Switzerland Cantonal Court and Taxation Concerning Forfeiture of Shares
The High Administrative Court of the Canton of Schwyz overturned an earlier practice regarding the tax treatment of forfeited employee shares upon termination of employment and the resulting loss of these shares, in a decision dated 26 August 2010.
Tax Treatment of the Forfeiture of Employee Shares before Vesting
In accordance with the tax treatment of the Swiss Federal Tax Administration and the new federal law on the taxation of employee stocks and options, employee shares are taxed at grant, typically when the ownership of the shares is transferred to the employee. Taxation at grant applies even when employee shares are forfeited at a later date but before vesting, resulting in over-taxation of the employee when the employee sustained a loss based on the shares received. This result requires a correction and, as Swiss federal statute law has no rule on how to correct this loss, the method is determined by the cantonal tax authorities.
The tax treatment of a loss due to the forfeiture of employee shares is not treated the same in each canton. The three typical approaches are (a) a retroactive correction of the tax assessment for the tax year of grant by way of a statutory audit (revision), (b) a correction in the current tax year by applying the so-called “negative compensation practice”, or (c) a deduction of the loss in the current tax year as the acquisition costs are deemed employment-related expenses.
Below we present the basic guidelines concerning the different approaches of the cantonal tax authorities.
1 Revision (statutory audit): The revision permits a tax assessment to be amended after res judicata, typically in the event that new facts have become known since the tax assessment was issued. The Canton of Schwyz has used this method of correction in the past to remedy the loss due to forfeiture of employee shares.
2 A correction by applying the negative-compensation practice: This is used in several cantons (notably Aargau, Basel-Stadt, Basel-Land, and Solothurn)4. A correction to the taxation of employee shares at grant and subsequent forfeiture is effected by means of a “negative compensation” in the year of forfeiture. In principle, the tax authorities allow the employee under certain conditions to claim the loss in the tax period when the shares were forfeited as negative income in the individual’s tax return.
3 Acquisition costs: Acquisition costs based on employment are costs that arise directly in order to produce corresponding employment income; they are, in other words, an inevitable condition, or the immediate effect, of income realization. The criteria for the recognition of acquisition costs are not the same for all income types. In the case of income from gainful employment, only those costs are deductible that are objectively necessary, i.e., must be spent to achieve the income in question.
Decision by the High Administrative Court of Schwyz
In its decision, the High Administrative Court of the Canton of Schwyz weighed the three possible correction methods and determined that the loss due to the return of the shares upon a termination of employment before vesting was best dealt with by allowing the loss to be treated as acquisition costs and business expenses and therefore deductible from taxable income in the tax year of forfeiture.
The argument being that the employee stock ownership plan requires the employee to forfeit the employee shares received in the event of a termination of employment.
This obligation and the related costs resulting therefrom are causal and objectively necessary to the employment relationship. Consequently, the loss resulting from the forfeiture of these shares at the time of the termination must be deductable as acquisition costs (employment-related expenses) from the employment income at the time of forfeiture.6
The High Court thereby overturned the previous practice of permitting the amendment of the final tax assessment in the year of grant by way of a statutory audit. As the possibility of the forfeiture of employee shares upon a termination of employment is sufficiently known at the time of grant (e.g., stated in the employee stock plan), the condition of a new fact turning up that would overturn the final tax assessment is not apparent. The Court also determined that the negative compensation practice used in other cantons would not be considered in the Canton of Schwyz.
As no appeal was filed to the federal courts by either party, this decision is final.
With this decision, the Schwyz tax authorities have aligned their method of deduction with the Zurich canton practice. Furthermore, based on the latest version of the draft tax law for equity compensation taxation, the federal authorities are expected to follow the line of argumentation of the High Court in Schwyz. Consequently, it is most likely that all cantons will have to adopt this rule at the beginning of 2013, when the new law will come into force.