Transfer Pricing Reasonableness Standard Refined by the Federal Court of Appeal in Glaxosmithkline Inc. v. Canada (2010)

In simple terms, when related corporations trade property, services or intangibles across international borders, the outlay is referred to as the transfer price. Pursuant to s. 69(2) of the Federal Income Tax Act, R.S.C. 1985, c. 1 (5th Supp.) (“ITA”), the transfer price must be “reasonable in the circumstances” that would exist if the non-resident person and the taxpayer had been dealing at arm’s length. In other words, to combat transactions structured for tax avoidance purposes, the Minister must accept that the price is of the amount that would have been paid if the taxpayer and non-resident person (eg. foreign corporation) were unconnected. Corporations and their subsidiaries are obviously connected, and thus are presumed to deal at non-arm’s length for tax purposes. (TheCourt.ca previously discussed transfer price in GE Capital v. The Queen 2009 TCC 563, found here.)

In the case of GlaxoSmithKline Inc. v. The Queen, 2008 TCC 324 [Glaxo I], the “reasonable in the circumstances” standard was applied to payments for a pharmaceutical product purchased by Glaxo Canada (“Glaxo”) from a non-arm’s length non-resident person, Adechsa SA (“Adechsa”), both members of the Glaxo Group of companies (“Glaxo Group”). The Minister and Tax Court of Canada agreed that the reasonable amount was the fair-market value of the pharmaceutical product.

However, according to the Federal Court of Appeal decision in Glaxosmithkline Inc. v. Canada, 2010 FCA 201 [Glaxo II], (reasons for judgement by Nadon J.A.) the failure of the Tax Court of Canada to “consider all relevant circumstances which an arm’s length purchaser would have had to consider…”, including a related licensing and purchasing agreement, was a legal error. Essentially, determining the price that is “reasonable in the circumstances” is a contextual process and not merely an exercise in determining the fair market value.

Legal Framework

Section 69(2) of the ITA states:

69. (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.

Pursuant to this section, a payment to a non-arm’s length non-resident person has to be an amount not greater than what would be “reasonable in the circumstances” if the payment was made to an arm’s length person.

Background and Facts

For the four years at issue (1990-1993), Glaxo purchased the pharmaceutical ingredient ranitidine, which is marketed as Zantac, from Adechsa SA (“Adechsa”), a related non-resident company, for the price of between $1512 and $1651 per kilogram. In the same period, two generic Canadian pharmaceutical companies purchased the same product for much less—between $194 and $304 per kilogram.

The Minister reassessed Glaxo for the years 1990-1993 for overpaying for the drug randitine and as a result its income was increased to account for the difference between the price paid and what the Minister considered to be the amount “reasonable in the circumstances.”

In Glaxo I, Rip A.C.J. (now C.J.) of the TCC deemed the reasonable amount to be the fair market value of ranitidine, as substantiated by the prices paid by the generic companies. The excess amounts paid to Adechsa were deemed to be benefits, and pursuant to s. 56(2) of the ITA, subject to non-resident withholding tax.

When Determining the “Reasonable Amount” Under s. 69(2) Business Circumstances Must be Taken Into Account

The main issue in the present case was what considerations were to be taken in order to determine what was a “reasonable amount” pursuant to s. 69(2) of the ITA. According to the Court of Appeal, for s. 69(2) to take effect the following criteria must be met:

1. There must be a taxpayer (as defined in subsection 248(1);

2. who paid or agreed to pay;

3. to a non-resident;

4. with whom the taxpayer was not dealing at arm’s length;

5. an amount and as a 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;

6. the amount must be “greater than 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 Federal Court of Appeal was primarily concerned with criterion 6. Glaxo contended that the business circumstances surrounding the transactions should have been taken into account when determining the price that would have been “reasonable in the circumstances.” The company argued that s. 69(2) should not apply if it could be determined that any reasonable business person, in the same situation, yet dealing at arm’s length, would have paid the amount.

To buttress this argument, the company contended that related license and supply agreements, which in part required that Glaxo purchase the product from Adechsa, should be taken into consideration; to do otherwise would be “ignoring a crucial business circumstance.” In part, the agreements provided the Glaxo subsidiary with select intellectual property rights, including the use of the ranitidine patent and associated trademark, along with “other patented and trademarked products.”

Conclusion

In Glaxo I, the Tax Court rejected the impact of the agreements. In Glaxo II, the supply and license agreements were together held to potentially validate the price difference at issue. According to the Federal Court of Appeal, the Tax Court of Canada erred by misunderstanding the test for s. 69(2). Real world conditions must be taken into consideration, “including all relevant circumstances which an arm’s length purchaser would have had to consider…” As a result, the issue was returned to Rip C.J. of the Tax Court for a rehearing.