Swiss Trust Law / Taxation (Part 2): Constitutionally compliant and tax-systematically codified tax solution proposal

Olivier Weber
Olivier Weber
Konrad K. Häuptli
Konrad K. Häuptli
Of Counsel
Swiss Trust Law / Taxation (Part 2): Constitutionally compliant and tax-systematically codified tax solution proposal

A Swiss trust is to be created so that the trust industry in Switzerland (approximately 400 Trustees) does not have to turn to foreign trusts. A Swiss trust would at the same time open up new application and business opportunities and thus strengthen Switzerland as a business location. The introduction of a trust law is in line with an international trend. 

In addition to the new regulation of trusts in the Swiss Code of Obligations, various federal laws are to be amended. For example, the tax laws should in future explicitly regulate how trusts are treated for tax purposes. Currently, taxation is based on the general principles of tax law and two circulars. Specifically, the Federal Council proposes to maintain the existing principles and to not allow a solution that might not be in line with the constitution. Irrevocable trusts without fixed claims of the beneficiaries are now to be taxed in principle in the same way as foundations. This proposal is not only wrong, but also unconstitutional (see previous article).

We support the introduction of a trust in principle, but we are concerned to find a solution for taxation as well.

In principle, two alternatives are possible: a) maintain the status quo, or as the Federal Council proposes, b) codify it in the tax laws. We focus on the latter. 

In our previous article we have first condemned the unconstitutionality. Now we will propose what we consider to be the correct codified tax solution:

Due to the unconstitutionality, the income on the trust assets cannot be taxed like a foundation (legal entity). Therefore, only income tax can be taken into account. The constitutionality of taxation according to economic capacity can be ensured by continuing to tax the income created on the trust assets at the settlor's level, whereby the settlor waives his constitutional right to taxation according to economic capacity (option 1). If the settlor exercises his constitutional right (right of election), the income from the trust assets is no longer taxed (option 2). Option 1 corresponds to current practice in the taxation of trusts, while the tax consequences of option 2 must be redesigned within the framework of existing tax law instruments:

Option 2: If the settlor exercises his (constitutional) right of election, the income from the trust is no longer recorded with him. Since the beneficiary has no claim to the trust assets or to the income, but only an expectancy, the income from the trust is not taxable for the beneficiary. The tax losses are to be avoided by codifying a specific tax coverage norm, whereby the regulation to be drafted must be both constitutional and use existing tax instruments. 

Our Tax proposal for option 2

The accrued income of the trust assets is to be taxed as income of the beneficiary upon distribution, with compensation for the present value advantage of deferred taxation. The income accrued between the exercise of the settlor's option and the distribution of trust assets to the beneficiary are subject to the beneficiary's income tax.

The taxpayers involved are not to derive any advantage from the option through deferred taxation, which is why the accrued income is to be recognised at a compound interest of 6%. The compensation of present value disadvantages is already known in tax law, cf. discount in the taxation of employee shareholdings. There is no reason why a corresponding discount should not also be introduced for the taxation of accumulated trust income. The income to be recognised in the distribution and the period for which the deduction is to apply must be proven by the taxable beneficiary.

The part of the distributed trust assets that derives from taxable income is subject to income tax with in addition the compound interest. Distributions from invested capital and non-taxable income are exempt from income tax but might be subject to cantonal gift taxes.

With respect to wealth taxes, the cantons may provide for subsequent taxation, which is similar to the one for agricultural and forestry real estate in order to close the taxation gap in the case of wealth taxes.

Since the income from the trust assets is not taxed between the settlor's waiver of taxation and the distribution to the beneficiary, neither the settlor nor the beneficiaries or the trust have any claims under double taxation treaties.

Well informed settlors will continue to pay taxes on the income of the trust assets (option 1) as the tax deferral advantages are fully compensates (or even over-compensates) by option 2. Not having access to double taxation treaties, taxation of the accrued income with rather high rate compound interest and full compensation of wealth taxes are more beneficial for the tax authorities that for the taxpayer.

The AEI report due on the distribution to the beneficiary does not correspond to the taxable income in terms of amount, but the report can be traced in the assessment.

The transfer of real estate is, in principle, subject to real estate gains tax, unless there is a tax deferral. In the event of a distribution, the proportionate distributed assets of the trust are subject to subsequent taxation with wealth tax. The subsequent taxation is limited to a maximum of 20 years.