By Silvan Thoma, Martin Burri and Roland Reding
October 2024
Silvan Thoma (Director, PwC Legal Switzerland), Martin Burri (Partner, Corporate Tax and Financial Services, PwC Switzerland), and Roland Reding (Partner, VAT Financial Services Tax, PwC Switzerland)
Silvan Thoma
Martin Burri
Roland Reding
Executive Summary
This article provides a comprehensive comparison of exchange-traded funds (ETFs) and exchange-traded products (ETPs), focusing on their unique characteristics, regulatory frameworks, and practical applications. ETFs, regulated under the Swiss Collective Investment Schemes Act (CISA), offer robust investor protections and are ideal for traditional investments, while ETPs, operating outside CISA, provide greater flexibility and quicker market entry, particularly for emerging asset classes like cryptocurrencies.
Key considerations include licensing requirements, tax implications, and VAT treatment, all of which differ significantly between the two vehicles. ETFs generally involve higher regulatory oversight and setup costs but are perceived as more secure. In contrast, ETPs offer tax advantages such as exemption from Swiss withholding tax on distributions and are often more cost-effective to establish. The article also highlights the suitability of each vehicle for specific investment strategies, helping asset managers and investors determine the best fit for their objectives.
Introduction
Asset managers can choose from a wide variety of investment vehicles to realise their strategies and let investors participate therein. Two popular investment vehicles are exchange-traded funds (ETFs) and exchange-traded products (ETPs). Both types allow realising passive and active strategies with a variety of asset classes. ETFs and ETPs are often structured very similarly, as far as parties to the structure and fee models are concerned, but they have distinct characteristics when it comes to regulation and tax treatment.
The terminology used for these two types of investment vehicles varies across regions, namely when it comes to ETPs. Here, we are using the term as defined by the rules of the Swiss stock exchanges SIX Swiss Exchange (SIX) and BX Swiss (BX). This means that ‘ETP’ is not an umbrella term encompassing different types of investment vehicles traded on an exchange, but a specific type of investment vehicle, comparable to an exchange-traded note (ETN) according to the rules of some non-Swiss exchanges.
According to the terminology used here, ETPs are secured, bearer debt securities that do not pay interest. Unlike traditional investment funds, ETPs are not regulated under the Collective Investment Schemes Act (CISA) and the issuers of ETPs do not have to be supervised or registered by the Swiss Financial Market Supervisory Authority (FINMA). Currently, around 200 ETPs are traded on SIX and 85 on BX.
ETFs on the other hand are shares or share classes of collective investment schemes listed on a stock exchange and continuously traded. ETFs are subject to the CISA, and the structures are authorised and supervised by FINMA. There are over 1,500 ETFs available on SIX and 730 on BX today. Typically, ETFs are passively managed funds tracking an index.
Regulatory perspective on ETPs and ETFs
Licence requirements
ETFs qualify as collective investment schemes under the CISA and must be open-ended. Swiss persons establishing or operating an ETF and the custodian bank must be licensed by FINMA. Swiss ETFs are typically share classes of sub-funds issued under a contractual umbrella fund and not investment companies with variable capital (SICAV). In such a structure, the persons requiring a FINMA licence are the fund management company (Fondsleitung), the custodian bank (Depotbank), the asset manager (Verwalter von Kollektivvermögen) and the paying agent (Zahlstelle). The fund contract has to be approved by FINMA. If the ETF structure is not Swiss but intends to be listed on a Swiss stock exchange, the ETF must be registered with FINMA. The most important requirements for the registration of non-Swiss funds are that the persons managing the fund as well as the custodian are subject to CISA-equivalent regulation and that a FINMA-authorised representative of foreign collective investment schemes as well as a Swiss paying agent have been appointed.
ETPs on the other hand do not fall under the CISA and the issuer does not necessarily require a FINMA licence. ETPs are, however, still subject to financial market regulation, because they qualify as structured products under the Swiss Financial Services Act (FINSA). Due to the requirements imposed on structured products, the issuer of ETPs does not need a FINMA licence if certain conditions are met. ETPs may be issued by an unlicensed special purpose vehicle (SPV), if the products are either guaranteed by a bank, insurance company or securities firm, or if the product is collateralised by a legally enforceable real security in favour of the investors. The collateralisation requirement can be fulfilled by, for example, keeping the underlyings of the ETPs either physically or in the form of futures on a segregated account held at a third party which is independent of the issuer. These requirements apply for all ETPs to be listed on a Swiss exchange, regardless of the jurisdiction in which the issuer is incorporated. Even though the issuer of ETPs does not necessarily require a licence from FINMA, other parties in the ETP structure, like the market maker or the paying agent, do.
Investment strategies
Both product types allow for the implementation of passive and active investment strategies. Eligible underlyings of the products are defined in the CISA for ETFs and in the stock exchange regulations for ETPs.
ETFs have to be open-ended collective investment schemes. According to the CISA there are three categories of open-ended collective investment schemes: securities funds, real estate funds and other funds for traditional and alternative investments. Besides the obvious investments of securities and real estate funds, like equity and bonds for the former, and buildings, mortgages and land for the latter, the funds may also invest to a limited extent in other instruments like derivatives. In addition, securities funds may enter into (reverse) repo transactions and apply leverage to a limited extent. The most versatile category is the fund for traditional and alternative investments. As the name suggests, the category consists of two sub-categories. The funds for traditional investments allow for investments in asset classes with a moderate risk profile and the application of some leverage. Funds for alternative investments on the other hand support investing in asset classes with a higher risk profile and the application of more leverage. The admission of asset classes as investments of such alternative funds is subject to FINMA’s discretion.
The eligible underlyings of ETPs are defined in the stock exchange rules. Both SIX and BX allow equity securities, bonds, and CISA-compliant funds as underlyings, provided these are listed or admitted for trading on a Swiss stock exchange or an equivalently regulated foreign stock exchange. Derivatives traded on SIX, and options as well as futures traded on exchanges subject to equivalent regulation are eligible too. Furthermore, an ETP may be invested in foreign currencies, reference rates, precious metals, commodities and cryptocurrencies, provided the underlying fulfils a set of requirements. Finally, specific indices and baskets composed of eligible underlyings are admitted as underlyings too. Only BX, but not SIX, allows tangible fixed assets like real estate as underlyings of ETPs, provided the assets are regularly valued by an independent valuation expert and the valuation methodology is disclosed in the prospectus of the ETP.
Parties to the structure
For both investment vehicles ETFs and ETPs, at least one market maker must be appointed to continuously quote bid and ask prices for the products. The prices are quoted based on the net assets value (NAV) of the product and ensure that the value of the units traded on the exchange do not deviate significantly from the NAV. Also, both investment structures have a Swiss paying agent that has to be a licensed bank. The paying agent is responsible for executing the transactions resulting from issuing or redeeming units. The custodian’s role is to safeguard the underlying assets and is typically a licensed bank too. A calculation agent and/or an administrator is appointed to, among other things, verify and valuate the NAV of an ETP or an ETF and provide price data.
In case of passive index tracking ETFs or ETPs, an index provider is calculating the composition of the index components. The product’s assets are invested according to this calculation. Index providers are often domiciled in the EU and are licensed under the EU Benchmark Regulation. In Switzerland there is no specific licence type for the provision of indices. In case of active strategies, the assets are allocated according to investment decisions taken by an asset manager. Asset managers of ETFs must be licenced under the Swiss Financial Institutions Act (FINIA).
The overall management responsibility for a contractual ETF lies with a licensed fund management company. At the end of the product lifecycle, it is the fund management’s responsibility to orderly liquidate the ETFs.
Unlike ETFs, ETPs are issued by legal entities as debt securities. At the end of the lifecycle of the ETP, the product is either cancelled by the issuer or the ETP has to be wound down due to an event of default or insolvency. For these worst-case scenarios, the issuer appoints a security agent at the beginning of the ETP’s lifecycle. The security agent is responsible for enforcing the investors’ rights under the terms of the ETP. Most importantly, the security agent gives an enforcement notice to the issuer upon request of investors and takes such action as it may think fit to enforce the rights under the terms of the ETP. Such actions can be organising the liquidation of the collateral and the distribution of the proceeds to the investors.
In the normal course of business, the creation and redemption of units of ETPs is triggered by the authorised participant, which is often the same person as the market maker. For ETFs the role of triggering the issuance and redemption of new units is with the fund management company and the distributors. Creations and redemptions of new units are typically a result of investors requesting investing or divesting large positions. Small positions may be bought or sold directly on the stock exchange.
Offering and product documentation
Primary market offerings leading to the creation of new units are handled by authorised participants in case of ETPs, and distributors and fund management companies in case of ETFs. Buyers of new units place a subscription order with these parties. Granting of subscriptions may be subject to specific requirements, such as minimum subscription amounts.
An ‘offer’ is any invitation to acquire an ETF or an ETP that contains sufficient information on the terms of the offer and the product itself. FINSA requires that structured products, such as ETPs, issued by SPVs may only be offered to retail clients by licensed financial intermediaries. The financial intermediaries must be licensed according to the banking act, the FINIA, the CISA, as insurance undertakings, or as equivalently supervised non-Swiss institutions. This requirement does not apply to the offering of ETFs.
In practice the offer can amount to investment advice. Investment advice is a financial service under FINSA and may only be provided by licensed institutions or registered client advisers. Investment advice and also portfolio management is subject to the code of conduct rules of FINSA. Depending on the characteristics of the services provided and the categorisations of the client, duties like assessing the suitability and the appropriateness of an ETP or an ETF for the specific client is required. Also, potential conflicts of interests and the market offer considered must be disclosed to the client. Compensations of third parties received in association with the provision of financial services must generally be passed on to the clients or waived by the clients and disclosed.
The product documentation requirements for both ETFs and ETPs are governed by FINSA too. A prospectus and a key information document (KID) must be produced and published for both product types. The prospectus for ETFs is typically drafted for the umbrella fund, contains the fund contract, and lists the sub funds and the share classes. Issuers of ETPs often opt for producing a base prospectus for an issuance programme. The base prospectus sets out the general terms of the product. The specific terms of the ETPs issued under the programme are set out in final terms. The KIDs must be produced for each ETP and generally for each share class of an ETF.
Tax perspective on ETPs and ETFs
Corporate tax and individual tax
ETFs are typically seen as transparent funds for Swiss individual tax purposes. This means that in the hands of a Swiss individual investor, the income of the fund is subject to income tax, no matter whether such income is distributed or accumulated. A great advantage in Switzerland is that capital gains are not subject to income tax. This principle is also applied for capital gains generated by the ETF. In order to apply this exemption, it is required that the fund separates taxable income (such as dividend income or interest income) from tax-free income (such as capital gains) and reports these values on an annual basis to the Swiss Federal Tax Administration. Based on our experience, most bigger asset managers do such Swiss tax reporting as a service for their Swiss investor base.
Most ETFs on the market are incorporated abroad and the distribution of proceeds to the investors is typically not subject to any withholding tax. In contrast to this, the income of Swiss domiciled ETFs is subject to Swiss WHT of 35%. Swiss ETFs can nevertheless be attractive for underlying Swiss investments. In this case, Swiss ETFs are entitled to reclaim Swiss WHT on income from underlying investments (such as dividend income). Consequently, a tax leakage on investment level can be avoided. The income of the fund is still subject to WHT, but investors resident/domiciled in Switzerland are entitled to reclaim WHT, and foreign investors may be able – based on a double tax treaty – to at least partially reclaim WHT.
In contrast to ETFs, ETPs are debt instruments. Compared to ETFs, one of the major advantages of ETPs is that there is no legal basis to levy Swiss withholding tax on the income or distributions to investors. For this reason, Swiss issued ETPs are also attractive for foreign investors. The main disadvantage (from a tax perspective) of a Swiss issued fund is therefore eliminated.
For Swiss individual income tax purposes, the treatment of the ETP depends on its investment strategy. While actively managed ETPs are generally treated transparently (i.e. like ETFs), passively managed ETPs are treated opaque for individual income tax purposes. This means that income is only taxed when it is distributed to the Swiss individual investors. On the other hand, there is no distinction between whether the underlying income is dividend income or capital gain in nature.
An additional advantage of ETPs is that – at least foreign issued ETPs and ETPs with a passive investment strategy – they do not qualify as taxable securities for transfer stamp tax purposes.
Value added tax (VAT)
Special Swiss VAT rules apply to Swiss ETFs subject to KAG (i.e. so called ‘fund silo’). This means that fund administration and management as well as fund offering activities related to Swiss ETFs are generally exempt from Swiss VAT. As a result, the added value is not subject to VAT, but on the other hand input VAT costs result in final costs (i.e. tax occult).
The administration and management of non-Swiss ETFs is subject to Swiss VAT, and the Swiss VAT treatment of offering activities depends on the status of the ETF (whether or not the non-Swiss ETF is subject to the regulatory regime for offering to retail investors).
Swiss and non-Swiss ETPs are subject to standard Swiss VAT rules, i.e. there are no specific Swiss VAT rules. This means that ETP administration and management activities are generally subject to Swiss VAT, currently at 8.1%. Fees for placement activities of ETPs may be taxable or exempt from Swiss VAT depending on the specific facts and circumstances. As a result, the added value is normally subject to VAT, but there is the possibility of claiming full input VAT.
Summary
ETFs and ETPs have many aspects in common. The key differences, however, are that ETFs and ETPs allow for implementing different investment strategies. Which investment vehicle is more suitable for a specific strategy must be assessed case by case. As of today, investment strategies involving cryptocurrencies are realised in Swiss ETP structures. Real estate investment strategies on the other hand are implemented with ETFs. An advantage of ETPs is that the time-to market is faster and the set-up costs are typically lower. This is because no FINMA licences or approvals are required, unlike for ETFs. The drawback of ETPs is that some investors perceive the products as less secure, because no FINMA licence or approval is required.
From a tax perspective, Swiss issued ETPs are attractive compared to Swiss ETFs, because distributions are (in most cases) not subject to Swiss withholding tax. Additionally, the transparent treatment of certain actively managed ETPs avoids a taxation of underlying capital gains for Swiss resident individuals.
The applicable VAT legislation and practice is completely different for ETPs and ETFs. Therefore, VAT aspects (e.g. final input VAT costs, output VAT on services) should be taken into account in the pricing of ETF and ETP products.
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