On May 30th, 2008 the Tax Court of Canada (herein referred to as "Tax Court") ruled on one of Canada's most significant transfer pricing decisions, the case of GlaxoSmithKline Inc. (herein referred to as "GSK"). When examined from all avenues, the case yields important conclusions that both practitioners and multinational corporations alike should note when dealing with contentious transfer pricing issues.1
The purpose of this article is to not only examine the Tax Court's choice of methodology in coming to its decision, but also to consider the benefits of pursuing alternatives to litigation, such as Competent Authority.
The case involved the reassessment of GSK's income tax returns for 1990 to 1993. GSK is a Canadian company and the distributor in Canada of Adechsa S.A. (herein referred to as "Adechsa"). The dispute focused on the price that GSK paid to Adechsa, a related Swiss company, for Ranitidine, an active ingredient found in Zantac. The Minister of National Revenue (herein referred to as "MNR") believed that GSK had paid an excessive amount ($1,600 per kilogram) for this active ingredient. MNR originally increased the income of GSK for the years in question by approximately $51 million.
MNR based its argument on the price that generic drug companies were paying third party manufactures for the same material, which ranged from $200 to $300 per kilogram. The Tax Court agreed, holding that the price paid to Adechsa was not reasonable. Rather, it determined that the "reasonable" price for Ranitidine was the highest price paid by the generic drug companies with a $25 adjustment to account for the fact that GSK was buying granulated Ranitidine, while the generic drug companies were not.
Two key areas that merit further exploration include:
- The Tax Court's decision to use a Comparable Uncontrolled Price (herein referred to as "CUP");
- The meaning of "reasonable in the circumstances" in subsection 69(2) of the Income Tax Act (Canada) (herein referred to as the "Act").
Decision to Use the CUP methodology
MNR took the position that the generic companies' purchases of Ranitidine from arm's length manufacturers (i.e. Apotex and Novopharm's purchases of the ingredient from unrelated manufacturers) were comparable transactions to GSK's purchase of the same ingredient from Adechsa. MNR's position also included a cost plus analysis to support the CUP analysis.
GSK's position was that the generics were not an appropriate comparator for two reasons, namely:
- GSK's actual business circumstances were wholly different from those of Apotex and Novopharm, such that the transactions were not comparable within the meaning of subsection 69(2) of the Act and the CUP method;
- The Ranitidine that GSK purchased from Adechsa was manufactured under Glaxo World's standards of good manufacturing practices, granulated to Glaxo World standards, and produced in accordance with Glaxo World's health, safety, and environmental standards ("HSE").
GSK submitted that independent third party licensees in Europe, which purchased the same Ranitidine under the same set of business circumstances as GSK, were the best comparators. It also relied on the resale price method to confirm its CUP analysis.
The major difference between the parties was whether the total cost of Ranitidine to GSK (including royalties for intangibles) should be considered, or only GSK's purchases of Ranitidine from Adechsa. GSK had separate inter-company licence and supply agreements with respect to Zantac. Under the licence agreements, GSK paid a 6% royalty to a related party in the United Kingdom for the rights to certain intangibles and services. These intangibles included trademarks as well as marketing support, technical assistance, and registration materials. Access to such intangibles and services were required to assist GSK in selling its drug in the Canadian market at a "premium".
GSK argued that both the supply agreement with Adechsa and the licence agreement with Glaxo Group should therefore be considered, and a failure to do so would not reflect the economic realities of GSK. Conversely, MNR argued that the two agreements were to be looked at separately, and that the only transactions relevant to the case were those with Adechsa.
The conclusion of the Tax Court was that the CUP method was the preferred method, and the transactions involving generic companies were held to be appropriate comparator CUPs. With regard to the evidence, the Tax Court was unimpressed by GSK's resale price analysis because it included insufficient data to accurately measure the profitability of the European licensees.
Meaning of "reasonable in the circumstances" in subsection 69(2) of the Act
The legislation relied upon by MNR is an aspect of the case that merits further discussion. The relevant provision applicable to the years under review was subsection 69(2) of the Act. Nevertheless, it seems as though the Tax Court relied almost exclusively on the new, more current legislation found in section 247 of the Act. While the section 69 standard requires that taxpayers show a reasonable effort when determining inter-company transactions, section 247 requires price setting to meet the "arm's length standard." The Tax Court's apparent reliance on the more current provision unfairly shifted the burden of proof to GSK.
The conclusion that follows must be qualified by the fact that we were not privy to all the facts in the GSK case or the discussions that lead to the decision to litigate the file. Nevertheless, the following discussion reviews the potential benefits that GSK may have been able to achieve through the Competent Authority process relative to seeking resolution from the Tax Court. This case illustrates that going to Court is, generally speaking a higher risk proposition than trying to settle through a Competent Authority procedure. Nevertheless, GSK likely had sound, strategic reasons for believing that seeking resolution through the courts was more appropriate. For example, it may be that the Swiss Tax Authority was not amenable to a Competent Authority application because Switzerland is a low tax jurisdiction, which provides little incentive to resolve double taxation disputes.
The Tax Court's apparent endorsement of the OECD guidelines, and the hierarchy of methods, should have resulted in all methods, in addition to the CUP, being considered. While the Tax Court discussed the applicability of some alternatives, including resale minus and cost plus, it appears that other methods were ignored, such as the transactional net margin method ("TNMM"). Despite being considered the method of last resort, its simplicity in application, and widespread use, leads to the conclusion that TNMM is always worth exploring.
While both sides presented a CUP analysis as their primary methodology in arriving at an appropriate price that GSK should have paid for the ingredient Ranitidine, experience shows that such a methodology can rarely be relied upon to settle a contentious file. Practically speaking, a CUP is an almost impossible standard to meet and the adjustments needed to make a CUP reliable are generally not possible. Even if adjustments could be made in theory, it is often difficult to reach consensus with other tax authorities as to the nature and number of adjustments to be made to a potential CUP. With respect to the GSK case discussed above, the Tax Court's decision to separate both the supply agreement with Adechsa and the licence agreement with Glaxo Group illustrates the inherent difficulties and subjectivity involved when applying a CUP method. This decision is likely to generate much debate.
In this case, the Tax Court of Canada concluded a CUP existed with minor adjustments. However, this may result in double taxation as the Swiss Tax Authority has no obligation to give relief through Competent Authority (because it was a court's decision) and the Canadian Competent Authority is precluded from making changes to a Canadian court decision.
Aside from the many reasons that a CUP is difficult to use, this case also illustrates why, in most cases, particularly where material amounts are involved, it is generally advisable to bring the case to Competent Authority prior to proceeding to court. Neither a taxpayer nor the courts are bound by a decision made in Competent Authority. Accordingly, if the taxpayer is satisfied with the Competent Authority's resolution, the taxpayer can stop there. If not, the option of proceeding to court remains available.
Even in cases where the only correct answer for the company is a complete reversal of the adjustment, it is generally advisable to proceed to Competent Authority prior to court as the same arguments that would be raised in court can be raised in negotiations. Given the high level of transfer pricing expertise at the Canadian Competent Authority, as well as the Inland Revenue, IRS, NTA, Swiss Competent Authority and other tax authorities, and the fact that generally tax authorities take a pragmatic approach to resolving cases, cases are almost always resolved without double taxation.
The Competent Authority process is often collegial, with an emphasis placed on reaching a settlement that is beneficial to all parties involved. The resolution of files, while fact based, often results in less contentious methodologies being employed in resolving issues of double taxation, such as the TNMM methodology. While this is considered the method of last resort, such methods are readily employed. The GSK case illustrates that going to Court can be a high risk, all-or-nothing proposal. In this case, the Tax Court chose a CUP method which is at the top of the hierarchy of methods (proposed by the OECD), and favoured the one proposed by the MNR. Had the Competent Authority process been available and pursued, it would have endeavoured to bridge the gap and find a solution acceptable to both parties, which would have eliminated the double taxation.
The Competent Authority negotiators would also have had to consider the issue of the royalty to a far greater extent than the Court did. The royalty would likely have played a much larger role in Competent Authority negotiations as it was an integral fact that was summarily dismissed by the Court because of the way it was presented. While the royalty was properly excluded from the pricing of Ranitidine, it is very likely that it should have been considered in the overall profits of GSK.
This case illustrates some of the complexities involved in determining how to proceed with a transfer pricing assessment. A full understanding of the Competent Authority process and the implications of alterative avenues is required to determine the appropriate course of action.