FACTS AND PROCEDURAL HISTORY

The appellant company (A. AG), a subsidiary of a corporation incorporated based on federal law (B. AG), is subject to limited tax liability in the Canton of Zurich on the basis of permanent establishments. [1] In 2013, A. AG entered into a credit facility agreement with its parent company with a maximum credit limit of CHF 1 billion. On the basis of this agreement, the two companies agreed on a fixed term loan (61 months) of CHF 500 million at an interest rate of 2.5% per annum. For the difference between the credit limit and the fixed loan, a current account was agreed at an interest rate of 3% per annum.

The Cantonal Tax Administration of Zurich ("TA ZH") took the view that the agreed interest rates were not at arm's length, in particular because the existing government guarantee of the parent company had not been taken into account when determining the disputed interest rates. The TA ZH subsequently claimed deemed dividends for the 2014 and 2015 tax periods. The deemed dividends were initially calculated on the basis of an interest rate of 1% per annum, which was determined at the discretion of TA ZH. A. AG's objection to this was partially upheld by the tax administration and the at arm's length interest rate was set at 1.08%. The TA ZH calculated the rate of 1.08% on the basis of the average interest rate for the refinancing of B. AG with bonds of 0.83% and added a margin of 0.25%. This approach was confirmed by the Tax Appeal Court of the Canton of Zurich in its decision of March 10, 2002.

The Administrative Court of the Canton of Zurich partially upheld the appeal against the ruling of the Tax Appeals Court and referred the case back to the lower court for recalculation and a new ruling in line with the considerations. In essence, the Administrative Court was of the opinion that the interest rates published annually by the SFTA should be adhered to and that these rates define the arm’s length range of applicable interest rates. A correction of a not at arm’s length interest rate was therefore only possible to the amount of the published minimum or maximum interest rates. The TA ZH appealed against this ruling to the Federal Supreme Court, which rejected the position of the Administrative Court and upheld the opinion of the TA ZH.

REASONING AND KEY STATEMENTS OF THE FEDERAL SUPREME COURT

On the merits of the case, the Federal Supreme Court addressed the objection raised by TA ZH that the interest rate circulars published by the SFTA are not applicable to state and cantonal income taxes and are only binding for the purposes of federal income tax and withholding tax. In this respect, the Federal Court recalled that the income tax rules are harmonised between the federal and cantonal levels, which means that the SFTA interest rates are also applicable to federal and cantonal income taxes.[2]

With regard to the nature of the SFTA circulars on permissible interest rates, the Federal Supreme Court first stated that they serve to simplify the application of the arm's length principle. The simplification lies in the fact that the published interest rates, as "safe harbour rules", justify the assumption that there is no deemed dividend if the taxpayer complies with these rules. [3] Conversely, or if the taxpayer deviates from the published rates, there is a rebuttable presumption of a deemed dividend. In this case, it is up to the taxpayer to prove that the interest payments are in fact at arms' length. In addition, the Federal Supreme Court stated that the interest rate circulars of the SFTA should only be deviated from if the applicable legal provisions are not convincingly specified. [4]

With regard to the case at hand, the Federal Supreme Court stated that the binding effect of the interest rate circulars only exists as long as the taxpayer itself adheres to the interest rates defined therein. If the taxpayer deviates from these rates, there is no reason why the tax authority should continue to be bound by the safe harbour rules and not be allowed to determine the actual arm's length interest rate. [5] In these cases, there is neither a violation of the protection of legitimate expectations nor of the principle of equal treatment, especially since the taxpayer itself has deviated from the SFTA interest rates. Finally, the deviation from these interest rates would also undermine the purpose of the safe harbour rules, i.e. administrative simplification, as the tax authorities would have to check in these cases whether the interest rate claimed was in line with the arm's length principle. [6] Against this background, the Federal Court did not see any violation of the law in the TA ZH's determination of what it considered to be the arm's length interest rate, which deviated from the FTA interest rates.

However, with regard to the actual determination of the arm's length interest rate by the TA ZH, the Federal Supreme Court found that the Administrative Court of the Canton of Zurich had not addressed the issue of the legitimacy of taking into account a "margin" of 0.25% based on the interest rate circulars of the SFTA. In this respect, the Federal Supreme Court referred the matter back to the lower court for reconsideration.

THOUGHTS ON THE REASONING OF THE FEDERAL COURT AND ITS IMPLICATIONS

The above-mentioned decision of the Federal Court raises several questions, both in terms of its reasoning and its possible consequences for practice, which will be addressed in the following.

To the extent that the Federal Court has denied a violation of the principle of equal treatment, one can agree with the court as long as it will be ensured that the tax authorities consistently apply the arm's length interest rate in all cases where a taxpayer deviates from the SFTA interest rates. In other words, the tax authorities should not be able to rely on the SFTA rates on a case-by-case basis as this would lead to unequal treatment of taxpayers who deviate from the SFTA rates. Similarly, the individual application of the effectively higher administrative costs by the tax authorities when assessing the participation exemption would also violate the principle of equal treatment – to the extent that this was actually intended by the legislator .[7] – gegen den Grundsatz der Gleichbehandlung.[8]

The Federal Court's argument that the purpose of the interest rate circulars in terms of administrative simplification can no longer be achieved if the taxpayer deviates from the maximum permissible interest rates is not entirely convincing, if at all. According to the case law of the Federal Supreme Court, the tax authorities can no longer limit themselves (while maintaining the principle of equal treatment) to examining the transfer pricing studies submitted as evidence of the arm's length principle, but must now - if they are of the opinion that the arm's length principle has not been verified - determine the effective market interest rate. It is true that the taxpayers' (attempted) proof of arm's length interest rates, as opposed to the SFTA interest rates, involves additional work for the tax authorities. However, this in itself only partially limits the purpose of administrative simplification. This purpose is only completely thwarted by the TA ZH's position, now confirmed by the Federal Court, that it is the tax authority's task to determine the specific market interest rate to be applied (and not merely a range of arm’s length interest rates). If it is indeed (only) a matter of administrative simplification, there is no obvious reason why the SFTA interest rates could no longer be used as a basis (for simplification reasons) if the arm's length interest rate cannot be proven. Instead, the tax authorities will have to determine the arm's length rate in accordance with best practice.

With regard to the requirements for the tax authorities to provide evidence of what they consider to be the arm's length interest rate, it seems reasonable to apply the same requirements for the evidence of the arm's length principle or the transfer pricing study as those defined in the SFTA applicable to taxpayers. The transfer pricing study to be carried out by the tax administration would therefore have to include the following elements, whereby the taxpayer's duty of cooperation could be invoked for the first two points[9]:

• A detailed description of the main features of the relevant transaction that could affect the interest rate.
• An analysis of the borrower's credit rating.
• A search for comparable transactions, which is created taking into account the most important comparability factors.

In terms of applicable transfer pricing methods, the Comparable Uncontrolled Price Method (CUP Method) is the primary transfer pricing method to be used for interest rates. In addition, the cost of funds method is also recognised in Swiss practice and appears to have been used by TA ZH in the present case. According to this method, the interest rate is determined on the basis of the lender's cost of funds plus a risk premium and a profit margin. The determination of the margin requires a case-by-case assessment, taking into account the borrower's credit rating. Against this background, the Federal Court's decision to refer the case back to the Administrative Court with regard to the 0.25% interest margin applied by TA ZH, which in turn is based on the SFTA's interest rate circular, is only consistent in the light of the other considerations.

Lastly, the statement by the Federal Court that it is the task of the tax authority to determine a specific interest rate to be applied and not (merely) a range of interest rates also raises questions. This statement cannot be reconciled with state-of-the-art transfer pricing methodology. The Federal Court fails to recognise that, in principle, only a range can be determined for the market interest rate or that it is unlikely that there is only one market interest rate for a specific transaction. [10] The principle applies that a correction to the actual terms agreed between related parties is only permitted at the upper or lower end of the identified arm’s length range. This principle has now been unnecessarily called into question by the Federal Supreme Court, at least as far as interest rates are concerned. It is also questionable to what extent the interest rates published by the SFTA correspond to the arm's length principle, if they cannot be used as a basis for determining deemed dividends. In this context, it should be noted that some tax administrations have taken the view that the range of arm's length interest rates is relatively narrow, meaning that a deviation of more than 25% from the SFTA interest rates is per se inconsistent with the arm's length principle and that the taxpayer is (effectively) denied the opportunity to provide rebuttal evidence. [11] This position can no longer be maintained if the case law of the Federal Court is consistently applied.

CONCLUSION

With regard to the specific facts of the present case, it can be said that the deviation of the TA ZH from the SFTA interest rates can be regarded as appropriate in individual cases. However, the reasoning chosen by the Federal Supreme Court to justify the deviation from the SFTA interest rates is not convincing and leads to unnecessary uncertainties. It would have been more appropriate to emphasise the special nature of the individual case at hand and thus follow a factual line of reasoning. In this respect, the Federal Supreme Court could have referred to the general rule that the interest rate circulars of the SFTA can (only) be deviated from if they do not convincingly specify the applicable legal provisions, which could certainly have been argued in the present case.

It would now be desirable for the SFTA to take the present decision of the Federal Court as an occasion to amend its interest rate circular and, in particular, to define more precisely the scope of application of the safe harbour rules. [12] This would increase legal certainty for taxpayers, and the expected additional workload for the tax authorities could be mitigated. In this context, it should be noted that the credit rating of the borrower and the specific structure of the financing are of considerable importance in determining an arm's length interest rate on a case-by-case basis. For example, the impact of collateral, maturity and prepayment rights (or lack thereof), as well as whether and how implicit group support or a group rating should be taken into account, must be assessed.

Since deviation from the SFTA's interest rate circulars has always led to a de facto obligation to provide evidence of the arm’s length of the interest rates used, it is still recommended - also in light of the discussed decision - that groups prepare a robust transfer pricing analysis and documentation.

Zurich, August 23, 2024

[1]    For a more detailed description of the facts, see the ruling of the Administrative Court of the Canton of Zurich SB.2021.00056 of May 25,2022..
[2]    Judgment FSC 9C_690/2022 of July 17, 2024, E. 6.1.
[3]    Judgment FSC 9C_690/2022 of July 17, 2024, E. 4.1.
[4]    Judgment FSC 9C_690/2022 of July 17, 2024, E. 4.2.
[5]    Judgment FSC 9C_690/2022 of July 17, 2024, E. 6.2.
[6]    Judgment FSC 9C_690/2022 of July 17, 2024 E. 6.2. in fine
[7]    Cf. GRETER, Der Beteiligungsabzug im harmonisierten Gewinnsteuerrecht, Diss., Zurich 2000, p. 142.
[8]    Cf. Attenhofer, in: Klöti-Weber/Schudel/Schwarb, Kommentar zum Aargauer Steuergesetz, 5th edition, Bern 2023, para 35 to § 27b; Vitali, ibid., para. 86 to § 76,
[9]    See https://www.estv.admin.ch/estv/de/home/internationales-steuerrecht/verrechnungspreise.html, question 23.
[10]   See https://www.estv.admin.ch/estv/de/home/internationales-steuerrecht/verrechnungspreise.html, question 32.
[11]    See Harbeke/Hug/Scherrer, Verrechnungspreisrecht der Schweiz, Grundlagen und Praxis, Zürich, 2022, para. 1188.
[12]    See also the criticism of the SFTA interest circulars in Harbeke/Hug/Scherrer, a.a.O., para. 1226.

BACKGROUND

In the present dispute, the complainant acted as an asset manager. She received two types of compensation for her activities under an asset management agreement: On the one hand, she was paid the brokerage fees paid by the asset management clients plus brokerage fees from the bank; on the other hand, she received a monthly management fee. Under the brokerage agreements with two different banks, the complainant received remuneration or external asset management fees resulting from the activities recorded in the clients' accounts.

The question is how to qualify these fees for VAT purposes. Even if terms are listed and defined in black and white according to administrative practice, these terms (in this case charges) would have to be analysed precisely and placed in the correct context, otherwise the results would be completely different.

DECISION OF THE FEDERAL ADMINISTRATIVE COURT 
A-5793/2022

In the present case, it is undisputed that the complainant acts as an asset manager and that the monthly management fee is subject to VAT at the standard rate. However, it is disputed whether the brokerage fees and external asset management fees are remuneration for a tax-exempt brokerage service or a taxable asset management service.

In case law and administrative practice, the view is held that the underlying transaction brokered is decisive for the categorisation of an intermediary activity. If the underlying transaction originates from the area exempt from tax, the remuneration for the brokerage is exempt from tax.

As an asset manager, the appellant offers both investment advice and execution for its clients and also receives separate and contractually agreed remuneration for these services. In the opinion of the complainant (based on point 6.1.6 of MBI 14 and on the previous case law of the Federal Supreme Court), brokerage fees (called: Courtagen) for execution are deemed to be exempt fees for trading in securities. Alternatively, the asset management service should be regarded as an exempt ancillary service to the brokerage service, as the European Court of Justice (ECJ) has already ruled in a similar case (C-453/05, 21 June 2007).

The complainant is of the opinion that it provides brokerage services in accordance with administrative practice. Non-application of this administrative practice would violate the constitutionally guaranteed protection of legitimate expectations.

Brokerage is clearly defined in section 5.10.1 of MBI 14 and refers to the activity of an intermediary acting in this capacity, which consists of working towards the conclusion of a contract in the area of money and capital transactions between two parties without being a party to the brokered contract and without having a vested interest in the content of the contract. Brokerage must be carried out as an independent intermediary activity. 

The FTA, on the other hand, considered the appellant's performance to be taxable asset management based on section 5.10.3 of MBI 14 and further believes that the financial contributions (retrocessions) represent a self-interest due to the obligation to deliver, which in turn would be contrary to exempt brokerage. 

The Federal Supreme Court is of the opinion that the complainant's execution service is to be regarded as ancillary to the main service of investment advice or asset management, as this service would not make sense on its own. It merely serves as an instrument for utilising the complainant's main service under optimal conditions. This type of service has no independent purpose for clients. If there were no asset management mandates, no client would utilise the execution services alone, but would commission a bank to do so.

Although the appellant is convinced that brokerage fees cannot be listed separately as an ancillary service in administrative practice, the Federal Supreme Court finds that the same service may have to be assessed differently depending on the context. In this case, the execution service (ancillary service) only fulfils a purpose in the context of an asset management mandate (main service).

With regard to the protection of legitimate expectations, the Federal Supreme Court points out that Chapter 6.1 of MBI 14 cited by the complainant under the heading "General banking services" refers specifically to services offered by banks. Therefore, the protection of legitimate expectations cannot be invoked in this context.

CONCLUSION

This judgement illustrates the relevance of a precise determination of the underlying service in the context of an intermediary activity. In this regard, it should be noted that even the explanations and terminology used in administrative practice are only valid in their respective context.