Swiss Salary Withholding Tax Violates Free Movement of Persons Agreement with the European Union

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1 Switzerland/European Union Reto Heuberger* and Stefan Oesterhelt** Swiss Salary Withholding Tax Violates Free Movement of Persons Agreement with the European Union The authors, in this article, discuss a recent decision of the Swiss Supreme Court wherein it was held that the denial of certain tax deductions under the Swiss salary withholding tax system applicable to non-residents employed in Switzerland is discriminatory insofar as a non-resident subject to the system is in a situation that is comparable to that of resident employees. The Swiss Supreme Court introduces the Schumacker doctrine of the European Court of Justice into Switzerland in this decision. 1. Introduction Several commentators have questioned the compatibility of the Swiss withholding tax system for non-resident employees with the Switzerland European Union Agreement on the Free Movement of Persons (the FMPA). 1 The Swiss Supreme Court recently dealt with this question for the first time. In a landmark decision it applied the principles of the European Court of Justice (ECJ) decision in Schumacker to the provisions of the FMPA regarding the free movement of employees 2 and held that the Swiss withholding tax system for non-resident employees violates the non-discrimination rule in Art. 2 of the FMPA and Art. 9(2) of Annex I FMPA due to the unequal treatment of non-resident persons and further that Art. 21 of the FMPA does not provide a justification for such a violation. The Swiss Supreme Court could rely on the Schumacker doctrine of the ECJ since Art. 16(2) of the FMPA states that insofar as the application of the FMPA involves concepts of Community (now EU) law, account shall be taken of the relevant case law of the ECJ. 2. Facts A Swiss national was resident in Geneva until In 2001, he relocated across the border to France, but continued to work as an accountant in Geneva until 31 October His income from employment was taxed at source in Geneva under the salary withholding tax system. His Swiss employment income amounted to about 95% of his total family income. In the tax years in question ( ), his income (in CHF) was as follows: Tax year Income Swiss salary withholding tax Professional expenses Pension fund contributions ,896 31,579 13,671 21, ,950 31,985 16,674 22, ,561 37,757 14,386 17,981 The taxpayer requested an adjustment to the salary tax that had been withheld at source. He requested to be taxed under the regular income tax system in the same manner as resident taxpayers and, in particular, to deduct professional expenses (commuting costs) and contributions to his pension fund (and tax privileged life insurance) from his taxable income. 3. Decision of the Supreme Court 3.1. Right to tax under the tax treaty Under Art. 17 of the France Switzerland tax treaty income from employment may be taxed in the country where the work is performed, as well as in the residence country. With regard to the Canton of Geneva, this also applies to frontier workers. Based on an agreement of 29 January 1973, the Canton of Geneva is obliged to compensate France in the amount of 3.5% of the gross salaries of French resident frontier workers in Geneva Domestic law The taxpayer, in the case at hand, was taxed under the salary withholding tax system because he performed his employment activities in Switzerland without being a resident therein. Therefore, he was subject to limited taxation in Switzerland. * Dr. iur., LL.M. (NYU), Attorney-at-law, Certified tax expert, partner, Homburger AG, Zurich. The author can be contacted at reto.heuberger@homburger.ch. ** lic.iur., LL.M. (Cantab), Attorney-at-law, Certified tax expert, associate, Homburger AG, Zurich. The author can be contacted at stefan. oesterhelt@homburger.ch. 1. P. Hinny, Impact on Swiss Tax Law of the Non-Discrimination Requirement in the EC-Swiss Bilateral Agreements, European Taxation 11 (2001), p. 423 et seq.; R. Cadosch, Switzerland: Taxation of Employment Income Compliance of Swiss Tax Law with the EC-Swiss Sectoral Agreement on Free Movement of Persons, Intertax 12 (2004), p. 586 et seq.; S. Oesterhelt, Nondiscrimination at the crossroads of international taxation, Cahiers de droit fiscal international, Vol. 93a (The Netherlands: Sdu Fiscale & Financiële Uitgevers Amersfoort, 2009), p. 587 at p. 602; M. Lamensch and S. van Thiel, Swiss Court Denies European Frontier Workers Their Schumacker Rights (Comment on the 31 August 2009 Decision of the Geneva-Based Commission Canonale de Recours en Matière Administrative in the Boitelle Case), Intertax 2 (2010), p. 93 et seq. 2. Supreme Court, 26 January 2010, Joined Cases 2C.319/2009 and 2C.321/2009. IBFD EUROPEAN TAXATION JULY

2 In general, Swiss resident individuals subject to unlimited taxation are taxed on their net income. They can deduct costs for commuting from their home to their place of work, certain costs for meals away from home and other costs that are necessary to exercise the profession. Individuals with no permanent residence in Switzerland, on the other hand, are subject to tax only on the part of their income that arises in Switzerland (limited taxation). In this situation Switzerland levies the salary withholding tax on the taxpayer s gross income from employment (Art. 5(1) Federal Income Tax Act, Art. 91 et seq. Federal Income Tax Act) and, therefore, such individuals are not entitled to deduct commuting costs, professional expenses or contributions to pension funds from their taxable income. These costs are reflected, in a general way, in the tax rates. Therefore, the Tax Administration of Geneva did not violate federal laws when it rejected the taxpayer s request Violation of the FMPA Application of the FMPA The FMPA applies only to cross-border situations. However, according to the ECJ, nationals of a Member State may also claim that their own state is hindering their freedom of movement. 3 As the Supreme Court has decided in several residency permit cases, a national of a contracting state of the FMPA can, based on Art. 2 of the FMPA and Art. 9(2) of Annex I FMPA, claim discrimination by the state of which he is a national. 4 Therefore, a taxpayer who is resident in France and works in Switzerland can claim the benefits of the FMPA even if he is a Swiss national Discriminatory taxation According to Art. 2 of the FMPA, nationals of one contracting state who are lawfully resident in the territory of another contracting state shall not, in application of and in accordance with the provisions of Annexes I, II and III, be subject to discrimination on grounds of nationality. This principle corresponds to Art. 18 of the Treaty on the Functioning of the European Union (TFEU). With regard to the free movement of employed persons, this principle is contained in Art. 9(2) of Annex I FMPA. In interpreting this clause, the case law of the ECJ (at least) up to 21 June 1999 (the date of conclusion of the FMPA)needs to be taken into account (along with the reservation on the limitations of Art. 21 of the FMPA). According to the jurisprudence of the ECJ in relation to direct taxes, not only overt discrimination, but also covert discrimination, which cannot be justified by overriding reasons in the public interest, is prohibited. The white paper of the Swiss Federal Council to the FMPA claims that the Swiss salary withholding tax regime for non-resident employed persons (Art. 5(1)(a) and Art. 91 et seq. Federal Income Tax Act) does not create any problems regarding equal treatment since the salary withholding tax is levied not only on the income of non-resident foreign nationals but also on non-resi- dent Swiss nationals (as in the case at hand). This view ignores the fact that the FMPA also prohibits covert discrimination. Because Switzerland does not grant non-resident taxpayers the tax benefits (in particular, allowances for the cost of commuting from the place of residence to the place of work) that it grants to residents, there is an unequal treatment that, in principle, violates the nondiscrimination rule of Art. 2 of the FMPA and Art. 9(2) of Annex I FMPA Comparability Non-residents and residents not comparable It is settled law of the ECJ that discrimination can arise only through the application of different rules to objectively comparable situations or the application of the same rule to different situations. In relation to direct taxes, the situation of residents and non-residents is not, as a rule, comparable since the income received in the territory of a state by a non-resident is, in most instances, only part of the non-resident s total income, which is concentrated in his state of residence. Moreover, a nonresident s personal ability to pay tax, determined by reference to his aggregate income and his personal and family circumstances, is easier to assess where his personal and financial interests are centered. In general, that is the place of his usual abode. 5 Consequently, the fact that a state does not grant to a non-resident certain tax benefits that it grants to a resident is not, as a rule, discriminatory since these two categories of taxpayers are not in a comparable situation Special case of significant income According to the ECJ, the position is different, however, in cases where the non-resident receives no significant income in the residence state and obtains the majority of his taxable income from an activity performed in the state of employment, with the result that the residence state is not in a position to grant him the benefits resulting from taking into account his personal and family circumstances. There is no objective difference between the situation of such a non-resident and a resident engaged in comparable employment that would justify a differ- 3. See ECJ, 7 February 1979, Case C-115/78, Knoors v. Secretary of State for Economic Affairs, Para. 24; ECJ, 3 October 1990, Case C-61/89, Bouchoucha, Para. 13; ECJ, 8 May 1990, Case C-175/88, Klaus Biehl v. Administration des contributions du grand-duché de Luxembourg, Para. 14; ECJ, 13 March 1993, Case C-19/92, Dieter Kraus v. Land Baden-Württemberg, Para. 15; ECJ, 23 February 1994, Case C-419/92, Ingetraut Scholz v. Opera Universitaria di Cagliari and Cinzia Porcedda, Para. 505; ECJ, 14 February 1995, Case C-279/93, Finanzamt Köln-Altstadt v. Roland Schumacker, Para. 28; ECJ, 11 August 1995, Case C-80/94, G. H. E. J. Wielockx v. Inspecteur der Directe Belastingen, Paras. 2 and 12; ECJ, 27 June 1996, Case C-107/94, P. H. Asscher v. Staatssecretaris van Financiën, Para. 32 et seq.; ECJ, 14 September 1999, Case C-391/97, Frans Gschwind v. Finanzamt Aachen-Außenstadt, Paras. 9 and 12; and ECJ, 16 May 2000, Case C-87/99, Patrick Zurstrassen v. Administration des Contributions Directes, Para Supreme Court, 23 April 2008, 2A.768/2006, consideration 3.3 and 16 January 2004, BGE 130 II, p. 137 et seq. and p. 145 et seq. 5. See Schumacker, note 3, Para. 31 et seq.; Wielockx, note 3, Para. 22; Gschwind, note 3, Para. 22; and Zurstrassen, note 3, Para EUROPEAN TAXATION JULY 2010 IBFD

3 ence in treatment in terms of taking into account for taxation purposes the taxpayer s personal and family circumstances. 6 As the French resident taxpayer in the case at hand received more than 90% of his income in in Switzerland, he is objectively in a similar situation as a Swiss resident taxpayer who performs the same employment activity Justifications Justifications according to Art. 45(3) TFEU The Supreme Court mentions that there are certain exceptions to the non-discrimination rule in the FMPA. Regarding the free movement of employed persons, Art. 45(3) of the TFEU contains the justifications of public order, public security and public health (a provision adopted from Art. 5(1) of Annex I FMPA). 7 These restrictions do not, however, have an impact on tax cases Justifications according to the ECJ No rule of reason justifications can be found in the jurisprudence of the ECJ prior to 21 June 1999 that would apply in the case at hand. In particular, the ECJ did not accept the argument brought forward by the German tax authorities in Biehl that the unequal treatment of a taxpayer subject to limited taxation was necessary to protect the system of tax progression Justification based on Art. 21 of the FMPA Art. 21(1) FMPA Art. 21(1) of the FMPA states that the provisions of a tax treaty between Switzerland and a Member State shall be unaffected by the provisions of the FMPA and that, in particular, the provisions of the FMPA shall not affect the tax treaty definition of frontier workers. In the case at hand, however, Switzerland s right to tax the taxpayer s income from employment is not limited by either Art. 17 of the France Switzerland tax treaty or any other provision of the FMPA. Therefore, the unequal treatment cannot be justified on the basis of Art. 21(1) of the FMPA. Art. 21(2) FMPA Art. 21(2) of the FMPA clarifies that the treaty does not prevent the states from distinguishing, when applying the relevant provisions of their tax law, between taxpayers that are not in comparable situations, especially as regards their place of residence. As the ECJ, in Schumacker, uses the same wording as Art. 21(2) of the FMPA with respect to the equal treatment of taxpayers who are in a comparable situation, 9 this treaty provision has to be interpreted in light of the ECJ case law. This interpretation is also supported by the white paper of the Swiss Federal Council, which makes reference to the interpretation of Art. 21(2) of the FMPA and, in particular, to the case law of the ECJ (and, explicitly, the Schumacker case). Art. 21(3) FMPA Art. 21(3) of the FMPA clarifies that the provisions of the FMPA do not prevent the states from adopting or applying measures in their domestic tax laws or tax treaties between Switzerland and a Member State to ensure the imposition, payment and effective recovery of taxes or to prevent tax evasion. This provision may justify the application of different methods of taxation (such as taxation at source instead of by assessment) but not a higher tax burden. In conclusion, in the case at hand, Art. 21 of the FMPA does not provide any justification for the violation of the non-discrimination rule contained in Art. 2 of the FMPA and Art. 9(2) of Annex I FMPA due to the unequal treatment of non-resident persons Swiss Constitution According to Art. 190 of the Swiss Constitution, the Supreme Court is not entitled to repeal a federal Act of Parliament based on unconstitutionality. This rule does not, however, justify a violation under Art. 91 et seq. of the Federal Income Tax Act of the FMPA. Art. 2 and Art. 9(2) of Annex I FMPA are self-executing laws that take precedence over the rules of the Federal Income Tax Act and the Cantonal Income Tax Act. The Supreme Court had taken the same view regarding the relationship between the FMPA and Swiss federal legislation in regard to social security and residency permits. 10 In conclusion, as there is no justification and the FMPA is self-executing, the taxpayer, in the case at hand, is entitled to the same deductions from salary withholding tax as Swiss resident taxpayers. 4. Comments 4.1. Tax aspects of the freedom of movement The provisions of the FMPA on the free movement of persons appear to mainly concern immigration and residency law rather than Swiss tax law. The free movement of persons can, however, be impeded not only by residency restrictions but also by tax provisions. If persons who want to make use of the freedom of movement experience tax disadvantages, their freedom of movement is hindered in practice. 6. See Schumacker, note 3, Para. 36 et seq. and Gschwind, note 3, Para. 26 et seq. 7. See Art. 5(1) of Annex I FMPA. 8. See Biehl, note 3, Para. 15. The German government brought forward in this case that a taxpayer who spreads his income, and consequently his tax liability, among at least two states distorts the system of taxation because he would be taxed at a more favourable rate than that applied to the income of a taxpayer who, with the same annual income, must declare all his income in only one state. 9. Schumacker, note 3, Para Regarding social security contributions see Supreme Court, 9 May 2005, BGE 133 V, p. 367 at p. 386 et seq. Regarding residency permits see Supreme Court, 14 April 2005, BGE 131 II, p. 352 at p. 355 and Supreme Court, 2 August 2004, 2A.7/2004, consideration 4.1. IBFD EUROPEAN TAXATION JULY

4 The Supreme Court recognized this aspect in its decision of 26 January 2010 for the first time. It based this decision on the ECJ case law on the fundamental freedoms of the TFEU and reached a conclusion in line with the interpretation of the ECJ. However, certain aspects of the reasons for the decision may raise questions Non-discrimination rule The Supreme Court held that the denial of certain tax deductions under the salary withholding tax system violates Art. 2 of the FMPA and Art. 9(1) of Annex I FMPA. The court did not make a distinction between these two non-discrimination rules General non-discrimination rule According to Art. 2 of the FMPA nationals of one contracting state who are lawfully resident in the territory of the other contracting state shall not be subject to discrimination on grounds of nationality. This wording follows Art. 18 of the TFEU, which prohibits discrimination on grounds of nationality in applying the TFEU. Since the provisions of the FMPA, which are based on the fundamental freedoms of EU law, must be interpreted in line with EU law, Art. 2 of the FMPA has to be interpreted on the basis of Art. 18 of the TFEU. This has been recognized by the Supreme Court. 11 The general non-discrimination rule of Art. 2 of the FMPA is self-executing and can, in general, be invoked by all nationals of the Member States and Switzerland directly. 12 But just as the general rule of Art. 18 of the TFEU is superseded by the specific freedoms of movement of workers of Art. 45 of the TFEU and the freedom of establishment of Art. 49 of the TFEU, the application of the general rule of Art. 2 of the FMPA is superseded by the specific free movement rules of Art. 9 of Annex I FMPA (employed persons), Art. 15 of Annex I FMPA (self-employed persons) and Art. 19 of Annex I FMPA (persons providing services) as leges speciales. 13 Therefore, the application of the general non-discrimination rule of Art. 2 of the FMPA is basically limited to nonemployed persons 14 who are lawfully resident in the other contracting state. As the case at hand concerns the taxation of an employed person, Art. 9 of Annex I FMPA supersedes the application of Art. 2 of the FMPA. This aspect is not reflected in the decision of the Supreme Court Free movement of employed persons Art. 9 of Annex I FMPA The FMPA grants to nationals of a contracting state, who are employed in another contracting state, the right to reside and pursue an economic activity, the right to visit another contracting state in order to seek employment, the right to occupational and geographical mobility throughout the territory of the host state and the right to equal treatment as regards conditions of employment and working conditions. 15 Art. 9(2) of Annex I FMPA further states that an employed person (and the mem- bers of his family) shall enjoy the same tax concessions and welfare benefits as national employed persons (and members of their family). 16 But the prohibition against discrimination of employed persons who exercise their freedom of movement, in comparison to nationals, already exists as a result of the comprehensive right to equal treatment contained in Art. 9(1) of Annex I FMPA. The ECJ held in Biehl that the right to equal treatment as regards pay would not be effective if it could, in practice, be violated by discriminatory domestic income tax laws. 17 Thus, Art. 9(2) of Annex I FMPA, which is the basis for the Supreme Court decision, is only of a declaratory nature Relationship with Art. 45 TFEU Art. 9 of Annex I FMPA basically parallels the freedom of movement of employed persons guaranteed by Art. 45 of the TFEU (and Council Regulation 1612/68). 18 Therefore, it has to be interpreted in light of the ECJ case law. It is a positive step that the Supreme Court stresses the overlap between Art. 9 of Annex I FMPA and Art. 45 of the TFEU and takes into account ECJ case law. The ECJ, since Biehl, has applied Art. 45 of the TFEU in regard to discrimination by Member States in respect of tax laws. 19 The Supreme Court followed this approach in regard to Art. 9 of Annex I FMPA in the case at hand Overt and covert discrimination The free movement of workers safeguarded by Art. 45 of the TFEU not only prohibits overt discrimination but also covert discrimination. This was confirmed by the ECJ in Sotgiu 20 and, for the first time in relation to tax laws, in Schumacker. 21 As Art. 9 of Annex I FMPA has to be interpreted in light of the ECJ case law on Art. 45 of the TFEU, the recogni- 11. See Supreme Court decision, note 2, consideration 12; Supreme Court, 27 November 2003, BGE 130 I, p. 26 at p. 35. In contrast, in BGE 129 I, p. 392 the Supreme Court argued that Art. 2 of the FMPA adopts the general non-discrimination rule of Art. 18 of the TFEU and the free movement of employed persons of Art. 45 of the TFEU for the area of the free movement of persons between Switzerland and the European Union (Federal Supreme Court Decision of 21 November 2003, BGE 129 I, p. 392 et seq. at p. 399). This statement is not correct since the free movement of employed persons of Art. 45 of the TFEU is not enforced by Art. 2 of the FMPA but by Art. 9 of Annex I FMPA. 12. See Supreme Court, 12 September 2003, 2A.607/2002, consideration 3.3; Supreme Court, 17 January 2003, BGE 129 II, p. 249 at p. 257 et seq.; Supreme Court, 21 November 2003, BGE 129 I, p. 392 at p See Supreme Court, 25 August 2005, 2A.325/2004, consideration In particular, students, retired persons, job applicants, other nonemployed persons and their family members who are lawfully resident in the territory of another contracting state. 15. See Art. 9(1) of Annex I FMPA. 16. This clause, in essence, corresponds to Art. 7 of the Regulation (EEC) No. 1612/68 of the Council of 15 October 1968 on free movement of employed persons within the Community (OJ L 257, 19 October 1968, p. 2 et seq.). 17. Biehl, note 3, Para Council Regulation (EEC) No. 1612/68, see note Biehl, see note 3, Para ECJ, 12 February 1974, Case 152/73, Giovanni Maria Sotgiu v. Deutsche Bundespost, Para See Schumacker, note 3, Para EUROPEAN TAXATION JULY 2010 IBFD

5 tion of covert discrimination applies also to the free movement of workers under the FMPA. The Supreme Court expressly confirmed this principle in the reasoning of the case, which involved covert discrimination. In this respect, the non-discrimination rule contained in Art. 9 of Annex I FMPA goes considerably beyond the non-discrimination rule of Art. 24(1) of the OECD Model Tax Convention (OECD Model) (non-discrimination on grounds of nationality), which is limited to overt discrimination Discrimination against resident persons Art. 9 of Annex I FMPA only applies to cross-border situations. No such situation arises with regard to an employed person who lives and works in his home country. The ECJ has not, therefore, applied Art. 45 of the TFEU in cases of discrimination against residents where no cross-border situation is involved. 23 However, there is a cross-border situation involved if a Swiss national (who is unfavourably taxed by Switzerland) does not reside in Switzerland but in a Member State. Such a person can consequently claim, under the free movement of workers principle, that he is discriminated against in comparison to a person having his residence in Switzerland. As the Supreme Court correctly stated, on the basis of the ECJ case law, there is a sufficient international element to such a case Discrimination analysis The Supreme Court noted that the taxpayer was not allowed to deduct all the costs (in particular, commuting costs) from his taxable income that a taxpayer subject to unlimited taxation would be allowed to deduct. The Court did not elaborate on why this constitutes discrimination. It should be noted, however, that discrimination in the sense of Art. 9 of Annex I FMPA only exists if the applicable tax rate does not compensate for the lack of deduction. The Supreme Court did not analyse this aspect any further. The Supreme Court should have made a clear statement regarding the person with which the taxpayer was being compared and the tax burden of such a person. In particular, in Switzerland, where all the cantons and even communities have different tax rates, it is very difficult to define the resident employed person to which the taxpayer should be compared. In this respect, there is a significant difference between Swiss tax law and German tax law, which was the basis for the ECJ decision in Schumacker regarding Art. 45 of the TFEU. It is clear, however, that in certain instances the general incorporation of deductions into the Swiss salary withholding tax rate system will be discriminatory and, therefore, the withholding tax rates, as such, will violate Art. 9 of Annex I FMPA Limitations of Art. 21 FMPA In general Under the heading Relationship to bilateral agreements on double taxation, Art. 21 of the FMPA lists three provisions that concern tax aspects of the FMPA. It is encouraging that the Supreme Court did not give Art. 9 of Annex I FMPA a more narrow scope than Art. 45 of the TFEU based on the provisions of Art. 21 of the FMPA. The short comments by the Supreme Court on Art. 21 of the FMPA, however, give little guidance on the meaning of this article Precedence of the tax treaty (Art. 21(1) FMPA) With respect to Art. 21(1) of the FMPA the Supreme Court states only that the taxing right of Switzerland is not limited by Art. 17 of the France Switzerland tax treaty (in particular, the definition of frontier worker). Since the meaning of Art. 21(1) of the FMPA is not enlightened by the considerations of the Supreme Court, the authors will provide a more detailed analysis of this provision Relationship between international treaties The relationship between older and newer international treaties is governed by Art. 30 of the Vienna Convention on the Law of Treaties (VCLT). 25 If all of the parties to the old agreement are also parties to the new agreement, without the old agreement having been terminated or suspended, the old agreement is only applicable to the extent that it is in line with the new agreement. 26 Thus, the new FMPA takes precedence over older tax treaties. The France Switzerland tax treaty, on the other hand, was concluded on 21 June 1999 and is, therefore, newer. 27 According to Art. 21(1) first sentence of the FMPA, however, the provisions of tax treaties between Switzerland and a Member State shall be unaffected by the provisions of the FMPA Taxation of income rules under tax treaties The first question is whether any tax treaty provisions may be superseded by the FMPA?Unlike the FMPA, tax treaty provisions mostly deal with allocating taxing rights over income between two contracting states. The 22. See See ECJ, 27 October 1982, Joined Cases 35/82 and 36/82, Elestina Esselina Christina Morson v. State of the Netherlands and Head of the Plaatselijke Politie within the meaning of the Vreemdelingenwet; Sweradjie Jhanjan v. State of the Netherlands, Para. 15 et seq. The Morson decision concerns Dutch citizens who intended to bring their parents with Surinamese citizenship to the Netherlands. 24. See sections The Vienna Convention on the Law of Treaties (VCLT) is applicable to treaties of the European Union (see, for example, ECJ, 4 July 2000, Case C-84/98, Commission of the European Communities v. Portuguese Republic, Para. 53; ECJ, 5 November 2002, Case C-466/98, Commission of the European Communities v. United Kingdom of Great Britain and Northern Ireland, Para. 24). 26. See Art. 30(3) of the VCLT. 27. For the states that joined the European Union after 21 June 1999, the dates of the respective protocols to the FMPA are decisive. IBFD EUROPEAN TAXATION JULY

6 FMPA does not allocate taxing rights. It provides for non-discrimination provisions and prohibitions on restrictions. This also follows from ECJ case law regarding the fundamental freedoms of the TFEU, which does not (at least to date) set up any criteria for eliminating double taxation between Member States. 28 The extent to which non-discrimination provisions and prohibitions on restrictions will impact allocation of taxing rights in a tax treaty is questionable. Non-discrimination provisions do, however, limit the taxing right of a country. If such a taxing right has been granted by a provision of a tax treaty, it could be argued, based on Art. 21(1) of the FMPA, that the non-discrimination rule of the FMPA would not be applicable. 29 But such a broad interpretation of Art. 21(1) of the FMPA is not in line with Art. 9(2) of Annex I FMPA, which contains an equal treatment rule regarding taxation. In addition, it is necessary to apply the non-discrimination rule of the FMPA in the tax area in order to achieve the goal of the FMPA (i.e. free movement of persons) 30 on the basis of EU law. 31 One could conclude that Art. 21(1) of the FMPA does not concern the income allocation rules of the tax treaty, however, the second sentence of Art. 21(1) of the FMPA clarifies that such a conclusion would be incorrect. This is because the frontier worker rule mentioned in that article is an income allocation rule Non-discrimination provision of the France Switzerland tax treaty Art. 21(1) first sentence of the FMPA could also be interpreted such that the non-discrimination provision of Art. 26 of the France Switzerland tax treaty supersedes the non-discrimination provisions of the FMPA. Such an interpretation would mean that the non-discrimination rules developed in the ECJ case law regarding the fundamental freedoms of the TFEU would not be applicable to the FMPA. This was obviously not the intention of the contracting states. Art. 9(2) of Annex I FMPA contains an express equal treatment provision regarding the taxation of employed persons. Such a rule would be redundant if the intention of the FMPA was to leave non-discrimination in the tax area to the application of the tax treaty provisions between Switzerland and the Member States. The result would be that the protection against tax discrimination would differ depending on the wording of the tax treaty between the Member State and Switzerland. Such a result would not be in line with the intention of tax treaties. Moreover, the non-discrimination provisions of tax treaties are only capable of reaching the goal of the FMPA to a limited extent because they protect only overt, and not covert, discrimination. This allows, in particular, the unequal treatment of non-resident persons. In addition, tax treaties only contain non-discrimination provisions and no prohibitions on restrictions. This is why all Swiss tax treaties do not limit exit taxation. The Swiss Federal Council, in the white paper, was not of the opinion that the FMPA non-discrimination provision is superseded by tax treaties. It states that an analysis, based on ECJ case law, needs to be made as to whether or not the salary withholding tax on employment income of EU citizens resident in Switzerland is in line with the non-discrimination provision of the FMPA. 33 The Supreme Court does not make a statement regarding the relationship between Art. 26 of the France Switzerland tax treaty and the FMPA. Based on the reasoning, however, it is clear that the Supreme Court is not of the opinion that the non-discrimination rule of the tax treaty supersedes the non-discrimination rule of the FMPA. After all, in the case at hand, Art. 26 of the France Switzerland tax treaty had not been violated because, on the one hand, the case concerned a Swiss citizen (who is not entitled to the application of Art. 26(1) of the France Switzerland tax treaty regarding the taxation by Switzerland) and, on the other hand, only covert discrimination was at stake to which Art. 26 of the France Switzerland tax treaty is not applicable Unaffected Art. 21(1) of the FMPA does not state that tax treaties supersede the provisions of the FMPA. The wording is, rather, that the provisions of the tax treaties shall be unaffected. Similar wording is also used in Art. 351 of the TFEU. Art. 351 of the TFEU states that rights and obligations from older treaties between Member States and third states are unaffected by the TFEU. But when an international agreement only allows, but does not require, a Member State to adopt a measure that appears to be contrary to EU law, the Member State must refrain from adopting such a measure See ECJ, 14 November 2006, Case C-513/04, Mark Kerckhaert, Bernadette Morres v. Belgische Staat; ECJ, 6 December 2007, Case C-298/05, Columbus Container Services BVBA & Co. v. Finanzamt Bielefeld-Innenstadt, Para. 45; and ECJ, 16 July 2009, Case C-128/08, Jacques Damseaux v. État belge, Para The only exception is Cyprus, with which Switzerland has not yet concluded a tax treaty. A tax treaty with Malta, on the other hand, was signed on 18 December See preamble to the FMPA. 31. If this were not the case, free movement could be hindered by an unfavourable taxation of such persons. 32. Art. 21(1) sentence 2 of the FMPA mentions solely the definition of a frontier worker rather than the tax allocation. But this means only that the tax allocation rules in the tax treaties and other international agreements concluded by Switzerland are not affected. 33. See white paper 1999, p et seq. at p The deliberations of the white paper regarding Art. 21(1) of the FMPA most likely point out that Art. 21(1) sentence 1 of the FMPA adds no further meaning to Art. 21(1) sentence 2 of the FMPA. However, this is hard to reconcile with the wording of Art. 21(1) of the FMPA. 34. See ECJ, 28 March 1995, Case C-324/93, The Queen v. Secretary of State for the Home Department, ex-parte Evans Medical Ltd and Macfarlan Smith Ltd, Para. 32 and ECJ, 14 January 1997, Case C-124/95, The Queen, ex parte: Centro-Com Srl v. HM Treasury and Bank of England, Para EUROPEAN TAXATION JULY 2010 IBFD

7 Art. 21(1) first sentence of the FMPA must be interpreted in an analogous manner: a contracting state of the FMPA may only refrain from complying with a non-discrimination rule of the FMPA where this would result in a violation of an obligation under a tax treaty. However, by complying with a non-discrimination rule contained in the FMPA, a contracting state can never violate a nondiscrimination rule of a tax treaty. Therefore, the non-discrimination rule of the FMPA has to be complied with by the contracting states without limitation. The non-discrimination rules of the tax treaties are not, however, superseded by the FMPA. If a non-discrimination rule of a tax treaty goes beyond the scope of the FMPA, the state has to follow this obligation. The result is that the non-discrimination rules of the tax treaty and the non-discrimination rules and prohibitions on restrictions of the FMPA have to be applied concurrently. The ECJ, in the Avoir fiscal case, decided that a difference in treatment that violates Art. 49 of the TFEU cannot be justified on the basis that the difference is due to a tax treaty. 35 The ECJ case law on the fundamental freedoms does not, therefore, stand for the proposition that the non-discrimination rule of a tax treaty supersedes the fundamental freedoms of the TFEU. In light of Art. 16 of the FMPA, this should, therefore, also be true with respect to the non-discrimination rule of the FMPA. The decision of the Supreme Court regarding the application of Art. 21(1) of the FMPA is consistent with this interpretation Comparable situations (Art. 21(2) FMPA) According to Art. 21(2) of the FMPA no provision of the FMPA may be interpreted in such a manner as to prevent the contracting states from distinguishing, when applying the relevant provisions of their tax legislation, between taxpayers whose situations are not comparable, especially as regards their place of residence Declaratory nature The non-discrimination rules and prohibitions on restrictions of the FMPA require equal treatment in cases where two taxpayers are in comparable situations. Therefore, the statement in Art. 21(2) of the FMPA concerning taxpayers who are not in comparable situations is only of a declaratory nature Comparability of non-resident and resident persons The statement in Art. 21(2) of the FMPA concerning the comparability especially as regards their place of residence simply rephrases the case law of the ECJ concerning the fundamental freedoms of the TFEU, which was expressly confirmed by the Supreme Court in the case at hand (by referring to the Schumacker case). Although the situations of non-resident and resident persons are not as a rule comparable, it cannot be concluded that they are never comparable. If there is no objective difference between the situations of the two groups of taxpayers that can justify the unequal treatment, the freedoms of the TFEU prohibit a distinction from being made. 36 This follows from the fact that the non-discrimination provisions of the TFEU protect taxpayers from covert discrimination, as well as overt discrimination. Therefore, Art. 21(2) of the FMPA codifies the case law of the ECJ regarding the fundamental freedoms of the TFEU. The white paper by the Federal Council also seems to take this view regarding Art. 21(2), because it expressly states that the reasoning of the ECJ in the Schumacker case is applicable to the FMPA. It is a positive step that the Supreme Court followed this reasoning in the case at hand Justifications Art. 21(3) FMPA According to Art. 21(3) of the FMPA no provision of the FMPA shall prevent the contracting states from adopting or applying measures under their domestic tax laws or tax treaties between Switzerland and the Member States to ensure the imposition, payment and effective recovery of taxes or to prevent tax evasion Rule of reason of the ECJ The rule of reason test, pursuant to which a restriction may be justified on the basis of an overriding reason in the public interest, can be relied on to justify a restriction of the non-discrimination rule of the FMPA. The measures to ensure the imposition and payment of taxes that are mentioned in Art. 21(3) of the FMPA correspond with the justifications of the effectiveness of fiscal supervision and the need to safeguard the cohesion of the tax system, which have been recognized by the ECJ as overriding reasons in the public interest capable of justifying a restriction on the exercise of fundamental freedoms guaranteed by the TFEU. The measures to prevent tax evasion correspond to the fight against tax avoidance and the prevention of tax avoidance and evasion, which also constitute overriding reasons in the public interest Declaratory nature of Art. 21(3) FMPA It is evident, particularly in light of Art. 16(2) of the FMPA, 37 and the purpose of the FMPA, which is to ensure the free movement of persons on the basis of EU law, that these two justifications (i.e. the need for measures to ensure the imposition of tax and the prevention of tax avoidance and evasion) are acceptable. Based on ECJ case law, this should apply to the interpretation of the FMPA regarding covert discrimination. In this respect, Art. 21(3) of the FMPA is of a declaratory nature. 35. ECJ, 28 January 1986, Case 270/83, Commission of the European Communities v. French Republic [Avoir fiscal], Para ECJ, 27 June 1996, Case C-107/94, Asscher, Para. 42 and 29 April 1999, Case C-311/97, Royal Bank of Scotland plc v. Elliniko Dimosio, Para Art. 16(2) of the FMPA states that insofar as the application of the FMPA involves concepts of Community law, account shall be taken of the relevant case law of the ECJ. IBFD EUROPEAN TAXATION JULY

8 Overt discrimination It is questionable, however, whether or not overt discrimination can be justified by Art. 21(3) of the FMPA. The TFEU does not expressly mention the justifications of the effectiveness of fiscal supervision or the prevention of tax avoidance and evasion. Thus, if the rule of reason developed by the ECJ were to be applied, overt discrimination would not be justified by Art. 21(3) of the FMPA. The fact that Art. 21(3) of the FMPA expressly mentions justifications (which are not expressly mentioned in the TFEU) does not make a difference Salary withholding tax The decision of the Supreme Court says little about the scope of Art. 21(3) of the FMPA. But it seems that the Supreme Court is of the opinion that Art. 21(3) of the FMPA justifies Switzerland levying a salary withholding tax on foreign resident taxpayers (rather than income tax under the standard procedure by assessment). 38 Indeed, the salary withholding tax for non-resident taxpayers leads only to covert discrimination in comparison to a resident taxpayer who is taxed under the standard procedure by assessment. This covert discrimination can be justified as a measure to ensure the imposition of tax. But one would have expected that the Supreme Court would have examined the principle of proportionality, as required by the ECJ. 39 The Swiss salary withholding tax system not only applies to non-resident employees but also to resident employees who are not Swiss nationals or holders of a long-term residency permit (so-called residency permit C). This second category of taxpayers is treated differently based solely on nationality. Such discrimination based on nationality is not justified by Art. 21(3) of the FMPA. 40 With regard to Swiss resident persons, there does not seem to be a necessity to ensure the payment of tax if the person is not a Swiss national Further justifications The need for measures to ensure the imposition of taxes (the need for effectiveness of fiscal supervision ) and the need for measures to prevent tax evasion are the most important justifications in practice. But they are not the only justifications that the ECJ has accepted with regard to tax law. Other justifications include the cohesion of the tax system and the preservation of the allocation of taxing powers between the Member States. Since the non-discrimination provisions and prohibitions on restrictions of the FMPA do not have a wider scope than the TFEU, these additional justifications under ECJ case law should also be applicable to the FMPA even though they are not expressly mentioned in Art. 21(3) of the FMPA. This would be true even if the justification had been developed by the ECJ after 21 June If such justifications (such as the need to preserve the balanced allocation of the power to impose taxes and the need to pre- vent losses from being deducted twice) were not applied because of Art. 16(2) of the FMPA, this would imply that the non-discrimination rule of the FMPA had a wider scope of application than the rules of the TFEU. 41 This would be contrary to the intention of the contracting states. The Supreme Court seems to have taken this view as it states that the non-discrimination rules of the TFEU can be limited. But it then mentions only the justification of the cohesion of the tax system, which was established in the Bachmann 42 case. The Supreme Court does not, however, apply this rule because, according to the Court, the justification of the cohesion of the tax system was not applied in subsequent ECJ decisions. In the case at hand, however, the justification of the cohesion of the tax system would not apply at all because there is no situation in which there is a direct link between a tax benefit and a particular tax Principle of proportionality According to ECJ case law, a restriction on the exercise of the fundamental freedoms of the TFEU can only be justified by an overriding reason in the public interest, subject to the proviso that the restrictive measure must also be proportionate to the objectives pursued. In addition to being appropriate,the restriction must not go beyond what is necessary in order to attain the objective of the legislation. This principle of proportionality also needs to be applied to the FMPA, in particular, with respect to the justifications contained in Art. 21(3) of the FMPA (the need for measures to ensure the imposition of taxes and to prevent tax evasion), as well as the other justifications accepted by the ECJ. The decision of the Supreme Court does not discuss this aspect. As it justified the application of the salary withholding tax based on Art. 21(3) of the FMPA, 44 it should also have analysed the application of the principle of proportionality ECJ case law The relationship between the FMPA and EU law is dealt with in Art. 16 of the FMPA. According to Art. 16(2) first sentence of the FMPA, insofar as the application of the FMPA involves concepts of EU law, account shall be 38. See Supreme Court Decision of 26 January 2010, 2C.319/2009 and 2C.321/2009, consideration 14.3 and See Switzerland has concluded tax treaties with almost all the Member States that include a provision in line with Art. 24(1) of the OECD Model. The nondiscrimination rules of the tax treaties do not provide for any justifications (unlike Art. 6 of the Swiss Federal Constitution). 41. Both reasons were recognized by the ECJ for the first time in ECJ, 13 December 2005, Case C-446/03, Marks & Spencer plc v. David Halsey. 42. ECJ, 28 January 1992, Case C-204/90, Hanns-Martin Bachmann v. Belgian State. 43. Besides it is not correct that the ECJ has not applied the justification of the cohesion of the tax system since the decision in Bachmann (see, for example, ECJ, 23 October 2008, Case C-157/07, Finanzamt für Körperschaften III in Berlin v. Krankenheim Ruhesitz am Wannsee-Seniorenheimstatt GmbH). 44. See EUROPEAN TAXATION JULY 2010 IBFD

9 taken of the relevant case law of the ECJ prior to the date of signature of the FMPA. The Supreme Court essentially follows the arguments of the ECJ in Schumacker and, therefore, in accordance with Art. 16(2) of the FMPA, took into account the relevant case law in interpreting the FMPA. However, the Supreme Court decision is virtually silent on the issue as to the extent to which ECJ case law after 21 June 1999 should be taken into consideration in interpreting the FMPA. In the case at hand, this was not necessary because the leading case (Schumacker) was decided in 1995, before the signing of the FMPA. On the other hand, the Supreme Court makes reference to several ECJ decisions that were made after 21 June The question of whether or not such decisions should be taken into consideration if they do not follow the previous case law, is still open. 5. Practical Impact of the Decision 5.1. Frontier workers The case at hand concerns a frontier worker that is resident in France but employed in the Canton of Geneva. Thus, the Supreme Court decision will have an impact on all frontier workers resident in France and employed in the Canton of Geneva. The taxation of frontier workers between France and Switzerland is not only governed by the tax treaty between France and Switzerland. There are several agreements between the Swiss Cantons and France. Under the agreement between the Canton of Geneva and France, the taxing right of the state of employment is not limited. In these cases, the Swiss salary tax system applies and violates, based on the Supreme Court decision, the FMPA. Other international agreements that provide for an unlimited taxing right of the state of employment are the Italy Switzerland and the Austria Switzerland tax treaties. The Supreme Court decision should, therefore, also impact the Swiss taxation of frontier workers resident in Italy and Austria. Under these agreements, which provide for an unlimited taxing right of the state of employment, the state of employment has to refund a portion of the revenue to the other country: France receives 3.5% of the gross salary of frontier workers employed in the Canton of Geneva; 45 Italy is entitled to 40% of the gross revenue from the payroll tax; 46 and Austria is entitled to 12.5% of the revenue. 47 Different rules apply for French resident frontier workers who are employed in the Cantons of Berne, Solothurn, Basle (city and country), Vaud, Valais, Neuchâtel and Jura. Under the international agreements regarding these cantons, Switzerland, as the employment state, has no taxing right but is entitled to remuneration from the French government of 4.5% of the yearly gross salary. 48 These frontier workers are not subject to the salary withholding tax of Art. 91 et seq. of the Federal Income Tax Act. Therefore, the Supreme Court decision will presumably not have any direct consequences for these types of frontier workers. The same is true for frontier workers resident in Liechtenstein since the tax treaty between Liechtenstein and Switzerland provides for a similar rule. 49 With respect to frontier workers resident in Germany, Switzerland is entitled to levy a salary withholding tax at a fixed rate of 4.5% of the gross salary. 50 In the authors view, Switzerland is not obliged, based on the FMPA, to allow additional tax deductions. The reason is that the taxing right of Germany, as the residence country, is not limited under the tax treaty. The deductions, therefore, have to be granted by Germany under the tax treaty. This would not apply, however, to top managers of Swiss companies within the meaning of Art. 15(4) of the Germany Switzerland tax treaty. Under this provision, Switzerland is entitled to tax the income International weekend commuters A frontier worker, in the tax sense, is basically a person who returns every day to his place of residence. The frontier worker definitions in the international agreements are not, however, always consistent. A person working in Switzerland but returning regularly (for example, weekly), but not daily, to his place of residence abroad is an international weekend commuter. In principle, such a person becomes subject to unlimited tax liability in Switzerland. But if the residence state is entitled to tax the income of such a person based on domestic law and the tie-breaker rule of Art. 4(2) of the OECD Model, this person will be subject to limited tax liability in Switzerland and his/her income from employment will be subject to salary withholding tax. In these situations, the Swiss taxing right is not limited by the frontier worker provisions of international treaties. This is even the situation if the taxpayer is classified, for residency permit reasons under the FMPA, as a frontier worker and receives a frontier worker permit. 51 Art. 21(1) sentence two FMPA expressly clarifies that the provisions of the FMPA shall not affect the tax treaty definitions of frontier workers. In conclusion, Switzerland will have to apply the Schumackerprinciple, as decided by the Supreme Court, to international weekend commuters Foreign nationals resident in Switzerland Foreign nationals who do not hold a residency permit C are subject to salary withholding tax under Art. 83 et seq. of the Federal Income Tax Act in Switzerland. But there 45. Art. 1 of the Accord entre le Conseil fédéral suisse et le Gouvernement de la République française sur la compensation fiancière relative aux frontaliers travaillant à Genève du 29 janvier Art. 2 (2) of the agreement between Switzerland and Italy of 30 October 1974 on the taxation of frontier workers. 47. See Sec. 4 of the protocol of 21 March 2006 (SR ), which applies not only to frontier workers but also to all Austrian residents working in Switzerland. 48. See Art. 2 of the agreement of 11 April 1983 between the Swiss Federal Council and France regarding the taxation of the income of frontier workers in the name of the cantons of Berne, Soleure, Basle city, Basle countryside, Vaud, Valais, Neuchatel, Jura. 49. Art. 5(2) of the Switzerland Liechtenstein tax treaty. 50. Art. 15a Germany Switzerland tax treaty. 51. According to the definition in Art. 7(1) of Annex I FMPA, a frontier worker is a person who returns daily or at least once a week to his place of residence. IBFD EUROPEAN TAXATION JULY

10 is a significant difference between the income tax rate system applicable to these persons and the withholding tax rate system of Art. 91 et seq. of the Federal Income Tax Act, which was dealt with in the Supreme Court decision at hand. The reasoning of the Supreme Court cannot, therefore, be applied to this category of persons without further deliberation. It is probably beyond question that the payroll withholding tax system of Art. 83 et seq. of the Federal Income Tax Act is, in many instances, discriminatory and, therefore, is not in line with Art. 9 of Annex I FMPA. One example is that the salary withholding tax rate is applicable to the whole Canton. Therefore, taxpayers resident in low-tax communities are discriminated against if they are subject to salary withholding tax rather than the standard income tax system. Even for persons with a yearly income of more than CHF 120,000, who are subject to subsequent standard income taxation, the salary withholding tax system is discriminatory because the payroll tax withheld is credited to the standard income tax without interest. In addition, it is questionable whether or not the taxation system itself violates Art. 9 of Annex I FMPA. The salary withholding tax for taxpayers resident abroad may be justified as a measure to ensure the payment of a tax. But with regard to Swiss resident persons, there does not seem to be a difference in applying a measure to ensure the payment of a tax whether or not the person is a Swiss national or has a long-term residency permit. Besides, this unequal treatment not only constitutes covert discrimination, but also overt discrimination. There is, therefore, no justification that can be relied on. Unlike frontier workers and international weekend commuters, these Swiss resident persons can rely not only on Art. 9 of Annex I FMPA, but also on the non-discrimination provision of Art. 24(1) of the OECD Model as incorporated into the tax treaty between their state of nationality and Switzerland. Since a violation of the nondiscrimination provision of Art. 24 of the OECD Model cannot be justified by measures to ensure the imposition of taxes, it should be clear that there is no justification for the application of a source tax system. 6. Conclusions In its decision of 26 January 2010, the Swiss Supreme Court, for the first time, analysed whether or not Swiss tax law violates the FMPA. In this decision, the Swiss Supreme Court introduced the Schumacker doctrine of the ECJ into Switzerland and came to the conclusion that the Swiss salary withholding tax system violates the FMPA. In view of the large number of frontier workers and international weekend commuters working in Switzerland, this decision is of great importance in practice. The foreign residents covered by the decision are not, however, the only persons that are discriminated against by Swiss tax law. Swiss resident foreign nationals who do not hold a residency permit C are also subject to salary withholding tax in Switzerland (as opposed to the taxation by assessment applicable to Swiss nationals and foreign nationals holding a residency permit C). Also the withholding tax for this category of persons provided that they are EU nationals presumably constitutes a violation of the FMPA. 294 EUROPEAN TAXATION JULY 2010 IBFD