The Zurich Cantonal Tax Authority (“ZCTA”) recently issued a new circular (“Circular”) on the taxation of financial institutions. The Circular substitutes the previous Circular of 1 January 2015 and enters into force retrospectively as of 1 January 2021 (i.e. for financial years ending in 2021) with a grandfathering period. The ZCTA issued the Circular to take into account the recent regulatory amendments and to officialize their new tax practices. The Circular applies to banks and professional securities dealers. The purpose of this blog is to present the key amendments compared to the previous Circular.
The new Circular contains the following three key amendments:
- the tax deductions for value adjustments for default risks of debtors will depend on the regulatory status of the bank,
- the rates for lump sum provisions are lower than in the previous Circular, and
- a lower participation deduction relief is applicable on dividends generated by shares held for trading purposes.
Tax deduction for value adjustments for default risks of debtors
Under the previous Circular, banks could constitute a 5% lump sum provision for default risks of Swiss debtors and a 7% lump sum provision for default risks of foreign debtors. Banks in FINMA category 1 and 2 (systemically important banks) can only make value adjustments and constitute provisions for default risks of debtors according to the expected loss approach as stated in the FINMA regulations. These banks no longer have the possibility to claim any tax deduction for lump sum provisions for default risks of debtors, as previously possible under the old Circular.
Lump sum provisions
For banks in FINMA category 3, 4 and 5, the new rates for lump sum provisions under the Circular are 3% for Swiss debtors, 5% for foreign debtors and 10% for any other unsecured claims (such banks also have the choice to apply the expected loss approach on a voluntary basis). In addition, these banks cannot constitute any lump sum provisions for default risks of debtors which are banks and governmental entities. Where the maximum of the acceptable lump-sum provisions is not reached, a new allocation to reserves for general banking risks can be deductible for tax purposes. The Circular provides examples illustrating the application of the lump sum provisions.
Depending on the amount of existing value adjustments and provisions for default risks of debtors, this change may lead to a considerable release of provisions resulting in a large additional corporate income tax burden, even if the Circular provides a grandfathering period in this respect: adjustments required due to the Circular must be made at the latest by 2027 on a linear basis.
Participation deduction relief
Financial institutions can benefit from the participation reduction on dividends, irrespective of whether the dividends come from equity investments or shares used for trading purposes, including as a hedge for derivative financial instruments. Under the new Circular, the participation reduction principle will not always lead to a virtual tax exemption in practice. Indeed, the ZCTA no longer cap the deduction for administrative costs at 5% and have expanded the interpretation of financing costs in the calculation of the participation deduction, reducing the potential net participation income. This change will affect financial institutions with large trading books, but less so other banks holding equity investments.
The Circular is applicable to any financial institution with its principle place of business in the Canton of Zurich. The taxation of financial institutions varies considerably from canton to canton, with certain cantons granting favorable lump sum deductions for provisions and reserves for banking risks. We understand that there is a clear intention of the cantonal tax authorities, supported by the Swiss Federal Tax Administration, to harmonize their tax practice in this respect. As a result, we cannot exclude the possibility that the new practice of the Canton of Zurich in the Circular will become the new standard approach for the taxation of financial institutions in all cantons of Switzerland.