Deduction of interest expense

The interest a company pays on its debts is, in principle, a deductible cost: it reduces taxable profit and therefore taxes. But “in principle” is not enough. Swiss tax law sets precise conditions, especially when the financing comes from shareholders or persons close to the business. Treating interest expense lightly exposes you to tax adjustments and double taxation. Let’s look at the rules that matter.

The principle: a cost justified by business use

Interest expense is deductible when it is justified by business use, that is, when the debt on which it accrues serves the activity of the business. A mortgage to buy a warehouse, working capital financing, a loan for a productive investment: the related interest reduces the taxable profit of the year to which it relates.

The logic is that of economic accrual: the interest burdens the year to which it refers, regardless of the payment date. Anyone keeping full accounts records interest accruals even if the due date falls in the following financial year.

Shareholder loans: watch the rates

The most delicate point concerns financing granted to the company by shareholders or persons close to them. Here the tax authorities apply the arm’s length principle (dealing at arm’s length): the interest recognised may not exceed what would be paid to an independent third party.

Each year the Federal Tax Administration (FTA) publishes a circular with the maximum permitted interest rates on loans in Swiss francs to shareholders, broken down by type of financing (operating credit, real-estate credit) and by the source of the capital. If the company pays the shareholder interest above that ceiling:

the excess portion is not deductible and is added back to taxable profit;
the excess is treated as a payment in kind (constructive dividend) in favour of the shareholder, subject to 35% withholding tax and taxable in the shareholder’s hands as income.

It is a double blow that is avoided simply by respecting the published reference rates.

Hidden equity

There is a second limit, less well known but important: that of hidden equity (thin capitalisation). When shareholders finance the company with loans rather than with equity, beyond a certain proportion the tax authorities reclassify part of the debt as “hidden” equity.

The FTA provides maximum permitted debt percentages by asset category (real estate, participations, receivables, inventory). If debt towards shareholders exceeds the borrowing capacity thus calculated:

the interest on the excess portion is not deductible;
that part of the debt is added to equity for the purposes of the capital tax.

The aim is to prevent risk capital from being turned into debt merely to generate deductible interest.

Interest towards independent third parties

With banks and independent creditors the matter is simpler: the interest actually agreed is deductible, because the market already guarantees the adequacy of the rate. The general requirements still apply: the debt must be real, documented and related to the business activity. Interest on the shareholder’s private debts made to appear in the company does not pass.

Common mistakes

Paying the shareholder “generous” interest while ignoring the year’s maximum FTA rates.
Financing the company almost entirely with shareholder loans, running into hidden equity.
Not documenting the loan terms in writing (amount, rate, maturities).
Deducting interest belonging to another financial year, distorting the result.
Forgetting the 35% withholding tax on the reclassified excess.

In summary

Interest expense is deductible if the debt serves the business.
For shareholder loans, the maximum rate published each year by the FTA applies.
The excess is non-deductible and becomes a payment in kind.
Hidden equity limits borrowing from shareholders.
With banks the market rate counts, but documentation is always needed.

How we help you

We check the deductibility of your company’s interest expense, compliance with FTA rates on shareholder loans and the hidden-equity limits, avoiding adjustments and double taxation. Optimise your tax structure.