Hot Topics in Cost-based Transfer Pricing Models

At first glance, cost-based transfer pricing models (cost-plus pricing tested with the TNMM) appear simple: Transfer prices are determined based on a given cost base, taking into account a profit mark-up. The mark-up can either be benchmarked with the use of commonly known commercial databases or, by referring to the low value-added services concept provided for in the OECD Transfer Pricing Guidelines (in English) and also applied by Switzerland, set at 5%. In recent years, however, tax administrations and courts have tended to focus less on the profit mark-up and more on the cost base. During tax audit assessment the focus is rather on what costs can or must be taken into account (and thus passed on to the related party) and on which cost items a profit mark-up shall be applied at all. The following are some of the current issues that Deloitte Switzerland has observed in recent tax audits and court decisions in Switzerland and abroad.

Swiss Cost Level

Switzerland has one of the highest cost and wage levels in the world. When Swiss headquarters charge foreign group companies for services provided from Switzerland (typically based the TNMM method), foreign tax administrations are increasingly raising the question of whether this cost basis is at arm's length. In the opinion of foreign tax administrations, the costs would be lower if the foreign group company purchased the same services from a local independent third party and cost charges may not pass the so-called benefit test.

In Deloitte Switzerland's view, there may be good reasons for a group to provide certain services from Swiss headquarters or other Swiss based entities (e.g. data protection, high quality, access to systems and processes). To be prepared for questions from foreign tax administrations, the reasons for providing the services from Switzerland should be well documented.

Exclusion of Tax Expense

The federal and cantonal tax administrations in Switzerland have previously held the practice that the cost base must also take into account tax expenses. This practice was based on the fact that corporate income taxes – opposite to many other tax jurisdictions – are tax deductible in Switzerland. This practice, which is not in line with the OECD Transfer Pricing Guidelines, was repealed at the beginning of 2024 by the Swiss Federal Tax Administration (in English) and also some cantonal tax administrations, for example the Zurich Cantonal Tax Administration (in German). This change in practice means that Switzerland is now more in line with standard practices in most tax jurisdictions to which cost plus based charges may be made.

However, a recently published decision by the Federal Supreme Court (9C_37/2023, in German) on a purely domestic Swiss case, which is based on a special legal provision, has prompted the Swiss Federal Tax Administration to issue a statement (in English). In it, the SFTA once again confirms that tax expense may not be taken into account in international matters.

Determination of Costs

In the case of cost-based transfer pricing models, tax administrations are increasingly scrutinizing “how” cost bases are determined. In addition to the question of whether to use actual or budgeted costs, the question of the accounting standard is also coming up more often. From a Swiss perspective, international groups may have costs according to Swiss statutory accounting rules or according to a "true and fair view" standard such as IFRS or US GAAP. The accounting standard used is particularly relevant for share-based compensation schemes, as this is associated with different methods of measurement and recognition.

In Deloitte Switzerland's view, there is no single correct approach. However, it is crucial that if a benchmark study is used to defend the profit mark-up, the cost basis of the comparables matches the tested party’s actual cost basis.

Cost Base of Manufacturer

In a recent decision (I R 54/19, in German), the German Federal Fiscal Court dealt, among others, with the question as to what extent the material costs of a toll manufacturing company need to be considered in the cost basis and whether profit mark-up should be applied. Toll manufacturers are typically characterized as follows:

• only perform production activities, but no sales and marketing activities;
• do not own any IP and are provided with the material for the production; and
• do not bear any production risks (e.g., quality, capacity, inventory).

According to the court as well as the OECD Transfer Pricing Guidelines, a profit mark-up shall only be charged on costs incurred by the company if such provide for extra added value and should not be considered a pass-through expense (i.e. costs that need to be passed on without a profit mark-up to avoid cascading mark-up effects). The Court ruled that in the case at hand that it would be unusual between unrelated parties to sell material to a manufacturer who then resales the material at a higher price – without having added value or processed such material. The handling or conversion of material at the level of a toll manufacturer generally constitutes a service.

This court decision emphasizes that the question of the costs on which a mark-up can be charged also depends on the functional and risk profile of the tested party. With regard to the manufacturer, it is therefore crucial whether the manufacturer qualifies as a toll manufacturer (with limited functions and risks) or as a full manufacturer (with comprehensive functions and risks).
 

Deloitte’s View

According to Deloitte Switzerland, more attention needs to be paid to the cost base when dealing with cost-based transfer pricing models. Tax administrations and courts in Switzerland and abroad are increasingly reviewing which costs are included in the base and how these costs are determined. There are various pitfalls that can be avoided by a careful set-up, implementation and documentation of such models.