In a unanimous decision, released on October 18, 2012, the Supreme Court of Canada upheld the judgment of the Federal Court of Appeal in Canada v. GlaxoSmithKline Inc. As the first transfer pricing case decided by the Supreme Court, this case provides needed guidance, in particular, with respect to the meaning of, and the proper approach to the determination of, an arm’s length price, and the role of the Organisation for Economic Co-operation and Development (OECD) Transfer Pricing Guidelines (the Guidelines) in Canada. The taxpayer was represented on appeal by Osler’s Al Meghji, Joseph Steiner, Amanda Heale and Pooja Samtani.
Transfer pricing issues arise in the context of non-arm’s length transactions involving entities resident in different jurisdictions, where ordinary market forces may not regulate terms and conditions of the transactions. From a policy perspective, the concern is that prices may be set so as to divert profits from higher tax jurisdictions. The objective of transfer pricing legislation is to align, as closely as possible, the prices of non-arm’s length contracts with the prices which would have emerged from arm’s length negotiations.
The taxpayer’s success in Canada v. GlaxoSmithKline Inc. means that, in determining appropriate arm’s length prices, courts will be required to consider the totality of the economic and business realities out of which non-arm’s length transactions arise, to the extent those realities would have prevailed if the parties to such transactions had been dealing at arm’s length.
In the relevant years, the taxpayer (Glaxo Canada), was a member of a multinational group of companies which discovered, developed, manufactured and marketed branded pharmaceutical products, one of which was the anti-ulcer drug named Zantac. Glaxo Canada acted as a secondary manufacturer and marketer of Zantac and other drugs. Pursuant to a Licence Agreement existing at the relevant time between Glaxo Canada and its parent (Glaxo Group), Glaxo Canada was granted rights to sell pharmaceuticals under the Zantac trademark and the patent for its active ingredient, ranitidine, both of which were owned by Glaxo Group. One of the conditions of the Licence Agreement was that Glaxo Canada purchase ranitidine for sale as Zantac from a source approved by Glaxo Group. Accordingly, Glaxo Canada entered into a Supply Agreement with another Glaxo Group affiliate (Adechsa), an approved source, for the supply of ranitidine. The combined effect of the License and Supply Agreements enabled Glaxo Canada to purchase the ranitidine, put it in a delivery mechanism such as a tablet, liquid or gel, and market it under the trademark Zantac.
The Minister reassessed Glaxo Canada on the basis that the price paid by Glaxo Canada for the ranitidine was not an arm’s length price because it was significantly higher than the price paid by two Canadian generic pharmaceutical companies for a chemically identical product acquired by them during the same period of time from arm’s length parties. The Minister took the position that paying more than the generic companies had paid would not have been “reasonable in the circumstances” if Glaxo Canada had been dealing at arm’s length with Adechsa, within the meaning of subsection 69(2) of the Income Tax Act, Canada’s transfer pricing provision during the years at issue.1 Those generic companies sold ranitidine products under their own trademarks at a discount to Zantac.
The taxpayer objected to the reassessment, arguing that the transactions entered into by the two generic pharmaceutical companies could not serve as arm’s length proxies for its transactions because their relevant circumstances were entirely different from those of Glaxo Canada. In particular, Glaxo Canada argued that the rights and benefits conferred on it by the Licence Agreement, and the requirement in the Licence Agreement that it purchase ranitidine from an approved source, were circumstances that an arm’s length purchaser would have considered relevant when deciding what price to pay Adechsa for the ranitidine.
On appeal to the Tax Court of Canada, the reassessment was upheld with a minor revision. The Tax Court concluded that the Licence and Supply Agreements had to be considered independently and that the former could not impact the determination of the appropriate arm’s length price under the latter. The Tax Court relied on the OECD Guidelines to apply the comparable uncontrolled price method, based on which it determined that the reasonable price to pay for the ranitidine was the highest price paid by the two generic companies.
On Glaxo Canada’s further appeal, the Federal Court of Appeal found that the Tax Court had erred in not considering the Licence Agreement when determining whether the price paid by Glaxo Canada for the ranitidine was reasonable, and remitted the matter back to the Tax Court for redetermination. The Court of Appeal concluded that the Licence Agreement was central to Glaxo Canada’s business reality and was a “circumstance” that had to be taken into account when evaluating the reasonableness of the price.
Supreme Court Decision
The Crown appealed the Court of Appeal decision to the Supreme Court of Canada, arguing that the Licence Agreement must not be considered in determining an arm’s length price for Glaxo Canada’s purchases of ranitidine. Glaxo Canada cross-appealed, arguing that the appellate court should not have remitted the matter to the Tax Court for redetermination.
The Supreme Court dismissed both the appeal and the cross-appeal. Justice Rothstein, writing for a unanimous seven-member panel, held that the Licence and Supply Agreements must be considered together in order to obtain “a realistic picture of the profits of Glaxo Canada.” The Court remitted the case back to the Tax Court to redetermine the arm’s length price, “having regard to the effect of the Licence Agreement on the prices paid by Glaxo Canada for the supply of ranitidine from Adechsa.”
Court Rejects the “Transaction-by-Transaction” Approach
In dismissing the appeal, Justice Rothstein rejected the Crown’s arguments that subsection 69(2) and the OECD Guidelines mandate a “transaction-by-transaction” approach, in which the supply of ranitidine by Adechsa must be considered separately from the rights and benefits conferred on Glaxo Canada by the Licence Agreement with Glaxo Group. Rather, Justice Rothstein held that a transfer pricing analysis necessitates a comparison of the “economically relevant characteristics” of the non-arm’s length transaction to those of arm’s length transactions to which it is compared. Those characteristics, said Justice Rothstein, may include “other transactions that impact the transfer price under consideration.”
Justice Rothstein stated that subsection 69(2), which requires the determination of the amount that would have been reasonable in the circumstances, necessarily involves “consideration of all circumstances of the Canadian taxpayer relevant to the price paid to the non-resident supplier”, including “agreements that may confer rights and benefits in addition to the purchase of property where those agreements are linked to the purchasing agreement”. A reasonable arm’s length price is then to be determined based on “what an arm’s length purchaser would pay for the property and the rights and benefits together.”
In the instant case, Justice Rothstein agreed with Glaxo Canada that the Licence Agreement was linked to the Supply Agreement because the rights and benefits of the former were contingent on Glaxo Canada entering into the latter, and, further, that the requirement that ranitidine be purchased from Adechsa under the Supply Agreement “was not the product of the non-arm’s length relationship between Glaxo Canada and Glaxo Group or Adechsa.” Rather, it arose because Glaxo Group controlled the trademark and patent of the brand-name pharmaceutical product Glaxo Canada wished to market. Those rights and benefits, according to Justice Rothstein, were not limited to the use of the Zantac trademark and the ranitidine patent, but also included such things as “guaranteed access to new products, the right to the supply of raw materials and materials in bulk, marketing support, and technical assistance.” Justice Rothstein found that those rights and benefits, along with the fact that ranitidine purchased from a Glaxo Group-approved source would be manufactured under Glaxo Group’s “good manufacturing practices,” added value to the ranitidine purchased by Glaxo Canada from Adechsa.
Back to the Tax Court
Justice Rothstein declined, however, to accept Glaxo Canada’s argument that the Court of Appeal, having rejected the Crown’s theory that it was not reasonable for Glaxo Canada to have paid more for ranitidine than its generic competitors, should simply have allowed the taxpayer’s appeal rather than sending the matter back to the Tax Court. Instead, the Supreme Court, like the Court of Appeal, remitted the case to the Tax Court to be redetermined, having regard to the effect of the Licence Agreement on the prices paid by Glaxo Canada for the supply of ranitidine.
Implications of the Decision
Although Justice Rothstein’s reasons for judgment are terse by Supreme Court standards, they nonetheless offer some important guidance for the Tax Court in making its determination – as well as for courts deciding future transfer pricing cases and for multinational corporate groups in developing their transfer pricing.
First, with regard to the role of the OECD Guidelines, which have been relied on extensively by litigants and lower courts in transfer pricing cases, Justice Rothstein offered the comment that the Guidelines, while they “contain commentary and methodology pertaining to the issue of transfer pricing,” “are not controlling as if they were a Canadian statute.” Any set of transactions or prices must be assessed, said Justice Rothstein, based on subsection 69(2) of the Income Tax Act rather than any particular methodology or commentary set out in the Guidelines.
Second, Justice Rothstein commented on the “reasonableness” standard enunciated by subsection 69(2). That provision, he held, allows “some leeway,” and requires only that a transfer price fall within what the court determines is a “reasonable range.” He also specifically countenanced the use of statistical measures, finding that courts may rely on averages, medians or modes to determine a reasonable arm’s length price. Both of these concepts have been strenuously rejected by the Canada Revenue Agency. Further, since it is “highly unlikely that any comparisons will yield identical circumstances,” Justice Rothstein said that courts must exercise their “best informed judgment” in determining a satisfactory arm’s length price.
Third, Justice Rothstein contrasted the relatively minor functions performed and risks borne by Glaxo Canada with those performed and borne by Glaxo Group and stated: “Transfer pricing should not result in a misallocation of earnings that fails to take account of these different functions and the resources and risks inherent in each.” This, clearly, is a direction to Canadian courts to keep an eye on the bigger picture in making their transfer pricing determinations.
Lastly, Justice Rothstein held that an arm’s length price determined under subsection 69(2) must reflect the court’s consideration of the independent interests of each party to a transaction. This two sided approach is fundamental to the determination of an arm’s length price, and distinguishes it from the narrower concept of “fair market value.”
Although the transfer pricing provision at issue in the Glaxo case, subsection 69(2), has since been repealed and replaced by the transfer pricing regime in section 247 of the Income Tax Act, much of the Court’s guidance on the interpretation and application of the historical provision and the role of the OECD Guidelines should be equally relevant under the current regime.