The decision of the Supreme Court of Canada in GlaxoSmithKline was released on October 18, 2012, upholding the decision of the Federal Court of Appeal and referring the matter back to the Tax Court of Canada for redetermination. The issue in the case was the transfer price for ranitidine, the active ingredient in Zantac, an ulcer drug produced by GlaxoSmithKline. The issue in the appeal was what circumstances are to be taken into account in determining the reasonable arm’s length price against which to compare the non-arm’s length transfer price.

The Canada Revenue Agency (“CRA”) took the position that the purchases made by generic drug companies for ranitidine were the comparable transactions that should be used to determine the amount that was reasonable in the circumstances. Thus, according to the CRA, the arm’s length price which the taxpayer ought to have paid to Adechsa was that paid by the generic companies for their ranitidine.

The taxpayer had argued that its business circumstances were wholly different from those of the generic companies and that generic transactions were not comparable within the meaning of subsection 69(2) of the Income Tax Act (Canada) (“ITA”) and the comparable uncontrolled price (“CUP”) method. The taxpayer had also argued that its ranitidine had been manufactured under Glaxo World standards of good manufacturing practices, granulated to Glaxo World standards, and produced in accordance with Glaxo World health, safety and environmental standards. The taxpayer submitted that the best comparables were the prices paid by independent third party licensees in Europe because they purchase ranitidine under the same set of business circumstances as the taxpayer.

The Tax Court found in favour of the CRA. Justice Rip stated that the issue before him was “whether the prices paid by Glaxo Canada to Adechsa [a related Swiss corporation], for ranitidine would have been reasonable in the circumstances if Glaxo Canada and Adechsa had been dealing at arm’s length.” He held that the issue at hand was the reasonable price to be paid for the purchase of ranitidine not Zantac. He rejected the argument that the European licensees were comparators using the CUP method on the basis of his finding that the economic circumstances between the Canadian and European markets were not comparable. The Tax Court held that the price that would have been reasonable in the circumstances for Glaxo Canada to pay Adechsa for a kilogram of ranitidine was the highest price that the generic companies paid per kilogram of ranitidine plus $25 per kilogram, as this was the approximate cost of granulation of the ranitidine.

The Federal Court of Appeal overturned the decision of the Tax Court of Canada. However, it did not determine the appropriate transfer price and sent the matter back to the Tax Court Judge for determination in light of the principles expressed in its decision. The Federal Court of Appeal held that the Tax Court Judge had erred by ignoring the license agreement between the parties. The Federal Court of Appeal stated that the appropriate test to apply under subsection 69(2) of the ITA is to ask whether if the parties had been dealing at arm’s length, would the price paid by the taxpayer for its ranitidine have been “reasonable in the circumstances.” The Federal Court of Appeal held that in order to make that determination, the Court had to consider all relevant circumstances which an arm’s length purchaser would have had to consider. In that regard, it cited the classic statement of the reasonableness standard as expressed by the Exchequer Court of Canada in Gabco Limited v. M.N.R., 68 DTC 5210, at page 5216:

“It is not a question of the Minister or this Court substituting its judgment for what is a reasonable amount to pay, but rather a case of the Minister or the Court coming to the conclusion that no reasonable businessman would have contracted to pay such an amount having only the business considerations of the appellant in mind. [Emphasis added]”

The Federal Court of Appeal indicated that the test requires an inquiry into the circumstances which an arm’s length purchaser, standing in the shoes of the taxpayer, would consider relevant in determining whether it should pay the price paid by the taxpayer to Adechsa for its ranitidine. In other words, in the real business world, one must consider the business realities which an arm’s length purchaser was bound to consider if he intended to sell Zantac. The Federal Court of Appeal held that the circumstances which must be taken into account in determining whether the price the taxpayer paid for ranitidine exceeded a “reasonable amount” are as follows:

  1. The Glaxo Group owned the Zantac trade-mark and would own it even if the appellant was an arm’s length licensee.
  2. Zantac commanded a premium over generic ranitidine drugs.
  3. Glaxo Group owned the ranitidine patent and would have owned it even if the appellant had been in an arm’s length relationship.
  4. Without the license agreement, the appellant would not have been in a position to use the ranitidine patent and the Zantac trade-mark. Consequently, in those circumstances, the only possibility open to the appellant would have been to enter the generic market where the cost of entering into that market would likely have been high, considering that both Apotex and Novopharm were already well-placed in position.
  5. Without the license agreement, the appellant would not have had access to the portfolio of other patented and trade-marked products to which it had access under the license agreement.

The circumstances under which the ranitidine was purchased “arose from the marketing power attached to Glaxo Group’s ownership of the intellectual property associated with ranitidine, the Zantac trade-mark and the other products covered by the license agreement with Glaxo Canada.” In other words, the Court was required to determine whether an arm’s length Canadian distributor of Zantac would have been willing to pay the price paid by the taxpayer to Adechsa for ranitidine taking into account all the relevant circumstances.

At the Supreme Court of Canada, the CRA took the position that the decisions in Singleton v. Canada, 2001 SCC 61 and Shell Canada Ltd. v. Canada, [1999] 3 S.C.R. 622 require the Court to treat each transfer as a separate transaction and, accordingly, that the licence agreement should not form part of the analysis in determining whether the price paid was “reasonable in the circumstances.”

In rejecting this submission the Supreme Court of Canada held that because subsection 69(2) of the ITA requires an inquiry into the price that would be “reasonable in the circumstances,” it necessarily involves consideration of all circumstances that were considered by the taxpayer in determining the price paid to the non-resident supplier. The Supreme Court of Canada went on to note that such circumstances will include agreements that may confer rights and benefits in addition to the purchase of property where those agreements are linked with the purchasing agreement.

The Supreme Court of Canada declined to determine whether the amount paid by the taxpayer was reasonable in the circumstances and remitted the decision back to the Tax Court of Canada for redetermination. In doing so, the Supreme Court of Canada made it clear that “the generic comparators do not reflect the economic and business reality of Glaxo Canada and, at least without adjustment, do not indicate the price that would be reasonable in the circumstances.”

In its closing remarks, the Supreme Court of Canada offered the following guidance with respect to redetermination:

  1. The term “reasonable amount” as used in subsection 69(2) requires some leeway and that a judge will be required to exercise his best informed judgment in establishing a satisfactory arm’s length price.
  2. The respective roles and functions of the parties should be kept in mind.
  3. Prices between parties dealing at arm’s length will be established having regard to the independent interests of each party to the transaction.
  4. The evidence tendered in the proceeding to-date suggests that higher-than-generic transfer prices are justified and are not necessarily greater than a reasonable amount under subsection 69(2).

This case is a significant victory for Canadian taxpayers in connection with transfer pricing matters. It reflects recognition by the Supreme Court of Canada that in determining the transfer price for the active ingredient of a branded drug, one must consider what an arm’s length Canadian distributor would have been willing to pay

for the active ingredient in a brand of drug as opposed to a generic drug. There is an acknowledgement by the Court that an intangible may attach to a product and enhance its value. Moreover, all relevant business circumstances must be considered in determining an arm’s length price.

It is to be hoped that the case will provide the CRA with clear guidance that valuable intangibles such as trade-marks and trade names must be taken into account in determining an appropriate arm’s length transfer price. In other words, the test is to look at what an arm’s length third party would have paid for the same branded product, not a generic product.