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GlaxoSmithKline: Elusive Valuations of Bundled Transactions - Defining a Standard of Reasonableness in Transfer Pricing
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. Taxand Canada looks at the effects of transfer pricing using a GlaxoSmithKline example, and contemplates the ramifications to the transfer pricing process arising there in an effort to define a standard of reasonableness.
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 a recent decision of Canada's Federal Court of Appeal, GlaxoSmithKline Inc. v. The Queen, 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 mechanised, 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.
With increasing globalisation, 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.
In an effort to combat these downward forces on the tax base, Canada has established transfer pricing legislation that seeks 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.
Difficulties for MNEs arise 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.
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 and delineate the factors that are properly included in an inquiry into what was reasonable in the circumstances.
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."
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.
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. The transfer price paid by Glaxo Canada was determined according to the "resale-price method". 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."
Two Canadian generic pharmaceutical companies, Apotex Inc. and Novophram Ltd., purchased their ranitidine 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 ranitidine bought by Glaxo Canada from Adechsa.
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 which Glaxo Canada paid a 6% royalty on its net sales of Zantac and other drugs in exchange for the following from the Glaxo Group:
- the right to manufacture, use and sell products
- the right to the use of the trademarks owned by Glaxo Group, including Zantac
- the right to receive technical assistance for its secondary manufacturing requirements
- 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")
- access to new products, including line extensions
- access to improvement in drugs
- the right to have a Glaxo World company sell [it] any raw materials
- marketing support
- indemnification against damages arising from patent infringement actions.
The CRA reassessed Glaxo Canada on the basis that it had overpaid Adechsa for the purchase of the drug, increasing 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, Glaxo Canada was assessed for its failure to withhold tax on dividends deemed to be paid to a non-resident shareholder equal to the amount paid in excess of what was reasonable in the circumstances.
Position of The Crown in the Appeal
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 amounts it paid for ranitidine 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.
Position of Glaxo Canada
Glaxo Canada argued that the determination of what a reasonable business person, standing in Glaxo Canada's shoes but dealing at arm's length with Adechsa, would have paid involved more 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.
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." 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".
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.
The Court emphasised that the test mandated by the Canadian transfer pricing legislation does not operate regardless of the real business world in which the parties to the transaction participate. 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. 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.
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The considerations for the valuation of an appropriate transfer price have been expanded by this case to include all relevant circumstances that may be considered by an arm's length purchaser.
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 analysed 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 Court's view, the value of the license should not be considered separately 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.