The Administrative Court of Appeal has determined in a new decision that the depreciation of goodwill is to be considered for transfer pricing purposes. Companies should review their transfer pricing routines and the types of costs compensated according to existing intra-group agreements.
After two global groups had been merged, it was decided by the joint management that in countries where the two groups had entities conducting similar business, the two entities would be merged. In Sweden both of the groups had distribution companies and as these were merged, a substantial goodwill item was created. The goodwill was treated as an intangible fixed asset which the surviving company depreciated annually in its income statement. As the goodwill was considered to be so called group goodwill, the made depreciations were reversed in the income tax returns as a non-deductible costs.
The Swedish company had purchased products from its foreign group affiliates. The group applied the transactional net margin method as a pricing method for the products, applying a return on sales as the profit level indicator. When calculating the transfer prices, the group had not considered the incurred costs related to the depreciation of goodwill. As the company had reported negative operating income during a six year period, the Tax Agency initiated an audit to undertake further examinations of the reported result. The Tax Agency stated that the company’s reported purchase prices were deemed to be too high since the depreciation costs had not been considered when calculating the operating margin with regard to the company’s distribution function.
The company objected, based on the OECD’s Guidelines, that the cost adherent to the depreciations had not been taken into consideration for transfer pricing purposes as such costs were deemed to be acquisition expenses incurred on behalf of the merged company. Consequently, the incurred costs did not relate to the distribution operations nor could they be deemed to be operating expenses. The company argued that the costs should be characterized as extraordinary costs, which should not impact the pricing of the intra-group transactions. Furthermore, the company stated that an independent supplier would have not reduced its prices due to the fact that a distributor had been subject to a merger and that the made depreciations could impact the comparability with independent comparables.
Assessment of the Administrative Court of Appeal
In line with the OECD Guidelines, the Administrative Court of Appeal initially considered whether depreciation of goodwill could be deemed to have a direct, or indirect, connection with the tested transaction, i.e. the distribution function. The court stated that the company, as a result of the merger, had acquired the other company’s sales operations so that it would become a part of the company’s own operations. Consequently, the goodwill item arising in conjunction with the acquisition and the cost of such item (i.e. the depreciation) should, at least be considered to have an indirect connection with the company’s distribution function.
Secondly, the court considered whether the depreciation could be treated as an operating expense. In this context, the Administrative Court of Appeal found no reason to deviate from the usual meaning of this concept in commercial or economic terms, and stated that depreciation or impairment of intangible fixed assets should consequently be regarded as an operating expense.
As a result, the Administrative Court of Appeal found, similar to the Tax Agency’s view that the depreciation of goodwill should be considered for transfer pricing purposes and should be treated as an operating expense to be included in the calculation according to the transactional net margin method.
As tax authorities has increased the number of audits with a certain focus on transfer pricing, it has become more and more important for companies to review their transfer pricing routines. In other words, it is very important that intra-group agreements and the cost items covered by such agreements are carefully reviewed. There to, repetitive losses in a group company may also lead to further scrutiny by the tax authorities.
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