Background

On May 30th 2008, GlaxoSmithKlein Inc. (Glaxo) lost what can arguably be described as the most important transfer pricing decision in Canadian history. In the context of a tax dispute, transfer pricing usually connotes the tax authority's view that the transfer price has been set too high or too low so as to transfer profits from a high tax jurisdiction to a low tax jurisdiction. Glaxo was appealing a reassessment of its tax returns by the Minister of National Revenue (MNR), who was seeking further taxes from the Zantac manufacturer for the years 1990 through 1993. The dispute focused on the price Glaxo agreed to pay Adechsa for the product ranitidine, an active ingredient in the heartburn drug Zantac. Adechsa, a Glaxo World company, is a related party to Glaxo Canada based out of Switzerland.

Issues Before the Court

The question before the Tax Court of Canada (Court) was whether the prices paid by Glaxo to Adechsa for ranitidine would have been reasonable in the circumstances if Glaxo and Adechsa had been dealing at arm's length. To do so, the Court had to define the meaning of "reasonable in the circumstances" in subsection 69(2) of the Income Tax Act, a subsection that has since been repealed for taxation years beginning after 1997. Glaxo and MNR each presented their submissions to the Court as to which companies they believed would serve as ideal comparators under the circumstances.

Determining Appropriate Comparators

Glaxo proposed that independent third party licensees in Europe were the best comparators because they purchased the same ranitidine under the same set of business circumstances as themselves. On the other hand, MNR suggested that generic companies' purchases of ranitidine from arm's length manufacturers were appropriate comparable transactions. MNR submitted that the arm's length price Glaxo would have paid Adechsa, should be the same as the prices paid by Apotex and Novopharm, two generic companies, to their suppliers. However, Glaxo argued that the transactions were not comparable because the ranitidine it 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. Despite the slight differences between the ranitidine purchased by Glaxo and the generic companies, a quick comparison of the purchase prices was enough to raise a concern. Glaxo purchased its granulated ranitidine from Adechsa for approximately $1,300 per kilogram, whereas the generic companies paid sums varying from $200 to $380 per kilogram of ranitidine from their various suppliers.

Selecting the Appropriate Transfer Price Evaluation Method

Glaxo put forward the transactional net margin method (TNMM), whereas MNR used the comparable uncontrolled price (CUP) method for its analysis. The Court stated that TNMM examines the net profit margin relative to an appropriate base (e.g. costs, sales, assets) that a taxpayer realizes from a controlled transaction. The CUP method, according to the Court, offers the most direct way to determining an arm's length price. The transfer price is set by reference to comparable transactions between a buyer and a seller who are not associated enterprises.

The Court's Analysis

The Court acknowledged that Glaxo's marketing and pricing strategies differed from most, if not all, of the generic companies' strategies. However, the issue at hand was the reasonable price to be paid for the purchase of ranitidine, not Zantac. The Court decided that the CUP method was the preferred method of evaluation, while discarding the other methods brought to their attention without much hesitation. In addition, it determined that the appropriate comparators in this case were in fact the generic companies, and that the purchase price paid by these companies was indeed an appropriate CUP. Further, the Court decided that the highest price paid by the generic pharmaceutical companies was equivalent, at the very least, to a reasonable price that Glaxo could have paid Adechsa for the supply of ranitidine. To account for the fact that Adechsa supplied granulated ranitidine and the other suppliers did not, the Court added an additional $25 per kilogram, the approximate cost for granulation. The addition of the highest price paid by generic companies, and the $25 added for granulation, totals $405, leaving an excess of $895 between the reasonable purchase price and the price paid by Glaxo to Adechsa. Glaxo's initial income increase established by MNR for the years in question was approximately $51 million. The slight adjustment by the Court surely did little to ease the pain.

Licensing Issue

Glaxo claimed that the prices paid to Adechsa were linked to a licence agreement with its UK parent company. Therefore, in Glaxo's opinion, the Court should have taken the separate intercompany licence and supply agreements with respect to Zantac into consideration. A royalty of 6% was paid by Glaxo to its parent company under this licence agreement in exchange for the rights to certain services and intangibles, such as trademarks and other valuable assets. As stated earlier, the supply agreement permitted Glaxo to purchase ranitidine from Adechsa.

The court chose to dismiss any association between the supply contract with Adechsa and the licence agreement with Glaxo World. The Court ruled that a 40 percent total profit to Glaxo might very well be reasonable. However, it reaffirmed the notion that the issue before the Court was whether the purchase price paid for ranitidine was reasonable. Royalty payments in Canada are subject to withholding tax, and the profit accrues to Glaxo Group, and is taxed in the United Kingdom. The purchase price for ranitidine is not subject to any withholding tax, and the profit accrues in Switzerland. The Court was of the opinion that one cannot combine the two transactions and ignore the distinct tax treatments that follow from each. The Court also stated that to suggest that Glaxo does not care whether its profits are in the form of royalty payments or purchase price belittles the issue in these appeals.

In Glaxo's opinion, such a decision does not reflect the actual economic realities of the company at the time. The Court has seemingly penalized Glaxo in this instance for its decision to structure its inter-company relations through multiple agreements. Regardless of one's opinion on the matter, one thing is certain: multinational corporations must keep this controversial decision in mind when contemplating potential avenues for their transfer pricing issues.

Final Thoughts

Although the Court can support its decision to give preferential treatment to the CUP method by saying that they are simply conforming with the OECD Transfer Pricing Guidelines, the licensing issue is likely to generate further debate. The mere thought of the accumulated interest owed by Glaxo in this instance is enough to send shivers down the spines of multinational corporations from Halifax to Vancouver. Meanwhile, the heads are high and the smiles are broad over at the Canada Revenue Agency, whose members are breathing a sigh of relief following this long-awaited decision. The Glaxo decision is an imposing new precedent in terms of transfer pricing taxation, an issue that has rarely been the subject of Canadian jurisprudence to date. Such a change in the Canadian legal landscape may serve as a deterrent to corporations and practitioners who are considering the litigation of similar disputes. A more attractive alternative at this point may be to proceed to the Canadian Competent Authority, whose members possess an extensive expertise in regards to transfer pricing issues. Reaching a settlement that is beneficial to both parties will be a far less "taxing" experience than the high risk, high reward gamble that is a court proceeding.