The sale of a company, regardless of its legal form, whether through an internal succession arrangement or by selling shares, never takes place without bureaucratic hurdles. One hurdle that is particularly important to consider is taxation. Contrary to what many business owners expect, the sale of shares is not always tax-free. Indirect partial liquidation represents one of the biggest tax risks when selling equity interests in a company. Regulated in Circular no. 14 of 6 November 2007 of the Swiss Federal Tax Administration, there are 5 criteria that you should be familiar with.
These are the 5 criteria that should be taken into account.
In addition, there are also these ones.
What is indirect partial liquidation?
Indirect partial liquidation occurs when a natural person sells participation rights from their private assets to another person, who then transfers these rights into their business assets. The purchase price is paid, in whole or in part, with the participation of the seller, using the distribution of non-operating funds of the acquired corporation.
Sounds complicated? Unfortunately, it is. The following example is intended to shed some light on the matter.
Imagine Mr. Müller owns shares in Müller AG. He sells at least 20% of the shares to Meier GmbH or to Mr. Meier privately, who then holds the shares as business assets of his sole proprietorship. If Mr. Meier finances the purchase price within the next five years using funds that are available in Müller AG, it is obvious that this constitutes an indirect partial liquidation.
Criteria of indirect partial liquidation
Indirect partial liquidation is deemed to occur when all of the following six criteria are cumulatively met:
- Sale
- Qualified participation
- System change
- 5-year period
- Seller’s participation
- Withdrawal of substance from distributable reserves under commercial law
The criteria can also be subdivided into the system change as well as into objective and subjective characteristics. While the withdrawal of substance is regarded as objective, the seller’s state of knowledge or participation is a subjective characteristic.
To better understand indirect partial liquidation, it is worth taking a step back and looking at the criteria individually.
6 criteria of indirect partial liquidation
Criterion 1 – Sale
The transaction must involve a transfer for consideration.
Criterion 2 – Qualified participation
For indirect partial liquidation to occur, at least 20% of the share capital or nominal capital of a corporation must be sold. Only sales by natural persons subject to unlimited tax liability in Switzerland are considered, who, prior to the sale (the first one), held at least 20% of these participation rights as private assets. There are special rules regarding a staggered timeline. If participation rights are sold in stages, the provisions intended for indirect partial liquidation apply if at least 20% has been sold within five years from the first sale.
Criterion 3 – System change
A system change occurs when the participation rights originate from a natural person’s private assets and are transferred into the business assets of another natural person or into the assets of a legal entity (for which the book value principle applies). It is also possible for the acquirer (natural person) to establish a financing company / an acquisition company or holding company to purchase the participation and acquire the rights in this way. The acquirer may also be a corporation. Put simply, this results in a transfer from private assets (nominal value or capital contribution principle) to business assets (book value principle).
Criterion 4 – 5-year period
Another condition is that there is a distribution of non-operating funds within five years of the sale. These non-operating funds already existed at the time of the sale. The five-year period begins upon conclusion of the business succession agreement for the participation between the seller and the acquirer. The time of purchase and the time of distribution therefore play a key role with respect to indirect partial liquidation. In the case of a staggered sale totaling 20%, a separate time limit begins for each sale. If, from the time of sale, non-operating funds are generated within five years that are sufficient for the buyer to finance the participation, no indirect partial liquidation exists.
Criterion 5 – Seller’s participation
The seller’s state of knowledge is also a criterion for the existence of indirect partial liquidation. The seller must know, or should know, that to finance the purchase price, non-operating or distributable funds under commercial law are withdrawn from the company and not returned. The seller’s knowledge relates, on the one hand, to the existence of non-operating funds that exist at the time of the sale of the participation, and on the other hand, to the buyer’s financial situation. The first point is relatively easy to determine. It is more difficult with respect to the acquirer’s financial circumstances. It makes a considerable difference whether the buyer plans to pay the purchase price from their own funds or to finance it with debt. In practice, the tax authorities often assume the seller’s knowledge.
Criterion 6 – Withdrawal of substance from distributable reserves under commercial law
As already mentioned several times, another requirement is that so-called distributable reserves under commercial law, or non-operating funds, that already existed at the time of sale are distributed.
- Distributable reserves under commercial law – To calculate these, the share capital or nominal capital and the maximum amount of statutory reserves according to the Swiss Code of Obligations or foreign law are deducted from the reported equity.
- Non-operating substance – Whether assets are deemed non-operating is determined based on recognised valuation principles. Allocable liabilities are deducted and deferred taxes on hidden reserves are taken into account. This valuation only needs to be carried out once a distribution occurs within the five-year period.
Distributions include not only dividends, but also hidden profit distributions as well as other benefits of monetary value in favour of acquirers or related parties.
Benefits of monetary value may arise from the following:
- Dividends in kind
- Loans from the target company or companies under its common control to the acquirers, where repayment appears at risk, or which cause a loss of assets for the lending companies
- Security for third-party loans to the acquirers (provided by target companies or companies under the same control), where utilisation appears likely and would result in a loss of assets for the guaranteeing companies
Restructurings can also constitute benefits of monetary value.
What are the tax consequences of indirect partial liquidation?
From a tax perspective, indirect partial liquidation means that non-operating funds, e.g. in the form of dividends, are distributed, which in turn triggers income tax. To avoid this, profits are retained and companies are subsequently sold for more than their actual value. The buyer can then use the non-operating funds to pay the purchase price. This distribution again reduces the value of the participation in the company sold; it is written down and the tax base is thus eliminated. Is indirect partial liquidation permitted? Indirect partial liquidation is therefore a way to avoid or reduce tax payments and is therefore prohibited. Income generated in this way is not considered tax-free capital gains under Art. 16 para. 3 DBG Federal Act on Direct Federal Taxation by the tax authorities, but is treated as taxable investment income. If unintentional, indirect partial liquidation can arise as a result of a leveraged buyout or an assumption of debt. Consequences of indirect partial liquidation If the elements of the offence, or in other words the criteria of indirect partial liquidation, are met, the amount of assets subject to tax must be determined. This is the smallest of the following amounts:
- Distribution amount
- Distributable reserves under commercial law
- Non-operating funds
- Sale proceeds