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How low can they go?

Tourists have long travelled to the picture postcard medieval city of Lucerne to enjoy the spectacular scenery and well-preserved medieval buildings. More recently, however, the canton of Lucerne has been attracting a new type of visitor – multinational companies in search of a low rate of tax.

In September 2009, voters in the canton of Lucerne approved a revision of their tax legislation that would cut the corporate income tax from January 2012 to a record low of 4% to 6.5%, depending on the municipality. The neighboring canton of Obwalden, which previously offered the lowest taxes in Switzerland as well as a flat personal income tax rate, is now contemplating cutting corporate tax rates even further from 2012 in order to compete with Lucerne. In recent years, Obwalden’s low tax policy has had a significant effect on its register of companies.

The European Commission takes notice

Competition between cantons to attract companies with low tax rates has been ongoing for a number of years. This downward pressure on taxes has created a highly competitive tax environment in the country as a whole that has led to a large number of multinationals relocating either their global or European headquarters to Switzerland. Indeed, the foreign trade development organization OSEC Business Network Switzerland says that competition between cantons is “one of the main reasons why Switzerland is such an attractive location.”

In addition to being able to vote on their own tax rates, Swiss cantons also offer tax holidays and tax privileges. Tax holidays are based on certain rules and regulations and require a formal decision by the government, because they are granted for macroeconomic reasons.

Headquarter relocations: Swiss cantons are very competitive in attracting foreign companies

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The European Commission has been highly critical of some aspects of the tax privileges defined in the tax laws of the cantons. In February 2007, it informed Switzerland that it considered certain cantonal tax privileges in favor of holding companies, mixed companies or domiciliary companies to be unlawful state aid. The EU announced its intention to reach an agreement with Switzerland on a regulation to put an end to differential tax treatment of domestic and foreign income in Switzerland as well as the non-taxation of non-investment income generated by holding companies in the cantons. Since then, Switzerland and the EU have held several talks on cantonal tax privileges aimed at correcting the perceived distortion of competition. To date, however, no results from these negotiations have been announced.“The differential treatment of profits depending on whether they are generated in Switzerland or abroad under the mixed company regime and certain aspects of the holding company regime are certainly questionable,” says Dominik Bürgy, Managing Partner Tax at Ernst & Young (EY) Switzerland and Vice-Chairman of the Swiss Chamber of Certified Accountants and Tax Experts. “This is all the more reason for Switzerland to become proactive in adjusting the tax privileges in their current form so that they are more ostensibly aligned with EU standards.”

Deterrents to corporate migration

Uncertainty over how this dispute will be resolved is deterring some companies from relocating to Switzerland because they fear that they will lose these special privileges. “At present, there is a great deal of legal uncertainty as to how the tax dispute with the EU can be settled,” says Peter Baumgartner, Director of Swiss Holdings, a body that represents multinationals based in Switzerland.

Some commentators in Switzerland fear that an agreement with the EU requiring the cantons to abandon or adjust their special rules would also lead to an exodus of corporates to other jurisdictions. But Bürgy of Ernst & Young (EY) believes that these concerns are overestimated. “In my view, the risk of emigration may be mitigated by a combination of a low regular tax burden with EU-approved tax privileges, which at the same time will also continue to attract new corporations,” he says. But while few companies may be willing to leave Switzerland, the numbers arriving have declined, with 54 making their way in 2008 and just 15 in 2009. The financial crisis has certainly added to uncertainty, with companies putting all major plans on hold while they dealt with the more pressing concerns of liquidity and, in some cases, solvency.

In the longer term, most commentators agree that Switzerland will continue to be at the forefront of international tax competition and, for this reason, is likely to remain a highly popular destination for multinationals seeking a new headquarters.

But while the influx of firms is broadly welcomed in Switzerland, it does have a knock-on effect in terms of costs. According to a recent study by the Zurich University of Applied Sciences, residential property prices around Lake Geneva have tripled since 2000 and those in the Zurich region have doubled, with vacant rental properties being scarce.

The political wind does appear to be changing slightly in the face of such developments. There have been isolated voices calling for a “more healthy level” of tax competition and representatives of the higher tax cantons are requesting that the Government set a minimum tax rate. The rationale for doing this would be twofold: first, it would protect the cantons from a ruinous “race to the bottom”; and second, it will avoid conflicts over revenue sharing. Currently, structurally weak cantons receive equalization payments from financially powerful neighbors, even if they have previously enticed companies away from other cantons. With expected changes the mix of cantons giving and receiving such payments may change substantially.

A provocative call

With international pressure on Switzerland’s low-tax strategy mounting in the face of ongoing attempts by cantons to ratchet up tax competition, one might think that the argument had reached its logical conclusion. But in July 2010, the Swiss economic commentator Philipp Löpfe took it one step further. His provocative suggestion was to abolish corporate taxes in Switzerland, or at least at a cantonal level. In this way, he said, tax competition “would no longer be about Obwalden versus Lucerne, but about Switzerland versus the rest of the world.” Tax competition, it seems, remains alive and well in this corner of Europe.

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EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients.

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