The treatment of treaties

Recent Swiss case law shows that Swiss courts are leaning towards a stricter interpretation of the conditions under which a US citizen residing overseas may apply for relief under the US double taxation treaty (DTT).[1] The findings of the Swiss Federal Supreme Court (the Court) raise some concerns, but also highlight novel planning opportunities for US citizens subject to tax in Switzerland, particularly if they avail of the lump-sum taxation regime.

The findings of the Court

The fact pattern behind this decision involved requests filed on the basis of the Swiss-US DTT for the refund of Swiss withholding tax levied on Swiss-sourced dividends received by a US citizen residing in the UK. Within this context, the Swiss Federal Tax Administration (FTA) asked the taxpayer to prove his qualification as a US resident on the basis of the DTT. Compared to other Swiss DTTs, one peculiarity of the Swiss-US DTT is the fact that a US citizen who does not live in the US may qualify as US-resident for DTT purposes as soon as ‘such person has a substantial presence, permanent home or habitual abode in the United States’.[2]

From the taxpayer’s point of view, he had a permanent home in the US and, therefore, argued that he had met one of the three (in his opinion) alternative criteria. The FTA, supported later by the Federal Administrative Court (the Federal Court), disagreed on the basis that the Swiss-US DTT calls for the three criteria to be applied as a tie-breaker rule. Bearing this in mind, the FTA and the Federal Court considered that the taxpayer did not qualify as a US resident for the purposes of applying the Swiss-US DTT, as he had failed to satisfy the permanent home test.

The Court agreed with the FTA and the Federal Court in terms of the outcome. Absent a permanent home and considering that the taxpayer did not prove that any of the two remaining criteria were met, he did not qualify as a US resident and therefore could not claim any Swiss withholding tax refund on the basis of the Swiss-US DTT. Unfortunately, the Court did not adjudicate on the question of whether the criteria under art.4(1)(a) of the Swiss-US DTT should be applied alternatively or cumulatively.

In the authors’ view, the interpretation of the Swiss-US DTT by the Swiss courts in their respective decisions is distorted. Indeed, an international agreement should first be understood according to its text, and its interpretation (taking into consideration its context and purpose) should remain compatible with the ordinary meaning of words used. In light of the clear wording of art.4(1)(a) of the Swiss-US DTT, there is no doubt that the three criteria are of an alternative nature. Considering also that US nationals are subject to an unlimited tax liability in the US on the basis of their citizenship, subjecting treaty benefits for US citizens residing in another jurisdiction to such cumulative conditions is, in the authors’ opinion, inappropriate.

This remains true for the reference made by the Swiss courts to a tie-breaker rule, which is at odds with the mechanism of DTTs, whereby the allocation of taxing rights among the contracting jurisdictions is rooted in the principle that a taxpayer is a resident of one jurisdiction only. The tie-breaker rule aims at achieving this by identifying the country with which an individual has the strongest ties when, on the basis of the general definition of residence in DTTs, that person is a resident of both contracting jurisdictions (for instance, by reason of residence in one jurisdiction and nationality in another). Referring to this rule in relation to the general definition of residence is, therefore, inopportune.

For these reasons, this decision could lead to US citizens being deprived of claiming the application of the Swiss-US DTT in bona fide situations. Although it is hoped that the FTA and Swiss courts will soon have the opportunity to review their position on this topic, even if it does not address the circumstances of US citizens residing in Switzerland, this decision raises issues with regards to the ability of the latter to claim the application of the US DTT network and how this may impact their Swiss tax burden under the lump-sum taxation regime.

The Swiss lump-sum taxation regime

To take a step back and give some context, the lump-sum tax regime allows non-Swiss citizens taking up residence in Switzerland, but not performing any gainful activity there, to opt out of the ordinary tax regime. The particularity of the lump-sum tax regime is that, instead of establishing taxation on worldwide income and wealth, it uses the taxpayer’s lifestyle expenses as a surrogate income tax base. In practice, eligible taxpayers agree on a lump-sum income tax base with the FTA by way of an advance tax ruling. Some cantons also impose a limited wealth tax in that context. Hence, this means that it is (in principle) unnecessary to report effective global earnings and assets under this regime.

That said, within the framework of the annual tax-filing process, lump sum taxpayers are required to report a limited number of elements on top of the lump-sum income tax base (the so-called ‘control computation’). These include Swiss-source income, Swiss-situs assets and foreign-source income for which the benefit of a Swiss DDT is claimed.[3] Such control computation is reviewed each year by the Swiss tax authorities, which compare the amount of income tax resulting from the lump-sum tax base with the total of the income and wealth taxes determined on the basis of the control computation. For each tax year, the taxpayer’s direct tax burden will be the highest of both amounts.

Implications for US citizens

To avoid an increase of their Swiss tax burden beyond the income (and limited wealth tax) charge resulting from their lump-sum taxation ruling, US citizens who realise significant yield from overseas investments that are subject to tax withholdings may consider relying on DTTs concluded by the US, rather than on the Swiss network of DTTs, to mitigate double taxation.

For instance, should a US citizen receive dividends from a German company, they may, at the first instance, consider relying on the Swiss-German DTT to reduce the withholding tax levied on this item of income from 30 per cent to 15 per cent. In such a case, the Swiss-tax-resident individual would be required to report in their control computation all Germany-sourced items of income. Depending on the amount at stake, this may result in an increase of their Swiss tax burden. To avoid this issue, they may alternatively envisage claiming the application of the US-German DTT on the basis of their nationality.[4] To that end, they should ensure, inter alia, that they have a substantial presence, permanent home or habitual abode in the US and check if a specific anti-abuse rule or an interpretation of the DTT by the German courts could lead to the denial of the US-German DTT taking into consideration their specific situation.

On the sole basis of the DTT text (and protocol), no ad hoc anti-abuse rule should apply to US citizens claiming US-German DTT benefits, provided they satisfy one of the three above-listed criteria. However, this would only be true so long as they have not put an arrangement into place purposely for meeting one of these criteria only with a view to benefiting from the DTT. If so, such benefit could be refused under the general anti-abuse provisions or doctrine.

Based solely on the wording of the provisions of US DTTs, it appears that US citizenship (alone or with substantial presence or permanent home or habitual abode) is sufficient to establish ‘residence’ in the US, with regard to more than 40 treaties.

In light of the above, US citizens living in Switzerland while benefiting from the lump-sum taxation regime should review their portfolio of assets to assess whether the yield from their investment is subject to tax withholdings that they may reduce on the basis of DTTs. If that is the case, and depending on the amounts at stake, as well as on the lump-sum income-tax base agreed upon with the FTA, they may consider relying on the US DTT network rather than claiming the application of DTTs entered into by Switzerland. This requires a careful examination of the wording of each individual DTT to assess whether these individuals may qualify for treaty benefits in light of the ties that they may have maintained with the US. Due consideration should be given in that context to the courts’ and tax authorities’ practices in each jurisdiction involved.