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Michele Vitali, Head of Startup Financing & VC, Partner @LEXR
Have you ever wondered about the ideal number of investors for convertible loans?
In this article, we’ll look at the 10/20 rule associated with convertible loans in Switzerland. Essentially, we’ll explain why you might want to hit pause after issuing 10 Convertible Loan Agreements (CLAs) with identical terms and get some legal advice from us.
The Swiss tax scene: a brief overview
Switzerland has a unique tax landscape when it comes to private and commercial loans. Unlike many other countries, Switzerland does not impose any interest withholding tax on private loans.
However, a 35% federal withholding tax comes into play for interest paid on bonds and similar debt instruments by Swiss companies. So, while most startup loans evade any withholding tax, convertible loans may qualify as ‘bonds’ for tax purposes under certain conditions (i.e. if the 10/20 rule applies), and the 35% federal withholding tax might (unwittingly) come into play.
When does a ‘simple CLA’ qualify as a bond or the 10/20 rule?
A convertible loan might earn the label of a ‘bond’ for tax purposes if:
- The company enters into loan agreements with over 10 ‘non-banks’ or institutional investors sharing substantially identical terms; or with more than 20 ‘non-banks’ or institutional investors, regardless of the terms (even if some have no discount while others do); and
- The total amount invested exceeds CHF 500,000.
Let’s clarify this with an example:
Imagine Startup X-Force issues 15 convertible loans to 15 private angel investors, and in this financing round manages to raise a total of CHF 1’000’000. The terms of the loans are identical, including the same interest rate of 5% and discount.
Over a year, the loan grew by CHF 50’000 to CHF 1’050’000 due to a 5% interest rate. The loan including the interest rate will convert into shares at a certain conversion event.
Given that X-Force issued over 10 loans at identical terms, exceeding the total investment limit of CHF 500’000, these loans qualify as ‘bonds’ for Swiss withholding tax.
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What are the consequences if the CLA qualifies as a bond?
The company is the debtor of the withholding tax and must pay a portion of the interest as tax. If a company, for example, pays CHF 1000 interest on a bond, it must pay CHF 350 to the Federal Tax Administration and the remaining CHF 650 to the lender. If the lender is a Swiss resident and correctly declares this interest income in their tax return, they will reclaim the CHF 350 from the Federal Tax Administration.
In our X-Force example, if the CHF 1’050’000 loan converts into shares, tax authorities assume the converted CHF 50’000 represents only 65% of the total interest amount. They’ll demand the remaining 35% from the company, which amounts to roughly CHF 27’000 – a process referred to as ‘gross-up.’ Typically, the company will not be able to ‘re-claim’ that amount from the investors.
Practical advice for founders that want to raise with a CLA
Planning to issue more than 10 convertible loans to private investors? Remember to keep the aggregate investment amount of CHF 500’000 in mind, and ensure the terms aren’t ‘substantially the same.’ A simple strategy could be significantly altering the interest rate in some of the loans, say, from 5% to 1%.
We know that each situation is unique, and we’re here to discuss yours in detail. Please don’t hesitate to book a free call with our Startup Financing & VC Experts. Let’s navigate the complexities of convertible loans together!
