Canada: Case Comment: GlaxoSmithKline Inc. (FCA) - Elusive Valuations of Bundled Transactions: Defining a Standard of Reasonableness in Transfer Pricing

Last Updated: August 6 2010
Article by Colleen McMullin

Introduction

The task of making valuations for transfer pricing involving bundled transactions has always been a daunting one. Placing dollar figures on exchanges between related companies for transactions incorporating a combination of goods, services, and intangibles is a considerable challenge for even the most well-versed tax practitioners.

Adding to the difficulty of making accurate assessments of these transactions is the unavailability of appropriate comparators. Often, due to the uniqueness and the exclusive nature of the combination being exchanged between non-arm's length companies (especially in the case of intellectual property rights), finding the "fair market value" may be impossible to do with any precision.

In the Federal Court of Appeal's recent decision, GlaxoSmithKline Inc. v. The Queen1, light was shed on the standard of reasonableness to be applied to such transfer pricing cases. The Court acknowledged that determinations of what is "reasonable" cannot be reduced to mechanized, formulaic assessments. The real-world business circumstances in which corporations operate should not be divorced from evaluations of whether or not the transfer prices paid were reasonable. To allow otherwise would be to condone a specious appraisal of fair market value in lieu of a genuine acknowledgement of the conditions under which multinational entities do business.

Background

Transfer pricing is defined as "the price that a member of a multinational group charges a foreign related party for goods, services and/or intangibles."2 With increasing globalization, the Canada Revenue Agency (the "CRA"), along with taxing authorities in other countries, has grown concerned by the potential for members of multinational entities ("MNEs") to erode the tax base by transferring profits to jurisdictions with lower tax rates, or to entities that have previously suffered losses.3

In an effort to combat these downward forces on the tax base, government authorities in Canada have established transfer pricing regulations that seek to ensure transfer pricing is not used as a mechanism for tax avoidance by MNEs. Where the CRA determines that a company has priced an inter-company transaction artificially low or high, it can reassess the transaction and in some instances impose a penalty equal to 10% of the transfer pricing adjustment.4

In order to decrease the potential for CRA scrutiny, the prices paid for goods, services and intangible assets, exchanged between related entities, should accurately reflect arm's length standards.5 Difficulty arises in making determinations of what price would prevail in the market in situations where the goods, services, or assets being exchanged are not made available to independent third parties. A further complication is that transfer pricing often involves "bundled transactions", scenarios in which a number of transactions for an assortment of goods, services, and intangibles are combined.6

In GlaxoSmithKline Inc., the issue under appeal involved the reasonableness of a transfer pricing arrangement for such a bundled transaction in the context of the pharmaceutical industry. Specifically, the court had to determine the legal standard mandated by the former section 69(2) of the Income Tax Act ("ITA"), and delineate the factors that are properly included in an inquiry into what was "reasonable in the circumstances."7

Facts

GlaxoSmithKline Inc. ("Glaxo Canada") was a wholly-owned subsidiary of Glaxo Group, which was itself a wholly-owned subsidiary of Glaxo Holdings plc. Both parent companies were United Kingdom corporations. Glaxo Holdings was "the ultimate parent of the Glaxo Group of companies ('Glaxo World companies')," which "discovered, developed, manufactured and distributed a number of branded pharmaceutical products."8

During the time material to the appeal, Glaxo Canada sold Zantac, a patented and trade-marked drug prescribed to treat stomach ulcers, in Canada. The active ingredient in Zantac, ranitidine, as well as the Zantac trade-mark, were owned by Glaxo Group, but were licensed to Glaxo Canada for their domestic use.9

The manufacturing of ranitidine was handled by two foreign companies within the Glaxo World companies and sold to Adechsa SA ("Adechsa"), a Swiss resident Glaxo World clearing company. The Swiss company in turn sold it to Glaxo Canada for an amount between $1512 and $1651 per kilogram.10 The transfer price paid by Glaxo Canada was determined according to the "resale-price method". According to this system of pricing, Glaxo World and its distributors agreed that a gross margin of 60 percent would be retained by the distributors, and the ranitidine would be priced accordingly. The starting point for determining the price the distributor would pay was the in-market price for the finished ranitidine product. The lower court used a simplified example to demonstrate this mechanism of price setting: "if the ranitidine product was sold for $10 in Italy, the transfer price would be $4; if the ranitidine product was sold for $20 in France, the transfer price would be $8."11

Elements of the Appeal

At the crux of the appeal were two contractual agreements. The first was a Supply Agreement between Glaxo Canada and Adechsa for the purchase of ranitidine. The second was a License Agreement between Glaxo Canada and the Glaxo Group. Pursuant to the latter agreement, Glaxo Canada paid a 6% royalty on its net sales of Zantac and other drugs in exchange for the following from the Glaxo Group:

  1. the right to manufacture, use and sell products;
  2. the right to the use of the trademarks owned by Glaxo Group, including Zantac;
  3. the right to receive technical assistance for its secondary manufacturing requirements;
  4. the use of the registration materials prepared by Glaxo Group, to be adapted to the Canadian Environment and submitted to the Health Protection Branch ("HPB");
  5. access to new products, including line extensions;
  6. access to improvement in drugs;
  7. the right to have a Glaxo World company sell [it] any raw materials;
  8. marketing support; and
  9. indemnification against damages arising from patent infringement actions.12

The Objection of the Minister

At all times relevant to the appeal, two Canadian generic pharmaceutical companies, Apotex Inc. and Novophram Ltd., purchased their rantidine from arm's length suppliers for an amount between $194 and $304 per kilogram. These prices were, at minimum, $1208 per kilo lower than the rantidine bought by Glaxo Canada from Adechsa.13 The CRA reassessed Glaxo Canada for the taxation years 1990 through 1993 on the basis that it had overpaid Adechsa for the purchase of the drug.14 Under subsection 69(2) of the ITA, the Minister of National Revenue increased Glaxo Canada's income by the difference between the price paid by the generic companies for their ranitidine and that paid by Glaxo Canada for its ranitidine. Further, the Minister asserted Part XIII of the Act against Glaxo Canada for its failure to withhold tax on dividends deemed to be paid to a non-resident shareholder pursuant to subsections 56(2), 212(2) and 214(3) of the ITA.15

The results of the Part XIII assessment hinged on the findings of the assessment under subsection 69(2), namely, "whether the prices paid by Glaxo Canada to Adechsa for ranitidine would have been reasonable in the circumstances if Glaxo Canada and Adechsa had been dealing at arm's length."16 The wording of that subsection follows:

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...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.17

[Emphasis added]

If it was found that Glaxo Canada did pay a reasonable amount in the circumstances, then the grounds for assessing the withholding tax would fail as the provisions deeming the payment of a dividend would cease to apply.

Position of The Crown

The Crown asserted that the only agreement that should be considered in evaluating the reasonableness of the transfer price was the Supply Agreement – the License Agreement, in its opinion, should be ignored. If accepted, this would effectively shut the door on any effort by Glaxo Canada to rely upon the goodwill value of the Zantac trademarks or the regulatory approval and marketing assistance received from Glaxo World as justification for the price disparity between the amount it paid for rantidine versus the amount paid by the generic companies. This is so because all intangibles were dealt with in the License Agreement. If it were excluded from an assessment of the reasonableness of the transfer price, all benefits conferred therein to Glaxo Canada would not be considered.

The Crown further alleged that even if the License Agreement and the Supply Agreement were taken together, Glaxo Canada failed to prove that a party transacting at arm's length would have paid the same amount for the right to sell Zantac in Canada.18

Position of Glaxo Canada

Glaxo Canada argued that an inquiry under subsection 69(2) requires a trier of fact "to assess whether any reasonable business person, standing in [Glaxo Canada]'s shoes but dealing at arm's length with Adechsa, would have paid the amount paid by [Glaxo Canada]."19 Glaxo Canada insisted that the determination is more involved than simply declaring any price above that of fair market value to be "unreasonable". It demands an analysis of the business circumstances surrounding the transaction.20

As Glaxo Canada asserted, and the Court ultimately agreed, to ignore the License Agreement would be to create "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."21 As no arm's length party could sell Zantac-branded products without the existence of a License Agreement, it would be improper to exclude it from an analysis of what was "reasonable in the circumstances".22

Decision of the Court

The Federal Court of Appeal unanimously rejected the contention that the License Agreement should be ignored. It decided that a determination of whether or not 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. In coming to this conclusion, the Court relied on the test enunciated in Gabco Limited v. Minister of National Revenue:23

It is not a question of the Minister or this Court substituting its judgment for what is a reasonable amount to pay, but rather a case of the Minister or the Court coming to the conclusion that no reasonable business man would have contracted to pay such an amount having only the business considerations of the appellant in mind.

[Emphasis added]

The Court correctly emphasized that "the test mandated by subsection 69(2) does not operate regardless of the real business world in which the parties to the transaction participate."24

Even if Glaxo Canada and Adechsa had been transacting at arm's length, the Court outlined a number of crucial "circumstances" that would have existed regardless of the parties' relation to each other. 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 License Agreement with Glaxo Canada."25 Any arm's length party would have consequently had to consider the contents of the License Agreement in deciding whether or not to pay the price asked for by Adechsa for the sale of Zantac ranitidine.

Conclusion

The Federal Court of Appeal accepted that there is no magic formula in determining whether or not a transfer price paid between related entities is reasonable. The totality of circumstances that would factor into any purchaser's decision must be carefully analyzed before a conclusion can be drawn; to accept less would be to turn a blind eye to the real-world circumstances in which such contracts are made. In the case of Glaxo Canada, it obtained the active ingredient ranitidine in conjunction with a license for various rights to Glaxo products including the right to sell Zantac branded products. In the Courts view the value of the license should not be considered seperately from the cost of the ranitidine. The Court acknowledged that significant brand power existed in the trademarked drug and, as a result, could afford the Glaxo Group a great deal of latitude in its transfer pricing demands. The favourable bargaining position of the Glaxo Group existed because of its ownership of the intangibles contained under the License Agreement. This was so regardless of whether it was transacting with a subsidiary or an arm's length party.

Footnotes

1. GlaxoSmithKline Inc. v. Canada 2010 FCA 201.

2. Dale Hill & Mark Kirkey, "Recent Developments in Trasfer Pricing" (2005) Gowlings Knowledge Centre at 1.

3. Ibid.

4. Ibid.

5. Dale C. Hill & Jamal Hejazi, "Transfer Pricing and the Pharmaceutical Industry: 2006 in Review" (2007) Gowlings Knoweldge Centre at 10.

6. Supra note 2 at 4.

7. Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.).

8. Supra note 1 at para. 7.

9. Ibid. at para. 9.

10. Ibid. at para. 1.

11. GlaxoSmithKline Inc. v. The Queen, 2008 TCC 324 at para. 47.

12. Supra note 1 at para. 16.

13. Ibid. at para. 1.

14. Ibid. at para. 17.

15. Ibid. at para. 2.

16. Ibid. at para. 23.

17. Supra note 7 at s. 69(2).

18. Supra note 1 at para. 47 and para. 51.

19. Ibid. at para. 40.

20. Ibid. at para. 41.

21. Ibid. at para. 78.

22. Ibid.  at para. 42.

23. Gabco Limited v. Minister of National Revenue (1968), 68 D.T.C. 5210 (Ex.Cr.) at 5216.

24. Supra note 1 at para. 74.

25. Ibid. at para. 80.

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Colleen McMullin
 
In association with
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert
Email Address
Company Name
Password
Confirm Password
Mondaq Topics -- Select your Interests
Accounting and Audit
Anti-trust/Competition Law
Consumer Protection
Corporate/Commercial Law
Criminal Law
Employment and HR
Energy and Natural Resources
Environment
Family and Matrimonial
Finance and Banking
Food, Drugs, Healthcare, Life Sciences
Government, Public Sector
Immigration
Insolvency/Bankruptcy, Re-structuring
Insurance
Intellectual Property
International Law
Litigation, Mediation & Arbitration
Media, Telecoms, IT, Entertainment
Privacy
Real Estate and Construction
Strategy
Tax
Transport
Wealth Management
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.