[author: David Spiro]
This morning, the Supreme Court of Canada dismissed the Crown’s appeal in The Queen v. GlaxoSmithKline Inc., the first transfer pricing case to be heard by the Supreme Court of Canada under subsection 69(2) of the Income Tax Act (Canada) (the “Act”) and ordered the parties to return to the Tax Court of Canada for the determination of the appropriate transfer price. The Supreme Court of Canada remitted the matter to the Tax Court of Canada:
 . . . to be redetermined, having regard to the effect of the Licence Agreement on the prices paid by Glaxo Canada for the supply of ranitidine from Adechsa. The Tax Court judge should consider any new evidence the parties seek to adduce and that he may choose to allow.
The Supreme Court endorsed and elaborated on the legal test set out by the Federal Court of Appeal and rejected the test applied by the Tax Court. However, it is important to note that subsection 69(2) has been replaced by subection 247(2) of the Act which applies in respect of taxation years and fiscal periods beginning after 1997. The taxation years at issue in this litigation were 1990-1993.
The reasons for judgment were delivered by Justice Rothstein for a panel of seven (the other members of the panel were the Chief Justice, Justice Deschamps, Justice Abella, Justice Cromwell, Justice Moldaver and Justice Karakatsanis).
By way of background, GlaxoSmithKline Inc. (“Glaxo Canada”) purchased ranitidine, the active ingredient in the anti-ulcer medication called Zantac, from a Swiss non-arm’s length source approved by Glaxo UK (“Adechsa S.A.”) which was part of the Glaxo Group in the U.K. It did so at a price approximately five times higher than the price at which the same ranitidine was sold in the market to Canadian generic drug manufacturers who did not have the right to manufacture or sell Zantac.
Glaxo Canada could not have gone into the market to purchase ranitidine at the price paid by the generic drug manufacturers and use that ranitidine to manufacture and sell Zantac in Canada. It had the right to manufacture and sell Zantac in Canada under an agreement with Glaxo Group pursuant to which it was required to purchase all of its ranitidine from Adechsa S.A. at a price determined by Glaxo Group. Glaxo Canada entered into a Licence Agreement with Glaxo Group which allowed it to manufacture and sell Zantac in Canada in consideration of a royalty payment to Glaxo Group. Glaxo Canada was also required to purchase the raw ingredient, ranitidine, from a source approved by Glaxo Group (i.e., Adechsa S.A.) under a Supply Agreement between it and Adechsa S.A. During the years at issue, the price of ranitidine purchased by Glaxo Canada was $1500 per kilogram while identical ranitidine was available and was purchased by generic drug manufacturers at $300 per kilogram.
The 1985 version of subsection 69(2) applicable to the years 1990-1993 reads:
(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, or as consideration for the carriage of goods or passengers or for other services, 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.
The Decision of the Tax Court of Canada
The issue before the Tax Court was whether the amount paid by the taxpayer to the non-arm’s-length party was “reasonable in the circumstances.” The Tax Court held that (a) the “comparable uncontrolled price” (or CUP) method was the most accurate way to determine the arm’s-length price for ranitidine and (b) the appropriate comparable transactions were the purchases of ranitidine by the generic manufacturers. Subject to a relatively minor adjustment, the Tax Court dismissed the taxpayer’s appeal.
The Decision of the Federal Court of Appeal
The Federal Court of Appeal allowed the taxpayer’s appeal. The Court of Appeal held that the Tax Court had erred in its application of the “reasonable in the circumstances” test, and that it should have inquired into the circumstances that an arm’s-length purchaser in the taxpayer’s position would have considered relevant in deciding what reasonable price to pay for ranitidine. The Court of Appeal set aside the Tax Court judgment and sent the matter back to the Tax Court to be reconsidered.
The Hearing Before the Supreme Court of Canada
At the hearing, Crown counsel emphasized the fact that the only transaction under review was the purchase of ranitidine. As counsel put it at the hearing, you don’t throw into the analysis “the whole deal.” She argued that the only question is “what is an arm’s length price to pay for ranitidine?” Counsel contended that one must strip away the non-arm’s length circumstance (i.e., the requirement to buy ranitidine at a price set by Glaxo Group).
(a) Questions for the Crown at the Supreme Court Hearing
Justice Abella was concerned about whether it was fair for the Crown to compare (under the CUP method) on the one hand the price paid by Glaxo Canada for ranitidine that was destined to become Zantac and, on the other hand, the price paid by generic drug manufacturers for ranitidine that was not destined to become Zantac. Justice Abella asked counsel whether “in the circumstances” in subsection 69(2) meant that you look at the whole deal. Counsel argued that you can’t look at the whole deal.
The Chief Justice focused on the words of 69(2) “that would have been reasonable in the circumstances” and asked Crown counsel what is to be included in “the circumstances”. Crown counsel contended that the only relevant circumstance is the price of ranitidine paid by the generic drug manufacturers in Canada. The Crown maintained that one cannot take into account any “non-arm’s length” circumstance (e.g., that Glaxo Canada must pay the price set by Glaxo Group) and that all non-arm’s length circumstances must be stripped out of the analysis under subsection 69(2).
During the Crown’s reply argument, Justice Cromwell described the Crown’s position as: ”Whatever the deal is, we ignore it.” Crown counsel agreed with that characterization.
Justice Moldaver asked counsel, in light of the decision of Parliament not to use the phrase “reasonable in the circumstances” in the successor provision to subsection 69(2) (subsection 247(2) of the Act), why would the Crown ignore that language and call the whole structure of the deal “background music” and not part of the “circumstances”.
Justice Rothstein remarked that Glaxo Canada was not simply purchasing ranitidine but was purchasing ranitidine for the purpose of resale as Zantac. If Glaxo Canada went into the market like the generics and purchased ranitidine, they would not have been able to resell it as Zantac and Zantac is their business. He asked Crown counsel why the words “reasonable in the circumstances” exclude the way that a business plans to use the product it is purchasing. He noted that there is a “generic market” and a “brand product” market for most drugs. He asked why those circumstances are not relevant in determining the price someone would pay for ranitidine to be used for “brand product” sales as opposed to ranitidine for ”generic product” sale.
In answer to some of these concerns, counsel referred to paragraph 89 of the reasons for judgment of the Tax Court:
 If the legislature intended that the phrase “reasonable in the circumstances” in subsection 69(2) should include all contractual terms there would be no purpose to subsection 69(2); any MNE would be able to claim that its parent company would not allow it to purchase from another supplier. No MNE would ever have its transfer prices measured against arm’s length prices, because all MNEs would allege that they could purchase only from sources approved by the parent company. The controlling corporation in a MNE would structure its relationships with its related companies, and as between its related companies, in this manner or in some similar manner. There is no question that the appellant was required to purchase Glaxo approved ranitidine. The issue is whether a person in Canada dealing at arm’s length with its supplier would have accepted the conditions and paid the price the appellant did.
Justice Deschamps observed that if the Crown is looking at a transaction with a generic company, it is not looking at the same transaction. Crown counsel responsed by saying that the transaction at issue is a simple purchase of ranitidine and the Minister is only trying to value that one transaction.
Justice Abella asked counsel whether it is relevant to the pricing analysis that this was not just a purchase of ranitidine but a purchase of ranitidine for the purpose of being sold as Zantac. Crown counsel maintained that this was just a purchase of ranitidine as subsection 69(2) strips out the non-arm’s length element.
Justice Rothstein asked counsel what there would be to argue if the matter were remitted back to the Tax Court. Counsel responded that the Minister’s position would be exactly the same (the price paid by Glaxo Canada was not “the reasonable amount”) based on the evidence of what the generic drug manufacturers paid. The Crown concluded by arguing that you simply cannot find a comparator selling Zantac without the concomitant non-arm’s length circumstances.
(b) Questions for Glaxo Canada at the Supreme Court Hearing
Justice Abella asked counsel whether there was any way of determining whether $1,500 per kilogram was the “fair market value” of the ranitidine to someone in Glaxo Canada’s position. How do you test the “reasonableness” of the $1,500 per kilo price? Counsel responded by saying that that wasn’t the Minister’s case. The Minister simply assessed on the basis that Glaxo Canada paid more than the generics did and that was the only relevant comparator. Once that theory was set aside by Federal Court of Appeal, that was the end of it.
The Chief Justice asked counsel whether it would be possible for taxpayers to avoid Part XIII tax on royalties for the use of intellectual property if no actual royalty was paid but was, instead, effectively embedded in the cost of the goods. Counsel replied that such “unbundling” is unnecessary as other provisions deal with abusive tax avoidance such as that. In any event, there are no such allegations in this case by the Minister (i.e., that “unbundling” is required or that inappropriate tax avoidance has taken place).
The Chief Justice wondered whether the Minister’s allegation that Glaxo Canada paid too much shifted the onus to Glaxo Canada to fully engage in the “unbundling” debate. Counsel responded that Glaxo Canada paid $1,500 per kilogram to Adechsa S.A. for the ranitidine and paid a separate royalty to Glaxo Group for the use of intellectual property. The Minister never argued that Glaxo Canada was obliged to do any sort of unbundling in this case.
Justice Rothstein asked counsel whether once the Federal Court of Appeal determined that the wrong test had been applied, it should have remitted the matter back to the Tax Court to determine the non-arm’s length price based on the proper legal test (i.e. taking into account the particular business circumstances around the transaction). Counsel argued that sending the matter back to the Tax Court would turn the rules of civil litigation in general, and tax litigation in particular, on their heads. He contended that the Tax Court cannot try a case that was never pleaded by the Crown. The Chief Justice wondered whether the taxpayer had not discharged its burden of showing that $1,500 per kilogram was “the reasonable amount”. Counsel responded by observing that Glaxo Canada, at trial, had demolished the basis for the Minister’s assessment and, in light of the judgment of the Federal Court of Appeal, the burden shifts to the Minister – the burden does not remain on the taxpayer to demonstrate why the price charged for the ranitidine was “the reasonable amount”. Glaxo Canada met the case pleaded against it and the Minister has no right to start all over again in respect of the taxation years at issue. On the pleadings as they currently stand, there is no case to go back to the Tax Court.
The Decision of the Supreme Court of Canada
In a nutshell, the Court held that the legal test applied by the Tax Court was incorrect as it ignored the Licence Agreement and the Supply Agreement which formed part of the relevant circumstances surrounding the transaction at issue. As there had been no factual determination of the appropriate transfer price in light of the correct legal test, the Court referred the matter back to the Tax Court to determine the appropriate transfer price.
More detailed commentary will follow in the days to come but, in the meantime, here are some of the more important passages in the decision:
The role of OECD Guidelines
 In the courts below and in this Court, there has been reference to the1979 Guidelines and the 1995 Guidelines (“the Guidelines”). The Guidelines contain commentary and methodology pertaining to the issue of transfer pricing. However, the Guidelines are not controlling as if they were a Canadian statute and the test of any set of transactions or prices ultimately must be determined according to s. 69(2) rather than any particular methodology or commentary set out in the Guidelines.
The relevant circumstances
 . . . The requirement of s. 69(2) is that the price established in a non-arm’s length transfer pricing transaction is to be redetermined as if it were between parties dealing at arm’s length. If the circumstances require, transactions other than the purchasing transactions must be taken into account to determine whether the actual price was or was not greater than the amount that would have been reasonable had the parties been dealing at arm’s length.
* * *
 Thus, according to the 1995 Guidelines, a proper application of the arm’s length principle requires that regard be had for the “economically relevant characteristics” of the arm’s length and non-arm’s length circumstances to ensure they are “sufficiently comparable”. Where there are no related transactions or where related transactions are not relevant to the determination of the reasonableness of the price in issue, a transaction-by-transaction approach may be appropriate. However, “economically relevant characteristics of the situations being compared” may make it necessary to consider other transactions that impact the transfer price under consideration. In each case it is necessary to address this question by considering the relevant circumstances.
* * *
 Because s. 69(2) requires an inquiry into the price that would be reasonable in the circumstances had the non-resident supplier and the Canadian taxpayer been dealing at arm’s length, it necessarily involves consideration of all circumstances of the Canadian taxpayer relevant to the price paid to the non-resident supplier. Such circumstances will include agreements that may confer rights and benefits in addition to the purchase of property where those agreements are linked to the purchasing agreement. The objective is to determine what an arm’s length purchaser would pay for the property and the rights and benefits together where the rights and benefits are linked to the price paid for the property.
Stripping out non-arm’s length elements
 There were only two approved sources, one of which was Adechsa. Thus, in order to avail itself of the benefits of the Licence Agreement, Glaxo Canada was required to purchase the active ingredient from one of these sources. This requirement was not the product of the non-arm’s length relationship between Glaxo Canada and Glaxo Group or Adechsa. Rather, it arose because Glaxo Group controlled the trademark and patent of the brand-name pharmaceutical product Glaxo Canada wished to market. An arm’s length distributor wishing to market Zantac might well be faced with the same requirement.
 The effect of the link between the Licence and Supply agreements was that an entity that wished to market Zantac was subject to contractual terms affecting the price of ranitidine that generic marketers of ranitidine products were not.
 As such, the rights and benefits of the Licence Agreement were contingent on Glaxo Canada entering into a Supply Agreement with suppliers to be designated by Glaxo Group. The result of the price paid was to allocate to Glaxo Canada what Glaxo Group considered to be appropriate compensation for its secondary manufacturing and marketing function in respect of ranitidine and Zantac.
The use of generic comparators
 . . . the generic comparators do not reflect the economic and business reality of Glaxo Canada and, at least without adjustment, do not indicate the price that would be reasonable in the circumstances, had Glaxo Canada and Adechsa been dealing at arm’s length.
Glaxo Canada was paying for more than just ranitidine
 Thus, it appears that Glaxo Canada was paying for at least some of the rights and benefits under the Licence Agreement as part of the purchase prices for ranitidine from Adechsa. Because the prices paid to Adechsa were set, in part, as compensation to Glaxo Group for the rights and benefits conferred on Glaxo Canada under the Licence Agreement, the Licence Agreement could not be ignored in determining the reasonable amount paid to Adechsa under s. 69(2), which applies not only to payment for goods but also to payment for services.
 Considering the Licence and Supply agreements together offers a realistic picture of the profits of Glaxo Canada. It cannot be irrelevant that Glaxo Canada’s function was primarily as a secondary manufacturer and marketer. It did not originate new products and the intellectual property rights associated with them. Nor did it undertake the investment and risk involved with originating new products. Nor did it have the other risks and investment costs which Glaxo Group undertook under the Licence Agreement. The prices paid by Glaxo Canada to Adechsa were a payment for a bundle of at least some rights and benefits under the Licence Agreement and product under the Supply Agreement.
* * *
 In addition, while, as Rip A.C.J. found, Glaxo Canada’s ranitidine and generic ranitidine are chemically equivalent and bio-equivalent, he also found that there was value in the fact that Adechsa’s ranitidine manufactured under Glaxo Group’s “good manufacturing practices” “may confer a certain degree of comfort that the good has minimal impurities and is manufactured in a responsible manner” (para. 118). Zantac is priced higher than the generic products, presumably, at least in part, because of that “degree of comfort” that Rip A.C.J. acknowledged.
 These are all features of the Licence Agreement and the requirement to purchase from a Glaxo-approved source that add value to the ranitidine that Glaxo Canada purchased from Adechsa over and above the value of generic ranitidine without these rights and benefits. They should justify some recognition in determining what an arm’s length purchaser would be prepared to pay for the same rights and benefits conveyed with ranitidine purchased from a Glaxo Group source. It is only after identifying the circumstances arising from the Licence Agreement that are linked to the Supply Agreement that arm’s length comparisons under any of the OECD methods or other methods may be determined.
Part XIII (withholding) tax
 Although I said above that the purchase price appeared to be linked to some of the rights and benefits conferred under the Licence Agreement, I make no determination in these reasons as to whether the rights under the ranitidine patent granted to Glaxo Canada to manufacture and sell Zantac and the exclusive right to use the Zantac trademark are linked to the purchase price paid by Glaxo Canada to Adechsa. However, arguably, if the purchase price includes compensation for intellectual property rights granted to Glaxo Canada, there would have to be consistency between that and Glaxo Canada’s position with respect to Part XIII withholding tax. This issue was not specifically argued in this Court and may be addressed by the parties in the Tax Court and considered by the Tax Court judge when considering whether any specific rights and benefits conferred on Glaxo Canada under the Licence Agreement are linked to the price for ranitidine paid to Adechsa.
Guidelines for the Tax Court of Canada in making its redetermination
 I agree with Justice Nadon that “the amount that would have been reasonable in the circumstances” if Glaxo Canada and Adechsa had been dealing at arm’s length has yet to be determined. This will require a close examination of the terms of the Licence Agreement and the rights and benefits granted to Glaxo Canada under that Agreement.
* * *
 I would offer the following additional guidance with respect to the redetermination. First, s. 69(2) uses the term “reasonable amount”. This reflects the fact that, to use the words of the 1995 Guidelines, “transfer pricing is not an exact science” (para. 1.45). It is doubtful that comparators will be identical in all material respects in almost any case. Therefore, some leeway must be allowed in the determination of the reasonable amount. As long as a transfer price is within what the court determines is a reasonable range, the requirements of the section should be satisfied. If it is not, 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. I repeat for emphasis that it is highly unlikely that any comparisons will yield identical circumstances and the Tax Court judge will be required to exercise his best informed judgment in establishing a satisfactory arm’s length price.
 Second, while assessment of the evidence is a matter for the trial judge, I would observe that the respective roles and functions of Glaxo Canada and the Glaxo Group should be kept in mind. Glaxo Canada engaged in the secondary manufacturing and marketing of Zantac. Glaxo Group is the owner of the intellectual property and provided other rights and benefits to Glaxo Canada. Transfer pricing should not result in a misallocation of earnings that fails to take account of these different functions and the resources and risks inherent in each. As discussed above, whether or not compensation for intellectual property rights is justified in this particular case, is a matter for determination by the Tax Court judge.
 Third, prices between parties dealing at arm’s length will be established having regard to the independent interests of each party to the transaction. That means that the interests of Glaxo Group and Glaxo Canada must both be considered. An appropriate determination under the arm’s length test of s. 69(2) should reflect these realities.
 Fourth, in this case there is some evidence that indicates that arm’s length distributors have found it in their interest to acquire ranitidine from a Glaxo Group supplier, rather than from generic sources. This suggests that higher-than-generic transfer prices are justified and are not necessarily greater than a reasonable amount under s. 69(2).