Over the last 15 years, Canada has established itself as one of the leading nations in the transfer pricing world, largely due to the significant investment it has made in personnel and programs to enforce the relevant provisions of the Income Tax Act (Canada) (“Act”), which has resulted in a sophisticated transfer pricing regime. However, with large government spending comes great pressure to yield a sizeable return on investment, leading to aggressive enforcement strategies which are sometimes seemingly influenced by the dollar amounts at stake rather than the facts of the case. Due to Canada’s place amongst the world leaders in transfer pricing, the limited jurisprudence by Canadian courts has garnered much attention from the international community, and is generally considered to carry much weight in foreign jurisdictions. On Oct. 18, 2012, the Supreme Court of Canada (“SCC”) released its first ever transfer pricing decision when it ruled on the case of Canada v. GlaxoSmithKline Inc.1 (“Glaxo case”). The SCC upheld the FCA’s decision and held that a comprehensive examination of all relevant facts as well as the entirety of GlaxoSmithKline Inc.’s (“GSK”) business model must be undertaken in order to determine a reliable transfer price.
The confirmation of such an approach is important on many levels. The real-world business circumstances in which related parties operate on a daily basis are far different from those of unrelated parties, making it difficult to find a true transfer price attributable to related party transactions. Nevertheless, when allocating profits within a related party setting, one must proceed with the assumption that related parties can indeed operate independently of one another, which creates a fictitious event. In such an environment, any transfer pricing conclusion can be subject to scrutiny and, as the many governments begin to understand the complexities of transfer pricing, we will continue to see increased audit controversy related to the arm’s length standard and increased efforts by companies to avoid double taxation. The SCC’s ruling that all factors, including the use of intangibles by related parties, be considered when determining the appropriate transfer price was correct and should serve as a useful precedent for future disputes.
Transfer pricing can be defined as the price that a member of a multinational group charges a foreign related party for goods, services and/or intangibles. A tax dispute will arise when the tax authority is of the view that the parties set the transfer price too high or too low in order to transfer profits from a high tax jurisdiction to a low tax jurisdiction. GSK, a Canadian company, was a wholly-owned subsidiary of Glaxo Group Ltd, a United Kingdom corporation. GSK and Glaxo Group were both members of the Glaxo Group of companies, which discovered, developed, manufactured and distributed a number of branded pharmaceutical products. GSK is the Canadian distributor of Adechsa S.A. (“Adechsa”), a related Swiss company.
i) Purchase Price of Ranitidine
The dispute focused on the price that GSK paid to Adechsa for ranitidine, an active ingredient found in Zantac, a popular drug used to treat and prevent stomach ulcers. The Minister of National Revenue (“Minister”) believed that GSK had paid an excessive amount ($1,600 per kilogram) for this active ingredient pursuant to the then applicable s. 69(2) of the Act (now s. 247(2)). The Minister based its argument on the price that generic drug companies, namely Apotex Inc. and Novopharm Ltd., were paying third party manufacturers for the same product, which ranged from $200 to $300 per kilogram. The Minister originally increased the income of GSK for its 1990 to 1993 taxation years by approximately $51 million, which represents the difference between the prices paid by the generic companies and GSK for their ranitidine. Further, the Minister assessed GSK under Part XIII of the Act with respect to GSK’s failure to withhold tax on dividends deemed to be paid to a non-resident shareholder.
GSK’s position was that the generics were not an appropriate comparator for two reasons, namely:
- GSK’s actual business circumstances were wholly different from those of Apotex and Novopharm, such that the transactions were not comparable within the meaning of s. 69(2) of the Act and the CUP method; and
- The ranitidine that GSK purchased from Adechsa was manufactured under Glaxo World's standards of good manufacturing practices, granulated to Glaxo World standards, and produced in accordance with Glaxo World’s health, safety, and environmental standards.
GSK submitted that independent third party licensees in Europe, which purchased the same ranitidine under the same set of business circumstances as GSK, were the best comparators.
ii) Contractual Agreements
The Glaxo case was centred around two contractual agreements: i) a Supply Agreement between GSK and Adechsa for the purchase of ranitidine; and ii) a Licence Agreement between GSK and the Glaxo Group. Under the Licence Agreement, GSK paid a 6% royalty to the Glaxo Group for the rights to certain intangibles and services. These intangibles included trademarks as well as marketing support, technical assistance and registration materials. Access to such intangibles and services were required to assist GSK in selling its drug in the Canadian market at a “premium”.
GSK argued that both the Supply Agreement with Adechsa and the Licence Agreement with Glaxo Group should therefore be considered, and a failure to do so would not reflect the economic realities of GSK. Conversely, the Minister argued that the two agreements were to be looked at separately, and that the only transactions relevant to the case were those with Adechsa.
The Tax Court of Canada (“TCC”) has often stated that the comparable uncontrolled price (“CUP”) method offers the most direct way to determining an arm’s length price. The transfer price is set by reference to comparable transactions between a buyer and a seller who are not associated enterprises. Rip A.C.J. concluded that the CUP method was the preferred method and that the price paid to Adechsa was not reasonable. Rather, it determined that Apotex and Novopharm were the appropriate comparator and that the “reasonable” price for ranitidine was the highest price paid by the generic drug companies with a $25 adjustment to account for the fact that GSK was buying granulated ranitidine, while the generic drug companies were not.
The TCC also ruled that the Licence Agreement should not be considered when determining the amount that would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm’s length because the Supply Agreement and the Licence Agreement covered separate matters.
Nadon J.A., writing for a unanimous panel, held that the TCC erred in failing to consider the Licence Agreement between GSK and the Glaxo Group. The Federal Court of Appeal (“FCA”) decided that a determination of whether the purchase price of the ranitidine was reasonable would need to factor in all relevant circumstances which an arm’s length purchaser would have had to consider. Nadon J.A. relied on the test enunciated in Gabco Limited v. Minister of National Revenue2 which requires an inquiry into those circumstances which an arm’s length purchaser, standing in the shoes of GSK, would consider relevant in deciding what price to pay. Hence, the arm’s length test does not operate regardless of the real business world in which the parties to a transaction participate.
The Court identified a number of “circumstances” which supports the contention that the Licence Agreement was a crucial consideration in determining the amount that would have been reasonable in the circumstances if the parties had been dealing at arm’s length. One of these circumstances was that the Licence Agreement was central to GSK’s business reality, and that it would be so even if the relationship with Adechsa was at arm’s length. These circumstances “arose from the market power attaching to Glaxo Group’s ownership of the intellectual property associated with ranitidine, the Zantac trademark, and the other products covered by its Licence Agreement with [GSK].”3 However, the FCA found that the “reasonable amount” remained to be determined for GSK’s ranitidine transactions, a matter which was remitted to the TCC for redetermination.
A seven member panel of the SCC heard the Minister’s appeal on Jan. 13, 2012. The SCC unanimously agreed with the FCA that Rip A.C.J. erred in refusing to take account of the Licence Agreement. Rothstein J. also agreed with Justice Nadon that “the amount that would have been reasonable in the circumstances” if GSK and Adechsa had been dealing at arm’s length has yet to be determined, which will require a close examination by the TCC of the terms of the Licence Agreement and the rights and benefits granted to GSK under that agreement.4
The SCC considered the Organisation for Economic Co-operation and Development’s (“OECD”) guidelines in finding that, while a transaction-by-transaction approach may be ideal, such an approach is not appropriate in all cases. Thus, if transactions other than the purchasing transaction are relevant in determining whether the transfer price was greater than the amount that would have been reasonable in the circumstances, these transactions must not be ignored.
The SCC held that in determining what an arm’s length purchaser would be prepared to pay for the same rights and benefits conveyed from a Glaxo Group source, one must recognize the various features of the Licence Agreement. “It is only after identifying the circumstances arising from the Licence Agreement that are linked to the Supply Agreement that arm’s length comparisons under any of the OECD methods or other methods may be determined.”5
In the present case, the SCC recognized that GSK could only purchase ranitidine from two approved sources, one of which was Adechsa, if it wanted to take advantage of the benefits offered by the Licence Agreement. This requirement was a product of Glaxo Group’s control of the trademark and patent of Zantac, rather than the non-arm’s length relationship between the relevant parties. Thus, this same requirement would likely apply to an arm’s length distributor wishing to market Zantac.
The SCC was of the opinion that the price paid by GSK to Adechsa was likely a payment for not only the ranitidine under the Supply Agreement, but consisted also of a payment for a bundle of at least some of the rights and benefits under the Licence Agreement with Glaxo Group. Thus, because the price paid by GSK was partly compensation to Glaxo Group for rights and benefits under the Licence Agreement, the SCC could not ignore the Licence Agreement. This bears the question of whether Glaxo Group should have been the recipient of part of the amounts paid by GSK to Adechsa. As stated by Rothstein J., if the price paid to Adechsa includes compensation for intellectual property rights granted to GSK, “there would have to be consistency between that and GSK’s position with respect to Part XIII withholding tax.”6 The SCC made no determination on the issue given that it was not raised by the Minister. However, the issue will be considered by the TCC when considering whether any specific rights and benefits conferred on GSK under the Licence Agreement are linked to the price for ranitidine paid to Adechsa.
GSK argued that that the FCA’s decision to remit the matter to the TCC for redetermination should be overturned. The SCC ruled that GSK had failed to demolish the assumption that the prices paid by GSK for ranitidine were greater than the amount that would have been reasonable in the circumstances had the parties been dealing at arm’s length. Therefore, the SCC remitted the matter to the TCC for redetermination, having regard to the effect of the Licence Agreement on the prices paid by GSK to Adechsa.
The SCC’s decision in this case supports the view that when examining an intercompany transaction, all relevant circumstances affecting the business reality of such transaction must be considered. The relevancy of other transactions, such as the Licence Agreement in the Glaxo case, need to be considered. The SCC held that the Licence Agreement between GSK and Glaxo must be considered conjointly with the cost of the ranitidine. The SCC decision illustrates the complexities involved when determining whether a transfer price paid between related entities is reasonable. Such a determination must take into account all relevant circumstances that would factor into any purchaser’s decision in order to reflect the real-world circumstances in which such contracts are made. This could be the start of a new test, “a business reality test”, used by the Canada Revenue Agency when conducting a transfer pricing audit. The SCC’s decision to refer the case back to the TCC leaves important issues still to be decided. This could lead to an interesting negotiation between the Canada Revenue Agency and GSK prior to going back before the TCC.
1 Canada v. GlaxoSmithKline Inc., 2012 SCC 52.
2 Gabco Limited v. Minister of National Revenue (1968), 68 D.T.C. 5210 (Ex.Cr.) at 5216.
3 GlaxoSmithKline Inc. v. Canada 2010 FCA 201 at para. 80.
4 Supra note 1 at para. 54.
5 Ibid. at para. 60.
6 Ibid. at para. 57.