Court Ruled Transfer Prices Must Be Arm’s Length Year-by-Year

In its decision of 5 December 2024 (A 2023 1, in German), the Zug Administrative Court addressed whether an average operating margin over three years, which corresponds to almost the lowest quartile of the arm’s length margin range, is acceptable for tax purposes. The court rejected this based on the principle of periodicity and ruled that transfer prices must be “at arm’s length” in each tax year.

The group company initially licensed IP rights to its subsidiaries. These IP rights were subsequently transferred within the group and the business activities in 2018 were limited to routine sales activities. For the tax year 2018, the company set the commercial operating margin at -21.8% (negative operating margin) to achieve an overall average operational margin of 1.2% over a three-year period (2016-2018). The arm's length margin range in the respective business area was between 1.1% and 7.3% (interquartile range over several years) per year. The tax administration did not accept the negative operating margin in the 2018 tax assessment and adjusted it to 1.2%. As the company appealed against this assessment, the Zug Tax Administration involved a transfer pricing specialist from the Swiss Federal Tax Administration (“SFTA”). Based on the specialist's technical analysis, the operating margin was set at 1.1%, the lowest quartile of the third-party comparison. The taxpayer has appealed to the Administrative Court.

Court decision

The Administrative Court reaffirmed that Swiss tax law - with the exception of certain provisions - does not follow a group perspective but treats each company as a legally independent entity. Legal transactions between group companies must therefore be carried out at arm’s length. The determination of appropriate transfer prices between group companies is based on the premise that remuneration depends on the functions, risks and assets of the parties involved in a service relationship. Routine companies should generally make a small but stable profit. Losses are only conceivable in limited start-up phases or crises.

In the case at hand, it was clear that the margin of -21.8 % in 2018 was not at arm’s length. The Court referred to the principle of periodicity stipulated in art. 58 Direct Federal Tax Act (German/French) and pointed out that there was no legal basis for a retrospective "smoothing" of the margins to an average of 1.2% over the three years from 2016 to 2018. Thus, a company is not free to artificially adjust its results downwards in a retrospective multi-year analysis. To allow this would be contrary to the basic principle of transfer pricing law, which is to ensure that each business unit is taxed according to the economic value it contributes to the value chain.

Since the taxpayer did not present any extraordinary circumstances that could explain its significantly negative result and justify it as arm's length, the operating margin must be adjusted to ensure that the taxpayer achieves a minimum arm's length target operating margin. By setting the margin only at the lowest quartile that still meets the arm's length standard, the taxpayer's economic freedom is taken into account.

Deloitte’s View

This decision clarifies that a multi-year average margin, which is still in the arm's length margin range, is - in general - not accepted for tax purposes. Rather, the principle of periodicity requires an annual assessment. We therefore recommend reviewing/calculating the respective margins on an annual basis as an “excessively” high margin in one year cannot be offset against an “excessively” low margin in another year. This cantonal court’s decision is in line with the SFTA’s practice.

It also shows that Cantonal Tax Administrations are increasingly using transfer pricing specialists for their assessments, either own transfer pricing specialists or such from the SFTA’s transfer pricing team.

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