Surveys of tax and finance directors of multinational companies show that transfer pricing is their greatest concern. Governments share the concern: More than 50 countries have some form of transfer pricing legislation. And American tax authorities estimate that the U.S. is losing at least US$28 billion annually in potential transfer pricing revenues.

Transfer pricing issues emanate from this simple truth: Multinationals are prone to tax planning that attempts to place as much of their profits as possible within lower-tax jurisdictions. One way of achieving this is through the allocation of revenue and expenses in intracompany 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 jurisdiction. The reduced profits in the higher-tax jurisdiction and increased profits in the lower-tax jurisdiction translate into a better after-tax bottom line for the enterprise as a whole.

To ensure that revenues and expenses are allocated fairly in cross-border intracorporate transactions, tax authorities in an increasing number of countries require taxpayers within the same group to ensure that any transfer of goods, services, intangibles or financing arrangements between them occurs on the same terms that independent parties would negotiate. This is known as the “arm's length principle.”

But implementing the arm's length principle is easier said than done. This is particularly true in Canada, the U.S.'s largest trading partner, where the statutory guidance found in section 247 of the Income Tax Act (ITA) is sketchy and the interpretive jurisprudence is embryonic even though the language has been in force since 1998.

Fortunately, interpretations are beginning to emerge, with the most significant of late being the Canadian Federal Court of Appeal's (FCA) July 26 ruling in GlaxoSmithKline v. The Queen, in which unanimous bench ruled that courts determining appropriate transfer prices cannot do so in a vacuum and must consider business realities.

Reasonable Questions

GlaxoSmithKline began when GlaxoSmithKline Inc. (Glaxo), the Canadian subsidiary of Glaxo Group plc, a U.K. corporation, agreed to purchase ranitidine, the prime ingredient in the best-selling drug Zantac, from Adechsa, the Swiss subsidiary of the Glaxo Group. Glaxo Group owned the intellectual property associated with Zantac.

At the time, generic drug manufacturers were marketing a generic alternative to Zantac. They managed to purchase ranitidine at C$194 to C$304 per kilogram–significantly less than the C$1512 to C$1651 per kilogram Glaxo paid.

Because the generic manufacturers paid so much less for ranitidine, the Canada Revenue Agency (CRA) challenged the deductibility of Glaxo's payments to Adechsa, arguing that the expense was not “reasonable in the circumstances” as required by the arm's length principal set forth in the ITA.

But Glaxo responded that a consideration of reasonableness should take into account a license agreement between the Glaxo Group and Glaxo that allowed Glaxo to use the parent's trademarks and brand, including Zantac. Glaxo paid Glaxo Group a 6 percent royalty on sales of drugs covered by the license agreement.

The trial judge refused to consider the license agreement because the two agreements covered separate matters. He ruled that the reasonable price for Glaxo to pay was the highest price paid by the generics, subject to a small adjustment.

Relevant Circumstances

But the FCA overturned the Tax Court's ruling and decided that the license agreement was relevant. In the FCA's view, the trial judge erred by equating the “fair market price” paid by the generics with what was “reasonable in the circumstances.” As the appeals court saw it, what was “reasonable in the circumstances” required “an inquiry into those circumstances which an arm's length purchaser, standing in the shoes of [Glaxo,] would consider relevant” in determining what it was willing to pay for ranitidine.

The relevant circumstances were that Glaxo Group owned the Zantac intellectual property, and that had nothing to do with the fact that Glaxo was an affiliated, non-arm's length purchaser; that Zantac commanded a premium over generic drugs; and that without the license agreement, Glaxo could not have used the Zantac trademark nor would it have had access to Glaxo Group's other products.

“The appeals court recognized that the trial judge ignored the fact that Glaxo's decision to pay $1500 for ranitidine was tied to a license agreement that gave it the right to sell one of the most profitable drugs in the world,” says Fran?ois Vincent, national leader of KPMG's global transfer pricing services group in Canada. “If you had the choice of buying an unbranded product that you could sell for five 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?”

Limited Resolution

Although the FCA sent the case back to the trial judge to determine the appropriate transfer price in light of its guidelines, observers still consider GlaxoSmith Kline a victory for taxpayers.

“What's important is the Federal Court of Appeal's acknowledgement that transfer pricing decisions don't exist in a vacuum and don't operate outside business realities,” says Claire Kennedy, a tax lawyer at Bennett Jones.

But that doesn't mean the battle is over for Glaxo. The Tax Court still faces the difficult task of establishing an appropriate transfer price without any guidance from the FCA on how to deal with the fact that the total price paid by Glaxo included two components payable to different parties: the price for the ranitidine paid to Adechsa and the 6 percent royalty paid to Glaxo Group.

“There is unlikely to be a comparable [case] in which an arm's length party has the rights to market a product at a specific level of royalty and then buy the raw material from a third party,” says John Tobin, a tax partner at Torys.

So while GlaxoSmithKline does move the jurisprudence forward, it's unlikely to put a large dent in the volume of transfer price litigation.

“The FCA has established a sensible principle, but the potential remains for future disputes about how to apply the standard and what it means in practice,” Kennedy says. “We do have an overarching principle now, but as happens so often, the devil is in the details.”

Surveys of tax and finance directors of multinational companies show that transfer pricing is their greatest concern. Governments share the concern: More than 50 countries have some form of transfer pricing legislation. And American tax authorities estimate that the U.S. is losing at least US$28 billion annually in potential transfer pricing revenues.

Transfer pricing issues emanate from this simple truth: Multinationals are prone to tax planning that attempts to place as much of their profits as possible within lower-tax jurisdictions. One way of achieving this is through the allocation of revenue and expenses in intracompany 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 jurisdiction. The reduced profits in the higher-tax jurisdiction and increased profits in the lower-tax jurisdiction translate into a better after-tax bottom line for the enterprise as a whole.

To ensure that revenues and expenses are allocated fairly in cross-border intracorporate transactions, tax authorities in an increasing number of countries require taxpayers within the same group to ensure that any transfer of goods, services, intangibles or financing arrangements between them occurs on the same terms that independent parties would negotiate. This is known as the “arm's length principle.”

But implementing the arm's length principle is easier said than done. This is particularly true in Canada, the U.S.'s largest trading partner, where the statutory guidance found in section 247 of the Income Tax Act (ITA) is sketchy and the interpretive jurisprudence is embryonic even though the language has been in force since 1998.

Fortunately, interpretations are beginning to emerge, with the most significant of late being the Canadian Federal Court of Appeal's (FCA) July 26 ruling in GlaxoSmithKline v. The Queen, in which unanimous bench ruled that courts determining appropriate transfer prices cannot do so in a vacuum and must consider business realities.

Reasonable Questions

GlaxoSmithKline began when GlaxoSmithKline Inc. (Glaxo), the Canadian subsidiary of Glaxo Group plc, a U.K. corporation, agreed to purchase ranitidine, the prime ingredient in the best-selling drug Zantac, from Adechsa, the Swiss subsidiary of the Glaxo Group. Glaxo Group owned the intellectual property associated with Zantac.

At the time, generic drug manufacturers were marketing a generic alternative to Zantac. They managed to purchase ranitidine at C$194 to C$304 per kilogram–significantly less than the C$1512 to C$1651 per kilogram Glaxo paid.

Because the generic manufacturers paid so much less for ranitidine, the Canada Revenue Agency (CRA) challenged the deductibility of Glaxo's payments to Adechsa, arguing that the expense was not “reasonable in the circumstances” as required by the arm's length principal set forth in the ITA.

But Glaxo responded that a consideration of reasonableness should take into account a license agreement between the Glaxo Group and Glaxo that allowed Glaxo to use the parent's trademarks and brand, including Zantac. Glaxo paid Glaxo Group a 6 percent royalty on sales of drugs covered by the license agreement.

The trial judge refused to consider the license agreement because the two agreements covered separate matters. He ruled that the reasonable price for Glaxo to pay was the highest price paid by the generics, subject to a small adjustment.

Relevant Circumstances

But the FCA overturned the Tax Court's ruling and decided that the license agreement was relevant. In the FCA's view, the trial judge erred by equating the “fair market price” paid by the generics with what was “reasonable in the circumstances.” As the appeals court saw it, what was “reasonable in the circumstances” required “an inquiry into those circumstances which an arm's length purchaser, standing in the shoes of [Glaxo,] would consider relevant” in determining what it was willing to pay for ranitidine.

The relevant circumstances were that Glaxo Group owned the Zantac intellectual property, and that had nothing to do with the fact that Glaxo was an affiliated, non-arm's length purchaser; that Zantac commanded a premium over generic drugs; and that without the license agreement, Glaxo could not have used the Zantac trademark nor would it have had access to Glaxo Group's other products.

“The appeals court recognized that the trial judge ignored the fact that Glaxo's decision to pay $1500 for ranitidine was tied to a license agreement that gave it the right to sell one of the most profitable drugs in the world,” says Fran?ois Vincent, national leader of KPMG's global transfer pricing services group in Canada. “If you had the choice of buying an unbranded product that you could sell for five 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?”

Limited Resolution

Although the FCA sent the case back to the trial judge to determine the appropriate transfer price in light of its guidelines, observers still consider GlaxoSmith Kline a victory for taxpayers.

“What's important is the Federal Court of Appeal's acknowledgement that transfer pricing decisions don't exist in a vacuum and don't operate outside business realities,” says Claire Kennedy, a tax lawyer at Bennett Jones.

But that doesn't mean the battle is over for Glaxo. The Tax Court still faces the difficult task of establishing an appropriate transfer price without any guidance from the FCA on how to deal with the fact that the total price paid by Glaxo included two components payable to different parties: the price for the ranitidine paid to Adechsa and the 6 percent royalty paid to Glaxo Group.

“There is unlikely to be a comparable [case] in which an arm's length party has the rights to market a product at a specific level of royalty and then buy the raw material from a third party,” says John Tobin, a tax partner at Torys.

So while GlaxoSmithKline does move the jurisprudence forward, it's unlikely to put a large dent in the volume of transfer price litigation.

“The FCA has established a sensible principle, but the potential remains for future disputes about how to apply the standard and what it means in practice,” Kennedy says. “We do have an overarching principle now, but as happens so often, the devil is in the details.”