## cr18174 - References

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### Introduction and context
- Swiss Federal Council proposed a corporate income tax (CIT) reform (“Tax Proposal 17”) on March 21, 2018, following the rejection of “Corporate Tax Reform III” in February 2017.
- Parliament foreseen to decide on the reform in 2018; major part could enter into force in 2020 at the earliest.
- A referendum could delay the timetable; if called, it would occur in 2019 with the major part becoming effective in 2021 if approved.
- Reform objectives:
  - Abolish preferential tax regimes to meet international commitments.
  - Maintain tax competitiveness in the absence of these regimes.
  - Ensure CIT revenues within budgetary parameters.
  - Respect the Swiss-specific relationship between cantons and the Confederation.
  - Avoid prolonged legal uncertainty.

### Switzerland’s international commitments regarding the CIT
- Switzerland committed to the four Minimum Standards of the G-20 OECD BEPS action plan; implementation is subject to peer review.
- Minimum standards and implementation notes:
  - Countering harmful tax practices:
    - Transparency framework regarding tax rulings: no recommendations after peer review; domestic legal framework for spontaneous exchange of information entered into force on 1 January 2017, allowing spontaneous exchange of information as of 1 January 2018 (revisions to the Tax Administrative Assistance Act and the Tax Administrative Assistance Ordinance, Convention on Mutual Administrative Assistance in Tax Matters).
    - Reviewing existing preferential regimes: October 2017 Progress Report classified the holding company, auxiliary company, mixed company, and commissionaire ruling practice as “in the process of being eliminated”. Tax Proposal 17 aims at abolishing the holding company, the auxiliary company, the mixed company and the commissionaire ruling regimes.
  - Preventing tax treaty abuse: On June 7, 2017, Switzerland signed the Multilateral Convention to Implement Tax Treaty Related Measures (MLI); alternatively stands ready to implement via bilateral DTA revision.
  - Transfer pricing documentation and country-by-country reporting (CbCR): Federal CbCR Law and Ordinance entered into force on December 1, 2017, implementing country-by-country reporting in line with transfer pricing documentation requirements; peer review made no recommendations.
  - Dispute resolutions: Recommendations made after peer review; Switzerland implementing through MLI or bilateral DTA revisions.
- Council of the EU included Switzerland in the group of cooperative countries subject to successful delivery of its commitments (‘grey list’); implementation will be monitored.
- Exchange of information and tax treaties:
  - Domestic legislation adopted international spontaneous exchange of information in January 2017.
  - As of end-January 2018: 51 tax treaties in force include an exchange of information provision conforming to international standards.
  - Switzerland signed 10 tax information exchange agreements, 9 of which are in force.
  - As of January 1, 2018, Switzerland has automatic exchange of information on financial accounts with over 75 states and territories.

### Structure and key features of the current Swiss CIT system
- Multi-level taxation:
  - Corporate taxation levied at three levels: federal, cantonal (26 cantons), municipal (2,222 municipalities as of January 2018).
  - Cantons are sovereign under the Federal Constitution except where limited; municipalities exercise taxing authority under cantonal law.
  - Federal government can harmonize cantonal direct taxation via the Federal Tax Harmonization (FTH) law.
- CIT base characteristics:
  - Deductions allowed for expenses necessary to earn income, commercially justified depreciation allowances, reserves and provisions.
  - Accelerated depreciation allowed for specific policy items.
  - Losses may be carried forward seven years but may not be carried back.
- Statutory and effective rates:
  - Federal statutory CIT rate: 8.5 percent; because the CIT itself is deductible, the ‘effective’ federal CIT rate is 7.83 percent (8.5%/(1 + 8.5%) = 7.83 percent).
  - 2017 ‘effective’ combined (federal, canton, and municipal) CIT rates in cantonal capital cities ranged from 24.16 percent in Genève to 12.32 percent in Luzern.
  - Unweighted average effective combined CIT rate in Switzerland: 17.7 percent.
  - Weighted average effective combined CIT rate in Switzerland: 19.6 percent (weighted based on federal CIT revenues’ weights averaged for 2012-2014).
- Cantonal net worth tax:
  - Cantons obliged to impose a tax on corporate capital (‘net worth’); no net worth tax at federal level.
  - Taxable base for net worth tax is equity (paid-in capital plus reserves).
  - Cantonal net worth taxes on legal entities range from 0.001 percent to 0.525 percent.

### Preferential tax regimes (status companies) and related practices
- Cantonal preferential regimes distinguish between “immobile CIT base” (Swiss-sourced income subject to ordinary CIT) and “mobile CIT base” (foreign-sourced income subject to lower taxation through cantonal preferential regimes).
- Three cantonal preferential regimes allowed by current FTH law:
  - Holding company regime:
    - Holding companies are, in principle, exempt from cantonal and municipal tax on income and pay only a reduced cantonal tax on net worth.
    - Qualification: participations (or income from participations) represent at least two thirds of total assets (or total income).
    - A holding company may not be actively engaged in commercial activity in Switzerland.
    - Applies to all income (including interest income) in addition to dividends and capital gains.
  - Auxiliary company regime:
    - Auxiliary companies obtain cantonal tax benefits if they carry on administrative activities only and derive income from abroad; they have legal seat in the canton but no commercial activities in the canton or in Switzerland.
    - Foreign-sourced income, including royalties and management fees and income from substantial participations, are exempt (albeit not fully) from cantonal and municipal CITs; Swiss-sourced income and real estate income are taxed at ordinary rates.
  - Mixed company regime:
    - Applies to management companies earning some business income in Switzerland provided underlying activity is predominantly performed outside Switzerland.
    - Condition considered satisfied if at least 80 percent of sales and purchases take place outside Switzerland and there is no production or manufacturing in Switzerland.
- Commissionaire ruling (principal company regime):
  - Structure: foreign-controlled manufacturer produces products on behalf of Swiss principal and receives cost-plus compensation; Swiss principal sells goods internationally through commissionaires typically receiving a commission of 3 percent of sales or costs.
  - Swiss system deems the foreign commissionaire affiliate as a permanent establishment (PE) of the Swiss principal; 70 percent of the net profit of the principal is considered trading profit and 30 percent manufacturing profit.
  - Commissionaire ruling practice attributes up to 50 percent of trading profit to the foreign deemed PE, exempting this income from federal, cantonal and municipal taxes.
  - In practice, combined with a mixed company regime, the effective tax rate of this arrangement may be as low as nearly 5 percent.
- Tax rulings and preferential treatment:
  - Taxation of cantonal status companies may be the subject of a tax ruling.

### Further international aspects of the CIT
- Federal withholding tax on dividends: 35 percent except as reduced by a double tax treaty (DTA) or other international agreement.
  - Under the 2004 agreement with the European Union, Switzerland exempts dividend payments to companies residing in EU Member States.
  - Switzerland has signed over 90 bilateral double tax treaties; withholding tax rates on dividends to qualifying shareholders generally reduced to between zero and 15 percent depending on the treaty.
- Withholding and investment income:
  - Switzerland has domestic anti-abuse rules applicable to withholding tax.
  - Switzerland does not impose withholding taxes on royalties or technical or managerial fees.
  - No withholding tax on interest on company loans.
  - Switzerland levies a federal withholding tax of 35 percent on certain types of investment income from Swiss sources (e.g., interest on Swiss bank deposits, income from bonds of Swiss issuers, Swiss shares and other participation certificates) and on lottery gains.
  - For Swiss resident beneficiaries, the withholding tax is not a final tax. For non-resident beneficiaries, Swiss withholding tax may represent a final tax on Swiss-source investment income.

### Tax Proposal 17 — key features
- Objective: abolishes cantonal preferential regimes and provides cantons with a modified financial and legal basis to reduce the tax burden in the absence of these regimes.
- Two key elements to maintain reduced effective tax rates in absence of preferential regimes:
  1. Legal element (innovation-related measures):
     - Cantons must introduce a patent box regime (a ‘mandatory’ measure) according to the G-20 OECD BEPS standards.
     - Cantons are free to set tax relief of up to 90 percent of qualified income from patents.
     - Cantons may introduce super R&D tax deductions of up to 50 percent (optional measure), i.e., qualified R&D expenses can be deducted at a rate of up to 150 percent.
     - General limitation: overall cantonal tax relief (all measures including R&D deductions and the patent box by a canton) may not exceed 70 percent of pre-tax profits (i.e., at least 30 percent of income must be subjected to taxation).
  2. Financial element:
     - Proposal would incentivize cantons to reduce their statutory CIT rates by raising the share of federal direct tax revenue that cantons would receive from 17 to 21.2 percent.
     - The federal statutory CIT rate remains 8.5 percent.
     - The new innovation tax incentives apply only to the cantonal tax.
- Additional measures under Tax Proposal 17:
  - Increases cantonal taxes on dividends for individuals by subjecting at least 70 percent of these dividends to taxation; cantons may tax a higher fraction than 70 percent.
  - Under current practice, in most cantons, 40–50 percent of dividends are exempt.
  - Minimum amount employers must pay for child and education allowance would be increased by CHF 30 per month.
  - Tax Proposal 17 contains transitional measures.

### Analysis — distributional and competitiveness effects
- Rationale for reform:
  - Align CIT with international standards to avoid reputational damage and countermeasures and to minimize outward spillover effects.
  - Abolishing existing preferential regimes is vital to respect Swiss commitments to the minimum standards.
  - Commissionaire ruling practice is difficult to reconcile with the arm’s length standard and can have particularly negative spillovers for developing countries.
- Expected changes in CIT rates and dispersion if reform implemented:
  - Combined effective unweighted average rate expected to fall from 17.7 percent to 13.9 percent.
  - Coefficient of variation for cantonal tax rates expected to decrease from 19.7 to 13.1 percent.
- Effective rates under maximum allowable cantonal relief:
  - Assuming cantons grant the maximum allowable tax relief (70 percent), effective CIT rates in Switzerland would range from 10.2 to 12.75 percent for companies that fully use the newly introduced tax benefits.
  - The effective unweighted average rate would be 10.9 percent.
  - The coefficient of variation would be close to 7 percent.
  - These rates are reference minimums; many companies would face higher rates depending on their use of innovation incentives.
  - Firms currently subject to approximately the federal rate (and some with even lower rates) would generally face an increase in tax burden as a result.
- International and investment implications:
  - Overall CIT rate cut is part of an international trend; several OECD countries have recently lowered their CIT rate.
  - Repealing preferential regimes combined with an overall lower effective CIT rate would maintain Switzerland’s position as a relatively low taxation location, albeit at some cost to revenue.
  - A low CIT rate can be problematic if it triggers a minimum tax in the home country of the foreign parent company (e.g., foreign CFC rules or the new U.S. minimum tax on ‘Global Intangible Low-Taxed Income’).

### Cantonal differences, competition, and profit allocation
- Competitiveness-efficiency trade-off:
  - Companies not benefiting from preferential regimes (often relatively immobile) would gain from the planned CIT rate cut, but lower CIT revenues from these companies imply an efficiency cost.
  - Lower CIT rates could reduce the cost of capital for less mobile firms; medium-term net effect depends on relative elasticities.
- Cantonal heterogeneity:
  - Cantons with larger economies tend to impose higher CIT rates.
  - Four cantons — Bern, Geneva, Vaud, and Zurich — together constitute about 50 percent of Swiss GDP and 52 percent of total CIT revenues in Switzerland.
  - These cantons have relatively low shares of CIT revenues from status companies; lowering the CIT rate in these cantons would result in higher revenue forgone from non-status companies.
  - Examples of announced/signaled rate cuts:
    - Geneva signaled a cut from 24.16 to 13.49 percent.
    - Vaud announced a cut in 2019 from 21.37 to 14 percent.
- Increased mobility and base differences:
  - Abolishment of preferential regimes makes cantonal CIT rate and base more prominent in firms’ location and investment decisions.
  - Differences in R&D tax treatment could induce allocation of R&D expenses to cantons with generous R&D deductions while maintaining legal ownership of patents in other cantons with generous patent box regimes.
  - Current inter-cantonal profit-splitting rules are based on case law (separate accounting or assigned quota, typically 10 to 20 percent to headquarters’ canton).
  - Short-term safeguard: strengthening domestic transfer pricing rules and their application would safeguard revenues.
  - Medium-term option: consider tax law-based formulary apportionment options to allocate profits between cantons.
- Fiscal equalization:
  - The fiscal equalization system provides an implicit limit to cantonal tax competition because attracting more direct income implies a canton receives less from (or contributes more to) the fiscal equalization scheme.
  - However, the general limitation rule restricting tax relief to a maximum of 70 percent of taxable income can intensify CIT rate competition: if the general limitation is binding, cantons may cut statutory CIT rates to lower tax burdens.

### Encouraging innovation through taxation
- R&D deductions vs. IP box regimes:
  - R&D deductions are generally more effective and efficient than IP box regimes (IMF, 2016b).
  - Policy question: what is the best option for spending CHF1 on a tax relief for innovation?
  - Evidence example: in the Netherlands, €1 spent on a patent box generates €0.56 of additional R&D, whereas granting €1 in an R&D tax incentive for inputs results in €1.77 expansion in R&D.
- Implication for Swiss design:
  - For a given cost, maximizing the use of R&D deductions in combination with a less generous patent box relief would yield the highest R&D activities.
  - The patent box effective rate in Switzerland would generally be at the higher end of international comparators because of the federal CIT rate and the 70 percent maximum allowed cantonal tax relief.
  - Nevertheless, the overall CIT rate in Switzerland would remain competitive.
- Comparative effective patent box rates (selected):
  - Belgium† 2007 3.75
  - Cyprus 2012 2.5
  - France 2000 15
  - Hungary 2003 4.5
  - India 2016 10
  - Ireland 2016 6.25
  - Israel 2017 6
  - Italy 2015 6.25
  - Korea 2014 12.5
  - Luxembourg 2008 5.84
  - Netherlands 2007 5
  - Portugal 2014 10.5
  - Spain 2008 12
  - CHE (Nidwalden) 2011 8.8
  - UK 2013 10
  - Switzerland (expected)‡ 2019 or 2020 10.9
  - Note: † Assuming the CIT rate is 25 percent. ‡ The patent box rate reported here is the average combined effective rates of cantons assuming that cantonal and municipal tax apply only to 30 percent of pre-tax income.

### Tax neutrality and dividend taxation
- Current situation:
  - Distributed corporate profits tend to be undertaxed compared to non-corporate business income.
  - A study by the Federal Finance Administration shows that incorporating a business with an annual income of at least CHF300,000 has a tax advantage relative to taxing it at the individual level in all cantons.
- Impact of lowering cantonal CIT rates:
  - Lowering cantonal CIT rates would further lower the marginal and average tax burden for distributed corporate profits, exacerbating non-neutrality between different legal forms.
  - Increasing dividend taxation becomes important to preserve the backstop function of the CIT.
  - Taxing 70 percent of dividends under prevailing CIT rates would still imply a tax benefit from incorporation in 17 Cantons.
  - Increasing the fraction of taxed dividends, as proposed under Tax Proposal 17, would alleviate distortions in organizational forms but would not achieve full tax neutrality.
- Alternative not included in Tax Proposal 17:
  - An allowance for corporate equity (ACE) would align the tax treatment of equity and debt financed investments and neutralize debt bias; design and anti-avoidance rules are critical and political economy considerations have complicated ACE adoption in Switzerland.

### Budgetary impact and behavioral responses
- Static cost:
  - The proposed reform is expected to have a static cost that includes revenue forgone due to lowering the cantonal CIT rates and the increase in dividend taxation, but does not consider possible dynamic effects on firms’ investment.
- Budgetary impacts are uncertain and depend on:
  - Behavior by individual firms.
  - Cantons’ final implemented tax packages (CIT rates and innovation tax incentives).
  - The exact federal package that will be implemented.
  - CIT developments in other countries.
- Key parameter: elasticity of taxable income.
  - Meta-analysis in Beer et al. (forthcoming) suggests the semi-elasticity of profit with respect to the CIT rate is -1.2 and tends to be larger for US companies.
  - Dowd et al. (2017) find using U.S. firm-level data that the profit semi-elasticity is nonlinear in the CIT rate, ranging from -0.7 (for an increase in the CIT rate from 29 to 30 percent) to -4.7 (for a CIT rate increase from 4 to 5 percent).

### Box 2 — Potential spillover effects of international tax reforms on Switzerland (key findings)
- FDI importance and magnitudes:
  - Stock of inward FDI equaled 128 percent of Swiss GDP in 2016.
  - Share of U.S. FDI in Switzerland (corrected for ultimate-beneficial owner) increased from about 30 percent in 2006 to about 44 percent in 2016.
  - FDI from the EU declined from 43 to 37 percent during this period.
  - According to the US BEA, about 5 percent of total U.S. corporate net income abroad was reported in Switzerland.
  - 1 percent of employment by US companies abroad is in Switzerland, corresponding to 118,000 employees.
- Recent international tax developments and comparisons:
  - Global trend toward lowering the CIT rate and strengthening rules against outbound profit shifting.
  - France and Belgium announced they will lower their CIT rates to 25 percent.
  - 2018 US federal statutory CIT rate cut to 21 percent (25.75 percent combined rate) remains higher than expected Swiss post-reform average of about 13 percent.
- Effective tax rates and expected changes:
  - One measure of the effective CIT rate on US investment in Switzerland was 7.7 percent in 2014.
  - Swiss effective CIT rate expected to increase to about 10.9 percent after abolishing preferential regimes.
- Country- and firm-specific effects of US reform:
  - Swiss FDI in the US benefits from the US reform; some Swiss companies may be negatively impacted by strengthening of US anti-abuse rules.
  - Swiss banks and insurance companies may be negatively impacted by BEAT and anti-hybrid rules.
  - BEAT applies to gross payments to foreign related-parties.
  - Anti-hybrid rule addresses capture as equity for capital requirement purposes in Switzerland but treated as debt in the US for tax purposes.
- Withholding tax and repatriation incentives:
  - Withholding tax rate on dividends for corporations in the bilateral treaty between the US and Switzerland is 5 percent (a final tax as US tax credits are no longer possible).
  - Routing dividends through third countries with zero withholding tax may be impeded by Swiss treaty anti-treaty-shopping rules and could trigger Swiss tax.
- Overall assessment:
  - Spillover effects from recent U.S. tax reform on Switzerland appear moderate; no evidence thus far of major shifts of US-Swiss FDI patterns.

### Annex I — Computing the corporate tax rate in Switzerland: illustration (Zurich example)
- Federal l rate  8.5%
- Canton of Zurich (8% * 1) 8%
- City of Zurich (8% * 1.2901) 10.3208%
- Total (statutory) rate Sum the above 3 rows: 26.8208%
- Effective combined rate† (because the tax itself is deductible) = statutory rate/(1+statutory rate) 21.15%
- Formula note:
  - † To compute the effective rate, let tStatutory be the amount of the final tax which is deductible, and consider 1 CHF of taxable income: (1 – tEffective)×tStatutory = tEffective, which implies that the tEffective = tStatutory/(1+tStatutory).

### EMP index construction and Swiss exchange market pressure (EMP)
- EMP construction:
  - EMP is the weighted sum of changes in the exchange rate, official foreign exchange reserves and interest rates, all relative to a reference country, written in first differences and standardized by w (standard deviation over the 1999–2018 sample period).
  - Variables: e (NEER or bilateral exchange rate), R (international reserves or monetary base), Y (nominal GDP), i (policy interest rate), w (standard deviation), Δ (first difference), * denotes reference central bank variables.
  - Weights are inverse of the standard deviation (precision weights).
- Interpretation:
  - Positive EMP indicates net appreciation pressure; negative EMP indicates depreciation pressure.
- Results — Switzerland:
  - Sample period: 1999–2018, monthly data.
  - Pre-2009: EMP small and bi-directional.
  - Post-GFC: exchange market pressure intensified with large appreciation pressure episodes, especially 2010–11 and 2015.
  - Since mid-2017: sign of EMP switched to negative and has mainly been reflected in depreciation of the franc.
  - Cumulative EMP has been large and positive; declined in 2011 after adoption of the exchange rate floor but increased until mid-2017.
  - EMP composition: initially exchange rate absorbed largest share; since 2012 reserve accumulation increased considerably; interest rates played a modest—if slightly negative—role.
- Extensions — counterfactuals for Switzerland:
  - If reserve accumulation had been dampened by half, the franc would, ceteris paribus, have been around 40 percent stronger as of early 2018.
  - If reserve accumulation had been dampened by half, Swiss interest rates would have had to decline to very negative levels.

### The SNB negative policy interest rate (NIRP) and financial transmission
- Policy interest rate: minus 0.75 percent (set in January 2015; initial negative rate minus 0.25 percent announced in December 2014 and lowered to minus 0.75 percent with removal of the exchange rate floor).
- Negative rate applies to banks’ sight deposits at the SNB, subject to bank-specific exemption thresholds of 20 times the minimum required level of reserves (fixed as of November 2014).
- Sight deposits above banks’ exemption thresholds and subject to the negative deposit rate currently amount to about CHF180 billion.
  - CHF180 billion equals 39 percent of total sight deposits and 27 percent of GDP.
- Effective rate on banks’ deposits at the SNB: about -0.3 percent.
- For all banks, SBA reports CHF234 billion of sight deposits at the SNB were subject to negative interest rates at the end of 2016.
- Transmission to money and government bond markets:
  - 3-month LIBOR converged quickly to the policy interest rate after NIRP introduction.
  - Target range for 3-month Swiss-franc LIBOR set between -0.25 and -1.25 percent in January 2015.
  - Short-term government bond yields were modestly negative before NIRP and decreased further thereafter; entire sovereign yield curve fell into negative territory on at least one occasion.
- Retail and institutional deposit pricing:
  - Banks kept most retail deposit interest rates floored at zero; institutional deposit rates turned negative.
  - Only 5 percent of franc-denominated deposits of domestic clients were subject to negative rates at end-2016.
  - Nonresidents’ deposits are only about 6 percent of total CHF-denominated deposits.
- Mortgage lending, lending rates, and bank margins:
  - Banks initially raised mortgage lending rates to preserve margins; interest rate on a 10-year fixed rate mortgage increased by 50 bps by mid-2015.
  - Spread between rates on mortgage loans and customer deposits decreased from 2.0 percentage points in 2010 to 1.5 percentage points in 2016.
  - Aggregate mortgage lending did not accelerate following NIRP; continued to expand but at a slowing pace after macroprudential measures in 2012–14; quickened since late-2017.
- Bank balance-sheet adjustments and risks:
  - Banks segment balance sheets into above-zero and below-zero books corresponding to retail and institutional customers.
  - Domestically-owned retail banks with larger SNB sight deposits in excess of exemption thresholds shifted into other assets (loans and financial instruments) and scaled back liabilities.
  - New lending by domestically-focused banks has been provided to borrowers with higher affordability risk; SNB survey: loan-to-income ratios on newly-issued mortgages reached a new peak in 2016.
- Profitability and cash demand:
  - Domestically-focused banks preserved/marginally increased return on assets during early NIRP years due to mortgage expansion, large exemption thresholds, higher rates on newly-issued mortgage loans in early 2015, lower credit losses, and greater cost efficiency.
  - Demand for cash increased only temporarily and modestly around NIRP introduction; increase concentrated in the CHF1000 note.
- Empirical findings cited:
  - Basten and Mariathasan (2018): arbitrage and interbank reallocation supported transmission and banks with larger SNB sight deposits adjusted by shifting into other assets and scaling back liabilities.

*Source: cr18174 - References (May 31, 2018).*

### References  _____________________________________________________________________________ 19

### cr18174 - References

### Introduction and context
- The Swiss Federal Council proposed a corporate income tax (CIT) reform (“Tax Proposal 17”) on March 21, 2018, following the rejection of “Corporate Tax Reform III” in February 2017. Parliament is foreseen to decide on the reform in 2018, and the major part of the reform could enter into force in 2020 at the earliest.
- A referendum could delay the timetable; a referendum, if called, would occur in 2019 with the major part of the reform legislation becoming effective in 2021 if approved.
- Reform objectives: abolish preferential tax regimes to meet international commitments; maintain tax competitiveness in the absence of these regimes; ensure CIT revenues within budgetary parameters; respect the Swiss-specific relationship between cantons and the Confederation; avoid prolonged legal uncertainty.

### Switzerland’s international commitments regarding the CIT (Box 1)
- Switzerland committed to the four Minimum Standards of the G-20 OECD BEPS action plan; implementation is subject to peer review.
- Minimum standards and implementation notes:
  - Countering harmful tax practices:
    - Transparency framework regarding tax rulings: Following peer review, no recommendations have been made. On 1 January 2017, the domestic and legal framework for spontaneous exchange of information entered into force, allowing for spontaneous exchange of information as of 1 January 2018 (revisions to the Tax Administrative Assistance Act and the Tax Administrative Assistance Ordinance, Convention on Mutual Administrative Assistance in Tax Matters).
    - Reviewing existing preferential regimes: In the October 2017 Progress Report of the Forum on Harmful Tax Practices, the holding company regime, the auxiliary company regime, the mixed company regime, and the commissionaire ruling practice were classified as ‘in the process of being eliminated’. Tax Proposal 17 aims at abolishing the holding company, the auxiliary company, the mixed company and the commissionaire ruling regimes.
  - Preventing tax treaty abuse: On June 7, 2017, Switzerland signed the Multilateral Convention to Implement Tax Treaty Related Measures (MLI). Alternatively, Switzerland stands ready to implement this minimum standard through bilateral revision of its Double tax agreements (DTAs).
  - Transfer pricing documentation and country-by-country reporting (CbCR): Following a peer review no recommendations have been made. On December 1, 2017, the Federal CbCR Law and Ordinance entered into force, implementing country-by-country reporting in line with transfer pricing documentation requirements.
  - Dispute resolutions: Recommendations following a peer review have been made. Switzerland is implementing this minimum standard through the MLI or through bilateral revisions of its DTAs.
- The Council of the EU included Switzerland in the group of cooperative countries subject to successful delivery of its commitments (‘grey list’). The Council did not define any measures; implementation of commitments will be monitored. Switzerland and EU Member States signed an understanding on business taxation on October 14, 2014; the Federal Council affirmed intent to remove certain tax regimes.

### Structure and key features of the current Swiss CIT system
- Multi-level taxation:
  - Corporate taxation levied at three levels: federal, cantonal (26 cantons), municipal (2,222 municipalities as of January 2018).
  - Cantons are sovereign under the Federal Constitution except where limited; municipalities exercise taxing authority under cantonal law.
  - The Federal government can harmonize cantonal direct taxation via the Federal Tax Harmonization (FTH) law.
- CIT base characteristics:
  - Deductions allowed for expenses necessary to earn income, commercially justified depreciation allowances, reserves and provisions.
  - Accelerated depreciation allowed for specific policy items (e.g., water pollution abatement machinery).
  - Losses may be carried forward seven years but may not be carried back.
- Statutory and effective rates:
  - Federal statutory CIT rate: 8.5 percent. Because the CIT itself is deductible, the ‘effective’ federal CIT rate is 7.83 percent (8.5%/(1 + 8.5%) = 7.83 percent).
  - 2017 ‘effective’ combined (federal, canton, and municipal) CIT rates in cantonal capital cities ranged from 24.16 percent in Genève to 12.32 percent in Luzern.
  - Unweighted average effective combined CIT rate in Switzerland: 17.7 percent.
  - Weighted average effective combined CIT rate in Switzerland: 19.6 percent (weighted based on federal CIT revenues’ weights averaged for 2012-2014).
- Cantonal net worth tax:
  - Cantons obliged to impose a tax on corporate capital (‘net worth’); no net worth tax at federal level.
  - Taxable base for net worth tax is equity (paid-in capital plus reserves).
  - Cantonal net worth taxes on legal entities range from 0.001 percent to 0.525 percent.

### Preferential tax regimes (status companies) and related practices
- Cantonal preferential tax regimes distinguish between “immobile CIT base” (Swiss-sourced income subject to ordinary CIT) and “mobile CIT base” (foreign-sourced income subject to lower taxation through cantonal preferential regimes). Preferential regimes apply at cantonal and municipal levels; federal tax applies to all companies.
- Three cantonal preferential regimes allowed by current FTH law:
  - Holding company regime:
    - Holding companies are, in principle, exempt from cantonal and municipal tax on income and pay only a reduced cantonal tax on net worth.
    - Qualification: participations (or income from participations) represent at least two thirds of total assets (or total income). “Participation” not specifically defined in statutes.
    - A holding company may not be actively engaged in commercial activity in Switzerland.
    - Unlike participation exemption regimes elsewhere, the Swiss holding company regime applies to all income (including interest income) in addition to dividends and capital gains, making it inconsistent with current international standards.
  - Auxiliary company regime:
    - Auxiliary companies obtain cantonal tax benefits if they carry on administrative activities only and derive income from abroad; they have legal seat in the canton but no commercial activities in the canton or in Switzerland.
    - Foreign-sourced income, including royalties and management fees and income from substantial participations, are exempt (albeit not fully) from cantonal and municipal CITs; Swiss-sourced income and real estate income are taxed at ordinary rates.
    - This differential treatment of foreign and Swiss-sourced income is considered inconsistent with current international standards.
  - Mixed company regime:
    - Similar to auxiliary regime; applies to management companies earning some business income in Switzerland provided underlying activity is predominantly performed outside Switzerland.
    - Condition considered satisfied if at least 80 percent of sales and purchases take place outside Switzerland and there is no production or manufacturing in Switzerland.
- Commissionaire ruling (principal company regime):
  - Practice enables federal tax relief and has been considered inconsistent with international CIT standards.
  - Structure: a foreign controlled manufacturer produces products on behalf of Swiss principal and receives cost-plus compensation; the Swiss principal sells goods internationally through commissionaires (local agents) typically receiving a commission of 3 percent of sales or costs.
  - Swiss system deems the foreign commissionaire affiliate as a permanent establishment (PE) of the Swiss principal; 70 percent of the net profit of the principal is considered trading profit and 30 percent manufacturing profit.
  - The commissionaire ruling practice attributes up to 50 percent of trading profit to the foreign deemed PE (which may not correspond to allocation in the PE’s country), exempting this income from federal, cantonal and municipal taxes.
  - In practice, combined with a mixed company regime, the effective tax rate of this arrangement may be as low as nearly 5 percent.
- Tax rulings and preferential treatment:
  - Taxation of cantonal status companies may be the subject of a tax ruling.

### Further international aspects of the CIT
- Federal withholding tax on dividends: 35 percent except as reduced by a double tax treaty (DTA) or other international agreement.
  - Under the 2004 agreement with the European Union, Switzerland exempts dividend payments to companies residing in EU Member States.
  - Switzerland has signed over 90 bilateral double tax treaties; withholding tax rates on dividends to qualifying shareholders generally reduced to between zero and 15 percent depending on the treaty.
- Withholding and investment income:
  - Switzerland has domestic anti-abuse rules applicable to withholding tax.
  - Switzerland does not impose withholding taxes on royalties or technical or managerial fees.
  - No withholding tax on interest on company loans.
  - Switzerland levies a federal withholding tax of 35 percent on certain types of investment income from Swiss sources (e.g., interest on Swiss bank deposits, income from bonds of Swiss issuers, Swiss shares and other participation certificates) and on lottery gains.
  - For Swiss resident beneficiaries, the withholding tax is not a final tax. For non-resident beneficiaries, Swiss withholding tax may represent a final tax on Swiss-source investment income.

### Paper structure and annexes (as presented)
- Main sections referenced:
  - A. Introduction
  - B. The Current System of Taxing Corporates in Switzerland
  - C. Tax Proposal 17 — main measures (discussion appears elsewhere in the paper)
  - D. Potential impacts of the proposed reform
  - E. Conclusions
- Figures and tables included in the document:
  - Boxes: 1. Switzerland’s International Commitments Regarding the CIT; 2. Potential Spillover Effects of International Tax Reforms on Switzerland
  - Figures: Effective Combined (Federal, Canton, and Municipal) CIT Rates in Canton Capitals; CIT Revenues in OECD Countries; Expected Effective Tax Rates in Cantons; CIT Rates, Selected Countries; Larger Cantons Have Higher CIT Rates and Lower Revenues from Status Companies
  - Table: Patent Boxes in Selected Countries
- Annex I: Computing the Corporate Tax Rate in Switzerland: An Illustration
- Additional chapters referenced: "SWITZERLAND’S MONETARY POLICY RESPONSE TO EXCHANGE MARKET PRESSURE IN A CROSS-COUNTRY EXAMINATION" and "BANKING SECTOR RESPONSES TO THE NEGATIVE INTEREST RATE POLICY" with their own figures, annexes, and references.

*Source: cr18174 - References (May 31, 2018).*

### 14.      In January 2017, the Swiss domestic legislation adopted international spontaneous

### 14.      In January 2017, the Swiss domestic legislation adopted international spontaneous exchange of information in tax matters.

### Exchange of information and tax treaties
- In January 2017, the Swiss domestic legislation adopted international spontaneous exchange of information in tax matters.
- This allows the spontaneous exchange of tax rulings regarding (i) corporate and individual income, (ii) corporate and individual net worth, and (iii) withholding taxes.
- As of the end of January 2018:
  - 51 tax treaties in force included an exchange of information provision conforming to international standards.
  - Switzerland has signed 10 tax information exchange agreements, 9 of which are in force.
- As of January 1, 2018, Switzerland has automatic exchange of information on financial accounts with over 75 states and territories.

### Anti-avoidance rules and transfer pricing
- The Swiss tax law contains selected anti-avoidance rules.
- Switzerland generally follows the arm’s length principle for transfer pricing, but:
  - There is no transfer pricing legislation specifying rules.
  - Cantonal authorities retain some degree of discretion to agree on transfer pricing methods.
- Thin-capitalization legislation denies deduction of interest expense of “hidden equity” (defined as debt which would not have been granted by third persons under the same conditions).
- A Federal Circular (from 1997) lays out safe-harbor rules for assessing total debt of a company in relation to assets (e.g., a debt-to-equity ratio of 6:1 for financial companies).
- Switzerland does not have controlled foreign corporation (CFC) legislation.

### Revenues from the CIT
- Revenues from the CIT comprise an above-average 11 percent of total tax revenues in Switzerland.
- The CIT-GDP ratio is 3 percent, above the OECD average (2.8 percent).
- A detailed fiscal equalization system is in place to mitigate differences between the cantons in terms of their financial capacity.

### Tax Proposal 17 — key features
- Objective: Abolishes cantonal preferential regimes and provides cantons with a modified financial and legal basis to reduce the tax burden in the absence of these regimes.
- Two key elements to maintain reduced effective tax rates in absence of preferential regimes:

  1. Legal element (innovation-related measures):
     - Cantons must introduce a patent box regime (a ‘mandatory’ measure) according to the G-20 OECD BEPS standards.
     - Cantons are free to set tax relief of up to 90 percent of qualified income from patents.
     - Cantons may introduce super R&D tax deductions of up to 50 percent (optional measure), i.e., qualified R&D expenses can be deducted at a rate of up to 150 percent.
     - General limitation: overall cantonal tax relief (all measures including R&D deductions and the patent box by a canton) may not exceed 70 percent of pre-tax profits (i.e., at least 30 percent of income must be subjected to taxation).

  2. Financial element:
     - Proposal would incentivize cantons to reduce their statutory CIT rates by raising the share of federal direct tax revenue that cantons would receive from 17 to 21.2 percent.
     - The federal statutory CIT rate remains 8.5 percent.
     - The new innovation tax incentives apply only to the cantonal tax.
- Additional measures under Tax Proposal 17:
  - Increases cantonal taxes on dividends for individuals by subjecting at least 70 percent of these dividends to taxation; cantons may tax a higher fraction than 70 percent.
  - Under current practice, in most cantons, 40–50 percent of dividends are exempt.
  - Minimum amount employers must pay for child and education allowance would be increased by CHF 30 per month.
  - Tax Proposal 17 contains transitional measures.

### Analysis — distributional and competitiveness effects
- Rationale:
  - Aligning the CIT system with international standards advised to avoid reputational damage and countermeasures (e.g., EU ‘black’ listing) and to minimize potential outward spillover effects from the Swiss system.
  - Abolishing existing preferential tax regimes is vital to respect Swiss commitments to the minimum standards.
  - Existing commissionaire ruling practice is difficult to reconcile with the internationally agreed arm’s length standard and can have particularly negative spillovers for developing countries.

- Expected changes in CIT rates and dispersion if reform implemented:
  - Combined effective unweighted average rate expected to fall from 17.7 percent to 13.9 percent.
  - Coefficient of variation for cantonal tax rates expected to decrease from 19.7 to 13.1 percent.

- Effective rates under maximum allowable cantonal relief:
  - Assuming cantons grant the maximum allowable tax relief (70 percent), effective CIT rates in Switzerland would range from 10.2 to 12.75 percent for companies that fully use the newly introduced tax benefits.
  - The effective unweighted average rate would be 10.9 percent.
  - The coefficient of variation would be close to 7 percent.
  - These rates are reference minimums; many companies would face higher rates depending on their use of innovation incentives.
  - Firms currently subject to approximately the federal rate (and some with even lower rates) would generally face an increase in tax burden as a result.

- International and investment implications:
  - The overall CIT rate cut is part of an international trend; several OECD countries have recently lowered their CIT rate.
  - Repealing preferential CIT regimes combined with an overall lower effective CIT rate would maintain Switzerland’s position as a relatively low taxation location, albeit at some cost to revenue.
  - A low CIT rate can be problematic if it triggers a minimum tax in the home country of the foreign parent company (e.g., foreign CFC rules or the new U.S. minimum tax on ‘Global Intangible Low-Taxed Income’).

### Cantonal differences, competition, and profit allocation
- Competitiveness-efficiency trade-off:
  - Companies not benefiting from preferential regimes (often relatively immobile) would gain from the planned CIT rate cut, but lower CIT revenues from these companies imply an efficiency cost.
  - Lower CIT rates could have favorable dynamic investment effects by reducing the cost of capital for less mobile firms; medium-term net effect depends on relative elasticities.

- Cantonal heterogeneity:
  - Cantons with larger economies tend to impose higher CIT rates.
  - Four cantons — Bern, Geneva, Vaud, and Zurich — together constitute about 50 percent of Swiss GDP and 52 percent of total CIT revenues in Switzerland.
  - These cantons have relatively low shares of CIT revenues from status companies; lowering the CIT rate in these cantons would result in higher revenue forgone from non-status companies.
  - Examples of announced/signaled rate cuts:
    - Geneva signaled a cut from 24.16 to 13.49 percent.
    - Vaud announced a cut in 2019 from 21.37 to 14 percent.

- Increased mobility and base differences:
  - Abolishment of preferential regimes makes cantonal CIT rate and base more prominent in firms’ location and investment decisions.
  - Differences in R&D tax treatment could induce allocation of R&D expenses to cantons with generous R&D deductions while maintaining legal ownership of patents in other cantons with generous patent box regimes.
  - Current inter-cantonal profit-splitting rules are based on case law (separate accounting or assigned quota, typically 10 to 20 percent to headquarters’ canton).
  - Short-term safeguard: strengthening domestic transfer pricing rules and their application would safeguard revenues.
  - Medium-term option: consider tax law-based formulary apportionment options to allocate profits between cantons.

- Fiscal equalization:
  - The fiscal equalization system provides an implicit limit to cantonal tax competition because attracting more direct income implies a canton receives less from (or contributes more to) the fiscal equalization scheme.
  - However, the general limitation rule restricting tax relief to a maximum of 70 percent of taxable income can intensify CIT rate competition: if the general limitation is binding, cantons may cut statutory CIT rates to lower tax burdens.

### Encouraging innovation through taxation
- R&D deductions vs. IP box regimes:
  - R&D deductions are generally more effective and efficient than IP box regimes (IMF, 2016b).
  - Policy question: what is the best option for spending CHF1 on a tax relief for innovation?
  - Existing evidence suggests that a CHF1 R&D deduction would result in significantly higher R&D activities than CHF1 spent on a patent box.
  - Example evidence: in the Netherlands, €1 spent on a patent box generates €0.56 of additional R&D, whereas granting €1 in an R&D tax incentive for inputs results in €1.77 expansion in R&D.
- Implication for Swiss design:
  - For a given cost, maximizing the use of R&D deductions in combination with a less generous patent box relief would yield the highest R&D activities.
  - The patent box effective rate in Switzerland would generally be at the higher end of international comparators because of the federal CIT rate and the 70 percent maximum allowed cantonal tax relief.
  - Nevertheless, the overall CIT rate in Switzerland would remain competitive.

- Comparative table (selected patent boxes, effective rates as reported):
  - Belgium† 2007 3.75
  - Cyprus 2012 2.5
  - France 2000 15
  - Hungary 2003 4.5
  - India 2016 10
  - Ireland 2016 6.25
  - Israel 2017 6
  - Italy 2015 6.25
  - Korea 2014 12.5
  - Luxembourg 2008 5.84
  - Netherlands 2007 5
  - Portugal 2014 10.5
  - Spain 2008 12
  - CHE (Nidwalden) 2011 8.8
  - UK 2013 10
  - Switzerland (expected)‡ 2019 or 2020 10.9
  - Note: † Assuming the CIT rate is 25 percent. ‡ The patent box rate reported here is the average combined effective rates of cantons assuming that cantonal and municipal tax apply only to 30 percent of pre-tax income.

### Tax neutrality and dividend taxation
- Current situation:
  - Distributed corporate profits tend to be undertaxed compared to non-corporate business income.
  - A study by the Federal Finance Administration shows that incorporating a business with an annual income of at least CHF300,000 has a tax advantage relative to taxing it at the individual level in all cantons.
- Impact of lowering cantonal CIT rates:
  - Lowering cantonal CIT rates would further lower the marginal and average tax burden for distributed corporate profits, exacerbating non-neutrality between different legal forms.
  - Increasing dividend taxation becomes important to preserve the backstop function of the CIT (protecting the personal income tax base).
  - Taxing 70 percent of dividends under prevailing CIT rates would still imply a tax benefit from incorporation in 17 Cantons.
  - Thus, increasing the fraction of taxed dividends, as proposed under Tax Proposal 17, would alleviate distortions in organizational forms but would not achieve full tax neutrality.
- Alternative not included in Tax Proposal 17:
  - An allowance for corporate equity (ACE) would align the tax treatment of equity and debt financed investments and neutralize debt bias.
  - The ACE encourages investment by taxing only abnormal returns (economic rent); its effectiveness depends on design (base, allowance rate) and requires appropriate anti-avoidance rules.
  - Political economy considerations have historically complicated ACE adoption in Switzerland.

### Budgetary impact and behavioral responses
- The proposed reform is expected to have a static cost.
  - The static cost includes revenue forgone due to lowering the cantonal CIT rates and the increase in dividend taxation, but does not consider possible dynamic effects on firms’ investment.
- Overall budgetary impacts are uncertain and depend on:
  - Behavior by individual firms.
  - Cantons’ final implemented tax packages (CIT rates and innovation tax incentives).
  - The exact federal package that will be implemented.
  - CIT developments in other countries.
- Key parameter: elasticity of taxable income.
  - Recent meta-analysis in Beer et al. (forthcoming) suggests that the semi-elasticity of profit with respect to the CIT rate is -1.2 and tends to be larger for US companies.
  - Dowd et al. (2017) find using U.S. firm-level data that the profit semi-elasticity is nonlinear in the CIT rate, ranging from -0.7 (for an increase in the CIT rate from 29 to 30 percent) to -4.7 (for a CIT rate increase from 4 to 5 percent).

*SWITZERLAND — INTERNATIONAL MONETARY FUND*

### 34.      The Swiss corporate tax system includes many aspects of a territorial regime; is highly

### 34. The Swiss corporate tax system includes many aspects of a territorial regime; is highly attractive for MNCs; and collects non-negligible revenues, but the status quo is not sustainable.

### Overview of the corporate tax reform proposal and implications
- Proposed reform would eliminate differences in the tax treatment of foreign and Swiss sourced income.
- Cantons are expected to lower their CIT rates, bringing the combined (municipal, cantonal, and federal) tax rate (averaged across cantons) to about 13.9 percent.
- Costs of lowering the CIT rates would be unequally distributed across cantons, and would be costlier for cantons with a large immobile CIT base.
- As the tendency towards CIT rate and base competition between cantons—including for less-mobile capital—intensifies, strengthening measures to tackle possible income shifting between cantons would safeguard revenues.
- From an international perspective:
  - There is a limit to the benefits from a low CIT rate as it can prompt the payment of tax in the country of the foreign investor, and hence become ineffective in attracting FDI.
  - The neutrality of the tax system with respect to the legal form is important because lack of neutrality may put the personal income tax base at risk.
- Regarding encouraging innovation:
  - At a given cost, the innovation package should maximize the use of R&D tax deductions in relation to the patent box to encourage real domestic investment and job creation.

### Box 2 — Potential spillover effects of international tax reforms on Switzerland (key findings)
- FDI importance and magnitudes:
  - The stock of inward FDI equaled 128 percent of Swiss GDP in 2016.
  - The share of U.S. FDI in Switzerland, after correcting for the country of the ultimate-beneficial owner, increased from about 30 percent in 2006 to about 44 percent in 2016.
  - FDI from the EU declined from 43 to 37 percent during this period.
  - According to the US BEA, about 5 percent of total U.S. corporate net income abroad was reported in Switzerland (noting this is likely an underestimate as it does not consider U.S. FDI in Switzerland through a third country).
  - 1 percent of employment by US companies abroad is in Switzerland, corresponding to 118,000 employees.
- Recent international tax developments and comparisons:
  - There is a global trend toward lowering the CIT rate and strengthening rules against outbound profit shifting.
  - France and Belgium have recently announced they will lower their CIT rates to 25 percent.
  - The 2018 cut in the US federal statutory CIT rate to 21 percent (25.75 percent combined rate) follows this international trend, but this rate remains higher than the expected Swiss post-reform average of about 13 percent.
  - The ‘territorial’ aspect of the new US CIT system intensifies international competition over U.S. investment, but Switzerland would remain relatively competitive compared to other countries.
- Effective tax rates and expected changes:
  - One measure of the effective CIT rate on US investment in Switzerland was 7.7 percent in 2014, close to the Swiss federal rate, possibly reflecting the use of cantonal preferential regimes.
  - The Swiss effective CIT rate is expected to increase (to about 10.9 percent after abolishing the preferential regimes), but other countries’ effective CIT rates will increase as well (e.g., in the EU under ATAD and recent European Court of Justice decisions regarding state aid).
- Country- and firm-specific effects of US reform:
  - Swiss FDI in the US benefits from the US reform; some Swiss companies may be negatively impacted by the strengthening of US anti-abuse rules.
  - Highly-profitable Swiss companies in the US, such as pharmaceuticals, benefit from the US CIT rate cut in the form of windfall gains and a lower cost of capital.
  - Swiss banks and Swiss insurance companies may be negatively impacted because of the strengthening of the US anti-abuse rules, such as the introduction of the ‘Base Erosion Anti-Abuse Tax’ (BEAT) and of the anti-hybrid rule.
  - The BEAT applies to gross payments to foreign related-parties.
  - The anti-hybrid rule addresses situations where instruments are captured as equity for capital requirement purposes in Switzerland but treated as debt in the US for tax purposes.
- Withholding tax and repatriation incentives:
  - Incentives to repatriate profits held by U.S. subsidiaries abroad can have a short-term impact on withholding tax revenues in Switzerland.
  - The withholding tax rate on dividends for corporations in the bilateral tax treaty between the US and Switzerland is 5 percent (a final tax as US tax credits are no longer possible).
  - Routing dividends through a third country with a zero withholding tax, such as the Netherlands or the UK, though possible, may be impeded by Swiss treaty rules against treaty shopping and may trigger, under certain circumstances, a Swiss tax.
- Overall assessment:
  - Overall, the spillover effects from the recent U.S. tax reform on Switzerland appear to be moderate.
  - There is no evidence, thus far, of major shifts of US-Swiss FDI patterns, but this is a preliminary view since it is still rather early to fully assess the spillover effects of the U.S. reform.

### Annex I — Computing the corporate tax rate in Switzerland: illustration (Zurich example)
- Federal l rate  8.5%
- Canton of Zurich (8% * 1) 8%
- City of Zurich (8% * 1.2901) 10.3208%
- Total (statutory) rate Sum the above 3 rows: 26.8208%
- Effective combined rate† (because the tax itself is deductible) = statutory rate/(1+statutory rate) 21.15%
- Formula note:
  - † To compute the effective rate, let tStatutory be the amount of the final tax which is deductible, and consider 1 CHF of taxable income: (1 – tEffective)×tStatutory = tEffective, which implies that the tEffective = tStatutory/(1+tStatutory).

*International Monetary Fund — Switzerland: selected excerpts from the staff report.*

### 8.      The EMP index adopted here is constructed as the weighted sum of changes in the

### 8.      The EMP index adopted here is constructed as the weighted sum of changes in the

### EMP index construction
- EMP is constructed as the weighted sum of changes in the exchange rate, official foreign exchange reserves and interest rates, all relative to a reference country. Specifically, EMP is written in terms of first differences (Δ) and standardized by 푤, the standard deviation of each variable over the 1999–2018 sample period.
- Variables and definitions:
  - 푒 is the NEER or bilateral exchange rate, defined as number of euro per unit of local currency.
  - 푅 is international reserves (measured in local-currency terms) or the monetary base of the central bank.
  - 푌 is nominal GDP, measured in local currency.
  - 푖 is the policy interest rate.
  - 푤 is the standard deviation of each variable over the 1999–2018 sample period.
  - Δ is the first difference operator.
  - Variables with a “*” denote those corresponding to the reference central bank (in this chapter, the ECB unless otherwise indicated); those without refer to the home country.
- Weighting note:
  - Weights are the inverse of the standard deviation (precision weights). Different weighting schemes can generate quite different measures of total EMP and relative contributions of each component. Precision weights imply more weight is given to components with less variation.

### Interpretation of EMP
- A positive EMP indicates net appreciation pressure and is typically associated with some combination of:
  - a strengthening exchange rate,
  - increasing reserves,
  - and/or a decrease in the gap between the home country’s and the reference country’s interest rates.
- A negative EMP indicates depreciation pressure which may be tempered by:
  - an interest rate increase and/or
  - reserve sales.
- Because EMP is measured relative to a reference country, changes in policy instruments by the reference country that are matched by the home country do not generate pressure.
- Footnotes and clarifications from the source:
  - Under a pegged exchange rate, inverse-standard-deviation weighting tends to give more weight to the exchange rate, with changes in reserves responding to exchange market pressures in such a regime.
  - An increase in the interest rate differential tends to increase appreciation pressure, and hence the interest-differential term enters with a negative sign.
  - Data for some countries begins in 2002.

### Results — dataset and scope
- EMP indices computed for: Switzerland, the Czech Republic, Denmark, Israel, Poland, and Sweden.
- Sample period: 1999–2018, using monthly data.
- Measures computed: point-in-time (12 month rolling window) EMP and cumulative EMP.
- Sources for data and calculations: Bloomberg Finance L.P.; Haver; and IMF staff calculations.

### Results — Switzerland (detailed findings)
- Pre-2009: EMP for Switzerland was small and bi-directional (both appreciation and depreciation pressures).
- Post-GFC: exchange market pressure intensified for Switzerland.
  - Several episodes of large appreciation pressure, especially during 2010–11 and again in 2015.
  - With interest rates already below the ECB’s and very close to zero, further reduction in the euro area policy rate narrowed the interest rate differential, leading to a negative EMP contribution (i.e., a tightening of policy).
  - As a result, the SNB accumulated foreign reserves to defend against appreciation pressure, but the franc nonetheless appreciated significantly.
  - In 2012, the SNB temporarily divested some reserves.
- Since mid-2017: the sign of EMP for Switzerland switched to negative and has mainly been reflected in depreciation of the franc.
- Cumulative EMP for Switzerland:
  - Has been large and positive.
  - Cumulative EMP declined in 2011 following the adoption of the exchange rate floor, but more generally pressures tended to increase monotonically until mid-2017.
- EMP composition for Switzerland:
  - Initially the exchange rate absorbed the largest share of appreciation pressure.
  - Since 2012, the role of reserve accumulation increased considerably.
  - Interest rates played a modest—if slightly negative—role owing to limited policy space.
- Robustness:
  - Results are similar if changes in reserves are replaced with changes in the monetary base, though the extent of EMP is somewhat lessened because:
    - (i) it excludes valuation effects on (mainly foreign) assets acquired by the SNB, and
    - (ii) it includes the ECB’s monetary base expansion due to purchases of euro-area assets.

### Results — Other countries (summary)
- Denmark:
  - EMP remained bi-directional since the GFC, with increased intensity in both directions.
  - Given the narrow band of the Danish krona against the euro and modest scope for interest rate differentials, most of Denmark’s EMP was absorbed by reserve accumulation.
  - The exchange rate helped absorb a significant share of bi-directional EMP but in cumulative terms its contribution was small.
- Sweden:
  - Bi-directional EMP since the GFC, with the exchange rate absorbing more of the pressure consistent with a more flexible regime.
  - Substantial depreciation pressure at the onset of the GFC, followed by two episodes of strong appreciation pressure, and since 2014 a return to moderate depreciation pressure.
  - During the initial appreciation episode, the interest differential increased as the Riksbank raised its policy rate, supporting reserve buffer buildup.
  - Since then, Sweden experienced sustained negative EMP which unwound previous cumulative appreciation pressure; the exchange rate was allowed to depreciate, tempered by some selling of official reserves.
- Israel:
  - Experienced significant positive EMP following the GFC; reserve accumulation absorbed most of the pressure.
  - Israel faced negative EMP before the GFC and substantial appreciation pressure early in the crisis, met primarily with reserve accumulation and a widening interest rate differential.
  - Later episodes combined reserve accumulation and a strengthening exchange rate; net effect was pressure mainly absorbed through reserve accumulation.
- Poland:
  - Bi-directional EMP with strong depreciation pressure at the onset of the GFC followed by net appreciation pressure thereafter.
  - Policy response included build-up of reserves for precautionary purposes since the GFC and interest rate cuts since 2013 to fight low inflation/deflation, helping to stabilize the zloty against the euro.
  - Reserve accumulation was in part to meet the qualification criterion on holding adequate reserves under the IMF’s Flexible Credit Line.
- Czech Republic:
  - Prior to adopting the exchange rate floor, faced bi-directional EMP, with appreciation pressures intensifying prior to removing the floor.
  - Before 2013, the exchange rate absorbed most EMP (both appreciating and depreciating).
  - With the introduction of the floor, exchange market pressures subsided and accumulation of reserves allowed the koruna to depreciate (move above the floor).
  - After pre-announcing in late 2016 that the floor would be removed, appreciation pressure increased significantly and the CNB substantially increased foreign exchange reserve purchases.

### Cross-country patterns
- At the onset of the GFC, all countries in the sample—with the exception of Israel—experienced depreciation pressure.
- Thereafter pressures were diverse but with extended periods of co-movement across countries (for example: Switzerland and Sweden during 2012–14; Israel, Poland and Switzerland during 2014–17).
- Denmark, Poland and Sweden experienced bi-directional pressures since the GFC and thus have generally small cumulative EMPs.
- The Czech Republic and Switzerland saw several episodes of intense appreciation pressure that only partially reversed, yielding large cumulative appreciation pressure.
- Israel shifted from bi-directional pressure to one-sided appreciation since 2014, leading to sizable cumulative appreciation.
- All countries experienced depreciation—or weaker appreciation—pressure since mid-2017.

### Extensions — illustrative counterfactuals for Switzerland
- Counterfactual approach assumptions:
  - Keep original path for EMP and the actual contribution from the interest rate channel; assume some channels (notably reserve accumulation) were less-actively utilized.
  - Results are illustrative and based on strong assumptions (e.g., they assume no countervailing market forces would have prevented the exchange rate or interest rate from reaching extreme levels).
- Counterfactual scenarios and illustrative outcomes:
  - If reserve accumulation had been dampened by half (i.e., reserve accumulation halved), the franc would, ceteris paribus, have been around 40 percent stronger as of early 2018.
  - If reserve accumulation had been dampened by half, Swiss interest rates would have had to decline to very negative levels — levels similar to shadow interest-rates estimated by Wu and Xia (2017) for the euro area under alternative assumptions.

### Conclusions
- Switzerland experienced positive and relatively-sustained appreciation pressure for much of the past decade, commencing with the onset of the GFC and continuing periodically until mid-2017.
- Unlike typical safe-haven behavior that would oscillate between positive and negative EMP, Switzerland’s EMP varied in intensity but generally did not reverse until mid-2017, producing one of the largest cumulative pressures among the group of small open economies on the perimeter of the euro area.
- Despite large purchases of international reserves to resist appreciation pressure, much of the pressure was nevertheless absorbed through the exchange rate.
- Reserve accumulation avoided the need for a more appreciated exchange rate and/or much lower interest rates.
- Notable event: the Swiss franc appreciated strongly in May, 2018.

*Sources: Bloomberg Finance L.P.; Haver; and IMF staff calculations.*

### 1.      The Swiss National Bank (SNB) set the policy interest rate at minus 0.75 percent in

### The Swiss National Bank (SNB) set the policy interest rate at minus 0.75 percent in

### Policy design, exemption thresholds, and computation
- Policy interest rate: minus 0.75 percent (set in January 2015; initial negative rate minus 0.25 percent announced in December 2014 and lowered to minus 0.75 percent with removal of the exchange rate floor).
- Negative rate applies to banks’ sight deposits at the SNB, subject to bank-specific exemption thresholds of 20 times the minimum required level of reserves (fixed as of November 2014).
- Balances below the exemption threshold carry a zero interest rate.
- Exemption threshold adjustment rule: threshold is reduced (raised) by the cumulative increase (decrease) in a bank’s cash withdrawals.
- Method and interest rate for computing minimum exemption thresholds: unchanged since January 2015.
- Foreign banks and some non-bank holders of SNB accounts have different, but constant, exemption thresholds.
- Exemption threshold computation (as stated): “the minimum reserve requirement of the reporting period of October-November 2014 times 20” minus/plus “an increase/decrease in cash holding from the reporting period of October-November 2014 to the current reporting period.”

### Scope and effective rate on sight deposits
- Sight deposits above banks’ exemption thresholds and subject to the negative deposit rate currently amount to about CHF180 billion.
- CHF180 billion equals 39 percent of total sight deposits and 27 percent of GDP.
- Effective rate on banks’ deposits at the SNB: about -0.3 percent (considerably less negative than the marginal rate due to exemption thresholds).
- For all banks, SBA reports CHF234 billion of sight deposits at the SNB were subject to negative interest rates at the end of 2016.
- Most banks have exhausted their exemption thresholds, including through interbank transactions.
- A market developed whereby banks with liquidity exceeding their exemption threshold transferred excess liquidity for a fee to banks below their exemption threshold.

### Transmission to money and government bond markets
- The 3-month LIBOR converged quickly to the policy interest rate after NIRP introduction.
- Target range for 3-month Swiss-franc LIBOR set between -0.25 and -1.25 percent in January 2015.
- Short-term government bond yields were modestly negative even before NIRP, and decreased further thereafter.
- Interest rates on longer-term instruments decreased (they had been decreasing prior to NIRP); the entire yield curve for sovereign bonds (through to 50 years) fell into negative territory on at least one occasion.
- SARON referenced as an overnight average rate referencing the Swiss Franc interbank repo market.

### Retail and institutional deposit pricing and pass-through
- Banks kept most retail deposit interest rates floored at zero; institutional deposit rates turned negative.
- Deposit rates for institutional investors and large retail depositors (reportedly above CHF1 million) are thought to have declined close to the policy rate.
- Interest rates on new 1-year term deposits exceeding CHF100,000 turned modestly negative immediately after NIRP adoption and have edged lower since then (but only to minus 0.25 percent).
- Rates on current accounts remain anchored at zero; savings deposits maintain marginally positive rates.
- Overall, only 5 percent of franc-denominated deposits of domestic clients were subject to negative rates at end-2016.
- Nonresidents’ deposits are only about 6 percent of total CHF-denominated deposits.
- Banks became somewhat less receptive to accepting new deposits, especially from institutional clients.

### Mortgage lending, lending rates, and bank margins
- To preserve interest margins when retail deposit rates are floored at zero, banks initially raised mortgage lending rates.
- Interest rate on a 10-year fixed rate mortgage increased by 50 bps by mid-2015.
- Rates on shorter-duration loans increased by considerably less.
- After the initial rise, mortgage interest rates declined partly due to competition from nonbank mortgage lenders with funding costs close to the policy rate.
- Rates have seen an uptick since late-2017, broadly in line with LIBOR swap rates used to price fixed-term mortgages.
- Interest rates on new fixed-rate mortgages have risen by much less than market interest rates since mid-2016.
- The spread between rates on mortgage loans and customer deposits decreased from 2.0 percentage points in 2010 to 1.5 percentage points in 2016.
- Aggregate mortgage lending did not accelerate following NIRP; mortgage lending continued to expand but at a slowing pace after macroprudential measures in 2012–14.
- Aggregate mortgage lending quickened since late-2017.
- Mortgage volume at domestically-focused banks has been growing significantly faster than at big banks since the onset of the global financial crisis in 2007.

### Bank balance-sheet adjustments and risks
- Banks are effectively segmenting balance sheets into above-zero and below-zero books corresponding to retail and institutional customers.
- Pricing of mortgage lending appears linked to retail deposit rates (around zero), while institutional and interbank deposit pricing is anchored to the cost of placing funds at the SNB (minus 0.75 percent).
- Domestically-owned retail banks with larger SNB sight deposits in excess of exemption thresholds reduced these balances by shifting into other assets (loans and financial instruments) and scaling back liabilities.
- Preference given to reducing longer-term bond financing rather than deposits to preserve long-term retail relationships, yet these banks became less receptive to accepting new deposits and saw balance sheets tend to contract.
- New lending by domestically-focused banks has been provided to borrowers with higher affordability risk.
- SNB survey: loan-to-income ratios on newly-issued mortgages reached a new peak in 2016.
- About one third of new mortgage loans are reportedly for residential investment properties, despite rising vacancy rates and decreasing rents.
- Interest rate risk from maturity transformation by domestically-focused banks increased in 2015 from an already-high level and has remained elevated since then.

### Profitability outcomes and income composition
- During early years of NIRP, domestically-focused banks preserved and even marginally increased return on assets.
- Factors supporting profits: (i) continued expansion of mortgage lending more than compensated for narrowing interest margins; (ii) limited burden of NIRP due to large exemption thresholds; (iii) higher rates on newly-issued mortgage loans in early 2015 supporting interest income over loan duration; (iv) lower credit losses, value adjustments and provisions; and (v) greater cost efficiency.
- The average interest margin on outstanding claims of domestically-focused banks decreased by 0.3 percentage points (equivalent to 2.5 percent) in 2016, while mortgage lending grew by 4.1 percent, resulting in an increase in net interest income.
- Ongoing pressure from nonbank mortgage lenders, dissipation of temporary mortgage rate increases, and already very-high credit penetration suggest difficulty in sustaining 2015–16 profit levels over the longer term.
- G-SIBs have a different business model and showed more volatile returns.
- Profit data for 2017: at time of writing, not yet available.

### Cash demand, currency in circulation, and potential hoarding
- Demand for cash increased only temporarily and by a relatively modest amount around NIRP introduction; increase concentrated in the CHF1000 note.
- Increase in cash demand was more modest than earlier spikes in 2008 and 2012.
- Growth of currency in circulation has slowed more recently, consistent with wider use of cashless-payment systems.
- Velocity of money (nominal GDP relative to cash in circulation) has been decreasing since the turn of the decade, with a small temporary increase in early 2015.
- Limited cash hoarding likely reflects banks’ decisions not to lower retail deposit rates below zero and that cash withdrawals by banks are factored into exemption threshold calculations.
- Note on cash hoarding economics: fixed and variable costs of hoarding imply breakeven interest rate for conversion to cash will be lower the longer negative rates are expected to persist; sustained negative rates for an extended period could make cash hoarding more attractive.

### Empirical findings and referenced studies
- Basten and Mariathasan (2018): evidence that arbitrage and interbank reallocation supported transmission and that banks with larger SNB sight deposits adjusted by shifting into other assets and scaling back liabilities.
- Turk (2016), Bech and Malkhozov (2016), Eggertsson, Juelsrud and Wold (2017), and others cited regarding NIRP impacts in Sweden, Denmark and other contexts.
- Swiss Bankers Association (SBA) data referenced for deposit subject to negative rates and development of interbank liquidity markets.

*Source: IMF staff summary prepared by Seung Mo Choi (EUR) based on the SNB and related materials in cr18174.*

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_Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18174.pdf_