According to the European Covered Bond Council s definition,

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1 SWITZERLAND COVERED BONDS SPECIAL FOCUS Swiss tax law s influence on covered bonds Benedikt Maurenbrecher, Dieter Grünblatt and Stefan Kramer of Homburger on Swiss tax law s influence on concepts of covered bonds According to the European Covered Bond Council s definition, covered bonds are secured debt instruments which meet the following criteria: (i) The issuer or the guarantor of the debt instrument is a prudentially regulated credit institute (i.e., a bank); (ii) the debt instruments are secured by a cover pool of mortgage loans (property as collateral) or public-sector debt to which investors have a preferential claim in the event of default; and (iii) the bank has a continuing obligation to provide a sufficient amount of assets to the cover pool in order to be able to satisfy the claims of the covered bond investors, and compliance with such obligation is subject to supervision by a public authority or independent third party. In Switzerland, there are two different legal concepts which correspond to this definition. Swiss Pfandbriefe On the one hand, in 1931, the Swiss legislator created the Swiss Pfandbrief system by enacting the Federal Pfandbrief Act (Pfandbriefgesetz, or PfG), complemented by a respective ordinance (Pfandbriefverordnung, or PfV). The PfG provides for explicit regulations regarding all key elements of the Pfandbrief system, such as the institutions authorised to issue instruments under the PfG, the structure and valuation of the cover pool, and certain insolvency-related issues. Accordingly, the instruments issued in accordance with the PfG the Swiss Pfandbriefe could be qualified as statutory covered bonds. The term Pfandbriefe is, however, widely recognised and protected by law and it is rather unusual to use the term covered bonds when describing the Swiss Pfandbriefe. According to the PfG, only two institutions are authorised to issue Pfandbriefe in Structure of Swiss Pfandbriefe Cash Loan Mortgage loan Pfandbrief holder Pfandbrief institutes Member bank Mortgagee Property Right of lien on loan receivable Right of lien on mortgage Right of lien on property Switzerland, namely the Pfandbriefzentrale der schweizerischen Kantonalbanken (PBZ), a vehicle issuing Pfandbriefe for the Swiss cantonal banks and the Pfandbriefbank schweizerischer Hypothekarinstitute (PBB), a vehicle issuing Pfandbriefe for all other Swiss banks. Both institutions are supervised by the Swiss Financial Market Supervisory Authority FINMA. The issuance of Swiss Pfandbriefe aims at financing the mortgage business of the member banks. PBZ and PBB use the proceeds from the issuance of Pfandbriefe to grant loans to their member banks which allow the member banks to enter into long-term mortgage loan agreements with real estate owners. Structured covered bonds Under Swiss law, on the other hand, the concept of freedom of contract allows an issuer to structure a covered bond programme based on contractual agreements with investors and other persons or institutions to be involved in the transactions. Instruments issued under such contractual agreements qualify as structured covered bonds. The avenue of structured covered bonds has only recently been explored in Switzerland, when first UBS (in 2009) and then Credit Suisse (in 2010) established their respective covered bond programmes. The key elements of covered bond structures are as follows: The Swiss bank, acting through a non-swiss branch, issues covered bonds as direct, unconditional and unsubordinated obligations of the issuer. The obligations of the issuer under the covered bonds benefit from a guarantee issued by a subsidiary of the issuer (Mortgage SPV) under a so-called guarantee mandate agreement in favor of the holders of covered bonds, represented by the bond trustee. Under the guarantee mandate agreement, all liabilities, costs and expenses incurred by the guarantor under or in connection with the guarantee will have to be reimbursed (or prefunded accordingly), by the issuer. As security for the relevant reimbursement and pre-funding claims of the guarantor, the Swiss bank transfers a pool of mortgage loans, together with the related mortgage security, to the Mortgage SPV. Accordingly, if the issuer defaulted under the covered bonds and the guarantee was to be drawn, the Mortgage SPV could claim for coverage by the issuer under the guarantee mandate agreement. Failure by issuer to pre-fund the payments lowered under the guarantee would allow the Mortgage SPV to enforce in the cover pool and to use the proceeds to satisfy its payment obligations under the guarantee. The cover assets mainly consist of Swiss mortgage loans granted by the issuing bank to Swiss domestic individuals and the respective mortgage certificates securing such loans. Additionally, cash and other qualifying substitute assets may be part of the cover pool. The structure of Swiss structured covered bonds is unique. It is to a some extent driven by the Swiss tax law considerations outlined below. Additionally drivers are legal, regulatory, and insolvency law considerations. Swiss vs international capital markets Under the taxation legislation in effect interest paid in respect of covered bonds by a Swiss issuer may be subject to Swiss withholding tax. While Swiss investors are used to Swiss withholding tax, experience shows, that there is only a limited market outside Switzerland for debt instruments subject to the tax. Covered bonds issued to investors outside Switzerland must therefore be issued under a structure which allows the issuer to make interest payment in respect of the covered bonds free of Swiss withholding tax. IFLR/July/August

2 SWITZERLAND Swiss covered bond structure acting through its head office as originator, assignor and servicer Collateral fee Swiss bank (Switzerland) Security Assignment for Secured Obligations acting through its foreign branch as issuer Mortgage SPV AG (Zurich) No withholding tax (Verrechnungssteue) provided proceeds not used in Switzerland Covered bonds Covered bond proceeds Guarantee fee Covered bond guarantee If covered bonds are secured by a mortgage over real property situated in Switzerland, additionally a special Swiss federal, cantonal, and communal income tax applies, but only if the interest payment is made to a beneficiary outside Switzerland. Therefore, identical to the situation in respect of Swiss withholding tax, it must be safeguarded that interest payments in respect of covered bonds issued to investors outside Switzerland can be made without such taxes being applicable. The Swiss withholding tax and the special income tax bifurcate the market for covered bods. Swiss Pfandbriefe issued by PBB and PBZ are subject to Swiss withholding tax and, potentially, the special income tax. They therefore mainly attract Swiss retail and institutional investors. The structure of covered bonds issued by Swiss banks allows them to make interest payments in respect of the covered bonds without deduction for Swiss withholding tax and special income taxes. They therefore appeal primarily to an institutional investor base outside of Switzerland. Swiss withholding tax rules Swiss Pfandbriefe Under Swiss withholding tax legislation in effect interest paid by a Swiss issuer other than a bank is not in principle subject to Swiss withholding tax (35%), unless the debt instrument under which interest is paid is classified as bond or debenture. The two vehicles issuing Swiss Pfandbriefe do not classify as banks for Swiss withholding tax purposes and can therefore issue covered bonds or covered debt instruments pursuant to these rules. The rules say that where a debt instrument issued by an issuer in Switzerland other than a bank can be held pursuant to its terms at any time by more than ten creditors that are not banks, the instrument will be characterised as bond and Swiss withholding tax will apply to the entire amount for the entire term of the instrument. Accordingly, if PBB or PBZ privately place Swiss Pfandbriefe, which pursuant to their terms cannot be held by more than ten investors, who are not banks, interest paid in respect of such Swiss Pfandbriefe is not subject to the tax. Swiss Pfandbriefe are, however, usually issued without transfer restrictions, and may therefore be held by more than ten investors, who are not banks. They therefore usually classify as bonds subject to Swiss withholding tax, and only exceptionally as non-taxable instruments. Swiss withholding tax is also triggered if the issuer in Switzerland other than bank has more than twenty lenders in the aggregate under any kind of debt instruments (including private placements, syndicated loans and, Covered Bondholders Guaranteed amounts subject to certain exemptions, intragroup loans, however not debt instruments classified as bonds). In such a case the aggregate of such debt instruments is reclassified as debenture for Swiss withholding tax purposes and Swiss withholding tax will apply on interest payable under such debt instruments from the date of reclassification. Accordingly, if PBB and PBS privately place Swiss Pfandbriefe they must safeguard that their aggregate number of investors who are not banks does not exceed twenty in order to avoid Swiss withholding tax becoming applicable. Covered bonds issued by banks in Switzerland Under the Swiss withholding tax legislation in effect, where a debt instrument is issued by a Swiss bank acting through its head office in Switzerland, Trustee interest paid under the instrument is generally subject to 35% withholding tax, irrespective of the number of holders of the instrument. Exemptions only apply for certain regulatory capital instruments and TLAC-bonds and if the bond is structured like a loan and is held by another bank (interbank exemption). Lacking any applicable exemption, covered bonds issued through the head office in Switzerland are generally restricted to the Swiss market. However, where a bond is issued by a foreign branch of a Swiss bank, interest payments in respect of the bond can be made without deduction for Swiss withholding tax, provided, however, that the proceeds from the issuance of the bonds must be received and, so long as the bond is outstanding, used outside of Switzerland. Furthermore, debt issuances by a Swiss bank through a foreign branch are permissible only if the branch effectively conducts banking activities in its jurisdiction with its own infrastructure and staff as its principal business purpose, and constitutes a permanent establishment situated and effectively managed outside Switzerland. This branch exemption is restricted to banks. Other issuers, for instance insurance companies, who also provide mortgage loans, are not permitted to issue bonds through foreign branches without deduction for Swiss withholding tax. The covered bonds issued by the Swiss banks under the covered bond structured outlined above classify as foreign covered bonds not subject to Swiss withholding tax only for so long as they use the proceeds outside of Switzerland. Swiss withholding tax therefore puts covered bonds in terms of use of proceeds into a disadvantage to Swiss Pfandbriefe, while it puts Swiss Pfandbriefe into a disadvantage as to the available markets. Banks in Switzerland having not foreign branches are fundamentally in the same situation as the two vehicles issuing Swiss Pfandbriefe, i.e. they are essentially limited to the Swiss capital markets. As a result of the two Swiss big banks being required to change their group structure in response to the Swiss regulatory requirements addressing the Too Big To Fail (TBTF) issue to facilitate resolution in the event of failure, the covered bond structure will no longer be used by the two banks for new issuances, the reason being that the wholly owned subsidiaries, established as a new Swiss banking entity, who hold the mortgage loans, are trapped by the non-use of proceeds restriction. Special income source taxes Where the cover pool includes mortgage loans, a special income tax levied at source must be considered in addition to the Swiss withholding tax: Recipients resident outside Switzerland of interest paid on a loan secured by a mortgage over real property situated in Switzerland is subject to a special income tax levied on federal, cantonal and communal levels. The tax 68 IFLR/July/August

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4 SWITZERLAND applies in principle in addition to the Swiss withholding tax. The tax must be deducted by the borrower from the interest payment and be remitted to the respective Swiss tax authorities. The tax rates range between 13% and 33% depending on canton and commune where the real property is located. Many of Switzerland s double taxation treaties, including those with the UK, US, Luxembourg, Germany and France, allocate the right to tax interest fully to the country where the beneficial recipient of the interest payment is resident. If a treaty applies, Switzerland reduces the tax at source to nil. However, for such a reduction to apply, the debt instrument must be restricted to persons in a treaty country as lenders under the instrument. Swiss Pfandbriefe do legally benefit from security over real property in Switzerland, making the tax in principle applicable. However, the covered bonds issued under the structures outlined above by Swiss banks are structured such that they do not legally but only economically benefit from security over real property. Because the purpose of the Mortgage SPV is restricted to holding the cover pool and providing the guarantee in favour of the holders of covered bonds and benefits from limited recourse and non-petition provisions, tax authorities could be of the view under the doctrine of substance over form that the position of a holder of a covered bonds is no different from the one of a person legally benefiting from security over real property in Switzerland. It must therefore be safeguarded that any such re-classification risk is excluded. This is achieved by having all competent tax authorities (i.e. all 26 cantons and the federation) confirm in tax rulings that the guarantee of the Mortgage SPV does not constitute a security over real property in Switzerland for purposes of the special income tax. Use of repack structure? For a number of debt issuances, the Swiss tax authorities permitted Swiss issuers to access international debt markets free of withholding tax by using a structure under which, in a nutshell, the issuer resident in Switzerland issues loan notes (Loan Notes), which it sells to a foreign multi issuance vehicle (MPV) typically resident in Ireland under a purchase agreement for a purchase price equal to the issue price less costs; and the MPV simultaneously issues notes (Secured Notes), which are secured by the claims under the Loan Notes (Security). The performance of the Secured Notes is linked to the Loan Notes. Thus, the MPV will make payments under the Secured Notes only to the extent it receives payment under the Loan Notes from the Swiss Issuer or from enforcement of the Security. The Loan Notes are restricted in terms of transferability such that the Swiss issuer is at all times in a position to comply with the Swiss withholding tax rules allowing a Swiss non-bank issuer to have up to ten or twenty non-bank creditors as lenders without triggering withholding tax on a particular debt issuance, its financial debt in aggregate, respectively. Hence, under such structure, Repack structure proceeds can be used in Switzerland without Swiss withholding tax. The structure as described works only if the Loan Notes are not subject to Swiss withholding tax. Swiss banks therefore cannot in principle rely on the structure except if an entity in Switzerland were interposed and a tax refund mechanisms allowing the intermediate entity to obtain a refund of the Swiss withholding tax to be withheld by the Swiss bank on interest payments to the intermediate entity in respect of proceeds on-lent. This is untested so far. Outlook According to the foregoing, the key tax aspects for covered bonds are: Investors resident in Switzerland are used to the Swiss withholding tax. The special Swiss income tax in respect of mortgage loans does not apply to Swiss investors. As the Swiss Pfandbriefe show, there is a Swiss domestic market for covered bonds subject to withholding tax. Experience shows that bonds subject to withholding tax do not normally find sufficient demand in international markets. For covered bonds to be sold internationally the issue is that Swiss banks are generally liable to Swiss withholding tax on interest paid without meaningful exemption. Under current law this has been be achieved by issuing the covered bonds through a foreign branch, using the proceeds outside Switzerland and avoiding the guarantee covered by mortgage loans to be classified as secured by real estate in favour of the holders of the covered bonds. On November , the Swiss Federal Council announced that it had mandated the Swiss Federal Finance Department to appoint a group of experts to prepare a proposal for a reform of the Swiss withholding tax system. The proposal is expected to, among other things, replace the current debtor-based regime applicable to interest payments with a paying agentbased regime for Swiss withholding tax. If such a new paying agent-based regime were to be enacted, a Swiss bank and any other Swiss issuer may no longer be required to use the proceeds from the notes outside of Switzerland in order for it not to become liable to Swiss withholding tax on interest payments in respect of any type of bonds. If this legislation were enacted, noting that it is at present unclear, when this could happen, the Swiss withholding tax issue discussed above would be solved. However, for international covered bond issuances the issue with the special source tax on interst paid on loans secured by real property still needed to tackled with. Swiss issuer Loan notes Proceeds Multi issurance vehicle (eg Dublin) Loan notes Proceeds Secured noteholders Security assignment of claims under loan notes in favour of secured noteholders Security (Secured noteholders) 70 IFLR/July/August

5 SWITZERLAND Dieter Grünblatt Partner, Homburger Zurich, Switzerland T: F: E: W: Benedikt Maurenbrecher Partner, Homburger Zurich, Switzerland T: F: E: W: About the author Dieter Grünblatt focuses on the tax structuring of national and international capital market transactions, collective investment schemes, real-estate investments, structured financial instruments, private equity and fund management structures. He designs acquisitions and reorganisations and advises on employee stock option plans, pension plans and social security taxes and VAT. Grünblatt regularly contributes to publications on tax-related topics. Grünblatt joined Homburger in 1997 and has been a partner since He graduated from the University of Basel School of Law in He holds a doctorate (Dr iur) in law from the University of Basel (1994) and an LLM from New York University, where he completed postgraduate studies with a focus on corporate finance and corporate tax law in autumn He was admitted to the Baselland Bar in 1996 and to the New York Bar in He has been a certified tax expert since About the author Benedikt Maurenbrecher s practice focuses on banking, finance and capital markets. He is experienced in a broad range of transactions, notably in the areas of equity capital markets, secured and unsecured lending, covered bonds, securitisation and derivatives. He is an authorised issuers representative at the SIX Swiss Exchange. Maurenbrecher also advises on domestic and cross-border aspects of banking, securities and investment fund regulation, and regularly represents market participants in related regulatory proceedings and civil litigation. He is a member of the banking committee and the securities committee of the International Bar Association, and heads the banking committee s sub-committee on opinions in legal transactions. Stefan Kramer Partner, Homburger Zurich, Switzerland T: F: E: stefan.kramer@homburger.ch W: About the author Stefan Kramer s practice focuses on capital markets and banking law. He regularly advises on asset-based financings (covered bonds and securitisations), banking regulation (including regulatory capital transactions) and derivatives markets regulations. Other areas of work include insolvency law and financial markets infrastructures. He has written various books and articles on financial services regulation and is a co-editor of the Commentary on the Swiss Banking Act. Kramer is admitted to the Swiss bar, holds a doctorate from the University of Zurich (2005) and an LLM from Harvard Law School (2010). IFLR/July/August

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