The Glaxo Canada tax case: a bitter pill.

• Author: Bernier, Jacques

Almost two years after settling its multi-billion dollar transfer pricing case with the Internal Revenue Service (IRS), GlaxoSmithKline (GSK) received another adverse decision, this time in Canada. While the dispute with the IRS focused on the creation of marketing intangibles in the United States, the Canadian case developed on a different footing: the use of generic prices by the Canada Revenue Agency (CRA) as a Comparable Uncontrolled Price (CUP). In the end, the decision--a premiere on the Canadian transfer pricing scene--was almost a total victory for the CRA.

Has the CRA just won a battle or the war? Only time will tell given that the matter has been appealed. In the meantime, this article discusses the decision from both Canadian and U.S. viewpoints.

Background

GSK is a well-known major multinational research-based pharmaceutical enterprise. It operates its business around the world in an integrated and coordinated fashion by using a number of subsidiaries, the activities of which include research and development, primary manufacturing, secondary manufacturing, marketing, sales, and distribution.

In the 1970s, GSK's predecessor discovered ranitidine, the active ingredient found in its champion anti-acid drug Zantac, which enjoyed phenomenal success around the world after its launch in the early 1980s. At that time, Canada had a peculiar patent protection system that allowed for generic competition while the branded drug was under patent protection. Under that system, called compulsory licensing, generic companies were able to import active pharmaceutical ingredients from countries where there was no patent protection with a view to manufacturing and selling the generic versions, and thus compete against the branded products. In return, the generic company had to pay the inventor a pre-set royalty of four percent. The compulsory licensing system was abolished in 1991 but the repeal did not affect previously granted licenses. The Canadian health and safety requirements were also less onerous for generic products. For instance, the requirements were limited to demonstrating that the generic products were chemically equivalent and bioequivalent (i.e., equivalent in the absorption by patients). In contrast, the approval for a new drug such as Zantac required extensive health and safety submissions on: (1) the chemistry and manufacturing of the product; (2) its pharmacological properties; (3) toxicity studies (on animals); and (4) clinical trials (on humans).

Furthermore, since most health costs are publicly funded in Canada, the various Canadian provinces established government-funded drug plans for all their low-income citizens to receive necessary drugs while maintaining their affordability. Once a drug became approved by such a provincial plan, the patient could be reimbursed for all of part of its costs. This approval by the provincial plan also generally allowed the pharmacist to substitute a generic drug for a branded one.

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The pertinent organizational structure of Glaxo is set forth in the nearby chart. GlaxoSmithKline Inc. (Glaxo Canada) was the taxpayer involved in the litigation. It was a wholly owned subsidiary of Glaxo Group Ltd. (Group), a U.K. corporation that in turn was a wholly owned subsidiary of Glaxo Holdings PLC, the publicly-traded corporation headquartered in the United Kingdom. In addition to holding Glaxo Canada, Group owned the shares of all other subsidiaries in the group as well as the valuable intangibles. Under a License Agreement, Group provided those intangibles (1) and related services to Glaxo Canada in exchange for a royalty set at six percent of net sales for all products, including Zantac. Glaxo Canada purchased its active pharmaceutical ingredients (API), such as ranitidine, under a Supply Agreement with Adechsa S.A. (Adechsa), a Swiss-based affiliate.

Zantac was launched in Canada in 1982. Beginning in 1987, generic competition emerged detrimentally affecting the market share of Zantac. Given this situation, Zantac was no longer promoted in Canada by 1993.

Substantial reassessments of Glaxo Canada by the CRA ensued for the 1990-1993 years, with the CRA using generic prices ranging between $194 and $304 instead of the transfer price of $1,512 to $1,651 per kilogram paid by Glaxo Canada to Adechsa. (Amounts are in Canadian dollars.)

Legal Context

For the years in issue, the rule enabling the CRA to adjust transfer prices was contained in subsection 69(2) of the Income Tax Act. (2) The provision reads, as follows:

69(2) Unreasonable consideration. Where a taxpayer has paid or agreed to pay to a non-resident person with whom he 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 of 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. (Emphasis added.) The Parties' Positions

The CRA's position focused on using the generic prices as CUPs, and was supported by a Cost-Plus Method (CPM). Glaxo Canada's attack against the reassessments was premised on the following arguments:

(a) That the CRA's CUPs were not a reasonable benchmark because:

(1) Glaxo Canada's business circumstances were materially different from those of the generic companies in question; and (2) Glaxo's ranitidine was materially different from the generic ranitidine in quality because of Glaxo's own high quality standards, including Good Manufacturing Practices (GMP).

(b) That Glaxo Canada's purchase prices from Adechsa were appropriate based on its own CUPs, principally transactions between Group and third party licensees in other countries. To support the correctness of those internal CUPs, Glaxo Canada relied on the Resale Price Method (RPM). (As discussed later in this article, Glaxo Canada also used the Transactional Net Margin Method (TNMM) as a further validator.)

The Tax Court Decision

On May 30, 2008, the Honorable Gerald J. Rip, Associate Chief Justice of the Tax Court of Canada, delivered his judgment after a 47-day hearing. An impressive roster of witnesses appeared before him (3) and the documentary evidence was voluminous. The 59-page Reasons for Judgment (supplemented by four Appendices) are clearly written, a remarkable accomplishment given the volume of material.

The threshold question Justice Rip answered dealt with the interpretation of the applicable statutory test in subsection 69(2). In particular, he determined that the statute considers as relevant only the purchase and sale of ranitidine (under the Supply Agreement) between Adechsa and Glaxo Canada. By this approach, the bundle of intangibles (under the License Agreement) flowing from the Group was simply disregarded. Implicitly, this approach renders irrelevant an inquiry into the valuation of those intangibles and any profitability analysis. The words Justice Rip uses are unequivocal: "It may well be that a 40 percent total profit to Glaxo Group is reasonable; however, the issue before me is whether the purchase price of the ranitidine was reasonable." (4) In arriving at his conclusion, Justice Rip made a determination, which he carefully called "a finding of fact," (5) that the License Agreement and the Supply Agreement can stand alone with the consequence that they "are to be considered independently." (6) He added that he is required to take such an approach based on the Supreme Court of Canada decision in The Queen v. Singleton, (7) while pointing out that a similar conclusion was reached by the U.S. Tax Court in Bausch & Lomb, Inc. (8)

After having dealt with the threshold question, Justice Rip delved into a comparability analysis, given the use of the phrase "reasonable in the circumstances" in subsection 69(2). In this regard, he referred to the Organisation for Economic Co-Operation and Development's Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, (9) with an emphasis on guidelines that were released in 1995 (after the period in question). Not surprisingly, in light of his answer to the threshold question, he found irrelevant from a comparability perspective the requirement imposed on Glaxo Canada to buy only Glaxo-approved ranitidine. In his view, it would be nonsensical to interpret the phrase "reasonable in the circumstances" in subsection 69(2) to require the consideration of all contractual terms. Otherwise, any multinational group could claim the distinction of not being allowed to purchase goods or services from outside the group and thus, never have their transfer prices measured against arm's-length prices.

Justice Rip also rejected Glaxo Canada's argument for non-comparability that Zantac was priced at a premium over the generic products (as well as over its branded competitor, the blockbuster Tagamet). In his view, the price premium came from Glaxo Canada's marketing efforts and the Zantac brand name...