Transfer-pricing issues emanate from the simple truth that 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 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.
The reduced profits in the first jurisdiction and increased earnings elsewhere translate into an improved after-tax bottom line for the enterprise as a whole.
To ensure the fair allocation 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, intangibles or financing arrangements between them occurs on the same terms as those that independent parties would negotiate.
This is known as the arm’s-length principle.
But implementing that notion isn’t so easy. This is particularly true in Canada, where the statutory guidance found in s. 247 of the Income Tax Act is sketchy and the interpretive jurisprudence is embryonic despite the fact that it’s been in force since 1998.
Fortunately, decisions are beginning to emerge, with the most significant of late being the Federal Court of Appeal’s July 26 ruling in GlaxoSmithKline Inc. v. Canada.
“The ruling has been very well-received in tax and business circles,” says Elinore Richardson, a tax partner at Borden Ladner Gervais LLP.
The case arose when GlaxoSmithKline, the Canadian subsidiary of the international pharmaceutical giant, agreed to purchase ranitidine, the prime ingredient in the bestselling drug Zantac, from Adechsa, an affiliated company that was the Swiss arm of the Glaxo Group, for between $1,512 and $1,651 per kilogram.
The Glaxo Group owned the intellectual property associated with Zantac.
At the time, generic manufacturers were marketing a generic alternative to Zantac. They managed to purchase ranitidine in the market at significantly lower prices of between $194 and $304 per kilogram.
The Canada Revenue Agency challenged the deductibility of Glaxo’s payments to Adechsa. It argued the expense wasn’t “reasonable 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 reasonableness should take into account a licence agreement between the Glaxo Group and its Canadian subsidiary.
The 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 covered by the licence agreement.
The trial judge refused to consider the licensing arrangement, reasoning that the two agreements covered separate matters. He ruled that the reasonable price for the Canadian company to pay was the highest amount borne by the generics subject to a small adjustment.
But the appeal court overturned the Tax Court of Canada’s decision and ruled the licence agreement was relevant. In its view, the trial judge had erred by equating the “fair market 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 circumstances which an arm’s-length purchaser, standing in the shoes of [the Canadian subsidiary], would consider relevant” in determining what it was willing to pay for ranitidine.
Here, the relevant circumstances 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 agreement, the Canadian subsidiary couldn’t have used the trademark for the drug nor would it have had access to the parent company’s other products.
“The appeal court recognized
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 profitable drugs in the world,” says FranÃ§ois Vincent of Moskowitz & Meredith LLP, a tax law firm affiliated with KPMG LLP.
“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?”
Although the appeal court sent the case back to the trial judge to determine the appropriate transfer price in light of its guidelines, observers still consider the matter a victory for taxpayers.
“What is important is the Federal Court’s acknowledgment that transfer-pricing
decisions don’t exist in a vacuum and don’t operate outside business realities,” says Claire Kennedy, a tax partner at Bennett Jones LLP.
“Here, the circumstances 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 battle is over. The trial judge still faces the difficult task of establishing an appropriate 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.
“There is unlikely to be a comparable in which an arm’s-length party has the rights at a specific level of royalty to market 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 unlikely to put a large dent in the volume of litigation related to transfer pricing.
“The [appeal court] 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.”