder to obtain.
- Clearly, this is not in line with the spirit of Swiss tax law, nor likely what the Supreme Court wanted to achieve with their ruling. But this ruling could be relatively easily instrumentalized by an overly eager tax authority, as it appears the Court is giving subjective judgment a prominent role at the expense of any safe harbor criteria, which exist e.g. for the concept of the professional securities dealer.
- While it is unlikely that Swiss tax authorities will now start taxing sellers in exit cases across the board based on this ruling, this development in jurisprudence is not without danger. Specific cases will need to be carefully examined, and this risk will need to be kept in mind and well advised. Sellers will be wise to assess the tax consequences of their exit structures thoroughly, to avoid any unfortunate surprises.
- With the relevant criteria becoming less clear-cut, only a tax ruling – filed in advance of the exit – can protect a seller and enable them to fully anticipate all tax consequences in an exit case.
Please contact the authors of this article directly to discuss any of the issues raised and to learn how A&M can help you.
https://www.alvarezandmarsal.com/insights/ma-tax-swiss-participation-dealer
