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 (Glaxo Canada) was a reasonable amount, having regard to the effect of a licence agreement between Glaxo Canada and another related party. On balance, the decision is a win for Glaxo Canada 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 the "economically relevant characteristics" of the given transaction to 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. Transfer pricing has been a significant focus of the Canada Revenue Agency in recent years, and the release of this decision will be significant for clients with payments to related non-residents.
Glaxo Canada was a distributor of the drug Zantac. Glaxo Canada was party to a licence agreement with Glaxo UK (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 Glaxo Canada 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 Glaxo Canada 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. Glaxo Canada submitted at trial that the pricing of ranitidine combined with the royalty would be such that Glaxo Canada 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 Glaxo Canada chose its pricing arrangements. In Canada, payments by Glaxo Canada to Glaxo UK 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. Glaxo, as an international group, set a transfer price whereby Glaxo Canada 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. The Tax Court judge reviewed the purchase of the ranitidine on a single transaction basis, without looking at the other arrangements between the related parties – in particular, the licence agreement. The Tax Court seemed reluctant to justify an excess payment for ranitidine to one related legal entity in Switzerland because of a contract between Glaxo Canada and a separate legal entity in the United Kingdom.
Ultimately, the Tax Court will have another chance to review this case and, on the basis of the comments from the Court, it likely will want to analyze whether the combined compensation for the overall transaction was appropriate, having regard for the business of Glaxo Canada, whether to deny any excess of the purchase price for the ranitidine 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 Glaxo Canada 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 will be considered a licence right and that amount may be subject to withholding tax.
- The OECD Guidelines are not law and do not supplant the Supreme Court’s role to arrive at an arm’s-length price.
- Transfer pricing is not an exact science.
- As long as a transfer price is within what the court determines is a reasonable range, the requirements will be met. If it is outside the range, a 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 relevant evidence.
- The transaction-by-transaction doctrine will not apply to transfer pricing. Instead, the arm’s-length principle will require that the "economically relevant circumstances" be taken into account.
- The overall purpose of the arm’s-length principle is to obtain a reasonable picture of profits, which seems to mandate a holistic approach looking at all arrangements that are linked to the particular transaction being tested.
- The Supreme Court’s decision is likely to make transfer pricing cases more complicated because they will require a broader review of the arrangements between the related parties, and even a reassessment on one specific cost or price will need to be tested in regard to the entire arrangement. It is also likely that courts will focus on profit splits as part of the overall test of whether an appropriate transfer price has been made. This case is far from over and 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 all economically relevant circumstances.
1 2012 SCC 52.
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