Withers Worldwide

(An edited version of this article appeared in Trust Law International, Vol. 20, No 1, 2006)

Part 1

Introduction

In this article I will discuss the draft guidelines regarding the taxation of trusts which are currently being worked on by the Swiss Tax Conference, the body which represents the Heads of the 26 cantonal tax authorities.

At the time of writing, the draft guidelines have not yet been published, but an advance copy makes for some worrying reading and raises important questions which need to be addressed urgently if Switzerland wants to achieve a place of pre-eminence in the international trust arena.

Before looking at the guidelines in detail, it may be useful to put them in context and to look first at the bigger picture of the fundamental tax issues facing countries which decide to formally recognise trusts.

1.1          Tax issues for countries that wish to recognise trusts

Art. 19 of the Hague Trust Convention provides that "Nothing in the Convention shall prejudice the powers of States in fiscal matters". This is not surprising, as the Hague Trust Convention is an instrument of private international law.  On the other hand, the correct tax treatment of trusts is a fundamental issue on which the success of trusts within the jurisdiction concerned will depend in practice.  The introduction of punitive tax treatment by a country that is considering ratifying the Hague Trust Convention (or otherwise formally recognising trusts)[1] will give the signal that trusts will simply be tolerated, whilst a balanced approach (or the introduction of advantageous tax rules) will give the signal that the jurisdiction concerned is open for business.

As is well known, Italy ratified the Hague Trust Convention without paying any attention to the tax angle and this has created a degree of uncertainty which is currently concerning Italian practitioners.  By contrast, San Marino has taken the wise decision of ratifying the Hague Trust Convention and introducing appropriate tax rules at the same time.  This is perhaps unsurprising, as San Marino is presumably aiming to attract trust business from neighbouring Italy.

The following is a selection of the fundamental tax issues which face a country considering recognising trusts (there may be others):

(a)         Should the transfer of property from the settlor to the trustee be subject to gift or estate/inheritance/succession tax, having regard to the fact that the trustee is not intended to benefit from the transfer (absence of an animus donandi)?

(b)         If the answer to the previous question is in the affirmative, which tax rate should apply?  This issue is particularly relevant for those (mostly civil law countries) which levy gift and inheritance/succession tax by reference to the degree of relationship between the donor and the donee.  The closer the relationship, the lower the tax rate applicable.  The correct application of gift/succession tax rates is particularly puzzling where the settlor transfers property into a discretionary trust where the potential beneficiaries are not yet ascertained or where the class of beneficiaries is not yet closed.

(c)         Moving on to direct taxes, who should be the tax subject?  The trust, the trustee, the settlor or the beneficiaries?

(d)         Should the gains and income of the trust be attributed to the settlor during the lifetime of the trust if he/she continues to benefit (or to be able to benefit) from the trust?

(e)         How should the gains and income of the trust be characterised in the event of a distribution to the beneficiaries?  Will an interest payment received by the trustee be taxed as interest in the hands of the beneficiary? Should payments to a beneficiary be treated as a dividend or as a special type of income or even as a gift from the trustee to the beneficiary?  The issue of characterisation (and re-characterisation) is particularly acute when the income of the trust is accumulated instead of being distributed during the same year in which it has been received by the trustee.

(f)           Should the beneficiary or the settlor (as the case may be) be entitled to claim tax relief e.g. in the form of a tax credit/tax refund , if the income and/or gains of the trust have already been taxed in the hands of the trust or in those of the trustee (issue of economic double taxation)?

(g)         Should the country in which the trustee is resident levy withholding taxes in respect of items of income which have their source in that country when the beneficiaries are resident abroad?  And if so, who should be entitled to reclaim those withholding taxes (the trustee or the beneficiaries)?

(h)         How do double taxation treaties apply in the context of a trust?  Is it correct to treat a trust as a "person" as defined for the purposes of Art. 3(1)(a) of the OECD Model Tax Convention? [2]

(i)           Finally, how does VAT apply in the trust context?  Should a trustee add VAT to his fees when the trust has its "seat" in the same country even though the beneficiaries are resident in another country / outside the EU?

1.2        The UK's approach to the taxation of trusts

The UK is an interesting jurisdiction for countries which are considering the ratification of the Hague Convention, not least because the UK has been dealing with trusts for centuries.

The UK has adopted a dual approach with regard to the taxation of trusts.  This approach is basically based on two underlying principles of fiscal policy which are that: (1) the use of trusts should not confer any tax advantages over outright ownership; and (2) the UK should serve as an attractive country for international trust business and certain expatriates.

Building on the first of these two underlying principles, the main UK tax characteristics of trusts can be summarised as follows (the following is only a selection):

(a)         Usually, the creation of a discretionary trust triggers an immediate UK inheritance tax charge which is equivalent to one-half of the charge of 40% which applies for transfers mortis causa.  The initial charge of 20% is topped-up to 40% if the settlor dies within 7 years from establishing the trust.  In addition to this ‘entry' charge, there is a periodic inheritance tax charge of 6% every ten years (payable by the trustees).

(b)         When these rules were brought in, all lifetime transfers were charged at one-half of the death rate applicable from time to time, so that the establishment of a discretionary trust and an outright gift would have the same tax consequences, which avoided distortions.  As to the periodic charge, it was thought that the typical time span for passing wealth from one generation to another was about 30 years and that a well advised client would take advantage of the one-half rate to make lifetime gifts, rather than allowing assets to pass at the full tax rate on his death.  A discretionary trust regime which resulted in tax at 38% over 30 years (i.e. ‘entry' charge of 20% plus 6% on each of 3 10 year anniversaries) was approximately equal to the total charge for a lifetime gift (charged at 20%) followed by another lifetime gift (also charged at 20%) a generation later.  Thus, broad fiscal parity was achieved between outright ownership and ownership via a discretionary trust[3].

(c)         Similar considerations of fiscal neutrality apply in the context of life interest trusts.  A life interest trust is a trusts under which a person is entitled to receive the income of the trust during his lifetime.  For inheritance tax purposes, the life tenant is treated as owning the underlying assets.  This means that when his life interest terminates with his death, the whole trust fund may be taxed at the tax rate of 40%, as if the trust did not exist.

(d)         Furthermore, the UK income and capital gains tax legislation contains provisions which are designed to prevent taxpayers from obtaining "unfair" tax advantages during the life of the trust. This approach is taken to the extreme.  Accordingly, there is an automatic attribution to the settlor of the income and capital gains realised by the trustees, if the settlor or his spouse benefit (or are potentially able to benefit) under the trust. Similarly, the UK inheritance tax regime treats settlors who retain the possibility of benefiting from the assets they have settled as if they had retained them in their own ownership (the ‘gift with reservation of benefit' rules). The idea is that the settlor should not obtain any tax advantage by inserting a trust structure between himself and his assets.  As a result of this draconian legislation, there is generally no tax incentive for a person to establish a settlement under which he can benefit, and most UK settlements are designed to benefit only non-settlors and accordingly contain a clause which excludes the settlor and his spouse from any possible benefit ("Excluded Persons"-clause).

(e)         In the same vein, the income and capital tax gains rate applicable to trusts has recently been aligned to the highest marginal rate applicable to individuals (currently 40%).  The idea is that most settlors who can afford a trust are higher tax rate payers and the introduction of a single tax rate for trusts which corresponds to the highest marginal rate for individuals is designed to prevent higher tax rate payers from creating a separate pot of assets which benefit from a privileged tax treatment.  On the other hand, the system is designed to be neutral with regards to beneficiaries.  Thus, in the event of a distribution, a beneficiary who pays tax at the lower rate of 10% or the basic rate of 22% may obtain a refund of part of the 40% tax paid by the trustees in certain circumstances.

(f)           The phenomenon of rolling-up ("parking") foreign income and capital gains offshore has been tackled by the introduction of sophisticated anti-avoidance rules.  These rules operate in such a way that if a trustee makes an (otherwise tax-free) capital distribution to a beneficiary in circumstances in which there is accumulated income or a pot of realised capital gains within the trust, the capital distribution is treated as a distribution of income or capital gains in the hands of the recipient beneficiary. In essence, these anti-avoidance provisions are an adaptation of the traditional Controlled Foreign Company ("CFC") rules to trusts.  Under these rules, the profit realised by a company which is resident in a low tax jurisdiction but which is controlled by a taxpayer who is resident in a high tax country is automatically attributed by that high tax country to the resident taxpayer, even if the profits have not been distributed to him but are instead accumulated offshore.  The present UK tax regime does not go to the extremes of attributing the profits to beneficiaries on an arising basis (though there was a brief period in the early 1980s when the applicable legislation sought to do so) but instead charges tax on those profits in the hands of the beneficiaries when they receive distributions.  It is important to note for the purposes of this article that, unlike the UK, Switzerland does not have any specific CFC legislation and has also voiced its strong opposition to this type of legislation on the international stage[4].

It will be seen from the above that the prevailing principle of fiscal policy is that the UK tax system should not create any distortion the unintended effect of which would be to favour one form of ownership (trust) over another (outright ownership).

On the other hand, the UK has introduced legislation to attract international trust business and certain expatriates to the UK. These measures can be summarised as follows:

(a)                 the UK income and capital gains tax legislation contains provisions which effectively turn a UK resident trustee into a non-UK resident trustee in certain circumstances where the settlor has no links with the UK. As the trustee is the main tax subject for trust income and capital gains (unless they are attributed to the settlor), having a non-resident trustee means that the trust is effectively exempt from UK taxation (with the exception of UK source income).

(b)                 In addition, certain expatriates (known in the UK as "non-domiciliaries")[5] who live in the UK benefit from a preferential tax regime both personally and when they use trusts.  In these circumstances, a discretionary trust or a life interest trust does not trigger any UK inheritance tax charge (provided the trust property is situated outside the UK). In addition, capital gains within the trust are not attributed to the settlor or to the beneficiaries in the event of capital distributions.  As to accumulated offshore income, this is attributed to the settlor or the beneficiaries, but only to the extent that it is remitted to the UK, which means that non-domiciliaries can roll-up trust income offshore while receiving capital distributions from the trust directly in the UK free of tax.

Part 2

The Swiss draft Tax Guidelines

2.1        Switzerland: a complex reality

Not all Swiss cantons are accustomed to dealing with trusts, but those which are, have developed a tax practice based on the existing tax rules.  Unsurprisingly, the existing cantonal practices vary considerably, not only because of the possible different interpretations of the existing tax rules, but also because some tax authorities have been driven by a desire to attract trust business to their territory by the prospect of increased revenues levied on the fees of trustees, custodians, lawyers, etc.  In practice, whenever two or more possible interpretations of a tax norm exist, these cantons have opted for the most liberal interpretation, whilst the other cantons tend to opt for the more rigorous interpretation.  Traditionally, the federal tax authorities in Berne have also opted for the more rigorous among available interpretations.  Where the various tax authorities are at liberty to set their own rules (as in the field of gift and succession taxes), the co-existence of different rules does not raise any conceptual concerns.  However, income tax is levied both at the cantonal and at the federal level based on harmonised rules[6].  In these circumstances, the different application of the same rules by different tax authorities has laid bare the deficiencies of the Swiss approach and also given rise to frictions between some liberal tax authorities and the federal tax authorities.  One reason for these tensions is that the cantons act as collecting agents for the federal authorities and are therefore supposed to correctly apply the federal statutes in the process.

2.1          Existing practice

The fiscal conundrum which exists in Switzerland manifests itself both in the field of gift and succession taxes and in the field of income tax:

With regard to gift and succession taxes, cantons have had to decide whether a gratuitous transfer of property from the settlor to the trustee is a taxable event (absent an animus donandi) and, if so, which tax rate should apply.  Unsurprisingly, the solutions adopted by the various cantons differ widely: some tax authorities disregard the beneficiaries and simply apply the tax rate in accordance with the degree of relationship between the settlor and the trustee, with the result in most circumstances that the establishment of a trust by a Swiss resident settlor triggers tax at a prohibitive rate, at least where the trustee is a non-related professional. At the other end of the spectrum, some cantons look exclusively at the relationship between the settlor and the beneficiaries (disregarding the trustee).  Finally, a third group of cantons apply an average between the lowest possible and the highest possible tax rates[7].  This difference in approach is clearly unsatisfactory.

The other fundamental question with which the Swiss tax authorities have been faced in the past is how any income and (where relevant) capital gains realised during the life of the trust should be taxed.  Should trusts be taxed by reference to the rules which apply to foreign companies? Under Swiss tax law, foreign legal entities are to be assimilated to the domestic legal entities which they most closely resemble[8]. In addition, foreign bodies of persons without legal personality with a branch / land in Switzerland are taxed thereon according to the rules on legal entities[9].  Clearly, a trust is not a legal person and it is doubtful whether it fits squarely within the definition of "body of persons", given that this term has been designed primarily with partnerships in mind.  However, as already mentioned in my previous article which appeared in a recent issue of Trust Law International[10], there is a controversy in Switzerland as to whether civil law terms contained in tax laws should be interpreted by strict reference to their civil law meaning (‘legalistic approach') or whether it is possible to interpret these terms autonomously according to economic considerations (‘economic or functional approach')[11]. The Federal Court has accepted the admissibility in principle of the economic or functional approach in more than one instance[12], so that the question in each given case is whether the terms used in the law, the intentions of parliament, the context and purposive considerations lead to the conclusion that a particular civil law term should be interpreted strictly by reference to its civil law meaning or more loosely, taking into account also economic considerations.

2.3          Switzerland's fiscal dilemma

Unsurprisingly, a first group of business friendly tax authorities has promoted the use of a legalistic interpretation (trust neither a legal person nor a body of persons), while a second group of tax authorities (including, it would appear, the federal tax authorities) has advocated the use of a functional approach in connection with trusts.  Under this approach, trusts are to be assimilated to foreign companies/ bodies of persons, with the result that most trusts with a Swiss trustee would be subject to Swiss corporation tax on their worldwide income (by virtue of management and control being situated in Switzerland).

In theory, both interpretations are possible, which is confirmed by the fact that the legal commentators are also split[13]. Even a layman may see that the continued reference, by the Swiss authorities, to company law concepts in connection with trusts (such as the reference to the "seat" of a trust or to the fact that beneficiaries "have certain control and supervisory rights which puts them into a similar position to officers of a company"[14]) opens the door to an assimilation of the trust to a company for tax purposes.  Even the strongest advocates of the legalistic approach find it difficult to reconcile the apparent contradiction between the conclusion that a trust is not a "body of persons" for the purposes of Swiss direct taxes but is nevertheless a "body of persons" for the purposes of Switzerland's tax treaties[15].

The real issue is not so much an issue of interpretation, as an issue of fiscal policy, i.e. does Switzerland really want to tax foreign trusts when its stated aim is to take on offshore trust jurisdictions such as the Channel Islands[16]?

In order to resolve this issue, the Swiss government announced in its Explanatory Report of 20 October 2004 the establishment of an ad hoc working group comprised of members of the federal and cantonal tax authorities[17] with a view to issuing guidelines dealing with the taxation of trusts.  Since the making of this announcement, the federal tax authorities have decided not to enter onto the stage and the work is currently being undertaken by the Swiss Tax Conference which represents the Heads of the 26 cantonal tax authorities. This body has prepared a first draft Tax Guidelines.

2.4          Fiscal policy objectives

The first policy objective pursued by Switzerland has already been mentioned and is Switzerland's desire to take on the offshore trust jurisdictions to become a pre-eminent platform for international trust business.  Obviously, the prospect of worldwide taxation for trusts administered in Switzerland is inconsistent with this objective.  Against this backdrop, it should come to no surprise that the prospect of applying the rules on companies to trusts has been brushed aside in the draft guidelines.  The verdict could not be clearer (my translation):

Given the extent to which this statement appears to have been influenced by fiscal policy considerations, it is perhaps unfortunate that the draft Tax Guidelines begin with the reference to the idea ventilated by the Department of Justice in the Explanatory Reports of 20 October 2004 and 5 December 2005 that beneficiaries "have certain control and supervisory rights which puts them into a similar position to officers of a company".  Whilst this idea is thought-provoking, it does not help to dispel the perception that a typical trust has certain functional affinities with a foreign family foundation (which are legal entities fully taxable in Switzerland to the extent that they are effectively administered in that country).  It is also perhaps unhelpful that the Swiss tax authorities are not consistent in their interpretation of the rules on legal entities.  Whilst they are most happy to accept that a trust is not a legal person, they also reject the idea that a Luxembourg SICAV (Société d'Investissement à Capital Variable) should be treated as a company for Swiss tax purposes.[20]

The second fiscal policy objective is more interesting as it appeared in the first version of the government's Explanatory Report of 20 October 2004, but was subsequently dropped in the version of 5 December 2005.  The Explanatory Report of 20 October 2004 contained the following statement (my translation):

As mentioned above, this statement was curiously dropped from the version of 5 December 2005 of the Explanatory Report but, although it is not expressly mentioned in the draft tax guidelines, it clearly pervades them. Indeed, the fundamental principle which underlies the draft Tax Guidelines is that a trust should not enable a Swiss taxpayer to obtain privileged tax treatment or simply to defer tax. 

In principle, there is nothing wrong in wanting to pursue the restrictive policy mentioned above.  Each country is free to define its fiscal policy as it wishes and we have seen that the UK has taken a similar approach (see point 1.2 above).  The problem with the Swiss guidelines is that they lack any legal basis and are absolutely arbitrary.

2.5          Missing legal basis for the current proposals

Here is what the draft tax guidelines say in relation to settlor-interested trusts (my translation):

2.6          Discussion

The current proposals are arbitrary.  Guidelines issued by administrative authorities (including the tax authorities) are supposed to clarify the interpretation of existing principles, not to re-write statutes.  This is a prerogative of Parliament (save in the case of delegation).

As regards the interpretation of tax statutes, the two main approaches which exist in Switzerland have already been mentioned above and are (a) the "legalistic approach" (according to which terms contained in tax legislation should be interpreted by strict reference to their civil law meaning); and (b) the "economic or functional approach" (which enable considerations relating to the ‘economic content'[24] of a legal transaction to be taken into account in interpreting the scope of a provision).

The draft Tax Guidelines state that any settlement which contains a power of revocation or which contains any other power in favour of the settlor or under which he is able to benefit is a revocable settlement (sic!), the upshot being that the funds comprised in the trust fund are treated as belonging to the settlor for tax purposes (look-through approach).

As a matter of trust law, the term ‘revocable trust' refers to a trust which can be terminated by the settlor by virtue of a power contained in the trust instrument.  Any other trust is irrevocable.  Whether or not the settlor is a beneficiary of the trust or has reserved to himself the powers mentioned in the draft Tax Guidelines (power to hire and fire trustees, power of veto in relation to trustees' decisions, etc.) is irrelevant.

Applying economic considerations there is some merit in the argument that a trust which contains a power for the settlor to change the trust instrument is functionally equivalent to a revocable trust, as the settlor may use his power to alter the trust instrument by including a power to terminate the trust and direct the return of the trust fund to the settlor.

However, a discretionary trust from which the settlor is able to benefit purely at the discretion of the trustees cannot be said to be functionally equivalent to a revocable trust.  Unless there is evidence that the trustees have used their powers to make distributions to the settlor to the exclusion of the other discretionary beneficiaries, the settlor-beneficiary has no legal rights in respect of the trust fund.  It is arbitrary to assimilate an irrevocable trust from which the settlor can benefit to a revocable trust using economic or functional arguments.

The same goes for the other cases mentioned in the draft Tax Guidelines.  The reservation of a power to hire and fire trustees does not mean that the settlor has economic dominion over the trust fund (which would justify a look-through approach).  Certainly, a settlor may use his power to hire and fire trustees as a threat to tame rebellious trustees and bend them to his own will.  However, it is also clear as a matter of trust law (at least where the power to remove trustees is a fiduciary one) that trustees should stand up to the settlor and, if they reasonably believe that the settlor is acting arbitrarily, they should resist any attempt to remove them and apply to the court for directions instead[25].

Similar consideration apply to a power of the settlor to appoint or replace a protector, which is also mentioned in the draft Tax Guidelines as an indication that the trust is ‘revocable', not in the legal meaning of the term, but in its functional meaning which is that the trust fund belongs economically to the sphere of the settlor (and should be taxed accordingly).  Again, the existence of a power to add or remove protectors does not in itself impinge on the power of the trustees to administer the settlement independently.

Moving on, the draft Tax Guidelines argue that the existence of a power of the settlor to add beneficiaries results in the trust being ‘revocable' and thus tax transparent.  This confuses the issue: adding to the class of potential beneficiaries of a discretionary trust cannot be equated to controlling the manner in which the trust assets are applied: it is for the trustees to decide who amongst the class of potential beneficiaries should actually receive funds and the settlor cannot control this merely by adding potential beneficiaries to the class.  Thus, even adopting an economic approach, it cannot be said, as the cantonal tax authorities do, that by virtue of a power to add to beneficiaries the settlor remains, despite the transfer, the economic controller of the trust fund, let alone its legal owner.

2.7          Proposals

The current proposals are arbitrary.  If the Swiss tax authorities wish to introduce draconian legislation dealing with settlor-interested trusts along the lines of the UK legislation, they should seek to amend the Federal Law on Direct Taxes and the Tax Harmonisation Law respectively.  In practice, it might be useful for the federal tax authorities to intervene in the debate.  Given that they are more remote from day-to-day commercial considerations, their intervention should guarantee a level of objectivity which may not be found at the cantonal level, partly because of the existing competition which exists between those cantonal tax authorities which are determined to defend and increase their share of revenue generated by the trust business (in the form of taxation of trustees' fees, etc.) and those tax authorities who are less exposed to trusts and thus perhaps more diffident.  In any event, the current compromise between the different currents is legally inappropriate.

It is also submitted that, as matters stand, the draft Tax Guidelines are contrary to Switzerland's current fiscal policy.  As mentioned above, Switzerland has declared on the international stage its principled opposition to the idea of Controlled Foreign Company legislation. However, by applying an extensive interpretation to the term ‘revocable trust' the cantonal tax authorities effectively aim at taxing accumulated profits of an offshore trust in the hands of the Swiss resident settlor, which is the functional equivalent of CFC legislation in the context of trusts.  Admittedly, Controlled Foreign Companies are not completely outside the Swiss tax net, insofar as the value of the shares in them are subject to cantonal wealth, gift and succession taxes in the hands of the Swiss shareholder.  By contrast, a beneficiary's interest under a discretionary trust cannot be subject to wealth, gift or succession tax (as the beneficiary does not have any legal rights in the trust fund).  However, wealth tax is a relatively minor tax (generally less than 2%) and its avoidance via a trust cannot, in my view, justify the disparity of treatment between CFCs and trusts for income and capital gains tax purposes.  As to gift and succession taxes, most cantons exempt transfers between spouses and between ascendants and descendants[26], so that the shares in a CFC can be passed on to the next generation free of gift and succession taxes in most cases.

The extensive look-through approach contained in the draft Tax Guidelines indicates the persistent distrust which seems to exist within various circles of the cantonal tax authorities when it comes to trusts.  Perhaps, the most telling indication is the direct reference to the case law of the Federal court in relation to family foundations as a legal basis for the interpretation contained in the draft Tax Guidelines.  That case law concerns cases of manifest abuse of law and the logical implication seems to be that any trust contains by definition an element of abuse.  This is neither here nor there and puts in question the seriousness of Switzerland's commitment to recognise trusts.

There is no doubt that the Explanatory Report issued by the Federal Department of Justice contains an excellent analysis of the trust concept and is a serious piece of work, but there seems to be a fundamental difference between the approach taken by the Federal Department of Justice and the cantonal tax authorities.  The difference in the quality of the work undertaken by the Federal Department of Justice and the cantonal tax authorities is illustrated by the following statement contained in the draft Tax Guidelines:

This contrast with the (correct) analysis contained in the Explanatory Memorandum issued by the Federal Department of Justice:

Perhaps the current problems could be resolved by an intervention of the Federal tax authorities with a view to reaching a balanced solution with the cantonal tax authorities which takes into account considerations of fiscal policy but also reflects legal principles.

2.8          Conclusions

For most international clients, it will be business as usual.  On the one hand, the ratification of the Hague Trust Convention will introduce much needed clarity.  On the other hand, the draft tax guidelines make it clear that the mere presence of a trustee in Switzerland does not expose a trust structure to Swiss tax.

However, the more cynical amongst the international clients will wonder whether the readiness shown by the Swiss tax authorities to bend the rules in order to achieve their objectives is something that only affects those authorities or whether it is emblematic of a more general approach.  The conclusion reached by these clients might be that one should steer clear of Switzerland in order to avoid bad surprises in the event of court proceedings, etc. and that it might be preferable to bring the business to a jurisdiction (such as Bermuda or New Zealand) with a longer track-record.

If the tax guidelines are adopted in their present format, the big losers will be the legion of expatriates who wish to grow grey and old in Switzerland.  Traditionally, Switzerland has acted as a magnet for this category of individuals principally because of the so-called "forfait" system which enables foreign taxpayers to make a deal with the Swiss tax authorities based on the taxpayer's estimated expenses (rather than on his income).  One of the drawbacks of the "forfait" system is that it leaves the taxpayer concerned exposed to Swiss gift and succession taxes and one of the ways traditionally used to minimise this exposure is to establish a pre-immigration irrevocable and discretionary trust - the argument being that the trust fund does not fall into the settlor's estate on his death.  If the look-through approach contained in the draft Tax Guidelines is taken to its logical conclusion, this will no longer be possible in the future.

Finally, the message sent to the Swiss taxpayer by the Swiss tax authorities is that the trust should continue to remain forbidden fruit in most circumstances, even though Art. 149c (2) of the Bill provides that nothing should prevent a Swiss resident from establishing a trust in favour of his family.

[1] Belgium has not ratified the Hague Trust Convention.  However, it has introduced private international law rules on trusts, see: http://www.notaire.be/info/actes/100_code_dip.htm.

[2] "For the purposes of this Convention, unless the context otherwise requires (...) the term "person" includes an individual, a company and any other body of persons".

[3] Since these rules were introduced, the inheritance tax rules for outright gifts have changed dramatically causing distortions in practice, but the initial policy statement remains unaltered. Under the current rules, lifetime gifts are potentially exempt from inheritance tax, unless the donor dies within 7 years (in which case the gifts are aggregated with the rest of his estate and taxed at 40%, subject to various allowances and exemptions and a reduction in the rate if the donor survives the gift by more than 3 years). This means that a donor and his family may now avoid any inheritance tax charge. By contrast, a discretionary trust remains subject to the initial ‘entry' charge of 20% followed by the periodic ten yearly charge of 6%.

[4] See Sol Picciotto, International Business Taxation (Weidenfeld & Nicholson, 1992), ch 7 (sec 1): "The OECD Fiscal Committee examined the tax treaty implications of anti-avoidance measures (OECD 19a-II abd 1987a-III). The Committee had to contend with the view, expressed by Switzerland, that anti-avoidance measures were contrary to the existing OECD model treaty (...). The Swiss view was that, since tax treaties define and allocate rights to tax, a residence country cannot use anti-avoidance rules to tax the undistributed income of a base company validly incorporated in a treaty-partner state".

[5] Under English law, the term "domicile" has a special technical meaning which should not be confused with the French concept of "domicil", the Italian concept of "domicilio" or the German concept of "Wohnsitz" which are akin to the idea of habitual residence or centre of vital interests.

[6] Although each canton has its own income tax law, cantonal tax laws have recently been harmonised on the model of the Federal Law on Direct Taxes (see Federal Law of 14 December 1990 on the Harmonisation of Cantonal and Communal Direct Taxes, commonly known as ‘Tax Harmonisation Law').

[7] See Sibilla Cretti, "Les Relations de Trust et la Fiscalité Suisse Nationale et Internationale", Helbing & Lichtenhahn, 2001.

[8] See art. 49(3) of the Federal Law on Direct Taxes (‘DTL') and art. 20(2) of the Tax Harmonisation Law (‘THL') which was introduced to harmonise the 26 different cantonal direct tax laws.

[9] See art. 11 DTL and art. 20(2) THL.

[10] See: Filippo Noseda, Switzerland and the Hague Trust Convention: where are we? Benefits and Missed Opportunities of the Current Proposals, Trust Law International, Vol. 19, No 1, 2005, p. 58.

[11] ‘Wirtschaftliche Betrachtungsweise' or ‘point de vue économique'.

[12] See e.g. ATF 115 1b 238.

[13] The functional approach has been advocated e.g. by Urs Landolf & Thomas Graf, "Der Trust im schweizerischen Steuerrecht", in Archives de Droit Fiscal Suisse, 63 (1994); In favour of the legalistic interpretation see See Robert J. Danon, Switzerland's direct and international taxation of private express trusts, Schulthess, 2004, p. 203.

[14] See Explanatory Reports of 20 October 2004 and 5 December 2005 at paras 1.2.5.4 and 1.3.3.4 respectively.

[15] See Robert J. Danon, op.cit., p. 202 and p. 271: "As a starting point, it can be observed that, at common law, a trust is not a company (...) The issue thus boils down to examining whether a trust can be characterized as a "body of persons" [for the purposes of double taxation treaties]. At first sight, a textual analysis of the expression "body of persons" seems to dictate a negative answer (...). It is precisely this reason which, in other areas, led us to contend that a trust could not fall into the scope of provisions containing similar language.  Specifically, we concluded that a trust is not a community of persons (Art. 11 DTL and 20 para. 2 THL) or a body of persons (Art. 55 letter b WTO).  Yet, in our view, these considerations may not be transposed in a double taxation convention context".

[16] "An increasing number of entities based in Switzerland specialise in the administration of trusts, mainly in the financial centres of Geneva, Zurich, Basle and Lugano. In addition, more and more banks have an in-house trust department. Moreover, lawyers and fiduciary companies are increasingly involved in the field of trust planning and trust administration. This business has a big potential for growth, since the so called offshore centres (the Channel Islands and some islands in the Caribbean), which have traditionally been the place of choice for establishing trusts, are increasingly coming under international pressure and Switzerland might offer a serious alternative, owing to the skills of its professionals, discretion and well recognised money laundering legislation." (Explanatory Reports of 20 October 2004 and 5 December 2005 at paras 1.2.4 and 1.2 respectively).

[17] See Explanatory Report of 20 October 2004, para 2.6.

[18] Under Swiss succession law (and the succession laws of most continental European countries), an estate does not pass in the personal representatives of the deceased, but vests automatically on death on the beneficiaries, both in terms of assets and liabilities. If there is more than one beneficiary, the beneficiaries as a whole form a so-called "community of heirs" which comes with no legal personality (but with a degree of legal autonomy).

[19] Draft Tax Guidelines, para 4.1.

[20] Although a SICAV is clearly a company under Luxembourg law, the federal tax authorities and most cantonal authorities treat them as partnerships.  The (rather convenient) upshot is that undistributed dividends of a SICAV are taxed in the hands of the Swiss shareholder on an arising basis (see Guideline n. 10 (1995/1996) issued by the Federal Tax Authorities on 6 May 1994, which is accessible online at: http://www.estv.admin.ch/data/dvs/druck/kreis/d/w95-010d.pdf).  Interestingly, some cantonal tax authorities characterise SICAVs as companies and accept that undistributed income should only be taxed upon distribution (however, the cantons of Zurich and Bern recently decided to align their practices to that of the federal tax authorities with effect from 1 January 2005 and 1 January 2006 respectively, see the press release issued by the Bernese tax authorities, which is available online at: http://www.fin.be.ch/sv_taxinfo/praxisaenderung-sicav-anlagefonds).

[21] Explanatory Report of 20 October 2004, para 1.4.5.2.

[22] Draft Tax Guidelines, para 3.7.

[23] Ibid, para 5.1.1.

[24] ‘wirtschaftlicher Gehalt", see Urs Landolf, Die Unternehmugsstiftung im schweizerischen Steuerrecht, PhD-thesis, Zuric, 1987, p. 261.

[25] See Underhill & Hayton, Law of Trusts and Trustees (16. ed, 2000), p. 33 et seq., p. 754 et seq. See also the following decisions of the Royal Court of Jersey referred to in Matthews & Sowden ,The Jersey Law of Trusts (3. ed, 1994), para 10.36, in the context of an arbitrary refusal by the protector to give a required consent: Johnson Matthey Bankers Limuted v Shamjii, 2 May 1986, unreported, Re Heerema Trust, 19 June 1984, unreported.

[26] This trend has been recently confirmed by the cantons of Geneva and Vaud (both cantons have introduced a spouse and ascendant/descendant exemption in 2004, with one exception for the canton of Geneva which applies to foreigners who benefit from a beneficial tax system generally known as "forfait".  These people will continue to be subject to the old rules, though they will be able to benefit from discounted rates in most cases).

[27] Draft Tax Guidelines, para 3.5.

[28] Explanatory report of 5 December 2005, para 2.2, commentary to Art.149a of the Private International Law.

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