Alongside many traditional, “conventional” types of investment such as accounts, equities, bonds, fixed-term deposits and precious metals, recent years have seen various financial instruments being launched on the market for investment purposes, examples of which include products that combine bonds with option contracts and futures.
In place of conventional bonds the financial industry initially started to deploy specific products entailing – either exclusively or predominantly – one-time interest payments. These included zero-coupon or discount bonds and bond issues with a single repayment of the principal on the maturity date (bullet bonds). Over time, these bonds started to experience competition from derivative financial products combining bonds with option contracts or futures and generating varying returns for investors.
Owing to these developments, the tax authorities were forced to amend their legislative frameworks and practices in line with the new market situation. One especially interesting aspect of the taxation of combined products for private investors is the issue of which income streams from the product represent taxable returns and the point at which these are deemed to have been realised for tax purposes, therefore becoming taxable.
For private investors with unlimited tax liability in Switzerland, the focus of (managing) their investments is always on the returns after taxes and fees generated by the products. We will therefore go on to summarise the principles of tax on financial instruments for the purposes of individuals’ income tax. Some readers may be interested in Circular No. 15 of the Swiss Federal Tax Administration dated 3 October 2017 for a more in-depth discussion of all the tax consequences.
Coupons on conventional bonds are exclusively paid periodically. As a result, these periodic interest payments are treated as taxable income subject to income tax in accordance with the general maturity principle as per the coupon’s maturity date. If the bond is sold, the accrued interest is generally treated as a tax-free capital gain.
Things become trickier from a tax perspective if a periodic interest payment is not made or is made only in part, i.e. not providing the usual level of income, as in the case of predominantly one-time interest-bearing products.
Discount bonds are issued at below par value, while repayment is made at their face value (issuance discount). In contrast, bullet bonds are issued at par, while repayment is made above par value (redemption premium). Investors receive no periodic coupon payments at all on pure-play discount and bullet bonds (zero-coupon bonds). Instead, investors’ entire proceeds from holding these bonds are exclusively paid on a one-off basis when the bonds are redeemed. In the case of combined discount and bullet bonds, as well as a one-time payment on redeeming the bonds investors also receive periodic coupon payments, which in such cases come in below the interest rate for investments on which interest is exclusively paid periodically. As far as the income tax implications are concerned, a mathematical finance formula is always required to check whether the bond concerned is chiefly characterised by one-time or periodic interest payments.
A bond is deemed to be a predominantly one-time interest-bearing product (referred to as intérêt unique prédominant/IUP) if more than half of the total returns on maturity stem from the issuance discount or redemption premium. In taxation terms, any periodic interest payment to investors always constitutes taxable investment income. In the case of predominantly one-time interest-bearing products, all actual income generated by investors on the sale or redemption of the bonds is taxed in line with the margin taxation method (growth in value principle: taxation of the positive differential between the sale or redemption amount and the purchase amount for the seller and for each transaction).
In the case of non-IUP products, i.e. those not predominantly characterised by one-time interest, the periodic coupon payments are taxed in line with the general maturity principle, while one-time payments are taxed at the time of redemption (“Devil take the hindmost”). Any increase in value realised if the product is sold is treated as a tax-free capital gain. Investors can therefore sell these products prior to redemption (at least three months before the maturity date), realising a tax-free capital gain without any income tax implications. In contrast, this is certainly not possible in the case of predominantly one-time interest-bearing products.
Derivative financial instruments are used for purposes including hedging and transferring risks as well as matching maturities or currencies for debt claims or liabilities. The value of derivatives depends on that of an underlying instrument, which may include equities, bonds, precious metals or equity indices, for example. Alongside conventional derivatives such as options, futures and swaps, there are now new forms of financial instruments known as structured or combined products.
According to judicial decisions of the Federal Supreme Court of Switzerland, gains generated from forward transactions (options and futures) are capital gains and remain – unless capital gains are expressly specified in the legislation – free from income tax as they fall within the scope of an investor’s personal assets. However, losses arising from such transactions are not tax-deductible.
Financial products such as these combine bonds with option contracts (e.g. option and convertible bonds or other capital-guaranteed derivatives), giving investors various remuneration components. In simple terms, the key issue when it comes to how these products are taxed is whether the product’s components can be analytically separated or not (transparent or non-transparent products). In the case of all transparent products, for tax purposes a distinction is made between the investment transaction (the bond whose returns are taxable and for which it is important to know whether or not it is a predominantly one-time interest-bearing product) and the hedging transaction (the option from which the gains generally constitute tax-free capital gains).
Unlike a transparent product, in the case of a non-transparent financial instrument – the option or the convertible right, for example – constitute the variable component of a return from the investment transaction. The tax consequence of this is that anything received by an investor in a non-transparent financial instrument above and beyond the capital he or she originally invested is subject to income tax. As a result, owing to the lack of tax transparency the option component of a product such as this does not – in contrast to a transparent product – remain tax-free. Instead, together with the product’s other return components the option component is taxed in full.
In my opinion, the key issue for investors or bank clients with unlimited tax liability in Switzerland is the return after income taxes and fees from the financial products they purchase. If investors and bank clients take note of financial products’ income tax implications when making their investment choices, they can optimise the net performance after tax, for example by opting for transparent financial products that are not predominantly one-time interest-bearing instruments.
Felix Reinhardt, Partner