How to practically apply the cost plus method in Switzerland?

Selected practical guidance from the Swiss Federal Court on the application of the cost plus method.

In brief

• Is there a preference in Swiss practice on the selection of a TP method?
• Should taxes be included as part of the cost base when using a cost-plus method?
• Is there any indicative guidance on suitable mark-ups when applying a cost-plus method in Switzerland? 

In the area of Transfer Pricing (“TP”), Switzerland is known to follow the Organization for Economic Co-operation and Development (“OECD”) Guidance and to have limited codified TP rules. Nonetheless, there are specific transfer pricing sections incorporated in the Swiss Federal Direct Tax Act (“FDTA”) as well as important decisions made by the Federal Tribunal or Court (“FC”) in this regard. This article aims to provide interesting insights on the application of TP methods in Switzerland based on one of the decisions of the FC.

Background and context

Company A, a mixed company fulfilling tasks of general interest, was active in the field of hydraulic energy production. All its shareholders agreed with Company A in a “partnership agreement” that the energy produced by Company A will be in favor of its shareholders who will in turn be responsible for meeting all of Company A's expenses and annually pay Company A a "dividend" calculated using a bespoke method.

After accepting the above-described methodology for several years, the Cantonal Tax Administration challenged the calculation of remuneration method of the Company A stating that the applied remuneration did not comply with the arm’s length principle and constituted a hidden dividend distribution. The case went through the Appeal Commission to the FC which addressed the arguments brought forward by Company A and by the Cantonal Tax Administration to finally agree with the taxable amounts submitted by Company A via the relevant tax returns, rejecting the claims of a hidden dividend distribution and the alternative way of computing the taxable income proposed by the Cantonal Tax Administration.

The following section includes some of the key takeaways extracted from the court decision on the topic of Transfer Pricing, which in principle are broadly applicable to any Swiss-based taxpayers considering the application of a cost-plus method.

Key points

When deciding between different TP methods, contrary to what many practitioners may believe, the Comparable Uncontrolled Price (“CUP”) method does not immediately have priority over the other TP methods, since Art. 58 of the FDTA does not provide any hierarchy between them.

The FC also confirmed that the cost-plus method remains fully applicable in Switzerland since this method is explicitly covered in art 58 of the FDTA.

When it comes to the profit margin to apply on the cost-plus method, it must be determined in accordance with the arm's length principle. As such, the automatic application of a margin of 5%, without an arm's length examination, should no longer apply.

Furthermore, when discussing the determination of the arm’s length profit margin, if no comparison is possible with a directly comparable transaction, the comparison must be made with a hypothetical arm's length margin, which must be determined on a case-by-case basis. Faced with the difficulty of establishing an arm's length margin, the (Swiss) doctrine proposes a classification of companies by distinguishing routine companies from strategy companies or entrepreneurs, to what is sometimes added the intermediate category of medium-sized or hybrid enterprises. Routine enterprises perform only simple functions and bear only minimal economic risks, in return for which they obtain small but stable incomes. Conversely, strategy companies or entrepreneurs take on risky functions, to which remuneration must correspond that takes this into account.

Also on the topic of the profit margin to apply on the cost-plus method, the (Swiss) doctrine refers to ranges of margins which are applied in practice as pragmatic solutions.Hülshorst/Mank mention a range of 5-10% or 5-15%, and 3%-10% for service companies. Baumhoff notes that a range of 5 to 10% on the cost is considered usual, emphasizing the importance of examining each specific case, namely the allocation of functions, risks, and means of production implemented.

In particular for the case under analysis, when it comes to the application of the cost-plus method, the judges determined the cost base as the cost of production (the operating expenses), but deducting the tax costs from the cost base (corporate taxes and capital duties). Further, in order to determine the arm's length margin, the FC applied the rate of 5% provided for by the circular letter of the Federal Tax Administration of September 17, 1997 concerning service companies.

In addition, the value of the services provided by Company A corresponded to the 5% margin and a corrective factor applied by the FC. Company A’s taxable arm's length profit was therefore obtained by adding the margin on the cost base and the corrective amount, after deducting the tax charges. The corrective amount was later removed by the FC given the lack of support and specific challenges raised by Company A.

On the topic of whether to include certain corporate taxes as part of the cost base when applying a cost-plus method, the FC also maintains that federal, cantonal and communal taxes should not be part of the cost base as these taxes remain deductible expenses by law, in accordance with art. 59 paragraph 1 let. a of FDTA.

Finally, on whether to include financial expenses as part of the cost base, according to Company A, financial expenses are not part of the current cost of production. However, the FC considered that it did not seem excessive to consider that financing by third parties as a necessary activity to deliver Company A’s activities. As such, the FC confirmed that the interest expenses could be well considered as integral part of the cost of production and hence, of the cost base.