[authors: Kennedy, Claire M.C.; Kratz, Martin P.J.; Pearson, Darrel H.]

The Supreme Court of Canada recently released its judgment in The Queen v Glaxo Smith Kline Inc.,¹ (Glaxo), which is the Court's first pronouncement on Canada's transfer pricing rules. Transfer pricing involves the allocation of profits in cross-border transactions among related parties and it is a contentious issue that can result in double taxation for taxpayers as governments in different jurisdictions seek to tax the same income. Transfer pricing is a high priority enforcement area for the Canada Revenue Agency and revenue authorities in other countries. Although the Glaxo case involved the interpretation of an earlier iteration of Canada's transfer pricing rules, the Supreme Court's reasons establish some key principles that should have application to Canada's current transfer pricing regime and the case is therefore an important one for Canadian multi-nationals. Overall, the decision is a positive one for Canadian businesses; however, the Supreme Court has sent a clear signal that allocation of transfer prices among related parties participating in multiple transactions, such as the licence of a trademark and the supply of goods and/or services, will be carefully scrutinized. Multiple transaction arrangements are common amongst multi-national enterprises large and small and, in light of the Glaxo case, businesses should revisit their transfer pricing documentation and legal agreements to mitigate the risk of reassessment and penalties by tax and customs authorities.

At issue in Glaxo were the prices paid by Glaxo Canada, the Canadian member of the Glaxo pharmaceutical group, to a related Swiss entity, Adechsa, for purchases of the active ingredient in the anti-ulcer drug, Zantac, during the period 1990-1993. The fact that the case involves events that occurred more than 20 years ago speaks to the burdens of tax compliance in transfer pricing and the need for taxpayers to maintain excellent records.

Glaxo Canada was a so-called secondary manufacturer and marketer of Zantac in Canada. In other words, it purchased the active raw ingredient (ranitidine), assembled it with other ingredients into pill form, and sold the finished brand name drug. Glaxo Canada did not own the patent for ranitidine; it did not conduct its own R&D on this drug and it did not own the trademark Zantac.

Glaxo Canada obtained essential inputs for its business from related parties. In particular, it entered into a Licence Agreement with a U.K. affiliate (Glaxo Group) that gave Glaxo Canada the rights under relevant patents to manufacture, use and sell Glaxo Group products, including Zantac, exclusive rights to Glaxo Group trademarks, including Zantac, and related technical and marketing support and services. It was a condition of the Licence Agreement that Glaxo Canada purchase ranitidine from a supplier approved by Glaxo Group. At the time, there were two such suppliers, both of which were Glaxo affiliates, and Glaxo Canada entered into a Supply Agreement with one of them (Adechsa).

Under the Licence Agreement, Glaxo Canada paid Glaxo Group a six-percent royalty. The Supply Agreement provided for a formula price for ranitidine that would yield a 60-percent gross margin to Glaxo Canada after taking into account the royalty. This formula resulted in a price per kg of ranitidine exceeding $1500. At that time, generic drug manufacturers were purchasing ranitidine from non-Glaxo sources for approximately $300/kg. The Canadian revenue authority reassessed Glaxo Canada on the basis that the purchase price paid to Adechsa was excessive and exceeded a "reasonable amount", which is the functional equivalent of the "arm's length standard" in the modern wording of the transfer pricing rules, which were rewritten in 1998 after the events of this case.

Zantac, the brand name drug, commanded a significant price premium in the market compared to the equivalent generic products. Nonetheless, the government argued that the Licence Agreement, which gave Glaxo Canada the right to use the brand name Zantac, was irrelevant and that the Licence Agreement transactions and Supply Agreement transactions had to be evaluated independently. Accordingly, the government concluded the generic suppliers' purchases of ranitidine represented comparable arm's length transactions and their price (approximately $300/kg) represented the "comparable uncontrolled price" or CUP that was reasonable in the circumstances.

The government's position was rejected by the Supreme Court of Canada. The Court held that the Licence Agreement added value to the Adechsa-sourced ranitidine over and above the value of generic ranitidine without the associated rights and benefits and could not be ignored.² The Court therefore rejected a strict transaction-by-transaction approach recognizing that it is necessary to consider "economically relevant characteristics" in applying transfer pricing principles, especially alleged arm's length comparables.

Importantly for taxpayers, the Court also acknowledged that "transfer pricing is not an exact science" and "some leeway must be allowed in the determination of reasonable amount" so that "as long as a transfer price is within what a court determines is a reasonable range, the requirement of [the transfer pricing provisions] should be satisfied."³

The Supreme Court's finding that the Licence Agreement was relevant to the determination of the purchase price paid under the Supply Agreement was fatal to the government's position that the generic price was the transfer price that Glaxo Canada should have used. The Court observed that considering the Licence and Supply Agreements together gave a "realistic picture" of Glaxo Canada's profits and noted the limited functions and risks of Glaxo Canada as a secondary manufacturer that did not originate new products and the related intellectual property.⁴

However, the Court also observed that the prices Glaxo Canada paid to Adechsa were a payment for both the raw ingredient under the Supply Agreement and a bundle of at least some rights and benefits under the Licence Agreement and correctly identified that the allocation could have Canadian withholding tax implications. Royalties paid by a Canadian entity to a non-resident for the use of intellectual property are generally subject to Part XIII withholding tax but the purchase price for goods is not. Moreover, transfer pricing rules also apply for customs purposes and certain royalties paid in respect of imported goods are dutiable while others are not, and the quantum of royalties is one factor impacting dutiability.

The Supreme Court referred the Glaxo case back to the Tax Court of Canada for a determination of the proper transfer price for ranitidine paid by Glaxo Canada, so we may not have heard the final word on this case.

Nonetheless, the Glaxo decision is immediately relevant to Canadian businesses transacting with affiliates in other countries. On the plus side, businesses can take comfort in the Supreme Court's recognition that transfer pricing is not an exact science and that some deference should be accorded to taxpayers in making transfer pricing evaluations. Moreover, the Court's insistence on considering all the economically relevant characteristics of the government's alleged CUP and rejecting the government's transaction-by-transaction approach, which did not yield a realistic picture of Canadian profits, establishes a common sense approach to what can be an arcane area.

The Supreme Court's careful scrutiny of elements of the Licence Agreement and observation that a taxpayer's allocation of transfer prices could have withholding tax implications is a clear signal that courts (and by extension the tax authorities) will carefully examine all the relevant elements of the relationship among cross-border related parties. We note that such allocation will have often overlooked ramifications for customs transfer pricing, which should be taken into account by businesses to achieve a unified approach to tax and customs transfer pricing.

Post-Glaxo, taxpayers should revisit their transfer pricing practices and ensure their transfer pricing documentation is adequate by:

• verifying the validity of the comparables cited in their transfer pricing study and
• ensuring that their legal agreements accurately, and in sufficient detail, identify all the related party transfers of services, goods and intellectual property.

Notes

1. 2012 SCC 52
2. Paragraph 60 of the Reasons
3. Paragraph 61 of the Reasons
4. Paragraph 51 of the Reasons