Is Switzerland under enough pressure from Europe institutions to clamp tax competition?

It is needless to say that international tax competition has become more intense as globalisation makes the world flatter. Switzerland is strategically centrally located in the hart of Europe and therefore in a privileged situation to attract foreign investment. A strong open economy, sacrosanct banking secrecy and a favourable tax system for multinationals have long made Switzerland amongst multinationals favourite headquarter locations.

As an example, the UK Times recently reported that Kraft Foods, the American multinational, recently announced that it is moving their European headquarters to Switzerland in search of efficient transport, lower taxes and an easier lifestyle.

The Swiss Federation, which includes 26 sovereign Cantons and approximately 2,900 independent municipalities, has a particular fiscally decentralised model for European standards. According to the Swiss Constitution, the Cantons have fiscal sovereignty and full right of taxation, except for particular sources that are allocated to the federal government. Basically, the Confederation (federal level) and the Cantons effectively share tax law making power for direct taxes on income and wealth.

Taking into account this decentralised model, the tax burden of a company may vary significantly depending on its Canton of residence. With a federal income tax levied at a flat rate of 8.5%, the effective income tax rate on profits for federal, cantonal, and communal taxes may be said to range between 13% and 30%, depending on the company’s place of residence. Nevertheless, at Cantonal level several tax incentives are available for example to newly established companies or holding, management and mixed companies. These incentives, which are ultimately designed to attract foreign investment, are an example of tax benefits available for multinational companies interested in locating their business in Switzerland.

The lowest corporate income tax rate in Switzerland is found in the business-friendly Cantons of Obwalden and Zug, where the effective income tax rate, including federal tax, is 13.1% and 16.44% respectively.

For much of the last decades, Switzerland has ranked amongst the wealthiest countries in Europe and recent studies have shown a boost of its international competitiveness. Low corporate tax rates, local tax incentives, favourable tax treaty network and recent access to EU free of withholding repatriation routes are amongst the main (tax) factors that explain the success of Switzerland in the international tax arena. Between international tax practitioners, Switzerland has become not only a favourable location for headquarters and holding structures, but also for finance and treasury activities (e.g. Swiss financing branches), commissioner and trading structures and last but not least a location for intellectual property and licensing activities.

The rise of Switzerland, just in the doorstep of Europe, as a favourable tax location has ignited again the tax competition debate. It is interesting to note that, both the OECD (which Switzerland is a member) and the European Union (with which Switzerland has several bilateral agreements) have been in the forefront of the discussion on tax competition.

It is important to recall that no longer than 10 years ago, OECD issued a groundbreaking report entitled, “Harmful Tax Competition: An Emerging Global Issue.” The project was based in three fronts: 1) identifying and eliminating harmful features of preferential tax regimes in OECD member countries 2) identifying “tax havens” and seeking their commitments to the principles of transparency and effective exchange of information and 3) encouraging other non-OECD economies to associate themselves with this work. As regards the first aspect, the 1998 report established a number of criteria for determining whether or not a preferential tax regime was harmful and included a commitment by the OECD Member countries to eliminate harmful tax regimes. The OECD work identified 47 preferential tax regimes as potentially harmful, out of which 19 regimes were, in the meantime, abolished, 14 amended to remove their potentially harmful features and 13 found not to be harmful on further analysis. In an annexed statement to the 1998 report, Switzerland (and Luxembourg) openly opposed the report.

In Europe, tax competition between member states has also been an issue for more than a decade now. The EU is marked by a significant diversity of company tax systems and as pointed out by the Ruding Committee report (1992), that tax differences among Member States distort foreign location decisions of multinational firms, and cause distortions in competition, especially in mobile activities. Following the OECD, the EU permissive attitude ended with the adoption on 1997 of the EU Code of Conduct for Business Taxation. On that occasion, the European Commission also made a commitment to clarify the application of state aid rules in the field of business taxation, which resulted on the 1998 Notice on the Application of State Aid Rules in the Field of Business Taxation. The EU Commission went on to defend that all 66 regimes that fell within the scope of the EU Code of Conduct for Business Taxation and were listed as harmful tax measures, were susceptible to a state aid investigation. This twin-track approach (code of conduct and state aid rules) implied a departure from the European Commission's previous policy and provided immediate success tackling tax competition within the EU borders. The problem is that outside the borders tax competition continues to increase (e.g. Singapore and Hong Kong) and only now EU Member States appear to be committed to promote the standard of the Code of Conduct with third countries.

The issue with Switzerland, from a EU perspective, stems from the fact that low cantonal tax rates and selective tax incentives may be said to contravene Art. 23 of the 1972 EU-Swiss Free Trade Agreement (FTA). Article 23 of the FTA reads as follows:

The following are incompatible with the proper functioning of the agreement in so far as they may affect trade between the Community and Switzerland:
(...)
- any public aid which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods.
Should a contracting party consider that a given practice is incompatible with this article, it may take appropriate measures under the conditions and in accordance with the procedures laid down in article 27.

Taking into account this provision, the European Commission in December 2005 launched a consultation procedure with the Swiss Authorities, stating that Cantonal tax incentives granted to holding, management and mixed companies, are incompatible with the FTA and constituted a distorting state subsidy. The EU authorities also understand that such a case against Switzerland may also be substantiated under WTO and OECD rules.

The growing importance of tax competition as a factor to attract capital and business activity, the limits of the EU bilateral path with Switzerland and its already lasting suspicion of joining the EU may have been the igniters of this new diplomatic offensive. This consultation has naturally a political backdrop, since in some member States view it is hard to accept that Switzerland, which benefits under certain bilateral agreements from a privileged access to the EU internal market, maintains an aggressive tax policy with the clear objective of attracting European mobile activities.

Nevertheless, Switzerland is not a member of the EU and State Aid, as such, is an alien and somewhat difficult concept to integrate in the existing legal order between the EU and Switzerland. Switzerland has since the rejection of the EEA agreement in 1992, adopted a different approach towards the EU, based on the conclusion of bilateral agreements. The political stakes were even raised after recently Swiss voters (narrowly) approved in November 2006 to give one billion Swiss francs (630m euros) in aid to the 10 new members of the European Union. The contribution to the European cohesion was the price agreed to pay when the EU and Switzerland agreed in 2004 a second package of bilateral treaties covering the EU-Swiss relations. On the other hand, the recent 2005 agreement between the Swiss Confederation and the European Community on the taxation of savings has even helped to reinforce the competitiveness of Switzerland tax system, by granting measures equivalent to those found in the EC Parent-Subsidiary and Interest and Royalty Directives to Swiss entities receiving or paying such items of income (see Art. 15 of the Agreement).

In this context, it is rather natural that Switzerland counter argued that the EU couldn't impose (indirectly) its State Aid rules by simply interpreting the said Art. 23 of the FTA in similar way as it interprets and applies Art. 87 of the EC treaty. In a fairly complete reply to the European Commission memorandum, the Swiss Federal Tax Administration responded by arguing:
- Firstly, that the said tax incentives do not fall within the scope of the FTA, which itself only governs the trading of certain goods, and that Art. 23 does not provide a sufficient basis for an appreciation of corporate taxation in terms of competition law;
- Secondly, that Art. 23 is not to be interpreted in the same manner as the EC treaty’s state Aid rules; and
- Thirdly, assuming that cantonal tax regulations would fall within the scope of the FTA, that the relevant incentives would not constitute a incompatible state subsidy because: (i) they take into account the (less) use of infrastructures and are justified; (ii) they are not selective; and (iii) there is no interference with the bilateral movement of goods.

The Swiss tax authorities concluded by simply rejecting any responsibility as a participant in the EU internal market and reiterated that Switzerland only "seeks to offer an attractive location for making business by providing for a package of advantageous conditions, as do all states. Corporate taxation is an important factor for choosing locations and making investment decisions – but not the only one by any means". To that effect the authorities pointed out that under the OECD parameters their system cannot be considered harmful, that in the EU one also finds a wide variety of tax levels and finally that the tax disparities in Switzerland do not arise at the federal level but instead at a Cantonal level.

The current state of play is unclear. One can argue that the fact that Switzerland is not a full EU member gives it more freedom regarding tax competition. Nevertheless, both politically and economically, Europeans should question whether Switzerland is under enough pressure from Europe institutions to clamp tax competition?

PS: this was my 201st post!