Premature cancellation of the fixed-rate mortgage

Mortgages are important financing elements when purchasing a home. There are different mortgage models. One of them is the fixed-rate mortgage with a fixed interest rate for a specific term. With the fixed-rate mortgage, the borrower can protect himself against rising interest rates, but cannot benefit from falling interest rates.

If the borrower nevertheless intends to benefit from low interest rates on a fixed-rate mortgage, the borrower must terminate the contract with the financial institution early. However, an early termination of the fixed-rate mortgage is usually associated with the payment of an early repayment penalty by the borrower to the bank.

Prepayment penalties are compensation payments for the loss of interest that a creditor suffers when the mortgage is terminated prematurely due to the meanwhile decreased interest level (compare. e.g. Tax Book Lucerne, Volume 1, Income Tax Instructions, § 40 No. 1).

Federal Court Jurisdiction

a) 2017

The tax treatment of such prepayment penalties was controversial until recently and was handled differently in the cantons. They have not been explicitly mentioned in the harmonised tax law, which is why the Federal Supreme Court within the framework of two leading decisions in 2017(BGE 143 II 382 and BGE 143 II 396), established three case constellations regarding the deductibility of prepayment penalties for income tax purposes resp. the inclusion of these costs in the investment costs for the purpose of real estate gains tax. (compare to our article from 2017 "Deductions in the case of early termination of the mortgage").

The case constellations can be summarized as follows:

In the two Federal Court decisions from 2017, in which the three case constellations were developed, the subjects of dispute were the deductibility of prepayment penalties that became due immediately before a property was sold. In this case, no new debt relationship was entered into by the previous debtor - with the same or a different lender - (case constellation 3). The deductibility of the prepayment penalties was assessed, on the one hand, under the aspect of investment costs in the sense of a value-enhancing expense for real estate gains tax (Art. 12 StHG(BGE 143 II 382) and, on the other hand, under the aspect of debt interest for income tax (BGE 143 II 396).

b) 2019

In a new ruling of 16 December 2019 (2C_1009/2019), case constellation 2 was the subject of dispute. In this ruling, the Federal Supreme Court confirmed the tax assessment that the court had established as a general rule obiter dictum in 2017.

Accordingly, an prepayment penalty charged to a taxpayer because the taxpayer cancels the existing fixed-rate mortgage and takes out a new mortgage with another financial institution does not qualify deductible as interest on debt for income tax purposes.

Criticism of the Federal Court Jurisdiction

a) Refusal as debt interest when changing financial institution

Why the case law of the Federal Supreme Court differentiates for the assessment under tax law whether the prepayment penalty has to be paid if a new mortgage transaction is concluded with the same financial institution or with another financial institution is unclear and again fails to convince.

Irrespective of whether the financial institution is changed after the early termination of the fixed-rate mortgage, the prepayment penalty is calculated in the same way (for the repayment amount, remaining term and the difference between the contractually fixed mortgage interest rate and the current money and capital market rates, see Haffner/Reichart, Die Vorfälligkeitsentschädigung im Hypothekargeschäft, p. 1402).

In cases 1 and 2, the purpose of the prepayment penalty is to ensure that the previous financial institution is not placed in a better or worse position than if the loan had continued to run until the end of the agreed term (BGer 4A_409/2011 of 16.12.2011 E. 3.2.2). In other words, the prepayment penalty is not owed because a new loan agreement is entered into with a new financial institution. In this sense, the prepayment penalty in case of a premature cancellation of the loan relationship is also always owed to the original and not to the new financial institution. In both cases, the economic connection required by Federal Supreme Court between the original loan agreement and the prepayment penalty is equally given.

For these reasons, we believe it is justified to accept the prepayment penalty charged under case constellation 2 as deductible debt interest by analogy with case constellation 1.

b) Refusal to change financial institution as an investment cost

According to the Federal Supreme Court, the fact that the prepayment penalty that has become due with a change of financial institution does not qualify as tax-deductible debt interest for income tax purposes does not automatically mean, that it can be claimed as an investment cost for real estate gains tax purposes. Indeed, according to the leading decisions from 2017, this would only be the case if the loan relationship is terminated only in order to ensure the sale of an unencumbered property.

The actual tax object of the real estate gains tax is the profit realised from the sale of a property. According to Art. 12 para. 1 StHG, the profit is defined as the difference between the proceeds and the investment costs, whereby these investment costs consist of the purchase price or the replacement value plus so-called value-enhancing expenses.

According to the practice of the cantons, the profit costs associated with the sale can also be deducted from the gross profit if they cannot be deducted from the income taxes. This typically concerns brokerage commissions.

In its leading decision from 2017(BGE 143 II 382), the Federal Supreme Court examined the qualification of the prepayment penalty as deductible investment costs within the meaning of Art. 12 para. 1 StHG. According to the Federal Supreme Court, deductible investment costs exist if, on the one hand, there is an effective increase in value by the seller and, on the other hand, there is a direct connection with the sale of the relevant real estate. The lapse of obligatory rights can also cause an increase in the value of the real estate (BGE 143 II 382 E. 4.2.3, 4.4.2). Since in the case under consideration (BGE 143 II 382) the mortgage was dissolved immediately before the sale and not replaced by a new mortgage, according to the Federal Supreme Court both conditions for qualification as investment costs were met.

The inseparable connection of an expenditure with the acquisition or with the sale, as required by Federal Supreme Court, is relevant under the aspect of profit costs. However, this means that the Federal Supreme Court's considerations in fact mix up the characteristics for "value-adding expenses" and for "profit costs" which makes the dogmatic classification and justification of the Federal Supreme Court difficult to understand.

In our view, the discountinuation of obligatory rights such as a fixed-rate mortgage can indeed contribute to the increase in the value of the property. However, this also applies if the mortgage does not cease to exist in direct connection with the sale, but the sale takes place at a later date and independently of the cessation of the obligatory rights, and the "more favourable" mortgage still exists in the event of a later sale. Unlike in the case of profit costs, a causal connection to an imminent sale is not required for value-enhancing expenses such as payment of a prepayment penalty.

Legislative freedom of the Cantons

The tax object of the real estate gains tax is the profit realized from the sale of a property. The profit is only just defined as the difference between the proceeds and the investment costs, whereby these investment costs, according to Art. 12 para. 1 StHG, are composed of the purchase price or the replacement value plus expenses. Neither the point in time of this realisation nor on the determination of the values that lead to this tax object is further specified in the tax harmonization act. According to the doctrine, the cantons are largelyfree to determine the tax object (Bernhard Zwahlen/Natalie Nyffenegger, in: Zweifel/Beusch (eds.), Art. 12 StHG N 43-44).

Changes in practice

The cantons of Basel-Stadt (Tax Practice Canton of Basel-Stadt), Baselland (Tax Practice Canton ofBaselland), Thurgau (Tax Practice Canton ofThurgau), Lucerne (Tax Practice Canton ofLucerne), Zug (Tax Practice Cantonof Zug) and Zurich follow the federal court ruling Jurisprudence, whereby prepayment penalties are only deductible as debt interest for income tax purposes if the mortgage is replaced by a new mortgage with the same lender. If the cancellation of the mortgage is inextricably linked to the sale of the property, the prepayment penalty is considered a deductible investment cost for real estate gains tax purposes.

The Canton of Bern declares the new practice applicable only for the 2020 tax period. Up to and including the 2019 tax year, Canton of Bern still allows prepayment penalties as deductible debt interest for income tax purposes. deductible debt interest for income tax purposes without restriction, provided that the cancellation of the mortgage is not inextricably linked to the sale of the property(tax practice Canton of Bern).

The Canton of St. Gallen declares the new practice applicable only for the tax period 2021. Up to and including the tax year 2020, the Canton of St. Gallen still allows allows prepayment penalties as deductible debt interest for income tax purposes without restriction, provided that the dissolution of the mortgage is not inseparably linked to the sale of the property.

Conclusion

If the law contains loopholes - as in the opinion of the Federal Supreme Court with regard to prepayment penalties - these can be filled in by Federal Supreme Court. The rules established by Federal Supreme Court have already been adopted by some cantonal tax administrations in their published practice. However, the conclusions of the Federal Supreme Court regarding the differentiated treatment of the prepayment penalty for income tax purposes are not convincing. With regard to the crediting of the prepayment penalty against the investment costs, we believe that there is room for harmonization law to permit crediting irrespective of an immediate sale. However, due to the clear verdict of the Federal Supreme Court, this change would have to be implemented by the cantonal legislator.