Glaxo SCC dealt with an issue that has quickly become the subject of much international scrutiny: the setting of transfer prices in the context of contractual and intangible property rights.
Put simply, transfer prices are the prices set between related entities in different jurisdictions to charge each other for products or services provided to one another. As the parties are related, they are able to exercise their control to set prices that may or may not be reflective of market realities – in the absence of regulation, such a scheme can be easily used to shift earned income from a high tax jurisdiction to a low tax jurisdiction.
This decision of the Supreme Court of Canada is of particular relevance to the IP Osgoode community as it directly considers the valuation of intellectual property rights and benefits that may be bundled into a transaction – this specific transaction bundled patent and trademark rights, among intangible rights such as marketing support and access to further supply.
In two recent cases, Alberta Printed Circuits v The Queen, 2011 TCC 232 and Glaxo SCC, the taxpayers attempted to adduce valuation evidence to demonstrate that the intangibles that were provided along with the property increased their value and should be considered in a determination of an appropriate transfer price under the “arm’s length principle”.
The CRA has taken an aggressive approach to valuation that systematically ignored valuation evidence regarding intangibles adduced in support of the taxpayers’ arguments that transfer prices were comparable to the arm’s length price. The aggressiveness of this approach was noted by the Tax Court in Alberta Printed Circuits, which affirmed the ruling in Glaxo FCA, noting that in Alberta Printed Circuits, the CRA simply ignored the taxpayer’s valuation evidence and “dropped the ball”.
Between 1990 to 1993, Glaxo Canada paid related entities within the Glaxo Group between $1,512 and $1,651 per kilogram for the active ingredient in Zantac, ranitidine, while at the same time, generic pharmaceutical companies in Canada were purchasing ranitidine for $194 to $304 per kilogram. Glaxo Canada would then package the ranitidine into a drug delivery system for distribution in Canada.
Based on a simple division between the midpoints of these ranges ($1581.5 and $249, respectively), Glaxo Canada was being charged approximately 6.35 times the price paid by the generics for ranitidine by the Glaxo Group related entities.
The transfer pricing scheme utilized by GlaxoSmithKline revolved around two agreements between Glaxo Canada and Glaxo Group (the parent of other Glaxo companies which discovered, developed, manufactured and marketed branded pharmaceutical products). These two agreements conferred certain rights and benefits to Glaxo Canada from the Glaxo Group, including patent and trade-mark rights, among others. The transfer price was set by the “re-sale price method”, which effectively set the price as 40% of the in-market price for the finished ranitidine product, resulting in the $1,512 to $1,651 per kilogram prices. It is important to note that Glaxo Canada was contractually bound and could not purchase ranitidine from non-Glaxo approved sources.
As noted under paragraph 18 of their factum, the CRA took a dim view of this strategy, alleging that “the tax strategy of [Glaxo] was to make as much profit in Singapore, tax free, and then the remainder of the Glaxo group’s [sic] profit in the United Kingdom.” The CRA also noted that transfer pricing is an international problem and pointed out Canada’s obligation as a member of the OECD to deem a “reasonable arm’s length price” as the transfer price.
The CRA reassessed Glaxo Canada for these years and increased its income by approximately $51 million dollars.
The Tax Court’s Ruling
The Tax Court affirmed the reassessment, finding (1) that the rights and benefits under the license agreement were not relevant in determining the appropriate arm’s length price for the supply of ranitidine, and (2) that the prices paid by the generic companies were appropriate comparators for Glaxo’s transaction.
The FCA’s Ruling
The FCA, in a unanimous decision, found that the phrase “reasonable in the circumstances” required the Tax Court to consider “all relevant circumstances which an arm’s length purchaser would have had to consider”. The FCA applied a “reasonable business person test” and found that the license agreement was central to Glaxo Canada’s business reality and thus was a circumstance that had to be taken into account when determining if the prices were reasonable. The FCA did not determine whether the prices were reasonable, remitting this back to the Tax Court for consideration.
Analysis of the SCC’s Ruling
The Supreme Court of Canada, in a unanimous decision, found that the CRA is required to consider all “economically relevant characteristics” in determining the arm’s length price for the property including the rights and benefits that are linked to the price paid for the property. The SCC affirmed the FCA’s decision and dismissed the transaction-by-transaction approach adopted by the CRA and the Tax Court.
The SCC found that these features of the license agreement and the requirement to purchase from a Glaxo-approved source add value to the ranitidine that Glaxo Canada purchased over and above the value of generic ranitidine without the rights and benefits.
The SCC further noted that there is a difference between the generic ranitidine and the ranitidine of an innovator pharmaceutical company, considering the “degree of comfort” that presumably allows Zantac to be priced higher than the generic products. As such, the comparators were not identical in all material respects and the SCC found that “some leeway must be allowed in the determination of the reasonable amount”.
Given that the value of intangible assets, including intellectual property rights, make up a significant proportion of the net asset value of most corporations, this ruling opens the door towards using valuations of intangible assets to justify the pricing utilized in transactions between related entities. This includes valuations of intellectual property assets, which have traditionally been difficult to value due to the characteristics of their potential income streams and lack of similar comparator transactions (an issue that occurs due to the inherent novelty, originality or distinctiveness requirements for intellectual property rights).
Further, the adoption of rigorous valuation approaches may have secondary benefits beyond tax considerations. Developing a consistent approach to valuation would assist corporations in understanding the value of their intangible assets in the broader context of their overall business strategies.
Background: Tax Issues with Transfer Pricing
Transfer prices are used to reflect the allocation of costs incurred between related parties for goods, services or the use of property. For example, if Ford Canada manufactures cars designed by Ford USA, Ford Canada could pay a transfer fee to Ford USA for the design and marketing work conducted in the United States. Where used legitimately in such a manner, transfer prices are used to efficiently allocate costs and resources across the international subsidiaries of a large organization.
However, these transfer prices are also subject to aggressive tax planning strategies: in transactions between related parties, a multi-national company could inflate transfer prices beyond those that can be legitimately allocated for the purpose of distorting the recognition of earned income and reducing tax liabilities. By inflating transfer prices beyond their fair value, a multi-national company can shift non-related income earned in a higher income tax jurisdiction to be recognized as income in a lower income tax jurisdiction. In doing so, the multi-national company reduces their overall tax payable.
In the absence of regulation, this would be a trivial exercise for related entities. The company could exercise its control over both entities to determine the price as between the parties, regardless of market realities.
The “arm’s length principle” is set out under Article 9 of the OECD Model Tax Convention and has been widely adopted by tax authorities worldwide to ensure that the price charged (“transfer prices”) between non-arm’s length entities (such as subsidiaries and similar controlled entities) accurately and fairly reflects that would have occurred had the parties themselves not been related.
Canada has adopted the “arm’s length principle” under s. 247(2) of the Income Tax Act, providing a deeming provision that readjusts the transfer prices paid on non-arm’s length transactions to what the CRA considers would have been the price in a comparable arm’s length transaction (with a further 10% penalty under 247(3) in certain circumstances). This adoption is supported by the CRA’s information circular 87-2R and transfer pricing memoranda, which consider in more depth the application of the “arm’s length principle”.
The “arm’s length principle” is conceptually simple, but challenging to implement in practice, particularly where the underlying assets include intangible assets. Intangible assets comprise of the majority of the assets in today’s companies, but they are difficult to value without involving a great deal of valuer subjectivity and financial modeling assumptions. To further complicate the issue, traditional methods of valuing tangible assets are limited in their application to intangible assets. This is due to a lack of comparable transactions, often unpredictable income streams and difficulty in defining clear substitutes for the asset.
Transfer pricing has been a “hot button” issue for tax authorities around the world. While estimates vary, the magnitude of the trade distortions is immense – theUnited States estimates that it alone loses $100 billion USD per year through offshore tax evasion.
In 2006, the IRS settled with GSK over a transfer pricing dispute, whereby GSK paid the IRS approximately $3.4 billion as part of an agreement to settle a dispute for the tax years of 1989 to 2005. At the time, this payment was the single largest payment to the IRS to resolve a tax dispute.
The CRA’s position is unenviable – the CRA is tasked with protecting the outflow of taxable income from illegitimate transfer pricing schemes, but has great difficulty in adducing pricing data for comparable transactions.
Background: Glaxo’s Transaction
GlaxoSmithKline is a multinational pharmaceutical company that was selling branded pharmaceutical drugs in Canada through its Canadian affiliate, Glaxo Canada. GlaxoSmithKline’s business model comprised of two stages: the first stage was the primary manufacturing of the active ingredient and the second stage was the packaging of the active ingredient in a drug delivery mechanism.
The first stage was conducted by GlaxoSmithKline’s affiliated subsidiaries in Singapore and the United Kingdom. These manufactured drugs were then sold to GlaxoSmithKline’s clearing companies, who then sold the drug to Glaxo Canada. Glaxo Canada conducted the second stage, where it would package the drugs with a delivery mechanism, market and sell it under a GlaxoSmithKline trademark. In this case, the trademark was Zantac.
Glaxo Canada had two agreements; a license agreement and a supply agreement, which provided Glaxo Canada with the intellectual property, product support to package and sell Zantac, and the active pharmaceutical ingredient (API). The specific rights included involved:
- The right to manufacture, use and sell the entire existing and future portfolio of Glaxo world products;
- The right to use the trademarks owned by the Glaxo Group (including Zantac);
- The right to receive technical assistance for secondary manufacturing of the products;
- The use of registration materials prepared by Glaxo Group;
- Access to new products and improvements in drugs;
- The right to have a Glaxo World company sell Glaxo Canada any raw materials;
- Marketing support; and
- Indemnification against damages arising from patent infringement actions.
Further, Glaxo Canada was contractually prohibited from buying ranitidine from the open market, namely non-GlaxoSmithKline approved sources.
In Canada, there was a compulsory licensing scheme (now repealed) that permitted generic drug companies to sell generic versions of pharmaceutical products under patent protection if the generic drug companies paid a 4% royalty to the patent owner. In the taxation years, ranitidine was sold under the ambit of this compulsory licensing scheme at prices substantially lower than those paid by Glaxo Canada for its ranitidine.
Brian Chau is a graduate of Osgoode Hall Law School.