GlaxoSmithKline Inc v The Queen

Practical implications for preparation of transfer pricing documentation, application of transfer pricing methods and selection of comparables.

On 26 July 2010, the Canadian Court of Appeal (the “Appeals Court”) handed down its decision in the case of GlaxoSmithKline Inc v The Queen.  The Appeals Court reversed the decision handed down by the Tax Court of Canada (the “Tax Court”) in 2008.

Background

Between the years 1990 and 1993, the taxpayer (“Glaxo Canada”) purchased ranitidine from a related non-resident company for an amount of between $1512 and $1651 per kg (“Glaxo Seller”).  Ranitidine is an active pharmaceutical ingredient in a drug marketed by Glaxo Canada in Canada under the brand name Zantac.  During that same period, two unrelated Canadian generic pharmaceutical companies, namely Apotex Inc. and Novopharm Ltd, purchased their ranitidine from arm’s length suppliers for an amount of between $194 and $304 per kilo.

It appears to the author that ranitidine to Zantac is by analogy similar to Paracetamol to Panadol (paracetamol being the active ingredient for Panadol).  Also the existence of generic products appears to suggest that ranitidine might have come out of patent protection.  The Glaxo group was the creator of ranitidine.

The manufacturing of ranitidine was performed by Glaxo companies located in Singapore and UK.   Following its manufacturing, the ranitidine was sold to Glaxo Seller, a Swiss corporation.   Glaxo Seller then sold the ranitidine to Glaxo World affiliates such as Glaxo Canada or to arm’s length distributors throughout the world.

Importantly, Glaxo Canada entered into a supply agreement with Glaxo Seller and a licensing agreement with another Glaxo Company.  The latter allows Glaxo Canada to sell the ranitidine under the Zantac trademark.  The product sold under the trademark can be sold at a premium to the generic brands.  Without the licensing agreement, Glaxo Canada might not be able to compete in the generic market.

The Canadian transfer pricing provisions

Broadly, the operative Canadian transfer pricing provision states:

“…Where a taxpayer has paid… to a non-resident person with whom the taxpayer was not dealing at arm’s length as price…an amount 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 reasonable amount shall…be deemed to have been the amount that was paid or is payable therefore.”

Two important points to note here are:

• Unlike the Associated Enterprises Article contained in international tax agreements,   the Canadian transfer pricing provision focuses on the price paid for the transaction  rather than profit outcomes.  This is similar to Australia’s transfer pricing provisions.
• The provision adheres to the arm’s length principle.  In simple terms, under this   principle, an arm’s length price is determined by reference to the expected outcome if the transaction was undertaken by independent parties.

Initial comments

It is noted that there are two potential comparables:

• The sale of ranitidine by Glaxo Seller to independent distributors (the  “Glaxoranitidine”); and
  
  
• The purchase of ranitidine by the generic pharmaceutical companies (the“generic ranitidine”).

It is noted that the Glaxo ranitidine and the generic ranitidine are chemically equivalent, bioequivalent and have the same molecules.  The case provides practical insights in relation to the documentation of business circumstances and selection of comparables when conducting a transfer pricing study.

The Taxpayer’s Approach

Glaxo Canada argued that the purchases made by the generic pharmaceutical companies were not appropriate as comparables.  The reasons given are:

- Glaxo Canada’s business circumstances were wholly different from those of the
  generic companies.
In  particular:
       - Glaxo Canada marketing and pricing strategy was different from the generic
         companies;   
       - Glaxo Canada receives marketing assistance from the Glaxo group; and
       - The sale under the Zantac Brand allowed the product to be sold at a premium.
-Glaxo’s ranitidine had been manufactured under Glaxo World standards of good   manufacturing practices, granulated to Glaxo World standards, and produced in   accordance with Glaxo World health, safety and environmental standards.

Glaxo Canada then pointed to sales made to independent European distributors/ licensees who were under the same set of business circumstances as it.  Glaxo Canada then applied the Comparable Uncontrolled Price (“CUP”) method to support its calculation.  The CUP method broadly compares the price charged in a transaction between related parties to the price charged to or between independent parties.  For example, if Company A sells a product to a related party and also sells the same product on comparable terms to an independent customer, the CUP method may be used.

The Canadian Taxation Authority’s approach

The Minister of National Revenue (the “Minister”) reassessed Glaxo Canada for taxation years 1990 through 1993 by, inter-alia, increasing the company’s income by the difference between the price paid by Apotex and Novopharm for their ranitidine and that paid by Glaxo Canada for its ranitidine.

The Minister also applied the CUP method.  However, the Minister’s position is that purchases made by the generic companies for their ranitidine were the comparable transactions that should be used to determine the amount that was “reasonable in the circumstances”.  It is noted at this juncture that under the license agreement, Glaxo Canada can only buy its ranitidine from the Glaxo group.

The Tax Court Decision

The Court held that the CUP method was the preferred method.

Theapplication of the method was impacted by one crucial initial finding. The court held that in applying the transfer pricing rules, the license agreement need not form part of his consideration.   The Judge, relying on an old court case, reasoned that the supply agreement and the licence agreement covered separate matters and he only need to consider the former.

Once the license agreement has been taken out from the equation, the Judge opined that the business circumstances and strategies that Glaxo Canada has said to distinguish it from the generic companies had no bearing on the transfer pricing issue.  The Judge noted that the issue at hand is the reasonable price to be paid for the purchase of ranitidine and not Zantac. In other words, it is irrelevant whether or not the product will be sold under the Zantac trademark.

In relation to the manufacturing process and health, safety and environmental standards applied by the Glaxo group to manufacture ranitidine, the Judge felt that the value added by them would have been modest.

The Judge then considered the application of the CUP method.  The Judge opined that the European distributors were not good comparators for the CUP analysis.  In this regard the Judge looked at the economic comparability, comparability of goods, comparability of point in the chain where goods are sold, comparability of functions of the enterprises, comparability of contractual terms and comparability of business strategies.

The Tax Court determined that the price which would have been reasonable for Glaxo Canada to pay to Glaxo Seller for each kg of ranitidine that it purchased was the highest price paid by Apotex and Novopharm for a kg of ranitidine during the years at issue, subject to an upward adjustment of $25 per kg to account for the fact that the ranitidine purchased by Glaxo Canada was granulated, whereas that purchased by Apotex and Novopharm was not.  In effect, the price paid for the generic version of ranitidine was preferred over the price paid by independent distributors to Glaxo Sellers.

This judgement by the Tax Court would have required transfer pricing practitioners to consider the inclusion/exclusion of agreements and material business circumstances during a transfer pricing analysis.

The Appeals Court Decision.

Nadon J.A. of the Appeals Court in essence considered whether the Judge in the Tax Court had erred in deciding to exclude the license agreement for the purpose of the transfer pricing analysis.

Nadon J.A. explained that in looking at whether the price paid by Glaxo Canada to Glaxo Seller was “reasonable in the circumstances”, the court has to take into account all circumstances which an arm’s length purchaser would have had to consider.   In other words, this requires an inquiry into those circumstances which an arm’s length purchaser, standing in the shoes of Glaxo Canada, would consider relevant in deciding whether it should pay the price paid by Glaxo Canada to Glaxo Seller for its ranitidine.  In particular, Glaxo Canada highlighted the following as key considerations:  the Glaxo Group’s ownership of the Zantac trademark, the premium that Zantac commanded over generic ranitidine drugs in the market, the Glaxo Group’s ownership of the ranitidine patent, the appellant’s inability to compete in the generic market without the availability of the Zantac trademark, and the portfolio of other patented and trademarked products to which Glaxo Canada had access under the license agreement.

Nadon J.A. noted that the approach taken by the Judge of the Tax Court does not reflect the business reality which an arm’s length purchaser was bound to consider if he intended to sell Zantac. The license agreement was central to Glaxo Canada’s business reality as it made it possible for that purchaser to obtain the rights to make and sell Zantac. Nadon J.A. also made reference to the Australian tax case of Roche Product Pty Limited and Commissioner of Taxation, [2008] AATA 639, which highlighted the importance and value of intangibles.

The Court of Appeal remanded the case back to the Tax Court to redetermine the appropriate arm's length price.

If you would like to discuss the above case or your transfer pricing issues, please contact Daren Yeoh, Tax Director, Moore Stephens on 03 8635 1800.