Tax-exempt assets and income in the pension scheme
Payments into the pension scheme can be deducted from taxable income, which is well known for Swiss people. For them, “saving taxes” is the main motivation for paying into a restricted pension plan. Regardless of whether it is a voluntary purchase in the pension fund or an (annual) payment into the third pillar. The legal possibilities for reducing the tax burden are being used extensively.
Less present among the Swiss, however, is the fact that the benefits are not limited to tax deductions from income. This is because pension assets are also tax-free. The tax authorities no longer have access to anything once it has been paid into the pension scheme*. The pension assets are not considered as taxable assets and the income does not have to be added to taxable income. This means that the pension assets can thrive unhindered and the compound interest effect comes into action.
All is fine, you might think, if there weren’t any withholding taxes which can put a damper on your business. If you invest in pension plans using investment instruments that are subject to foreign withholding tax, the return on your pension assets can be severely reduced. Over the years and decades, you unnecessarily lose money. It’s about time to take a closer look at withholding tax and the potential savings.
*The capital gains tax will be discussed in a later article.
What is the withholding tax and what is the government’s objective with it?
Withholding taxes are taxes that are levied at the time when money flows out of an entity, for example, when a dividend is paid out of corporate profits. The manager of the source (e.g. a bank) is legally obliged to transfer a specific portion of the cash flow to the state. To stick to the dividend example: the manager of the source may only credit the net dividend to the beneficiary.
The government uses the withholding tax as a pledge. The pledge is not returned until the beneficiary declares the dividend as income on his tax return statement. If the beneficiary fails to declare the dividend income, he cannot reclaim the withholding tax. The government then books the withholding tax as final income. In 2018, the surplus (revenue minus refunds) from the withholding tax in the federal budget amounted to almost 8 billion Swiss francs.
Part of this surplus is attributable to persons with residence abroad. These people cannot, in principle, reclaim Swiss withholding tax. A reclaim is only possible once Switzerland has entered a double taxation agreement with the respective country.
Can withholding tax be saved in pension provision as a result of double taxation agreements?
Just as individuals with residence abroad have to deal with Swiss withholding tax, Swiss citizens also have to cope with foreign withholding tax: a double taxation agreement is necessary to reclaim the foreign withholding tax.
Since pension funds are exempt from taxation, they typically have a special position in such agreements. The relief from withholding tax for pension funds often extends further than for ordinary investment funds or private individuals.
In 1996, Switzerland entered a double taxation agreement with the USA. This provides that dividends are not subject to withholding tax if the beneficiary is a pension institution (Art. 28 para. 4 b). The same provision is also found in the double taxation agreement with Japan, which was extended in 2012 (Art. 10 para. 3 b). At the moment, however, there is still a significant difference between the two agreements: In the double taxation agreement with Japan, the third pillar is also exempt from withholding tax on dividends. In the agreement with the USA only the second pillar. Nevertheless, with the approval of the Protocol of Amendment to the Agreement with the USA by the US Senate on July 17, 2019, the withholding tax exemption will also be extended with the USA. Provided that the Protocol of Amendment comes into force in 2019, third pillar institutions will also be exempt from US withholding tax from January 1, 2020.
In addition to the USA and Japan, Switzerland has concluded double taxation agreements with 86 other countries (as of July 2019).
How high are the withholding tax savings?
Direct approach: comparing the returns of two funds
The direct approach to show the savings potential is by comparing returns from two different funds. One fund can reclaim the withholding taxes of the USA and Japan in full — for simplicity’s sake, we refer to it as a “pension fund” — while the other fund can only reclaim part of the withholding taxes (comparative fund). To make the comparison as valid as possible, it is advisable to use passively managed funds. In addition, any difference in TER costs should also be taken into account.
Over a period of five years, the Credit Suisse Pension Fund (able to reclaim withholding tax in full, due to double taxation agreements) outperformed the MSCI World by 2.2 %. This is depicted in the table below:
|Performance||1 year||3 years||5 years|
|CSIF (CH) III Equity World ex CH — Pension Fund QB||4.33%||41.12%||54.17%|
|CSIF (CH) Equity World ex CH QB||‑4.14%||‑39.99%||‑51.72%|
|Correction for lower TER costs in Pension Fund QB (0.05% p.a.)||‑0.05%||‑0.15 %||‑0.25%|
|Outperformance Pension Fund QB||0.14%||0.98%||2.20%|
Indirect approach: Estimation of the additional return based on the withholding tax relief
The indirect approach is the more difficult of the two. This is because you have to consider even more carefully what exactly you are comparing.
The US withholding tax on dividends is 30 %. Japan deducts 20 % at source from dividends. Due to the double taxation agreements, non-pension funds can reclaim part of the withholding tax (15 % USA, 10 % Japan) too. Pension funds benefit from an additional relief of 15 % or 10 %, which means that they no longer pay any withholding tax at all. Let’s assume that the comparative fund reclaims the withholding tax as far as possible (which is not certain, since the reclaim involves a relatively big effort). Then the extra relief for the pension fund amounts to 15 % for US withholding tax and 10 % for Japanese withholding tax.
The USA and Japan account for 70 % of the MSCI World. With a current dividend of around 2 %, these two double taxation agreements result in an annual advantage of 0.2 % for pension funds (withholding tax = WHT):
|Share of MSCI|
Participation in withholding tax exemption requires investor group control
In order for a fund to be relieved of tax at source, investor group control is required. Only investors who qualify for the relevant categories of double taxation agreements may invest in the fund. Otherwise, the fund will be contaminated, with the result that all shareholders can no longer benefit from their special status.
To keep the group of investors under control, pension funds are not listed on the stock exchange. They are therefore not Exchange Traded Funds (ETFs). Either strategy funds or index funds, which can only be purchased from the issuer, are used (for a detailed comparison of ETFs with index funds, see the linked article). In some cases, separate fund classes or tranches are created for pension funds. A separate fund number (ISIN) is assigned to each of these classes.
- Pension assets and the resulting income are tax-free.
- Nevertheless, a withholding tax can be deducted on foreign income.
- Funds that are reserved for pension funds can reclaim a large part of the withholding taxes thanks to double taxation agreements.
- Pension funds have outperformed conventional funds over the years, which should be considered when comparing fund costs.
- Pension funds are subject to investor group control to ensure that the fund assets are not contaminated.
- Simply because a fund is called a retirement fund does not necessarily mean that it reclaims withholding tax and saves in your favour.
- If the pension fund is also available on the stock exchange, you can assume that the fund is not optimized for withholding tax.
- Request for pension funds that reclaim US withholding tax and Japanese withholding tax on dividends in full.
- Let yourself show the difference in performance compared to the fund without investor group control — as shown in the first table.