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updated 6/8/2010 4:50:16 PM ET 2010-06-08T20:50:16

Switzerland's effort to end a tax-evasion dispute with Washington hit a major setback Tuesday when lawmakers blocked a treaty that would have seen the largest Swiss bank give U.S. authorities files on thousands of American clients.

The Swiss government and Washington had painstakingly crafted the treaty last August to resolve a long-standing dispute over UBS AG's alleged role in aiding tax evasion, but 104 nationalist and left-wing lawmakers in Switzerland's lower house, the National Council, voted against the deal, compared to 76 in favor, after their demanded amendments were refused. Sixteen lawmakers abstained.

The government and industry groups had urged lawmakers to sign off on the treaty to avert harm to the Swiss economy, which is heavily dependent on the country's banking industry.

"With today's negative decision the National Council has unfortunately done a disservice to Switzerland's standing as an economic and financial center," said the Swiss Bankers Association, which has pushed for the UBS case to be concluded so the industry can move forward.

The association called on lawmakers to change their minds and approve the treaty, claiming that failure to do so "would strain even further the important bilateral relations between Switzerland and the United States."

U.S. Justice Department spokesman Charles S. Miller declined to comment on the matter. Sen. Carl Levin, a Democrat who has led a congressional investigation of UBS and other banks, criticized the move and called for the U.S. to go ahead in its case against UBS.

"Rejection of the treaty is an international embarrassment that can be laid at the feet of Swiss legislators who are willing to continue to allow their banks to facilitate U.S. tax evasion," he said.

The deal is crucial to UBS, which has faced intense pressure from U.S. authorities since 2007, because it allows the bank to bend Switzerland's strict banking secrecy rules as an exception without committing others to do so.

Last year UBS agreed to turn over hundreds of client files and pay a $780 million penalty in return for a deferred prosecution agreement, after admitting that it had for years helped U.S. clients hide money from the International Revenue Service using offshore accounts.

Washington has signaled that unless UBS reveals a further 4,450 American names by August as demanded in the U.S.-Swiss agreement, it may face a crippling civil investigation just as the bank is recovering from the subprime crisis and seeking to rebuild its U.S. business.

Shares in UBS AG fell 2.2 percent to close at 14.40 Swiss francs ($12.52).

The U.S. deal was blocked by lawmakers from Switzerland's two biggest parties, the People's Party and the Social Democrats, and the Greens.

The Social Democrats had tied their consent to stricter regulation for big banks and a binding government commitment to tax bankers' bonuses. The People's Party wanted parliament to vote against such a tax before dealing with the U.S. tax treaty. Both parties' demands were rejected by the government.

The bill will now be passed back to the upper house for further debate and could be voted on again by the lower house later this month.

But lawmakers also decided Tuesday to put any eventual compromise to a popular referendum, making a further delay likely.

A spokesman for UBS would not say what the bank would do if a second vote goes against it as well.

"We wait for the vote, let parliament decide, and then we will see further," said Serge Steiner.

Hans Geiger, an emeritus professor of banking at Zurich University, said UBS would likely have a backup plan.

"They will not just sit on their hands and wait till the good guys from Bern help them," Geiger said.

One possibility would be for UBS to simply refuse to hand over the names of suspected tax cheats to the IRS, and risk prosecution, he said.

Geiger, a critic of the government's decision to negotiate the treaty with Washington, also warned that the one-off exception to Swiss banking secrecy foreseen in the treaty could become the norm.

"If parliament agrees then it's a sign that you can blackmail Switzerland and other countries will try the same," he said.

Switzerland has made many compromises in recent years to fend off demands by Germany, France, the United States and others for an end to its treasured banking secrecy rules, but the treaty that failed Tuesday would have gone far beyond those measures.

Last year, the government agreed to do away with the difference between tax evasion and tax fraud — a key legal distinction that has allowed foreigners with accounts in Switzerland to avoid having their details handed over to investigators back home.

Copyright 2010 The Associated Press. All rights reserved. This material may not be published, broadcast, rewritten or redistributed.

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