In its recently-released judgement in Canada v. GlaxoSmithKline Inc.1 the Supreme Court of Canada has considered transfer pricing tax issues for the first time. This decision is important to multi-national enterprises ("MNEs") because the Supreme Court makes it clear that Canadian courts have broad scope to determine whether prices used for the transfer of property or services between a Canadian resident taxpayer and non-arm's length non-residents are reasonable. The Supreme Court agreed with the Federal Court of Appeal in overturning the original decision of the Tax Court of Canada (the "Tax Court") to essentially confirm the income tax reassessment of GlaxoSmithKline Inc. ("Glaxo Canada") issued by the Minister of National Revenue (the "Minister"). The Tax Court held that the reasonableness of transfer pricing should be determined on a strict transaction-by-transaction basis and other agreements or transactions entered into by the parties should be ignored. However, the Supreme Court concluded that if other transactions are relevant in determining whether transfer pricing is reasonable, these transactions should be taken into account. In this case, the existence of both a licence agreement and a supply agreement between Glaxo Canada and certain affiliated non-resident corporations was pertinent to the analysis.
Although the Supreme Court dismissed the Crown's appeal of the Federal Court of Appeal decision, it did not determine whether the transfer pricing used by Glaxo Canada was reasonable in the circumstances. Instead, the Supreme Court remitted the matter back to the Tax Court for redetermination based on the Supreme Court's guidance. As a result, Glaxo Canada's victory at the Supreme Court is tempered by the reality that it still must prove to the Tax Court that the prices it paid to its non-resident affiliates are not greater than what would have been reasonable in the circumstances if they were dealing with each other at arm's length.
The Minister reassessed Glaxo Canada for tax years 1990 to 1993, arguing that Glaxo Canada had overpaid its Swiss affiliate Adechsa S.A. ("Adechsa") under a supply agreement for ranitidine. Ranitidine is the active ingredient in the ulcer medication Zantac, which was manufactured, marketed and distributed by Glaxo Canada under a licence agreement with Glaxo Canada's parent, Glaxo Group Ltd. ("Glaxo Group"). During the years at issue, Glaxo Canada had paid Adechsa between $1,512 and $1,651 per kilogram of ranitidine. The Minister used subsection 69(2) (a precursor to subsection 247(2)) of the Income Tax Act ("ITA") 2 to argue that this transfer pricing was unreasonable based on the fact that other Canadian pharmaceutical companies were paying, at a maximum, just over $300 per kilogram to their non-affiliated suppliers for generic versions of the drug.
Under a separate licence agreement, Glaxo Canada was granted certain intellectual property rights, including the right to sell the medication under the Zantac trademark. In return, Glaxo Canada paid an annual royalty of 6% of its net sales to Glaxo Group.
The Lower Courts
The Tax Court3 accepted the Minister's approach and compared the Glaxo Canada ranitidine purchase transaction to a ranitidine purchase transaction made by two generic pharmaceutical companies and concluded that the arm's length pricing was marginally higher than the highest generic drug pricing. The Tax Court ordered the Minister to issue an income tax reassessment of Glaxo Canada on the basis that payments to Adechsa in excess of the arm's length transfer price were not deductible by Glaxo Canada in computing its income for Canadian tax purposes. In addition, the Tax Court ordered the Minister to assess Glaxo Canada under Part XIII of the ITA on the basis that the excess amounts paid to Adechsa were deemed dividends subject to Canadian non-resident withholding tax.
The Federal Court of Appeal4 overturned the Tax Court decision and sent the case back for re-hearing on the basis that the Tax Court judge had erred in not taking into account all the relevant circumstances surrounding the transaction. Such circumstances include the fact that, because of the licence agreement, Glaxo Canada could command a premium for Zantac over the generic ranitidine drugs, and hence, would be willing to pay more for the means by which to sell the non-generic version.
The Supreme Court granted the Crown's request for leave to appeal. Glaxo Canada also sought (and received) leave to cross-appeal the decision of the Federal Court of Appeal in respect of the order referring the matter back to the Tax Court for determination of the reasonable arm's length transfer prices.
The Supreme Court Decision
In the unanimous decision of the Supreme Court, Justice Rothstein's reasons support expansion of the factors that may be taken into account when determining the reasonableness of transfer pricing. Since reasonableness is relative: one must compare the amount paid by the entity to its affiliate to that which would have been reasonable had the parties been dealing at arm's length in similar economic circumstances. In order to assess this hypothetical amount, however, a court should not be restricted to considering a particular transaction in isolation if the facts do not warrant such a narrow inquiry. On these facts, for example, any definition of reasonableness would need to account for agreements between the parties (such as the licence agreement) outside the transaction for the purchase of ranitidine itself.
Noting that subsection 69(2) of the ITA does not define "reasonable", the Supreme Court considered the reliance by the lower courts on the 1995 OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the "OECD Guidelines"). The Supreme Court cautions that the OECD Guidelines are "not controlling as if they were Canadian statute"; determination ultimately rests with the provisions of the ITA. Justice Rothstein acknowledged that the OECD Guidelines suggest four methods for determining the reasonableness of a transfer price: (i) the comparable uncontrolled price ("CUP") method; (ii) the cost plus method; (iii) the resale-price method; and (iv) the transactional net margin method. The Supreme Court made no definitive determination as to the appropriateness of any of these four methods in the circumstances, leaving any determination for re-hearing at the Tax Court.
Justice Rothstein rejected the strict application of a "transaction-by-transaction" approach stating: "while a transaction-by-transaction approach may be ideal, [the OECD Guidelines] themselves recognize that it is not appropriate in all cases.5 Furthermore (and again quoting the OECD Guidelines), Justice Rothstein noted that "an arm's length comparator is only useful if economically-relevant characteristics... [are] sufficiently comparable." 6
The Supreme Court concluded that the licence agreement between Glaxo Group and Glaxo Canada must be taken into account to determine whether the transfer price for the ranitidine purchase is reasonable. It was because of the licence agreement that Glaxo Canada was purchasing its ranitidine from its parent's preferred source: Adechsa. Without the licence agreement, Glaxo Canada would not have been able to manufacture, market or distribute the ranitidine it received. Also, the licence agreement allowed Glaxo Canada to avoid the risk involved with product development. The Supreme Court concluded that these rights and benefits "could not be irrelevant" in an assessment of whether the higher price was reasonable as compared to generic peers. 7 However, the Supreme Court stopped short of determining whether the transfer pricing was, in fact, reasonable.
The Supreme Court offered the following guidance for the Tax Court in redetermining whether the transfer prices in this case are reasonable. First, as transfer pricing "to use the words of the [OECD Guidelines]... 'is not an exact science'," "reasonable amount" should be interpreted as "reasonable range."8 If the transfer price used Glaxo Canada is not within this reasonable range, then "the court might select a point within a range it considers reasonable in the circumstances based on an average, median, mode or other appropriate statistical measure, having regard to the evidence that the court found to be relevant."9 Second, the Tax Court must look at the respective roles of Glaxo Canada and Glaxo Group to determine whether a higher price was justified on the basis of compensation for intellectual property rights. 10 Third, both the interests of Glaxo Canada and Glaxo Group must be considered by the Tax Court having regard to their independent interests.11 Lastly, the fact that arm's length parties have purchased ranitidine from Glaxo Group suppliers (rather than from a generic source) indicates that some amount of price increase will be justified.12
In dismissing the cross-appeal, the Supreme Court held that while Glaxo Canada had successfully demolished the Minister's assumption that the transfer price paid to Adechsa for the purchase of ranitidine should not be greater than the prices paid for ranitidine by the Canadian generic pharmaceutical companies, it had not demolished the Minister's assumption that the amounts paid to Adechsa were unreasonable. On this basis, the Supreme Court remitted the matter to the Tax Court for redetermination. 13
Fasken Martineau Commentary
While novel to the extent that the Supreme Court has never considered a transfer pricing case or the OECD Guidelines, it may be many more months before this case will be concluded and the extent to which the outcome may be considered a "victory" for Glaxo Canada.
As the Supreme Court sent the case back to the Tax Court for redetermination, both the Minister and Glaxo Canada are, in some ways, back to where they started. The case at first instance was lengthy and, as has been the recent trend in tax litigation, required the testimony of tax experts on both sides, leading to lengthy transcripts. This testimony will need to be re-visited and re-assessed and new testimony may be introduced. During the initial trial before the Tax Court, Associate Chief Justice Rip (now Chief Justice) favoured the testimony of the Minister's expert, Dr. Jack Mintz, citing that the testimony of the Glaxo Canada experts was unreasonable. With a broadened definition of what may be considered in the reasonableness assessment, it is not clear that on re-hearing the conclusion will be the same.
While the Supreme Court admitted that the purchase price was likely linked to rights under the license agreement, it refused to determine whether some portion of the purchase price for ranitidine was really a royalty payment for Glaxo Canada's licence of the intellectual property of its UK parent. 14 The Supreme Court points out that if it is the case that part of this transaction can be characterized as a Canadian entity paying a royalty to a non-resident, there would have to be "consistency" between this characterization and Glaxo Canada's obligations with respect to withholding tax under Part XIII of the Income Tax Act.15 To guide the Tax Court, the Supreme Court refers to three specific provisions regarding royalties under the licence agreement.16
It is worth noting that even if the Tax Court concluded that some portion of the payments to Adechsa were on account of intellectual property rights, since the principal focus of this appeal is the deductibility of the payments such "embedded" royalties should still be deductible by Glaxo Canada.
These comments are also interesting from a procedural standpoint. While Justice Rothstein states that Glaxo Canada's Part XIII tax position may be addressed by the parties and considered by the Tax Court judge as part of the redetermination, it is unclear whether this concept of embedded royalties for use of intellectual property has been raised previously by the Minister in these proceedings. Query whether it is open to the Minister to do so now at this late stage.
Generally, the Supreme Court's requirement for a fact-driven, holistic approach to assessing the reasonableness of transfer pricing will give MNEs some leeway in structuring arrangements within their corporate groups. Based on Justice Rothstein's reasons, it seems clear that the OECD Guidelines are not determinative for purposes of interpreting the transfer pricing rules in the ITA. In fact the only statement from the OECD Guidelines that the Supreme Court appears to have confirmed was that determining arm's length transfer prices is not an exact science. As a result, even though the Tax Court favoured the CUP method of transfer pricing analysis, the Supreme Court indicated that this may not be the best method for analysis in this case, due to its narrow focus on particular transactions. Since the Supreme Court declined to elaborate further, the door appears to be open to any, or none, of the four OECD methods being acceptable for determining a reasonable transfer price, depending on the circumstance of the particular taxpayer as compared to that taxpayer's economic comparator group.
1 2012 SCC 52 ("GlaxoSmithKline").
2 Income Tax Act R.S.C. 1985 c.1 (5th Supp). It is worth noting that unlike the old subsection 69(2), subsection 247(2) does not contain a requirement that the pricing be "reasonable in the circumstances", only that the terms and conditions of the transaction or series of transactions between the parties "had been those that would have been made between persons dealing at arm's length."
3 GlaxoSmithKline Inc. v. The Queen, 2008 TCC 324, 2008 D.T.C. 3957.
4 GlaxoSmithKline Inc. v. Canada, 2010 FCA 201, 405 N.R. 307.
5 GlaxoSmithKline at para 40.
6 Ibid. at para 42.
7 Ibid. at para 52.
8 Ibid. at para 61.
9 Ibid, at para. 61.
10 Ibid. at para 62.
11 Ibid. at para 63.
12 Ibid. at para 64.
13 Ibid. at para 74.
14 Ibid. at para 57.
15 Ibid. at para 57.
16 Ibid. at para 55.
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