Taxable income and tax-free capital gains: What is the difference?

While all recurring and non-recurring sources of income such as wages, compensation for special services, commissions, allowances or non-cash benefits from employee shareholdings are subject to the income tax, private capital gains are tax-free. But why is this the case and which income exactly is tax free? As a Federal Supreme Court ruling shows, there is no clear answer to these questions.

What income is subject to the income tax in Switzerland?

All recurring and non-recurring income is subject to the income tax. This includes, for example, income from self-employment and employment, investment income, income from pension benefits and a number of other sources of income.

However, capital gains from the sale of private assets are tax-free.

Which capital gains are tax-free?

Not subject to the income tax are capital gains on private assets. These are gains in value that are achieved when assets are sold.

Thus, if someone sells a component of his or her assets, the gain realized is not subject to the income tax. It is important to distinguish this term from capital wins, which constitute taxable income.

While a taxable capital win is generated by holding or owning an asset, the asset must be sold in order to generate a tax-free capital gain.

One speaks of the necessity of a so-called consumption of substance for the tax-free capital gain, i.e. the taxpayer virtually loses a part of his assets.

Example

If, for example, a person owns shares in a company that pay an annual dividend, the latter is a taxable capital win (taxable income), because the additional money is a consequence of owning the shares. The taxpayer owns both the shares themselves and the distributed dividend.

If, on the other hand, someone sells his car at a profit, said profit is a tax-free capital gain. The added value results from a loss of substance, namely that of the car. After the sale, the taxpayer only owns the sales profit, but not of the car itself anymore.

This distinction can cause a lot of confusion in practice, because it is not always as clear as in this example.

Is there a difference between movable and immovable property?

Yes there is! - Gains from the sale of immovable assets, such as real estate or land, are not taxed by the Confederation. On the other hand, capital losses cannot be deducted at the federal level.

That means if someone sells their house successfully, the federal government does not collect taxes on the profit. If the sale does not go as hoped, however, no deductions for the loss are possible either

In the cantons, the real estate gains tax must be paid on the profits of a successful sale. As the on federal level, in many cantons losses from the sale of real estate cannot be claimed or can only be claimed to a limited extent either, even though profits are taxed.

On a cantonal level this means that although the tax is levied on the profit from the sale of a house, in the event of an unsuccessful sale no or only small deductions may be claimed for the loss incurred.

Gains from the sale of movable private property are not taxable either at the federal level or in the cantons. Conversely, losses on disposal cannot be deducted either. The sale of a car, for example, has no effect on the income tax either at federal or cantonal level.

Justification for the wealth tax

But why aren't private capital gains taxed? The exemption of private capital gains from taxation is repeatedly criticised. Critics argue that it is an unlawful exception to the principle of taxation of total net income and the principle of taxation according to economic performance.

The lack of capital gains taxation can be justified by the wealth tax, which Switzerland as one of only few countries still has. It is one of the many special features of the Swiss tax system. The argument brought foward is that the tax exemption of private capital gains partially compensates for the wealth tax levied.

When exactly is a capital gain tax-free ?

The distinction between tax-free capital gains and taxable income is often difficult. According to the Federal Supreme Court, tax-free capital gains are those gains that arise from the simple management of private assets or from a random opportunity.

If, on the other hand, an activity is aimed at making a profit, it is assumed that it is a self-employed activity that generates taxable income.

However, this distinction can be challenging in individual cases, as the following example shows.

Is holdback subject to the income tax?

In case 2C_731/2017 of November 12, 2018, the Federal Supreme Court had to decide whether a payment of CHF 854,003 qualified as taxable income or a tax-free capital gain.

The complainant, who was liable to pay taxes in the Canton of Solothurn, had sold his share in a public limited company (PLC) to a third company on June 1, 2012. According to a clause in the purchase agreement, he was to retain his employment relationship with the PLC for a further three years. In return, he would receive a payment totalling CHF 854,003 at the end of the three years.

Should the employment relationship be terminated beforehand due to incapacity for work or by mutual agreement, the purchase agreement provided for immediate payment of the sum.

On November 18, 2013, the employment relationship was terminated by mutual agreement and the CHF 854,003 paid to the taxpayer. On June 29, 2016, the complaintant and his wife were assessed by the relevant tax authority and the payment was added to taxable income.

The couple did not want to pay the income tax and unsuccessfully defended themselves by means of objections and going to court. They were of the opinion that the so-called "holdback" did not constitute taxable income but a tax-free capital gain.

Federal Supreme Court disagreed

The couple argued that the holdback did not constitute compensation for the husband's work and therefore could not be taxed. Furthermore, they supperted their claim by stating that a salary had continued to be payed and that a payment in case of employment termination could not qualify as income from employment. Accordingly, the payment of CHF 854,003 should not be subject to the income tax.

However, they were not able to convince the Federal Supreme Court, which assessed the question in the same way as the lower courts. It emphasized that all recurring and non-recurring income is subject to direct federal tax. In particular, income from employment relationships, whereby ancillary income such as compensation for special services, commissions, allowances, long-service and anniversary gifts, gratuities, tips, bonuses or non-cash benefits from employee shareholdings are also subject to taxation.

In the present case, the taxpayer had received the payment for the fact that the employment relationship was terminated and no more work performed. Such a severance payment is considered income by the Federal Supreme Court and is therefore subject to the income tax.

Unsure whether or not the income tax has to be paid on an income? Our specialists at taxea are happy to assist you with their extensive expertise.