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In simple terms, when related corporations trade property, services or intangibles across international borders, the outlay is referred to as the transfer price. Pursuant to s. 69(2) of the Federal Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (“ITA”), the transfer price must be “reasonable in the circumstances” that would exist if the non-resident person and the taxpayer had been dealing at arm’s length. In other words, to combat transactions structured for tax avoidance purposes, the Minister must accept that the price is of the amount that would have been paid if the taxpayer and non-resident person (eg. foreign corporation) were unconnected. Corporations and their subsidiaries are obviously connected, and thus are presumed to deal at non-arm’s length for tax purposes. (TheCourt.ca previously discussed transfer price in GE Capital v. The Queen 2009 TCC 563, found here.)
In the case of GlaxoSmithKline Inc. v. The Queen, 2008 TCC 324 [Glaxo I], the “reasonable in the circumstances” standard was applied to payments for a pharmaceutical product purchased by Glaxo Canada (“Glaxo”) from a non-arm’s length non-resident person, Adechsa SA (“Adechsa”), both members of the Glaxo Group of companies (“Glaxo Group”). The Minister and Tax Court of Canada agreed that the reasonable amount was the fair-market value of the pharmaceutical product.
However, according to the Federal Court of Appeal decision in Glaxosmithkline Inc. v. Canada, 2010 FCA 201 [Glaxo II], (reasons for judgement by Nadon J.A.) the failure of the Tax Court of Canada to “consider all relevant circumstances which an arm’s length purchaser would have had to consider…”, including a related licensing and purchasing agreement, was a legal error. Essentially, determining the price that is “reasonable in the circumstances” is a contextual process and not merely an exercise in determining the fair market value.
Legal Framework
Section 69(2) of the ITA states:
69. (2) Where a taxpayer has paid or agreed to pay to a non-resident person with whom the taxpayer was not dealing at arm’s length as price, rental, royalty or other payment for or for the use or reproduction of any property, or as consideration for the carriage of goods or passengers or for other services, an amount greater than the amount (in this subsection referred to as “the reasonable amount”) that would have been reasonable in the circumstances if the non-resident person and the taxpayer had been dealing at arm’s length, the reasonable amount shall, for the purpose of computing the taxpayer’s income under this Part, be deemed to have been the amount that was paid or is payable therefor.
Pursuant to this section, a payment to a non-arm’s length non-resident person has to be an amount not greater than what would be “reasonable in the circumstances” if the payment was made to an arm’s length person.
Background and Facts
For the four years at issue (1990-1993), Glaxo purchased the pharmaceutical ingredient ranitidine, which is marketed as Zantac, from Adechsa SA (“Adechsa”), a related non-resident company, for the price of between $1512 and $1651 per kilogram. In the same period, two generic Canadian pharmaceutical companies purchased the same product for much less—between $194 and $304 per kilogram.
The Minister reassessed Glaxo for the years 1990-1993 for overpaying for the drug randitine and as a result its income was increased to account for the difference between the price paid and what the Minister considered to be the amount “reasonable in the circumstances.”
In Glaxo I, Rip A.C.J. (now C.J.) of the TCC deemed the reasonable amount to be the fair market value of ranitidine, as substantiated by the prices paid by the generic companies. The excess amounts paid to Adechsa were deemed to be benefits, and pursuant to s. 56(2) of the ITA, subject to non-resident withholding tax.
When Determining the “Reasonable Amount” Under s. 69(2) Business Circumstances Must be Taken Into Account
The main issue in the present case was what considerations were to be taken in order to determine what was a “reasonable amount” pursuant to s. 69(2) of the ITA. According to the Court of Appeal, for s. 69(2) to take effect the following criteria must be met:
1. There must be a taxpayer (as defined in subsection 248(1);
2. who paid or agreed to pay;
3. to a non-resident;
4. with whom the taxpayer was not dealing at arm’s length;
5. an amount and as a price, rental, royalty or other payment for or for the use or reproduction of any property, or as consideration for the carriage of goods or passengers or for other services;
6. the amount must be “greater than 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”.
The Federal Court of Appeal was primarily concerned with criterion 6. Glaxo contended that the business circumstances surrounding the transactions should have been taken into account when determining the price that would have been “reasonable in the circumstances.” The company argued that s. 69(2) should not apply if it could be determined that any reasonable business person, in the same situation, yet dealing at arm’s length, would have paid the amount.
To buttress this argument, the company contended that related license and supply agreements, which in part required that Glaxo purchase the product from Adechsa, should be taken into consideration; to do otherwise would be "ignoring a crucial business circumstance." In part, the agreements provided the Glaxo subsidiary with select intellectual property rights, including the use of the ranitidine patent and associated trademark, along with “other patented and trademarked products.”
Conclusion
In Glaxo I, the Tax Court rejected the impact of the agreements. In Glaxo II, the supply and license agreements were together held to potentially validate the price difference at issue. According to the Federal Court of Appeal, the Tax Court of Canada erred by misunderstanding the test for s. 69(2). Real world conditions must be taken into consideration, “including all relevant circumstances which an arm’s length purchaser would have had to consider…” As a result, the issue was returned to Rip C.J. of the Tax Court for a rehearing.
8 Comments
Creative Accounting ("transfer pricing"): A hard pill to swallow.
In addition to the tax-saving implication of GSK's action, I was wonder if this case would also be considered a form of "price-fixing with a twist"? The result of lawful vs. unlawful agreement (twist) between a parent company (manufacturer/purchaser) and subsiduary company (producer) to set and maintain specified prices ("reasonable in the circumstances") on a typically competing product (ranitidine "Zantac") at inflated market values.
I applaud this ruling because it seems GSK's practice of "arm's length" only extends to their back pockets.
I have a few things to mention on this case. First a disclaimer though, I am a practitioner that deals with transfer pricing issues. Second, I take some umbrage to the notion that transfer pricing constitutes creative accounting, because it's not financial reporting issue; it's a tax issue. This is not an issue of price fixing.
The FCA's ruling was correct in my view. The license agreement would have been a relevant consideration to a reasonable business-person dealing at arm's length. Glaxo Canada was able to command a much higher price for its output because of its access to Glaxo International's trademarks and patent portfolio. Without the license agreement, Glaxo Canada would have been no different from the generic drug makers that purchased ranitidine at the stated prices, but would not be able to sell the product as Zantac. The license agreement and the purchase of product were worth more together than they would be separately.
Also, I don't think that a transfer price in excess of $1,500 per kilo would constitute earnings stripping. If I do recall, in the lower court trial it was noted that even at that price, Glaxo Canada still earned a gross margin of something like 60% on Zantac sales.
I gather I was way off base on this one, even with a twist. Sorry. I do appreciate your professional feedback.
I did attempt to try and view this case from a tax perspective: historical costs and accrual accounting in purchasing a generic product to resale under an existing trademark. I appreciate the point you have made about the international value of combined worth. I totally agree that this is a tax issue.
My question (not related to this case) is:
How does earnings stripping (non-arms length?) happen when the compliance and/or tax rules for a reporting company are so well defined?
I think that, in this case, the two transactions ( license agreement and supply agreement) should be evaluated separately, because related parties abroad are not the same in the two transactions ( the GSK parent company in the license agreement and the swiss related company in the supply agreement) . otherwise, the risk is a double remuneration of intangibles ( trademark, ecc...) to the two different related companies abroad: one time to the parent company as 6% royalty and the other one to swiss related company included in the (higher) price paid for the active ingredient ranitidine. if the related party abroad was the same for the two transactions ( license and supply agreement) probably it would be easier to evaluate them together, probably using a transactional profit method, because the CUP for ranitidine wouldn't be comparable.
p.s. sorry for my english which is not fluent
@m.diane kindree
Actually, the tax compliance rules for transfer pricing are principle-based and not prescriptive. What constitutes earnings strippings is a matter of opinion, not fact.
The overriding principle is that related-party transactions should be priced as if the parties were at acting at arm's length. In practice, good comparable arm's length transactions are hard to find, and the related-parties generally try to structure the transaction to achieve a tax efficient outcome while attempting to minimise the risk of audit and adjustment. They do this by shifting most of the significant functions, risks and assets to one party (preferably in a lower tax jurisdiction), while the other party's contributions are minimal. Transfer pricing practice (and economics) holds that the the party that performs the most substantial functions, bears the most risk and contributes the most assets, should generally be the party that earns the most profit. This gives some latitude for companies to shift profit around in order to achieve a tax efficient outcome, subject to the limits of how their operations are set up. I would note that under the transfer pricing rules in Canada, and as set out by the OECD, this is entirely legal and accepted practice. This practice only gets abhorrent when multinational enterprises try to get away from the principle that rewards should accrue to the members that contribute the most, such as with paper entities in tax havens.
@alex
You are right in saying that it would be best for the transactions to be evaluated separately; however, doing so ignores the notion that they are collectively more valuable than they are individually, and a reasonable businessperson would take this into account. The FCA judge's ruling effectively invalidates the use of the comparable uncontrolled price method, and the comparable transactions that the government used. You are right that a transactional profit method could be used to evaluate the results of the pricing of the ranitidine sales combined with the licensing transaction. If the TCC judge applies the transactional net margin method (TNMM), only the margins earned by Glaxo Canada need to be compared. Just because the related-party transactions are between separate parties in the corporate group does not mean that the TNMM cannot be applied, though as you noted, it would be preferable if the transactions could be evaluated separately.
Your concise and thorough response gives rise to these additional questions: How would the court determine a value of product(s) (end selling price) based on intangibles (e.g. brand names, intellectual property, patents, formulas, trademarks, contracts, copyright, etc.) in transfer pricing? Doesn't the entire package have to be at arm's length to properly asses "value of combined worth"? Alex has suggested an evaluation based on application of TNMM which seems to be a viable approach (tangible) which a TCC judge could correctly apply to this case. Isn't this case about trying to clarify the interdependence of various functions contractually while objectively measuring the high-value intangibles involved to determine how to rationally, correctly and fairly scrutinize the tax treatments of those assets?
Is there a formula that can convert these intangibles (difficult to measure) to tangibles by comparative analysis (principle based) of similar-type products and related-party transactions of other multinationals? Do you think this suggested approach might help to illuminate the value of the "sum of the parts" (licensing, supply agreement and value of intangibles) in accounting for the price differences?
Is what constitutes 'earning stripping' also considered a matter of opinion, not fact, south of the border?
Mr. John J. Tobin's article "Canadian Court Overturns Decision on International
Pharmaceutical Transfer Pricing Case" (September 2, 2010) has answered some of my questions.
Q: Given the intangible properties issue and no quality comparable data available
would the use of two transactional profit methods: transactional net margin method (TNMM) and the profit split method be the courts combined approach in this challenging transfer pricing case?
A: ?
Every now and then I like to follow-up on interesting cases especially those that may have a global impact. In 2012, Russia, Australia and China (may be others which I have not yet reviewed) passed new transfer pricing methods legislation. These countries added the profit-based methods: transactional net margin method and profit split to the traditional methods: comparable uncontrolled price (CUP), resale price and cost plus.
How did the TCC deal with this case?