Use of Profits by Legal Entities

The allocation and distribution of profit is a crucial aspect of any business operation. Companies need to balance various needs while fulfilling specific legal requirements.

This article explores the intricacies of profit distribution in Switzerland for both the  GmbH and AG entities. We discuss the different ways that profits can be used and what to consider when deciding which of these uses is optimal. We also outline the importance of creating a comprehensive profit distribution plan and how to practically go about allocating profit.

A Swiss GmbH or AG can use its profits in three main ways: allocate them to statutory or voluntary reserves, distribute them to shareholders as dividends or royalties, or carry them forward as retained earnings. How a company uses and distributes its profits at year-end depends on stakeholder preferences, the company's financial position, and legal requirements.

Here is a breakdown of the three primary ways that a company’s profits can be allocated:

1. Allocation of profit to reserves (profit stays within the company):

Firstly, the company may choose, or be required to, allocate a portion of their year-end profit to reserves. We can distinguish between statutory and voluntary reserves:

Statutory profit reserves:

The Swiss Code of Obligations (OR) stipulates that all businesses need to allocate a certain minimum amount of their profits to the statutory profit reserve. According to Art. 672 OR:

• A company must allocate 5% of their annual profit to statutory retained earnings until the statutory retained earnings, together with the statutory capital reserve, reach 50% of the share capital specified in the commercial register (20% for holding companies).  
• The statutory capital reserve may be repaid (i.e., distributed) to shareholders if it exceeds 50% of the share capital value specified in the commercial register, after deduction of losses.
• Losses carried forward are deducted from the profit figure before calculation of the required 5% contribution amount.

Prior to 2023, there was also a provision specifying a second allocation of profits to statutory reserves, which was calculated as a percentage of the dividend payment in excess of the basic 5% dividend payment (so-called “super dividends”). However, with the reforms in the OR which came into effect on 1 January 2023, the requirement of the second reserve allocation was removed. This greatly simplified the calculation of the statutory profit reserve allocation.

Voluntary profit reserves:

In addition to the mandatory statutory reserves, the company may decide, through the general meeting, to allocate some of its profits to the formation of voluntary reserves which is outlined either in the articles of association or by shareholder resolution (Art. 673 OR).

It is important to note that the law stipulates that “Voluntary retained earnings may only be formed if justified in order to ensure the long-term prosperity of the undertaking, taking account of the interests of all the shareholders.” (Art. 673 OR). The issues surrounding when voluntary reserves are needed, along with the rights and interests of shareholders to a distribution of profits, will be discussed in more detail later.

2. Distribution of profit to shareholders (profit flows out of the company):

The second way that company profits can be used is to distribute them to the shareholders in the form of dividends and (less commonly) royalties. This represents an outflow of profits from the company.

• Dividends are the portion of a company’s profits which are distributed to shareholders. There are ordinary and special dividends. Ordinary dividends refer to regular dividend payments, which are typically a predetermined monetary amount or a fixed percentage of the company’s profits. Special dividends are irregular or one-time dividend distributions, which could be due to excess profit in a year, special incentives for shareholders, or general prosperity of the company.
• Royalties are another way to distribute earnings to shareholders. In Switzerland, the term can be used to refer to profit-sharing payments made to shareholders based on the revenue generated from their contributions to the business. As such, they are usually given as performance-related remuneration to members of the board of directors in addition to their regular compensation.

It is important to note that both dividend and royalty payments are subject to  double taxation: firstly, at the corporate level, whereby the company has to pay a profit tax; and secondly, at the personal level, whereby shareholders have to pay income tax on the dividends and/or royalties they receive. In addition, dividend distributions are subject to a 35% federal withholding tax (Verrechnungssteuer), which is refundable to Swiss-resident shareholders who properly declare the income on their tax returns.

3. Unallocated/undistributed profit (retained earnings or carrying losses)

Finally, a company may carry forward a portion of their profit or loss as undistributed profit. Retained earnings refer to accumulated profits from previous years that have not been specifically allocated to the company’s reserves nor distributed as dividends/royalties. These profits get carried over to the next financial year. Losses carried forward are typically offset against profits in the subsequent financial year. Under Art. 67 of the Federal Direct Tax Act (DBG), tax losses may be carried forward and offset against taxable profits for a maximum of seven years.

As the distribution of profits is a complex decision-making process, it is crucial for companies to draw up a comprehensive profit distribution plan. The profit distribution plan (which is also known as the profit appropriation calculation or profit appropriation plan) indicates how much profit is available for distribution and how it will be allocated. As such, it provides information on the following:

• The total earned profit available for distribution based on the balance sheet profit calculation after adding or subtracting profit or loss carried forward (i.e., retained earnings as per the balance sheet)
• The portion of profit that will be kept in the company as reserves (both statutory and voluntary),
• The portion of profit that will be distributed as dividends and/or royalties,
• The undistributed balance of the retained profit that will be carried into the next financial year (or in some cases, losses which are carried forward)

Once the profit distribution plan has been formulated by the management of the company, it is subject to approval by the general meeting. The decision on the formation of (voluntary) reserves and the distribution of dividends is finalised through a simple majority of votes at the general meeting on an annual basis.

The exact steps to creating a profit distribution plan and allocating profit are therefore as follows:

1. Calculate the amount of profit to be distributed, which is the current year’s earned profit with the addition of retained profits or losses from the previous year’s balance sheet.
2. Allocate the appropriate amount of profit to statutory reserves, taking account of the value of statutory reserves already in existence. This step always comes prior to any other decisions about profit distribution, as the amount of the allocation is set by law and not in the company’s own hands to decide.
3. Decide how to distribute the remaining profits at the general meeting. The possible uses are to allocate profit to voluntary reserves, distribute it to shareholders in the form of dividends, and/or keep a portion as undistributed retained earnings. The resolution needs to be passed by a simple majority vote.
4. Form the voluntary reserves decided upon at the general meeting.
5. Distribute dividends/royalties to shareholders.
6. Calculate and carry forward the remaining profit/loss as retained profit/loss.