Transfer pricing involves the price that one member of a multinational firm charges another for goods, services and intangible assets transferred between related parties. The central theme in transfer pricing is to ensure that the prices at which these goods, services and intangible assets are transferred represent arm's length standards.

Several factors are changing the way we look at transfer pricing in the pharmaceutical industry, from both domestic and international perspectives, and how we determine these intercompany prices. The rise of generic drug companies, current regulatory issues relating to patent protection and, more recently, the 2006 congressional mid-term elections in the U.S., are altering the risks faced by pharmaceutical companies and the regulatory environment in which they operate.

Allocating profits among the various entities of a multinational entity ("MNE") can also prove very difficult. While the Internal Revenue Service ("IRS") often takes the view that patent development drives profits, the Canada Revenue Agency ("CRA") attributes a significant portion of a company's residual profits to marketing. From the CRA's perspective, this may be because it has become commonplace in recent years for MNEs to ascribe their Canadian entities with the responsibilities for marketing and distribution. In any event, the differing methods of profit allocation have led to several lengthy disagreements between the two revenue-collecting bodies. It is therefore imperative for MNEs to maintain proper and detailed documentation describing the facts and circumstances under which profits are generated and how the related parties operate in relation to one another.

Recent Transfer Pricing Issues Related to Large Pharmaceutical Companies

The CRA and other tax authorities have stepped up their enforcement activities related to various industries, including pharmaceuticals. The CRA has announced that it has set up eleven centers of expertise to assist with the performing of transfer pricing audits. With increased resources available to it, the CRA is combining both its rapidly improving knowledge of the transfer pricing discipline with legislative powers, to raise transfer pricing adjustments within the pharmaceutical industry.

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

An application of the government's power to re-characterize a particular transaction has been seen with 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 given Merck "adjustments related to certain intercompany pricing matters". On October 10, 2006, the CRA issued a notice of assessment related to various intercompany transactions totaling 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 news outlets 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 size of the notice of assessment, it can be surmised that the negotiations between the CRA and Merck have not resulted in an acceptable resolution for one or both parties. Consequently the CRA has used its ability to apply existing legislation to recharacterize 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 stunning. Merck may be required to post a deposit of up to half of the tax and interest assessed.

The Merck case, while representing the biggest tax adjustment case in Canada history, is smaller than adjustments raised in the U.S. In a recent case in the U.S., the IRS settled a long-standing transfer pricing dispute with Glaxo SmithKline Holding (Americas) Inc. & Subsidiaries ("GSK"). Under the terms of this settlement, GSK agreed to pay approximately US$3.1 billion to resolve all outstanding transfer pricing issues for the tax years 1989 through 2005. This is the single largest tax dispute settlement/payment in U.S. history.

Concluding Thoughts

The year 2006 witnessed various tax authorities raising significant adjustments on large pharmaceutical companies. The size of the potential adjustments should highlight the need on the part of large pharmaceutical companies to properly and effectively document all related party transactions in order that they might withstand a transfer pricing audit. Such a course of action can mitigate against the risk of substantial financial penalties, that an audit can bring about.