Substance requirements for international holding structures

International Holding Structures for SMEs: risks associated with a lack of substance

The international corporate structures of SMEs are increasingly coming under scrutiny from tax authorities. A key principle here is substance over form. This principle states that it is not merely a company’s formal legal structure that is decisive for tax purposes, but its actual economic activity.

International initiatives, for example within the framework of the OECD BEPS measures or European anti-abuse rules, aim to prevent artificial structures without genuine economic activity. Holding or financing companies within international groups are subject to particularly critical scrutiny. A lack of substance can trigger significant tax consequences, for example regarding the question of a company’s residence, the allocation of profits in the context of transfer pricing, or the application of national and international rules (DTA) on withholding tax relief. It is therefore crucial, particularly for internationally active SMEs, to identify these risks at an early stage and avoid them through appropriate structuring.

Substance Requirements in International Holding Structures

In international group structures, tax authorities are increasingly examining whether a company has sufficient economic substance. In particular, the key question is whether a company actually performs entrepreneurial functions or merely serves as a formal intermediary entity.

Tax authorities typically distinguish between three dimensions of substance:

Personnel substance

Personnel substance exists where a company has its own resources, such as:

• its own office premises
• qualified personnel
• operational infrastructure

It is not necessarily required that all functions be performed in-house. Supporting activities, such as accounting or administrative tasks, may also be outsourced. What is decisive, however, is that the company has sufficient internal resources to effectively perform its core functions.

Functional Substance

Functional substance relates to the actual business activities carried out by the company.

In the case of holding companies, a distinction is generally made between:

• passive holding activity, meaning the mere holding of participations
• active holding activity, meaning the strategic management of the group

As a rule, only active holding activity is recognized as sufficient economic activity. This includes, for example:

• strategic management decisions for the group
• determining investment decisions
• supervising subsidiaries
• group-wide management functions

Purely formal decisions or administrative activities are often not sufficient.

Financial Substance

In addition to personnel and functions, financial capacity also plays an important role. Companies that perform financing functions within a group must also be economically capable of bearing the corresponding risks.

In practice, such companies are often expected to have adequate capitalization and to actively manage financing transactions. From a financial substance perspective, an equity ratio of at least 30% is generally considered sufficient.

Withholding Tax and Substance Requirements

Lack of substance can lead to tax disadvantages, particularly in the case of cross-border dividend, royalty or interest payments.

Many double tax treaties provide for a reduction or exemption from withholding taxes. However, these benefits are often granted only if the recipient of the payment qualifies as the beneficial owner, the receiving company demonstrates sufficient substance, and no abusive intermediary structure is involved.

If a holding company does not meet these requirements, foreign tax authorities may:

• deny the application of the double tax treaty
• refuse the withholding tax reduction
• reject claims for withholding tax refunds

As a result, the full withholding tax burden remains in the foreign jurisdiction. This can lead to economic double taxation, as the profit is taxed both in the source state and at the level of the recipient.

Withholding Tax Risks in Switzerland

From a Swiss perspective as well, insufficient substance can have tax consequences. In particular, in connection with transfer pricing and intra-group services, adjustments made by tax authorities may result in Swiss withholding tax consequences.

If intra-group transactions are not recognized as being at arm’s length, tax authorities may make profit adjustments. Such adjustments may be classified as constructive profit distributions and may therefore be subject to Swiss withholding tax.

The risk arises in particular in connection with:

• management or advisory services within the group
• intra-group loans
• royalty payments or service fees

Such adjustments may not only lead to additional tax burdens but, in an unfavorable case, may also trigger a definitive Swiss withholding tax charge.

Conclusion

International holding structures must now meet significantly stricter tax requirements than they did just a few years ago. A lack of substance or non-arm’s-length intra-group transactions may result in the denial of tax benefits and in additional tax burdens.

For internationally active SMEs, it is therefore essential to regularly review their group structure and ensure that business functions, risks and decision-making processes are genuinely located where they are claimed for tax purposes.

Important tax-related questions you should ask when setting up international structures:

• Do the companies have sufficient economic substance?
• Are the national withholding tax rules and international double tax treaty provisions being applied correctly?
• Are the transfer pricing principles correctly applied to intra-group transactions?
• Is there a Swiss withholding tax risk in connection with intra-group transactions, and are you aware of that risk and its consequences?
• Is there sufficient documentation on these matters, including a description of the structure and the transactions as part of a transfer pricing documentation?