Memo regarding U.S. - Swiss Tax Treaty

MEMORANDUM

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To:	Client
From:	Robert L. Sommers
Re:	Outline and Checklist of Swiss - U.S. Tax Issues

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NOTE: This is a generic memo intended as a preliminary discussion regarding the potential structure and issues concerning your client. It is not intended as a legal opinion. There might be additional facts that could impact on the matters discussed in this memo. Also, the operation of Swiss law will have an effect on the final decisions that are made. Your client is cautioned against taking any definitive action on the basis of this memo.
The Basics of Foreign Taxation

Introduction

As a general rule of international taxation, the country in which income is earned has the right to tax that income. Often, this is referred to as "the first bite of the apple." The taxpayer’s country of residency may then tax the income again (the "second bite of the apple"). Usually, the taxpayer is given a foreign tax credit for the taxes paid in connection with the first bite of the apple, so that the taxpayer ends up paying tax on the income as would have been imposed if the income were earned in the country of residency. For example, assume a taxpayer from country X (which taxes its residents on their world-wide income at a flat rate of 25%) earns $10,000 in the U.S., and pays $1,500 in taxes to the U.S. The taxpayer will report $10,000 on his or her tax return for country X, and will be charged $2,500 on the income (25% of $10,000), but the taxpayer will have a foreign tax credit of $1,500 for payments made to the U.S. Therefore, country X will collect another $1,000.

Definitions

The taxation of foreign individuals and corporations is complicated and the taxing scheme contains several concepts and definitions. The following is intended as a set of basic and general definitions that may be used in the analysis that follows. There could be several important exceptions to these definitions and those exceptions, if applicable to the following analysis, will be discussed at that time.

1. U.S. source income: This is income generated in, or arising from, the U.S., including, business operations and investments located in the U.S. and payments from U.S. persons or entities.

2. Foreign taxpayer: A foreign taxpayer is a person or entity that is not a U.S. citizen or U.S. resident for income tax purposes. The definition of residency for income tax purposes is different that the definition of residency for estate tax purposes.

3. U.S. taxpayer: A resident or citizen of the United States and who is taxed on their world-wide income under the Internal Revenue Code of 1986 ("IRC").

A U.S. corporation owned by a foreign taxpayer is considered a U.S. citizen and pays taxes just like any other U.S. corporation. There are special tax withholding rules for U.S. corporations which own U.S. real estate and are owned by foreign taxpayers.

4. Engaged in a trade or business in the U.S.: When a foreign taxpayer is engaged in a trade or business in the U.S. ("ETB"), that taxpayer is treated as though he or she were a U.S. taxpayer with respect to the income that is effectively connected with the trade or business.

5. Effectively connected income ("ECI"): Effectively connected income is that income which is effectively connected with a trade or business operated by a foreign taxpayer in the U.S..

6. Fixed or Determinable, Annual or Periodic Income ("FDAP"): This type of income usually consists of interest, dividends, rents, royalties and personal services. It is usually income that is passive in nature and has a high gross-to-net ratio. In other words, FDAP income generally does not have business-type deductions associated with its production.

The Basis U.S. Taxing Scheme

The U.S. taxes income is two different ways, depending on whether the income is classified as FDAP or as business-generated:

1. Foreign taxpayers are subject to U.S. taxation on their "U.S.-source" income. FDAP income is taxed at a flat rate of 30%.

2. A foreign taxpayer who is engaged in a trade or business within the U.S. is taxed on the income that is effectively connected with the trade or business at regular tax rates as though the foreign taxpayer were a U.S. taxpayer.

Most importantly, income tax treaties between the U.S. and the foreign taxpayer’s country will override the tax provisions contained in the IRC.

Sometimes, the above rules apply to both income earned in the U.S. For instance, if a foreign taxpayer who is ETB will be taxed at regular tax rates on its ECI. If a foreign corporation operates as a branch office in the U.S., is a partner in a U.S. partnership, or a member of a Limited Liability Company, then in addition to paying tax at regular rates, it could be subject to the branch profits tax, which, in effect, will treat the after-tax income as dividends under the FDAP rules and impose an additional 30% flat tax on the income.

The purpose of the branch profits tax is to approximate the same tax treatment, whether a foreign corporation operates as a branch in the U.S. or forms a U.S. corporation as a subsidiary, since the subsidiary’s after-tax dividend to its foreign parent would be subject to the flat 30% tax as a dividend under the FDAP rules.

Impact of the U.S. - Swiss Income Tax Treaty

Corporations that are engaged in a trade or business in the U.S. are taxed at regular corporate rates on the income that is effectively connected with the trade or business. Example: If a foreign corporation conducts business in the U.S. and earns $1,000 in income and has $400 in deductions, it pays regular corporate tax under IRC Sec. 11 on $600 of profits. A foreign corporation that owns stock in a domestic (U.S.) subsidiary is not engaged in a trade or business by virtue of its stock ownership.

Corporations pay a flat 30% tax on income that is not effectively connected with a trade or business. This income is called "fixed or determinable, annual or periodic" income and generally consists of interest, dividends, rents and royalties. Example: A corporation invests in General Motors stock and receives $1,000 in dividends. It pays a flat tax of $300.00. The tax is withheld at the source by the agent for the corporation.

These first two principles are modified by an applicable income tax treaty between the U. S. and the foreign taxpayer. The U.S. and Switzerland have an income tax treaty. Therefore, the above rules would be modified as provided by the treaty.

The U.S. - Swiss treaty states that dividends will be taxed at 15% instead of 30%. Also, the treaty provides, in general, if a Swiss corporation owns 95% or more of a U.S. corporation, then dividends paid to the Swiss corporation will be taxed at 5%, provided the Swiss corporation is not engaged in a trade or business in the U.S. For example: If a Swiss corporation received $1,000 in dividends, it would pay a tax of $150, unless it owned 95% or more of the dividend-paying corporation in which case, it would pay $50 in taxes.

Furthermore, if a Swiss corporation receives royalties from a U.S. corporation, the payment of royalties is exempt from U.S. taxation, provided the Swiss corporation is not engaged in a trade or business in the U.S. For example, if a Swiss corporation licensed technology to a U.S. corporation and received $1,000 in royalty payments, none of those payments would be taxed by the U.S..

Interest paid to a Swiss corporation by a U.S. corporation is subject to a reduced, 15% withholding rate instead of 30%. However, the earnings stripping rules will apply to the interest payments to prevent the Swiss corporation creating an artificially high debt structure.

Note: The above principles apply to the U.S. taxation of earnings by a Swiss corporation in the U.S. Once the proceeds leave the U.S., Switzerland may impose another level of taxation on the income. To what extent Switzerland will tax dividends, interest and royalties received by a Swiss company from the U.S. is a matter for Swiss tax counsel to address.

Treaty Provisions

Impact of the U.S. - Swiss Income Tax Treaty.

The U.S. - Swiss treaty states that dividends will be taxed at 15%, instead of 30%.

Also, the treaty provides, in general, if a Swiss corporation owns 95% or more of a U.S. corporation, then dividends paid to the Swiss corporation will be taxed at 5%, provided the Swiss corporation is not engaged in a trade or business in the U.S.

For example: If a Swiss corporation received $1,000 in dividends, it would pay a tax of $150, unless it owned 95% or more of the dividend-paying corporation in which case, it would pay $50 in taxes.

Furthermore, if a Swiss corporation receives royalties from a U.S. corporation, the payment of royalties is exempt from U.S. taxation, provided the Swiss corporation is not engaged in a trade or business in the U.S.. For example, if a Swiss corporation licensed technology to a U.S. corporation and received $1,000 in royalty payments, none of those payments would be taxed by the U.S..

Interest paid to a Swiss corporation by a U.S. corporation is subject to a reduced, 15% withholding rate instead of 30%. However, the earnings stripping rules will apply to the interest payments to prevent the Swiss corporation from creating an artificially high debt structure.

Note: The above principles apply to the U.S. taxation of earnings by a Swiss corporation in the U.S.. Once the proceeds leave the U.S., Switzerland may impose another level of taxation on the income.

To what extent Switzerland will tax dividends, interest and royalties received by a Swiss company from the U.S. is a matter for Swiss tax counsel to address.

Application of the Above Principles to ACME

ACME is a Swiss corporation that will engage in certain business transactions in the U.S.. It may engage in the sale of software created by the Swiss corporation. The fundamental questions involving the structure of the U.S. company are:

l Whether the company should be incorporated as a subsidiary of the Swiss company or as a limited liability company;

l Whether profits should be retained in the U.S. or repatriated to the Swiss company;

l Whether the individual shareholders of ACME should own the technology in a separate Swiss corporation;

l Whether the relative income tax rates between individuals and corporations in Switzerland will cause adverse Swiss income taxation; the taxation on the sale of stock or assets by a corporation, compared with an individual; and

l Whether earnings retained in an off-shore corporation will be taxed immediately by Switzerland or whether the taxation on those profits will be deferred until the profits are distributed to the Swiss taxpayers?

Corporate Subsidiary vs. A Limited Liability Company.

California now permits limited liability companies to conduct business in this state. The owners of an LLC are called members.

A limited liability company with foreign members will be taxed as a partnership with foreign partners. Income will be taxed at the foreign partner’s U. S. tax rates (as either an individual or a corporation as the case may be), however, the income would not be taxed a second time, unless the member is a corporation and thus subject to the branch profits tax.

Whether or not an LLC would be considered a corporation for purposes of the Swiss - U.S. tax treaty is an open question. I believe a California LLC with Swiss members would be taxed as an LLC (a partnership under U.S. law), and each member would be treated as ETB in the U.S.

In contrast to an LLC, a U.S. corporate subsidiary would be taxed as a separate taxpayer. It would pay tax at corporate tax rates, but could accumulate income without distributing it. Under the U.S. - Swiss tax treaty, dividends will be taxed at 15% or 5%.

The main advantage of an LLC is to distribute profits directly to its members with one level of tax. But for corporate members, the branch profits tax will apply as though a dividend were paid, thereby causing a second level of tax.

Consequently, an LLC will not provide ACME with a tax advantage, although if the investors invested directly in the U.S. as LLC members, there could be an advantage, namely, one level of taxation on the earnings of the LLC.

Retaining Profits vs. Repatriating Them.

The first critical inquiry concerns how Switzerland will tax the profits received from a U.S. company. There are favorable treaty provisions with respect to the taxation of dividends and royalties, but if Switzerland will then tax those sources of income at high rates, then it would not be economically feasible to repatriate those profits.

My understanding is that a Swiss corporation, headquartered in Zurich, will pay a combined income tax of 27%. The tax rate for U.S. corporations would then be more favorable for taxable incomes of $75,000 or less, but less favorable for incomes exceeding $75,000.

The corporate tax rate is 15% on the first $50,000 in taxable income; 25% on taxable income between $50,000 and $75,000, and 34% thereafter.

The favorable brackets of 15% and 25% are phased-out at taxable incomes between $100,000 and $330,000 (the effective tax rate is 39%).

The general U.S. corporate tax rate is 34%, but corporations earning over $10,000,000 pay 35%.

Another alternative might be to use a tax haven, such as the Cayman Islands or another off-shore location, to structure the business.

For instance, the Swiss company could create a subsidiary in the Cayman Islands which, in turn, forms a California LLC.

The drawback in the ACME situation is that dividends will be taxed at either 15% or 5% under the U.S. - Swiss treaty, but will be taxed at 30% if paid to the Cayman Islands, since the U.S. does not have a tax treaty with Cayman. Interest will be taxed at 15% under the treaty, but at a flat 30%, if a Cayman Islands corporation is used.

Also, royalties which are tax-free under the U.S. - Swiss treaty will be taxed at a flat 30% if a Cayman Islands corporation is used.

In conclusion, since Switzerland has a favorable tax treaty with the U.S., use of an off-shore corporation would not be beneficial with respect to direct U.S. - Swiss business.

A Cayman Islands corporation may be beneficial for business operations outside the U.S., or in other circumstances where a Swiss company does not have a favorable tax treaty with the country in which ACME will be doing business.

Swiss tax counsel should advise ACME whether another tax-haven might provide benefits that are more favorable than under the U.S. - Swiss tax treaty.

Dealing with the Technology-Based Assets.

Certain technology has been developed that will be licensed to various companies in the U.S. and other countries. The key issue is: In what entity should the rights to the technology (the patents) be held?

If individual Swiss taxpayers are not taxed on the sale of corporate stock, and if this exception applies to closely-held corporations, then the individual owners of ACME should consider forming a Swiss corporation that only holds the patents.

In this manner, if the patents are sold in the future, the buyer can purchase the corporation and the shareholders will have sold their shares without tax.

Also, a Swiss corporation can receive royalty payments tax-free from the U.S. under the U.S. - Swiss income tax treaty. If the taxable income from the U.S. exceeds $75,000, then the Swiss corporation should be taxed at a lower rate than a U.S. corporation.

It appears the patents should be held in a separate Swiss corporation, but Swiss legal and tax counsel must analyze this premise under Swiss law.

If the patents are held by an off-shore corporation, the sale of stock in the off-shore corporation should not be taxable in the corporation’s country of registration. However, Swiss tax law could adversely impact such a situation and Swiss tax counsel will have to advise ACME on this point.

Transfer Pricing Issues.

Both the U.S. and Switzerland require that related entities price their products and services as though engaged in an arm’s length transaction.

The U.S. taxing authorities are extremely aggressive in this area, and careful and thorough economic analysis and reasoning must be employed in setting the price of any inter-company transaction.

Therefore, if technology will be licensed between ACME and a related party in the U.S., the price charged under the license must comply with U.S. tax law regarding arm’s-length pricing. Also, stringent tax reporting requirements are part of the law.

Since the transfer pricing rules apply to related corporations, if either shareholder formed a U.S. corporation, and ACME provided goods or services to it, one could argue that the two entities were not related since the owner of the U.S. corporation would only own 50% of ACME and would not be in control of it. Therefore, theoretically, there would be no common control of the enterprises.

This, of course, would be an aggressive position and should be considered only after careful research.

Creative Alternatives for Structuring the U.S. Enterprise.

The Swiss corporation is owned equally by two individuals who are not related.

If one of them forms a U.S. corporation and the other loans funds to the corporation, the lender will qualify for the portfolio interest exception, which means that all interest payments will be made free of U.S. tax. Currently, there is a 15% tax on interest paid between related parties.

For example: Assume the U.S. corporation earns $150,000. It has an outstanding loan of $1,000,000 at 12% interest, and makes a $120,000 interest payment. If that payment is made to an unrelated party (a party that does not own 10% of the borrower), and if the loan is properly structured, then the U.S. company will be entitled to a deduction of $120,000, and the payment of that amount will be made to the lender tax-free.

Of course, the lender in this situation will not have an ownership interest in the U.S. company (or his ownership interest will be less than 10%) so that any increase in value will inure to the majority shareholder.

But the concept of a portfolio interest loan is worth exploring, especially if the two shareholders are willing to own the U.S. company unequally, as described above.

In this situation, the Swiss corporation would license its technology to the U.S. company, since it cannot have a direct ownership interest therein (otherwise, the lender would own 50% of the borrower and the portfolio interest exception will not apply).

Tentative Conclusions

Depending on the answers received from Swiss tax counsel as to the issues posed in this memo, the following is an outline of suggested tax results arising from a series of different scenarios. This discussion is merely a checklist of primary options. (See the Note at the beginning of this Memo regarding its use).

Scenario 1: A Separate Swiss Corporation Holding the Technology and Licensing its Use by the U.S. subsidiary of ACME.

Description: Under this scenario, a new corporation would be formed in Switzerland (by the investors as individuals) and it would hold the patent. It would then license the use of the patent to a U.S. subsidiary of ACME (which will conduct the software sales).

Advantages: If the patent is held in a separate Swiss corporation, then as I understand Swiss law, the sale of corporate stock by individuals will be tax-free. Royalties will flow into the Swiss corporation free from U.S. tax under the U.S. - Swiss treaty. The income tax paid on the royalties will be taxed at a lower corporate rate in Switzerland than in the U.S. (for taxable income over $75,000 a year).

There would be no dividends or interest payments from the U.S. to this corporation, since its sole function would be to license its patent.

Disadvantages: Transferring the patent asset into a new company could cause tax and employment issues in Switzerland, since ACME may have been the company that created the technology. Swiss tax and employment counsel will have to advise ACME on these and related issues.

There will be a Sec. 482 transfer pricing issues relating to the pricing of the royalties between the new Swiss corporation and the ACME subsidiary, since under U.S. tax law, both the new Swiss corporation and the ACME subsidiary are considered related.

Comment: If this works, it is the best approach for the patent.

Scenario 2: ACME Holding the Patent and Licensing It to Its Subsidiary.

Description: This is similar to Scenario 1, except that ACME would own the patent and a later sale of the patent will be considered a taxable capital gains transaction since corporations are subject to Swiss capital gains tax. The tax, however, would be less than if the U.S. subsidiary held the patent and sold it.

Advantages: Lower capital gains tax on the sale of the technology or the ACME stock, tax-free flow of royalties to ACME in Switzerland. None of the issues described in Scenario 1 involving the transfer of the asset to ACME are present here since (presumably) it was involved in the development of the technology. Dividends will be taxed at 5%, assuming the U.S. subsidiary is at least 95% owned by ACME of Switzerland (otherwise dividends are taxed at 15%). Interest will be taxed at 15%.

Disadvantages: Capital gains tax in Switzerland, Sec. 482 transfer-pricing issues. The earnings stripping rules will apply to interest deductions taken by the U.S. subsidiary.

Comment: This appears to be the second choice with respect to the patent.

Scenario 3: Using a Cayman Island Corporation.

Description: Instead of using a Swiss corporation to hold the patent, why not transfer the patent to a tax-haven such as a corporation formed in the Cayman Islands?

Advantages: None with respect to business operations in the U.S. since the U.S. - Swiss treaty is much more favorable.

Swiss tax counsel will have to advise ACME as to whether there are other tax havens that would provide benefits greater than those obtainable under the U.S. - Swiss tax treaty.

Disadvantages: There will be a flat 30% withholding rate on all interest, dividends and royalties paid from the U.S. to a Cayman Islands corporation. There would be no Cayman Islands tax on the sale of stock or the patent held by a Cayman Islands corporation, but Swiss law might tax the transaction as though the Cayman Islands corporation did not exist.

Swiss tax counsel needs to provide an answer to this issue.

Comment: Since use of a Cayman Island corporation will cause the maximum flat tax on dividends, interest and royalties, it should not be considered with respect to business dealings with the U.S.. With dealings in other countries, however, use of a Cayman Islands corporation or other tax-haven might be beneficial.

Swiss tax counsel is needed to advise on the taxation by Switzerland of income earned by a related corporation formed in a tax-haven country.

Scenario 4: Use of an LLC vs. a Corporate Subsidiary.

Description: Under this scenario, if an LLC is used, its members are taxed directly. Corporate members are subject to a withholding tax of 35% and individuals face a 38.5% withholding tax, pending the filing of U.S. income tax returns. If a U.S. subsidiary is used, there is no withholding tax issue.

Advantages: An LLC really does not provide a tax advantage to ACME as its structure is presently contemplated. An LLC could provide an advantage to foreign members who are individuals, since there is no branch profits tax for individual members. The payment of FDAP (interest, dividends, rents and royalties) would be governed by the U.S. - Swiss treaty, and would be the same whether an LLC or corporate subsidiary is used. Likewise, the 30% flat rate on FDAP would apply to a Cayman Islands corporation which was a member of an LLC.

Disadvantages: ACME, as a corporate member of an LLC, faces a branch profits tax of presumably 5% or 15%, depending on how the branch profits tax applies when an LLC is used. A Cayman Islands corporation would face a 30% branch profits tax.

Comments: The branch profits tax should equal the dividend tax under the Swiss treaty. Consequently, there is no advantage to using an LLC under this scenario. Since the tax would be approximately equal, whether a corporate subsidiary or an LLC is used, the corporate subsidiary would provide more flexibility, and the tax on dividends would be postponed until an actual distribution is made.

An LLC could be useful if individuals wanted to invest directly in the U.S., since the branch profits tax would not apply to them. Also, an LLC, as a joint-venture vehicle between two or more corporations could prove beneficial from a business standpoint.

Structure of ACME in the U.S. with Corporate Subsidiaries.

Description: Whether or not a new corporation is used to hold the patent, ACME should use the following structure in the U.S. for its business operations:

A U.S. parent holding company, with a separate corporate subsidiary for each line of business. Assuming ACME will have three lines of business, computer software, computer hardware and stereo speakers, a separate subsidiary should be formed for each of them. See the attached diagram.

Advantages: ACME will be able to use the consolidated return rules to combine the income and losses from each corporation at the U.S. parent corporate level. Also, if it needs to sell one of the businesses, it can sell either the stock or the assets of that separate business.

Disadvantages: More complexity to the structure and more tax and accounting records.

Comments: This is the structure typically adopted by corporations engaged in more than one separate business in the U.S.. This structure permits the sale of an entire business or the tax-free reorganization thereof, without affecting the other businesses.