By John J. Tobin
On October 18, 2012, the Supreme Court of Canada (the "Court") released its first ever decision on transfer pricing in Canada v. GlaxoSmithKline Inc.1 The Court dismissed the appeal and sent the matter back to the Tax Court to re-determine whether the price paid by the taxpayer was a reasonable amount having regard to the effect of a licence agreement between the taxpayer and another related party. On balance, the decision is a win for the taxpayer since it will likely obtain greater relief on the re-determination in the Tax Court than what was originally obtained at trial. The decision includes important comments on the arm’s length principle and the approach to be taken when there is a series of connected and interrelated arrangements instead of merely one single payment. The Court also diverged from its "transaction-by-transaction" jurisprudence holding that the review of a transfer pricing transaction requires that the "economically relevant characteristics" of the given transaction be taken into account.
Transfer pricing seeks to arrive at an appropriate level of profit for goods and services between related parties so as to ensure that the profit being taxed in a particular country is consistent with the profit that would have been earned had the parties been dealing at arm’s length. This is the so-called arm’s length principle.
OECD Guidelines Are Not Law
The Act2 does not contain any rules about how to determine an arm’s length price.3 The Court referenced the OECD 1979 Guidelines and the OECD’s 1995 Guidelines which contain detailed commentary and methodology regarding transfer pricing and which have been referenced in the trial decision. The Court observed:
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.4
A Reasonable Amount Must Be Within the Range
The Court further observed that "to use the words of the 1995 Guidelines 'transfer pricing is not an exact science'".5The Court, therefore, determined that some leeway must be allowed in the determination of the reasonable amount. It stated:
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.6
These observations are likely to be helpful to taxpayers in future cases - preference being given to landing within a range of appropriate comparators without focus on the particular placement in the range. Only if the amount is outside the range is a trial court instructed to place the transaction within the range that could include using an average, median or mode or other methods.
Glaxo Is Relevant to Current Section 247
Although this case dealt with former subsection 69(2) (the predecessor provision to Canada’s current transfer pricing regime found in section 247), the Court’s comments here will likely be applicable to the current rules. In fact, the decision appears to address the shortcomings of former subsection 69(2) which, on its face, seems focused on specific payments for specific transactions and not transactions as a whole. For example, one significant difference between former subsection 69(2) and the current wording of subsection 247(2) is that subsection 247(2) now tests the overall series of transactions. The relevant wording imposes an adjustment if:
terms and conditions made or imposed, in respect of the transactions or series, between any of the participants in the transaction or series differ from those that would have been made between persons dealing at arm’s length.7
This test specifically requires a review of connected and interrelated arrangements: a result that the Court imposed under subsection 69(2) in its decision through the "reasonable in the circumstances" standard. Although section 247 no longer refers to the test of "reasonable in the circumstances," given the broader focus on the series of transactions, the difference should not affect the guidance given by the Court in this case. In particular, the Court’s reasoning for distinguishing the earlier cases of Singleton8 and Shell9 (described below) seems to be equally applicable to the "transactions or series" test in section 247, which dictates a review of the series of transactions.
Most readers will be familiar with the facts in Glaxo. Glaxo Canada was a distributor of the drug Zantac. Glaxo Canada was party to a licence agreement with Glaxo U.K. (a related party) under which it was required to pay a royalty based on a percentage of sales of Zantac. Under a separate purchase contract, Glaxo Canada obtained the pharmaceutical ingredients (ranitidine) from a Swiss company, Adechsa. The licence agreement included a term that required the taxpayer to purchase its ranitidine from Adechsa in order to maintain its rights under the licence agreement. At trial, the judge determined (without taking the licence agreement into account) that the taxpayer could have obtained ranitidine in the same form as supplied by Adechsa for $350 per kilogram instead of the $1,500 per kilogram it had paid Adechsa. The taxpayer submitted at trial that the pricing of ranitidine combined with the royalty would be such that the taxpayer would retain a gross profit margin of 60%, an appropriate profit margin to be taxed in Canada.
Pricing the Ranitidine
It is interesting to note that the taxpayer chose its pricing arrangements. In Canada, payments by the taxpayer to Glaxo U.K. for the right to use intellectual property would have been subject to a withholding tax as a royalty of 15% under the Canada U.K. Tax Treaty. However, the purchase price for ranitidine would have been part of the cost of goods sold and would not have been subject to any Canadian withholding tax. Both payments would ordinarily have been deductible in computing income. The difference in taxes imposed in Canada is only the imposition of the withholding tax. Presumably, as well, income earned in the United Kingdom is subject to a different level of taxation than income earned by Glaxo in Switzerland through Adechsa. Consequently, Glaxo, as an international group, set a transfer price whereby the taxpayer was paying a royalty fee to Glaxo UK subject to Canadian withholding tax and taxed in the United Kingdom and was paying a separate purchase price to another Glaxo legal entity for the ranitidine without any Canadian withholding taxes. CRA did not challenge the fees paid under the licence agreement, nor did the taxpayer argue that any excess paid under the ranitidine purchase (if any) was alternatively compensation for a royalty and deductible as such (albeit subject to Canadian withholding tax). At trial, the only payment that was subject to the assessment was the payment to Adechsa for the purchase price of the ranitidine. The interplay between these two separate legal agreements, and the payments made thereunder, made the decision difficult for the Court and will likely make it difficult for the Tax Court in reviewing again. This is because, as discussed below, the Court did not give clear guidance on how to unbundle the costs when reviewing only the supply agreement.
One approach was to look at the price paid for the ranitidine and to consider it in light of the licence agreement that required that the taxpayer purchase from an approved Glaxo supplier. In the Federal Court of Appeal, the taxpayer argued that the test in subsection 69(2) had to take into account 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 taxpayer argued that it was reasonable to buy from Adechsa given the need to maintain the licence. The taxpayer argued that by not looking at the licence agreement, the trial judge ignored an important business circumstance and that the transfer price had to be determined in relation to the licence agreement.
This issue was central in the Court’s analysis. The Court framed the issue for the appeal as identifying the circumstances that are to be taken into account in determining the reasonable arm’s length price against which is compared the non-arm’s length transfer price.10
Distinguishing Transaction-by-Transaction Cases
The Court addressed the Tax Court’s comments on the "transaction-by-transaction" doctrine. One reason the Tax Court had ignored the licence agreement is that it held that individual transactions had to be considered independently from surrounding circumstances on a transaction-by-transaction approach consistent with such cases as Singleton and Shell. The Court distinguished the approaches taken in those cases arguing that the statutory provisions underlying such cases called for a determination of the taxpayer’s bona fide legal relationships and did not require any analysis of the particular circumstances in which the transactions related. In particular, referring to subparagraph 20(1)(c)(i), the Court stated that:
Nothing in s. 20(1)(c)(i) entitles a court to search for anything other than the use to which the borrowed funds are put. The factual determination is simply whether the use of borrowed funds was for the purpose of borrowing income.11
Having cleared that hurdle, the Court adopted paragraph 1.15 of the 1995 Guidelines that:
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.12
The Court stated that subsection 69(2) will require an analysis of:
agreements that may confer rights and benefits in addition to the purchase of property where those agreements are linked to the purchasing contract. 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.13
The trial judge’s conclusion indicated that there was a link between the licence agreement and the price paid for the ranitidine, the Court stated:
The effect of the link between the License 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.14
The Court further stated that considering the licence and supply agreements together offered a realistic picture of the taxpayer’s profits. This suggests that the purpose of transfer pricing is to obtain a "realistic picture of profits" as part of the arm’s length principle. This concept is likely to be applied in future cases. Applying that holistic approach, the Court observed that:
The prices paid by Glaxo Canada to Adechsa were a payment for bundle of at least some rights and benefits under the Licence Agreement and product under the Supply Agreement.15
Despite this conclusion, the Court declined to determine whether the payments should be treated as part of the purchase price of the goods or whether the amounts ought to be treated as additional compensation for the licence rights and if so how to tax them.
The Court avoided the issue by agreeing with the Federal Court of Appeal that the arm’s length price was yet to be determined and will "require a close examination of the terms of the licence agreement and the rights and benefits granted to Glaxo Canada under that agreement."16
The Court did, however, leave some observations for the trial judge stating:
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.17
Ultimately, the Court remanded that issue back to the Tax Court to consider stating:
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.18
The Task for the Tax Court
Given these instructions, it seems likely that the Tax Court will want to analyze whether the combined compensation for the overall transaction was appropriate having regard for the business of the taxpayer, whether to deny any excess and how to allocate the remaining expenses to the purchase of goods and intellectual property rights. Finally, it will want to apply withholding tax to any applicable amounts. It is possible that the taxpayer will be able to demonstrate that the full amount of the excess price paid for the ranitidine will be deductible on the basis that part of the excess price was payment for additional benefits. However, if deductible, it may well be that part of it is considered a licence right and that amount may be subject to withholding tax.
The Court also made some comments regarding the taxpayer’s assertion that purchasing ranitidine from an approved source provides additional value. The Tax Court had downplayed the amount of value derived from buying from a name brand source. The Court, however, stated that the purchase from the Glaxo approved source:
should justify some recognition in determining what an arm’s length purchaser would be prepared by pay for the same rights and benefits conveyed with ranitidine purchased from a Glaxo Group source.19
Similarly, this issue will be remanded back to the Tax Court. However, it seems likely that the Tax Court will give some additional increase in value above the $350 per kilogram in light of this factor.
The Court left one final observation that will also likely influence future cases. It took a very broad approach to the taxpayer’s related group. The Court observed:
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. The 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 into account these different functions and the resources and risk inherent in each. As discussed above, whether or not compensation for intellectual property rights is justified in this particular case, it is a matter for determination by the Tax Court judge.20
This statement seems to overcome some of the practical issues that had perhaps existed in this case where only the purchase price for the ranitidine was being challenged, but the licence agreement was not an issue. The Court seems to be inviting the Tax Court to look more broadly at the overall relationships in making its determination. Although, this comment may be restricted to the particular facts of this case, it suggests that even in a transfer pricing challenge of one single transaction a broader analysis may be required, including a review of all the facts and circumstances of an arrangement and a review of all transfer prices made by the taxpayer. This is only going to lead to increased complexity in the review of transfer pricing cases.
Impact on Future Cases
The Court’s comments will be instructive for transfer pricing cases currently in the pipeline. Transfer pricing has been a significant focus of the CRA in recent years making the release of the decision all the more significant for tax practitioners and their clients. The Tax Court’s interpretation of the Court’s findings promises to be an equally important case as the Tax Court reviews the two contracts in a holistic manner to determine the appropriate profit to be taxed in Canada, taking into account the economically relevant circumstances.
1 2012 SCC 52.
2 All statutory references are to the Income Tax Act (Canada) except as noted.
3 The Canada Revenue Agency’s (CRA) administrative practice is set out in Information
Circular 87-2R entitled “International Transfer Pricing,” which generally adopts the OECD
transfer pricing guidelines.
4 Supra note 1, para. 20.
5 Ibid., para 61.
6 Ibid. [emphasis added].
7 Supra note 2, para. 247(2)(a) [emphasis added].
8 Singleton v. Canada, 2001 SCC 61.
9 Shell Canada Ltd. v. Canada,  2 S.C.R. 622.
10 Supra note 1, para 3.
11 Ibid., para. 34.
12 Ibid., para. 42.
13 Ibid., para. 44.
14 Ibid., para. 48.
15 Ibid., para. 57.
16 Ibid., para. 54.
17 Ibid., para. 57.
18 Ibid., para. 57
19 Ibid., para. 60.
20 Ibid., para. 62
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