Law Times

Law Times • sepTember 27, 2010 FOCUS PAGE 9 Glaxo case sets principle for dealing with transfer pricing But court battle not over as drug matter goes back to trial judge for ruling BY JULIUS MELNITZER For Law Times tionals are prone to tax plan- ning that attempts to place as much of their profi ts as pos- sible within lower-tax jurisdic- tions. One way of achieving this is through the allocation of revenue and expenses in intra- company transactions. A subsidiary in a high-tax jurisdiction, therefore, may minimize the prices it charges for goods supplied or services rendered to a sister company in a lower-tax location. Th e reduced profi ts in the fi rst ju- risdiction and increased earn- ings elsewhere translate into an improved after-tax bottom line for the enterprise as a whole. To ensure the fair alloca- T tion of revenues and expenses in cross-border intra-corporate transactions, authorities in an increasing number of countries require taxpayers within the same group to ensure that any transfer of goods, services, in- tangibles or fi nancing arrange- ments between them occurs on the same terms as those that independent parties would ne- gotiate. Th is is known as the arm's-length principle. But implementing that notion isn't so easy. Th is is particularly true in Canada, where the statutory guidance found in s. 247 of the Income Tax Act is sketchy and the in- terpretive jurisprudence is em- bryonic despite the fact that ransfer-pricing issues emanate from the sim- ple truth that multina- it's been in force since 1998. Fortunately, decisions are beginning to emerge, with the most signifi cant of late being the Federal Court of Appeal's July 26 ruling in GlaxoSmith- Kline Inc. v. Canada. "Th e ruling has been very well-received in tax and busi- ness circles," says Elinore Rich- ardson, a tax partner at Borden Ladner Gervais LLP. Th e case arose when Glaxo- SmithKline, the Canadian subsidiary of the international pharmaceutical giant, agreed to purchase ranitidine, the prime ingredient in the bestselling drug Zantac, from Adechsa, an affi liated company that was the Swiss arm of the Glaxo Group, for between $1,512 and $1,651 per kilogram. Th e Glaxo Group owned the intellectual property associated with Zantac. At the time, generic manu- facturers were marketing a generic alternative to Zantac. Th ey managed to purchase ra- nitidine in the market at signif- icantly lower prices of between $194 and $304 per kilogram. Th e Canada Revenue Agency challenged the deductibility of Glaxo's payments to Adechsa. It argued the expense wasn't "rea- sonable in the circumstances," as required by the act. A reasonable amount, the CRA argued, was the amount paid by the generics. But Glaxo responded that a consideration of reasonable- ness should take into account a licence agreement between the Glaxo Group and its Cana- dian subsidiary. Th e agreement allowed it to make use of the parent company's trademarks and brand, including Zantac, and provided access to other drugs. At the same time, it paid the Glaxo Group a six-per-cent royalty on sales of drugs cov- ered by the licence agreement. Th e trial judge refused to consider the licensing arrange- ment, reasoning that the two agreements covered separate matters. He ruled that the rea- sonable price for the Canadian company to pay was the highest amount borne by the generics subject to a small adjustment. But the appeal court over- turned the Tax Court of Can- ada's decision and ruled the li- cence agreement was relevant. In its view, the trial judge had erred by equating the "fair mar- ket price" paid by the generics with what was "reasonable in the circumstances." As the court saw it, what was "reasonable in the circumstances" required "an inquiry into those circum- stances which an arm's-length purchaser, standing in the shoes of [the Canadian subsidiary], would consider relevant" in de- termining what it was willing to pay for ranitidine. Here, the relevant circum- stances were that the Glaxo Group owned the intellectual property rights to Zantac; the drug commanded a premium over generic drugs; and that, without the licence agree- ment, the Canadian subsidiary couldn't have used the trade- mark for the drug nor would it have had access to the parent company's other products. "Th e appeal court recognized decisions don't exist in a vacuum and don't operate outside busi- ness realities," says Claire Ken- nedy, a tax partner at Bennett Jones LLP. "Here, the circum- stances did not arise out of the non-arm's-length relationship between Glaxo and the Glaxo Group but from the business realities imposed by the market power of the product." But that doesn't mean the 'The ruling has been very well- received in tax and business cir- cles,' says Elinore Richardson. that the trial judge ignored the fact that Glaxo's decision to pay $1,500 for ranitidine was tied to a licence agreement that gave it the right to sell one of the most profi table drugs in the world," says François Vincent of Moskowitz & Meredith LLP, a tax law fi rm affi liated with KPMG LLP. "If you had the choice of buying an unbranded product that you could sell for fi ve times the purchase price or a branded product for which you paid a much higher price but could sell for 10 times the purchase price, which would a reasonable business person choose?" Although the appeal court sent the case back to the trial judge to determine the appro- priate transfer price in light of its guidelines, observers still consider the matter a victory for taxpayers. "What is important is the Federal Court's acknowledg- ment that transfer-pricing battle is over. Th e trial judge still faces the diffi cult task of establishing an appropri- ate transfer price without any guidance from the appeal court on how to deal with the fact that the total price paid by the Canadian subsidiary had two components: the price for the ranitidine paid to Adechsa and the six-per-cent royalty to the Glaxo Group. "Th ere is unlikely to be a comparable in which an arm's- length party has the rights at a specifi c level of royalty to mar- ket a given product and then buy the raw material from a third party," says John Tobin, a tax partner at Torys LLP. So while the case moves the jurisprudence forward, it's un- likely to put a large dent in the volume of litigation related to transfer pricing. "Th e [appeal court] has es- tablished a sensible principle, but the potential remains for future disputes about how to apply the standard and what it means in practice," Kennedy says. 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