I. Introduction

If a multinational corporation had the luxury of perfect hindsight, it would optimize its global positioning and operational efficiencies by migrating intangible assets prior to those assets proving valuable. Most companies, however, do not have such luxury, and the decision to migrate assets often comes well after their value is realized. In light of this, it comes with little surprise that discussions regarding government crackdowns on tax havens have occurred recently as more and more multinational organizations move profits offshore to low tax jurisdictions. 

The CRA and other tax authorities have stepped up their enforcement activities related to various industries that employ valuable intellectual property, including pharmaceuticals. The CRA announced in 2005 that it set up eleven centers of expertise to deal with aggressive international tax planning. These centres are located in regional Tax Services Offices across Canada, and they bring together international tax auditors and tax avoidance officers. One of the priorities of the centers will be to to develop new ways to address aggressive international transactions. It seems that transfer pricing transactions, and specifically the migration of IP, are a major target in CRA's audit compliance reviews.

With increased resources available to it, the CRA is combining both its rapidly improving knowledge of transfer pricing disciplines, with improved legislative powers, to raise transfer pricing adjustments within the pharmaceutical industry.

From a tax perspective, any financial planning that involves moving profits offshore by multinational organizations can be justifiable if the corresponding functions, assets and risks borne to earn these profits are also shifted offshore, and where the appropriate buy in payments have been made. The world economy has become increasingly globalized, and the need to minimize after-tax profits is not only advantageous to improving corporate profits, but is also necessary in order to remain competitive. While implementing such a framework is a long and complex process, it can result in material tax savings.

II. Recent Transfer Pricing Issues Related to Large Pharmaceutical Companies and IP

While there are many clear benefits to migrating intangibles, such a strategy poses risks, including the potential for significant transfer pricing adjustments. Ideally, intangibles should be migrated when they do not possess considerable economic value. However, as stated earlier, companies often do not have the benefit of hindsight and often decide to migrate after the intangibles prove valuable.

During transfer pricing audits, government authorities have used existing legislation (i.e. section 247(2)(b) of the Canada Income Tax Act) to re-characterize related party transactions after settlement negotiations have broken down, resulting in transfer pricing adjustments.

An application of the government's power to re-characterize a particular transaction has been seen in the recent transfer pricing dispute between the CRA and Merck Frosst Canada ("Merck"). The CRA is examining the tax returns of Merck from 1998 through 2004, and has reassessed Merck for "adjustments related to certain intercompany pricing matters". On October 10, 2006, the CRA issued a notice of reassessment related to various intercompany transactions totalling US$1.4 Billion plus, US$360 Million in interest. While all details of the case are not known, it has been disclosed in various media sources that the adjustments relate to Merck's patent for its asthma drug Singular. The drug, developed in Quebec, generated sales of US$950 Million in the second quarter of 2006. The patent was later transferred to Barbados. Given the considerable size of the adjustment, it can be surmised that the negotiations between the CRA and Merck have not resulted in an acceptable resolution. Consequently, the CRA has used its ability to apply existing legislation to re-characterize the transaction as if the transaction did not occur, thus raising the corresponding adjustment. 

While the dispute with Merck is yet to be resolved, the financial resources required to handle such a dispute can be daunting. Merck could be required to post a deposit of up to half of the tax and interest assessed.

III. Opportunities for Migrating Intangibles: Textbook Application

Tax authorities around the world have begun to target structures which migrate profits offshore. As a result, multinational companies need to ensure that their documentation is sufficient to support the migration of valuable intangibles, and the profits they drive.

Three methods commonly used to migrate these intangibles assets include:

(i) cost sharing agreements;

(ii) buy-in payments; and

(iii) sale of intangibles.

Cost Sharing Agreements ("CSA")

CSAs are one of the most effective ways to migrate intangibles. A CSA is an agreement between two parties, which defines the contributions each party will make in terms of costs expended, and the associated benefits that will be returned to the parties for such an investment. In order for a CSA to be effective, it must:

(i) make business and economic sense;

(ii) include upfront and well-documented terms;

(iii) indicate costs incurred by each party relative to the reasonability of expected profits; and

(iv) if providing for entry, exit, or termination of a CSA, provisions must involve arm's length prices.

Failure on the part of companies to draft effective CSAs serves only to increase audit risk. In this respect, great care must be taken to ensure that CSAs make both economic and business sense.

CSAs are often found in industries that require substantial research and development ("R&D") activities, such as the pharmaceutical industry. In such an industry, some of the costs associated with performing the R&D activities are performed in low tax jurisdictions. Given that these related parties pay for a portion of the R&D, they are entitled to exploit an interest in the intellectual property that was developed. As a result, no royalty on the CSA will be required to be paid.


Buy-in/buy-out payments are another way to migrate intangible income offshore. Buy-in payments require a party in a related party setting to "buy-in" to a CSA, or "buy-out" of one. In order to do so, the buy-in/buy-out payments must be payments that represent arm's length prices. Buy-in options are very valuable given that they provide many opportunities. They also involve associated risks, which must be reflected in the purchase price. Subsidiaries must pay fair market value to buy-in. Failure to do so will increase the firm's audit risk for an unfavourable audit.

Sale of Intangibles

The final approach regarding the migration of intangibles is through the sale of intangibles. Intangibles are a large source of profits, and selling them to offshore affiliates will help build support for the argument that profits that are generated from these assets should be taxed in these offshore jurisdictions. It is important, as in the other two cases above, to ensure that this is done at arm's length prices. Determining the arm's length sale of intangibles is very complicated. The most common way of determining the price at which this should be transacted involves the Comparable Uncontrolled Price ("CUP") methodology. This requires that we find external comparables that involve the sale of very similar intangibles, which is often difficult to achieve.

IV. Conclusion

The migration of intangibles is an acceptable tool in an effort to maximize after-tax profits. However, doing so normally requires the migration of functions, assets and risks. One should be cautioned that with respect to intangibles that have proven valuable, and are subsequently migrated, taxing authorities will certainly be on the alert to scrutinize the transactions, as the Merck case has shown. It is imperative that any strategic decision to transfer intangibles be supported by comprehensive transfer pricing documentation that incorporates as much evidence supporting an arm's length price as possible.