Canada: Federal Court Of Appeal Adopts A "Business Reality" Test For Transfer Pricing Analysis

On July 26, 2010, the Federal Court of Appeal issued its decision in the case of GlaxoSmithKline v. R., reversing the Tax Court of Canada's decision and sending the case back to the Tax Court for reconsideration. In 2008, Assistant Chief Justice Rip (as he then was) of the Tax Court had held that the taxpayer, GlaxoSmithKline Inc. ("Glaxo Canada"), had paid in excess of a reasonable amount for its purchases of a pharmaceutical ingredient, ranitidine, from Adechsa S.A., a non arm's length company.

Glaxo Canada was a wholly-owned subsidiary of Glaxo Group Limited ("Glaxo Group"), a United Kingdom corporation. Beginning in 1982, Glaxo Canada packaged and sold Zantac, a patented and trade-marked drug, in Canada. The Zantac trade-mark and patents for its active pharmaceutical ingredient, ranitidine, were owned by Glaxo Group, which licensed them to Glaxo Canada for use in Canada.

Glaxo Canada had a Licensing Agreement in place with Glaxo Group for access to, and use of, the latter's intellectual property including trade-marks and technical expertise. In consideration, Glaxo Canada paid Glaxo Group a 6% royalty on its net sales of Zantac. The intellectual property contract also required Glaxo Canada to purchase ranitidine from Adechsa S.A. Under a separate Supply Agreement with Adechsa S.A., Glaxo Canada paid Adechsa S.A. between $1,512 and $1,651 per kilogram for ranitidine.

The issue in this case was whether Glaxo Canada had paid Adechsa S.A. a "reasonable price" for the ranitidine. According to the evidence, in the years in question Canadian generic companies were able to purchase ranitidine for $193 to $304 per kilogram. The Tax Court of Canada held that these purchases made by arm's length Canadian generic companies were comparable to those made by Glaxo Canada. The Tax Court determined that the Licence Agreement with Glaxo Group and the Supply Agreement with Adechsa S.A. covered separate matters and must be considered separately. Based on this conclusion, the Tax Court decided that Glaxo Canada had paid in excess of a reasonable amount on its purchases of ranitidine and allowed the CRA's assessment to increase the taxpayer's income by the difference between the price that Glaxo Canada had paid for the ranitidine and the highest price paid by the generic companies.

The Federal Court of Appeal, however, was of the opinion that the Tax Court judge had erred in his assessment of the reasonable price for the ranitidine because he did not take into account the "business reality" of Glaxo Canada and made his determination in a "fictitious business world where a purchaser is able to purchase ranitidine at a price which does not take into account the circumstances which make it possible for that purchaser to obtain the rights to make and sell Zantac". Specifically, the Court of Appeal said that the Tax Court judge failed to consider the impact of the Licensing Agreement on what an arm's length party would have paid for the ranitidine. The Court of Appeal noted that the Licensing Agreement was an essential consideration in the determination of a reasonable transfer price because Glaxo Canada was legally bound to purchase the active ingredient from Adechsa S.A. in order to distribute Zantac in Canada. The Licensing Agreement was also important since the Court of Appeal concluded that Glaxo Canada could not have viably penetrated the generic ranitidine market since entrance costs to this market would have been prohibitive, and as such the price paid by the generic companies was not comparable. Thus, the Court of Appeal held that the assessment of Glaxo Canada's transfer price for the active ingredient had to be undertaken in light of the terms and conditions of the Licensing Agreement, and sent the matter back to the Tax Court for reconsideration of a reasonable transfer price taking the Licensing Agreement into account.

This decision suggests a broader approach to transfer pricing analyses that is sensitive to surrounding business realities. In other words, in making an assessment of a "transaction" for transfer pricing purposes, this decision suggests that all transactions and agreements which affect the price of a particular good or service should be taken into account when determining the price for that particular good or service. This is counter to the position often taken by the Canada Revenue Agency that each transaction should be reviewed in isolation from other transactions and agreements even where these other transactions impact on the terms or pricing of the first transaction. Taxpayers should consult their tax advisors to determine what impact this case will have on their current transfer pricing methodologies.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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