Citation: 2008TCC324
Date: 20080530
Docket: 98-712(IT)G
BETWEEN:
GLAXOSMITHKLINE INC.,
Appellant,
and
HER MAJESTY THE QUEEN,
Respondent.
REASONS FOR JUDGMENT
Rip A.C.J.
Note to
Reader
In order not to add to lengthy reasons
for judgment, four appendices have been attached to these reasons and form part
of the reasons. The appendices include a ruling on a motion by the appellant
pursuant to section 100 of the Tax Court of Canada Rules (General Procedure)
(Appendix I), a diagram of the corporate structure of the Glaxo
corporations headed by Glaxo Holdings (Appendix II), a List of Witnesses and
the subject of their testimony, listed in order of appearance at trial
(Appendix III) and a Glossary of terms used during trial, some of which are
included in these reasons (Appendix IV). [The Glossary was adapted from a
Glossary submitted by the appellant at trial.] There was an effort to have
these appendices in as concise a form as possible for ease of reading.
[1] GlaxoSmithKline
Inc. ("Glaxo Canada") appeals income tax assessments in which the Minister of National
Revenue ("Minister"):
a) reassessed
the appellant for its 1990, 1991, 1992 and 1993 taxation years by increasing
its income for each year on the basis that the appellant overpaid its non-arm's
length supplier for the purchase of ranitidine hydrochloride ("ranitidine"), applying
sections 3, 4 and 9 and subsections 69(2) of the Income Tax Act
("Act") ("Part
I assessments"); and
b) assessed
the appellant for tax under Part XIII of the Act for amounts deemed to
have been paid by the appellant as dividends in 1990, 1991, 1992 and 1993 to
its non-resident shareholder, Glaxo Group Limited ("Glaxo Group"), in
accordance with subsections 56(2), 212(2) and 214(3) of the Act.
Alternatively, the respondent says that the appellant, pursuant to paragraph
246(1)(b) of the Act, is deemed to have made payments in 1990,
1991, 1992 and 1993 to its shareholder to which Part XIII of the Act applies
("Part XIII assessments").
[2] The
appeals were heard on common evidence.
INTRODUCTION
[3] Ranitidine is the
active pharmaceutical ingredient ("API") in a drug that was marketed
by the appellant in Canada under the brand name Zantac. The drug was prescribed to relieve stomach
ulcers without the need for surgery. Before the discovery of ranitidine the
most successful API used to relieve ulcers was cimetidine. Cimetidine was
marketed by a competitor of the appellant under the brand name Tagamet.
Ranitidine was discovered by the appellant's parent company in 1976 and was
approved for sale in Canada in 1981. Zantac was launched by the appellant in 1982.
[4] During the period
under appeal other pharmaceutical companies ("generic companies")
were selling generic versions of Zantac in Canada. These companies purchased
ranitidine for much less than the appellant. According to the Minister, a
reasonable amount for the appellant to have paid for ranitidine was the price
paid by these other companies.
[5] Glaxo Canada paid
Adechsa S.A., a person with whom it
did not deal at arm's length, the following amounts for ranitidine during the
years in appeal:
|
Taxation Years
|
Price per kilogram
|
|
1990
|
$1,512
|
|
1991
|
$1,575
|
|
1992
|
$1,635
|
|
1993
|
$1,651
|
[6] At the same time the
generic companies in Canada paid the following amounts to their suppliers of
ranitidine:
|
Taxation Years
|
Price per kilogram
|
|
1990
|
$292 - $304
|
|
1991
|
$244 - $289
|
|
1992
|
$220 - $253
|
|
1993
|
$194 - $248
|
[7] In making the Part
I assessments the Minister did not permit the appellant, in computing its
income for the years in appeal, to deduct the amounts by which the purchase
prices paid to Adechsa for a kilogram of ranitidine exceeded the highest price
paid by the generic companies for a kilogram of ranitidine at the appropriate
time.
[8] The appellant's position is that
the Part I assessments have no basis because the price it paid for the
ranitidine "closely mirrored [the price paid by] . . .
independent third parties in comparable circumstances" and the amounts
paid by the appellant were "reasonable in the circumstances" within
the meaning of subsection 69(2) of the Act. The appellant also
submits that its business model and circumstances are not comparable to those
of the generic companies. The respondent's position is that the appellant did
not pay a reasonable price for the purchase of ranitidine in order to minimize
profit in Canada and move the profit to a related
corporation in a low tax jurisdiction.
Subsection 69(2) of the Act
[9] Subsection 69(2) of the Act,
in force during the period in appeal, read as follows:
|
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.
|
Lorsqu'un contribuable a payé ou est convenu de
payer à une personne non-résidente avec qui il avait un lien de dépendance,
soit à titre de prix, loyer, redevance ou autre paiement pour un bien ou pour
l'usage ou la reproduction d'un bien, soit en contrepartie du transport de marchandises
ou de voyageurs ou d'autres services, une somme supérieure au montant qui
aurait été raisonnable dans les circonstances si la personne non-résidente et
le contribuable n'avaient eu aucun lien de dépendance, ce montant raisonnable
est réputé, pour le calcul du revenu du contribuable en vertu de la présente
partie, correspondre à la somme ainsi payée ou payable.
|
Preliminary Facts
[10] Glaxo Canada is a wholly owned
subsidiary of Glaxo Group, a United Kingdom
corporation, which in turn is a wholly owned subsidiary of Glaxo Holdings PLC,
also a corporation headquartered in the United Kingdom. Glaxo Holdings headed an integrated multinational group
of entities, which discovered, developed, manufactured and distributed
pharmaceutical products throughout the world. Glaxo World
products are sold through subsidiaries and unrelated distributors in local
markets.
[11] Pharmaceutical products are
manufactured in two basic stages, referred to as primary manufacturing and
secondary manufacturing. Primary manufacturing is making the active pharmaceutical
ingredient for a pharmaceutical product. Secondary manufacturing includes the
process of putting the active ingredient into a delivery mechanism or
packaging, such as a tablet, liquid, or gel.
[12] Two Glaxo World companies carried
on the primary manufacturing of ranitidine: Glaxo Pharmaceuticals (Pte) Limited,
a corporation incorporated and carrying on business in Singapore, and Glaxochem
Ltd., a United Kingdom corporation located in Montrose, U.K. Upon completion of
the primary manufacturing process, the ranitidine was sold at a uniform price
by the primary manufacturer to one of two Glaxo World clearing companies:
Adechsa S.A., a Glaxo World company based in Switzerland, and Glaxo Far East. The clearing companies then sold the
API to local companies in various countries at a variety of prices. Glaxo Holdings
established the price of the API based on the price the local company could
expect to fetch on sales of Zantac in its local market. During the period in
appeal, the ranitidine purchased by the appellant was manufactured in Singapore and sold to the appellant by
Adechsa.
[13] Adechsa had an agreement with the
Swiss tax authorities under which it agreed to pay tax on the basis that it
earned a minimum profit of four percent. Few
taxes were paid by the Singapore
manufacturer because it qualified for a ten‑year pioneer relief tax
holiday that began in 1982. After the expiry of the ten‑year period, the tax rate
was ten percent. Under the pioneer relief program, Glaxo World benefited from
"tax sparing" between Singapore and the United Kingdom. Glaxo World's Singapore company did not pay any
tax on the profits earned in Singapore; income apparently was deemed by the United Kingdom tax
authority to have been fully taxed at the current Singapore tax rate. When the profits were
brought into the United Kingdom in the form of dividends, United Kingdom tax
was payable only on any excess in terms of the United Kingdom tax rate over the
Singapore tax rate. Glaxo World's transfer pricing arrangements allowed Singapore to earn gross profits
of around ninety percent in Singapore on the sale of ranitidine to Adechsa during the period
1990 to 1993. During the same period, Glaxo Canada was earning gross profits of
around 57 percent. According to a memorandum by Lionel Halpern, the "Group"
taxation controller of Glaxo Holdings, Glaxo World's strategy to minimize its taxes worldwide was:
1. to make as much profit as possible in Singapore;
2. to make as
much of the remainder of the Group's profit as possible in the U.K.; and
3. to ensure the Group does not pay tax on the same
profit twice.
AGREEMENTS
[14] Glaxo Canada had
two contracts with respect to Zantac: a "Licence Agreement" dated July 1,
1988 with Glaxo Group and a "Supply Agreement" with Adechsa dated October 1,
1983.
Under the terms of the
Licence Agreement, which applied to all drugs and not just Zantac, Glaxo Canada
paid a six percent royalty to Glaxo Group on its net sales of Zantac and
Glaxo Group provided the following services and intangibles to Glaxo Canada:
a.
right to manufacture, use and sell
products;
b.
right to the use of the trademarks
owned by Glaxo Group, including Zantac;
c.
right to receive technical
assistance for its secondary manufacturing requirements;
d.
the use of registration materials
prepared by Glaxo Group, to be adapted to the Canadian environment and
submitted to the Health Protection Branch ("HPB");
e.
access to new products, including
line extensions;
f.
access to improvements in drugs;
g.
right to have a Glaxo World
company sell Glaxo Canada any raw materials;
h.
marketing support; and
i.
indemnification against damages
arising from patent infringement actions.
[15] The Supply Agreement between Glaxo Canada and Adechsa granted the appellant the right to purchase ranitidine and set out the price of the ranitidine. The transfer price was
established by Glaxo Holdings. Adechsa's role was to administer the transfer
prices. The Supply Agreement
also provided protection against foreign currency exchange, indemnity insurance
and the provision of intellectual property to "the extent that [the
appellant] shall not previously have received it or shall not otherwise receive
it directly from [Glaxo Group]".
[16] The respondent argued that the only item of value received
under the Supply Agreement was the ranitidine. Respondent's counsel submitted
that the protection against foreign currency fluctuations was largely
irrelevant given that under the Agreement either party could change the
currency. Glaxo Canada was charged separately by Glaxo Group
for indemnity insurance in each of the years under appeal. With respect to the
additional intellectual property, the appellant’s general counsel, Mr. McTeague,
admitted that he wasn't sure what intellectual property remained to be provided
under the Supply Agreement given the wide ambit of the Licence Agreement. Thus,
according to the evidence, the only item of value received by Glaxo Canada under the Supply Agreement was ranitidine.
THE CANADIAN PHARMACEUTICAL INDUSTRY
Regulation
[17] The prescription
pharmaceutical market in Canada was regulated by the HPB of Health Canada during
the period under appeal. Prescription pharmaceuticals could not be marketed in Canada without
approval from the HPB. The HPB had the responsibility of evaluating the safety,
effectiveness and quality of all drugs and medical devices before they could be
marketed in Canada.
[18] During the period
1980 to 1993, the HPB was responsible for the review of New Drug Submissions ("NDS").
The HPB was ultimately responsible for ensuring that all drugs, including
ranitidine products, were safe and effective for their intended use. A NDS was
made by the appellant for ranitidine tablets. When a NDS is prepared for a new
chemical entity, the data provided may be divided into information relating to
the following sections:
a. Chemistry and Manufacturing
of the Product: the drug substance (API) and dosage forms must meet
appropriate standards and the drug must be manufactured in a manner that allows
the product to exert its inherent pharmacologic effects.
b. Pharmacologic Properties of
the Drug: This information provides the results of all studies performed in
vitro or conducted in vivo in animals. The purpose of these experiments is to
elucidate the basic pharmacologic effects of the drug.
c. Toxicities of the drug:
Toxicological studies are undertaken in animals to determine the adverse
effects of each new drug, with the purpose of predicting the possible
toxicities the compound may show in humans.
d. Effects of the Drug in
Humans: These clinical studies explore the absorption, distribution,
metabolism and excretion of the drug in humans, as well as its ability to treat
the disease of concern and its adverse effects.
Generic Drugs
[19] At all relevant
times a compulsory licensing system existed in Canada which allowed the
marketing and sale of a generic version of patented pharmaceutical products,
including ranitidine products, in exchange for a royalty of four percent
paid to the patent owner. Thus, a generic company could sell a generic version
of a drug to the public notwithstanding that the patent for the drug was still
in effect.
[20] Like innovator
companies such as the appellant, generic companies were required to satisfy
HPB's standards with regard to the proposed product's safety, efficacy and
quality. However, unlike innovator companies, generic companies did not have to
provide evidence of clinical testing. Instead, HPB would accept adequate
published data on drug safety and accept published clinical data from well
controlled trials.
[21] Generic
manufacturers therefore sought to establish that their drug products were
equivalent to those of innovator companies for which a Notice of Compliance had
been issued. This was accomplished by submitting complete chemistry and
manufacturing data establishing chemical equivalence, as well as
bioavailability studies to demonstrate bioequivalence. A Notice of Compliance
by HPB for a NDS constituted a declaration of equivalence, as the generic
product had been determined to be pharmaceutically equivalent and bioequivalent
to the Canadian innovator product.
[22] Two companies,
Apotex Inc. and Novopharm Ltd., began selling generic ranitidine products in Canada in 1987
and 1989, respectively. Apotex and Novopharm purchased ranitidine from arm's
length manufacturers. The
sales of the generic ranitidine products had
a negative impact on Zantac's market share; Zantac's share during the period
under appeal dropped from 38 percent to 20 percent of unit sales of tablets.
The appellant's market share as a percentage of total sales of all ranitidine
products declined from 49 percent to 40 percent.
Formularies
[23] During the years
in issue, the provinces operated government-funded drug plans in order to
ensure that Canadians covered by provincial health insurance received the
necessary pharmaceutical products and to maintain the affordability of these
required drug products. For this purpose, each of the provinces established a
drug formulary, which is a listing of those drugs for which the government pays
some or all of the cost. If a drug is not listed on its formulary, the
province's insurance plan does not pay for the drug and the consumer/patient
must pay for the drug out of his or her own pocket. This negatively affects sales.
[24] Mr. Lorne Davis,
a pharmacologist for the Saskatchewan Prescription Drug Plan, explained that
each provincial government regulates admission of a drug to its formulary.
Submission for approval to a formulary does not derogate from the requirement
that each innovator or generic drug product must also be approved by HPB, but
only those drugs approved by a provincial government will be listed on that
province's formulary. Generally, the formulary is published and distributed to
the province's doctors to make them aware of the drugs that are on the
formulary. Such information would influence the doctors' decisions about what
drugs to prescribe to their patients. For generic products, inclusion on the
formulary means the generic drug has been approved as being interchangeable
with the innovator product and that it can be substituted by a pharmacist when
filling a prescription.
[25] Generic products
were listed at a lower retail price than innovator drugs. And, even as between
themselves, the generics competed to list on the formularies at a lower price.
According to Mr. Fahner, Vice-President, Finance at Apotex, the first generic product
on a market typically sells at 80 to 85 percent of the price of the
branded product. The next generic product that enters the market usually would
be priced slightly under the first generic, and so on.
[26] Mr. Fahner
explained that because of the provincial substitution programs, the generic
companies directed their sales efforts towards pharmacists, as opposed to
doctors. In addition to offering their products at prices that were less than
the branded products, the generic companies sought to market their products by
providing volume discounts, mostly to the large pharmacy chains, and delivering
incentives to the smaller independently owned pharmacies. The goal was to have
various pharmacies stock a wide range of the generic company's drug products,
which would lead to greater sales. In some cases the provinces tendered
contracts (mostly for hospitals sales) to the least expensive generic product
distributor.
[27] One of the main
purposes of provincial drug insurance plans is to reduce the cost of drugs in Canada. To that
end, the drug plans allowed for the substitution of less expensive generic
products where such products were available. For a time the provincial drug
plans allowed the prescribing of the more expensive innovator products where
the prescribing physician included the notation "no substitutions" on
the form. Later, the provincial drug plans required mandatory substitution,
that is, the drug plan would not pay any of the cost of the more expensive
branded innovator product where there existed a less expensive generic product.
Mr. Fahner testified that Saskatchewan stopped accepting no-substitution prescriptions in
1991.
MARKETING AND PRICING
[28] When ranitidine was discovered, Glaxo Group's then
Chief Executive Paul Girolami (later Sir Paul and head of Glaxo Group)
was advised by his Research Director that Zantac was superior to Tagamet because
of its greater selectivity, more favourable safety profile, higher efficacy and
easier dosage regimen. As a result, Sir Paul decided that Zantac should be
priced at a substantial price premium of approximately 20 percent to Tagamet to
reflect that superiority, and that the global marketing platform for the
product would be focused on the demonstrated advantages of Zantac over Tagamet.
[29] Once launched, Zantac achieved significant sales volume
and overtook Tagamet as the premier anti-ulcer drug. It became, according to
Paul Meade, who worked in Glaxo's marketing group in both Canada and the United Kingdom, the "gold standard in ulcer
therapy".
Marketing
[30] As was the case with other pharmaceutical products, the
marketing of Zantac was restricted to claims supported by data and approved by
regulatory authorities. Glaxo Group
established a world-wide marketing strategy for Zantac which was implemented by
each subsidiary at the local level. The British parent's "core marketing
strategy" for Zantac was based on the medical uses of the drug product.
Its main claim was that Zantac lessened or prevented gastric ulcers and
esophagitis. Mr. Meade described the marketing plan as follows:
Zantac will be
positioned as a major evolutionary advance in the management of peptic ulcer
and other acid pepsin-aggravated disorders of the upper gastrointestinal tract.
Zantac contributes three important new parameters to ulcer therapy - simplicity
of dosage, unsurpassed efficacy and a remarkable freedom from clinically significant
side reactions.
[31] Glaxo Group made the
decision to promote a particular product such as Zantac and did the initial
research and product development and then provided this information to the
local distributor. In Canada, the appellant added a "Canadian flavour",
in the words of Mr. Woloschuk, who worked in marketing at Glaxo Canada from
1976 to 1996. He explained that the way a product is sold in England may not be
the same way it is sold in Canada. The strategy, he declared, was "sell the product
and [stress that] it's good for this indication, but we need to change that to
make it more Canadian".
[32] Each local Glaxo World distributor, including the
appellant, was required to apply the message in its local market. Glaxo Group
provided written material to the distributors and sponsored marketing workshops
which were attended by employees of its distributors. The local distributors
then communicated the Glaxo message to their local markets. Marketing personnel in Canada delivered promotional directives
and material to the local sales managers, who would then oversee the marketing
efforts of a team of local sales representatives. The local sales
representatives would visit local doctors and communicate to them the various
marketing information about Zantac. The appellant's goal
was to convince doctors to prescribe Zantac over other ulcer-relief products.
Anti-Generic Marketing Strategies
[33] When the generic companies were preparing to enter the
ranitidine market in Canada in 1985, Glaxo Canada was very aggressive in attempting
to abort or at least delay the generic companies' efforts. This is
notwithstanding the appellant's position at trial that the generic companies
were not its competitors. Five tactics to deal with the generics were set out
in a document entitled "Report on the Genericization of Zantac in Canada" ("Report"): legal
challenges, positioning, sales force, brand image, and investment in the brand,
including the launch of an ultrageneric drug.
1) Legal Challenges
[34] According to the Report, "all legal avenues to
have the generic removed from the market, or delisted from provincial
formularies were pursued." In 1987, Mr. K.F. Read, the appellant's
Director of Regulatory Affairs, attempted to convince HPB to refuse a generic
company a Notice of Compliance for a ranitidine product by raising potential
safety concerns. The appellant also tried to obtain an injunction against HPB,
but failed. In his reasons for an order dismissing the application for an
interim injunction Rouleau J., was of the view that the appellant's "sole
motive . . . in bringing this application . . . [was] . . . to
prevent competition in a market where it has . . . enjoyed a virtual
monopoly".[10] An
appeal to the Federal Court of Appeal was dismissed. Mr. Jacques Lapointe,
who was the appellant's president during the years in appeal, agreed that the
application was "one of the tactics" used by Glaxo Canada to fight
the availability of generic ranitidine in Canada.
2) Positioning
[35] The appellant sought to establish Zantac as the standard of excellence
in ulcer therapy. The superior profile of Zantac was compared and contrasted
with the questionable quality of the generics to physicians, pharmacists and
provincial formularies.
3)
Sales Force
[36] Once generics
entered the market, the appellant expanded on its sales force and created a
Pharmacy Service Sales Force to deal exclusively with pharmacies. This allowed
the Physician Sales Force to concentrate exclusively on physicians. The
appellant launched an anti-generic campaign, which included the "no‑substitution
campaign". The Physician Sales Force sought to persuade doctors to include
the phrase "without substitutions" or "no substitute" on
Zantac prescriptions which meant that a pharmacist could not substitute a
generic product in place of Zantac. The Pharmacy Service Sales Force encouraged
pharmacists to stock and dispense Zantac instead of a generic drug for all
customers, who were not covered under a provincial drug plan.
[37] In addition, the
Glaxo Hospital Savings Plan was devised to enable Glaxo Canada to
compete effectively with generic ranitidine in the Canadian hospitals. Under
this plan, hospital pharmacists received an on-invoice discount and a volume
discount based on the whole portfolio of the drugs purchases. The initial on-invoice discount for Zantac
products was 25 percent. The rebate was
increased to 40 percent and then to 45 percent. The discounts allowed the
appellant to match the price of generic ranitidine products in hospitals.
4) Brand
image
[38] Mr. Faheem Hasnain, a Glaxo official discovered by
respondent's counsel, explained that Zantac's success in Canada was due to the brand's perception
in the marketplace. "That was our ace in the hole." He added that
"what it came down to is marketing . . . we had a pretty good marketing
team, in fact we had a great marketing team". There was a perception in
the marketplace that Zantac was a high-quality, superior agent. He acknowledged
that every marketing campaign takes into account local nuance and local
understanding of customer base. In Canada, for example, the advertising campaign played on the suggestion that
there were quality problems with generics and that it was only with Zantac that
the patient could be sure of the quality.
[39] In 1988, ACIC, a Toronto manufacturer of ranitidine, offered to sell its product to Glaxo Canada. The proposed price was a one time
payment of $240,000 for research and thereafter $350 to $400 per kilogram. Jacques Lapointe
testified that Glaxo Canada and Glaxo World had some concerns about the
ramifications of entering into an agreement with this supplier. In a letter
dated April 21, 1988 to Jeremy Strachan of Glaxo Holdings, Mr. Lapointe
wrote:
From a marketing point of view the longer we can
keep Novopharm from entering the market with a second generic ranitidine the
better we are able to defend our position against Apotex who are recognized in
the marketplace to have a definite quality problem. It would also be much
more difficult to defend against generics if the generics' quality was equal to
or superior to that offered by Zantac.
There could be significant financial implications as
well. We have been challenged, as you know, by Revenue Canada on
transfer pricing of ranitidine in view of the availability of raw material on
the world market in the $350 price range. … In addition to the argument
concerning the inclusion of development costs in Glaxo material, another
possible defence would be the poor quality of this cheaper material from
off-shore sources. ACIC's unnegotiated offering price for material of good
quality is $400 and this from a Canadian source. If we were to enter into a
purchase agreement at this price, however, the world-wide ramifications would
need to be critically assessed. Such a precedent could jeopardize transfer
pricing on a much larger scale.
. . .
Our planned course of action is to stall [ACIC] for
as long as possible. We have requested a further sample of the initial batch
which will be sent to John Padfield's laboratories for evaluation along with
the report of our analysis as soon as available. Assuming that the quality of
this material is confirmed, we may want to consider tying up this source of
production indefinitely before the material becomes available in the marketplace.
[Emphasis added.]
[40] Glaxo Canada ultimately decided not to purchase
ranitidine from ACIC. Mr. Lapointe testified that the reason for this was
because its marketing strategy involved the claim that Glaxo manufactured
ranitidine was superior to the generic ranitidine and that the only way to be
sure you were getting a quality product was to buy Zantac. In his view, if the
appellant started sourcing its ranitidine from a supplier that could be
available to the generics, it would lose credibility in the positioning of the
product. Mr. Lapointe testified that this decision was not related to any
concerns about the quality or purity of ACIC's ranitidine.
[41] Canada was
unique in that it was one of the first markets in which generic drugs were
available and it had provincial formularies with mandatory substitution. While
Glaxo World may have one marketing plan for most drugs that also applied across
Canada, Lapointe agreed that for certain products there would be different
marketing plans for Quebec and even in some provinces where
mandatory substitution of generics was at a different level. Mr. Meade
also agreed that the appellant "did certain things differently" in Quebec. Language and cultural
differences, he said, made that province different.
5) Investment
[42] In 1989, Glaxo World launched another ranitidine product in the Canadian market to compete
directly with the generics on price. Glaxo Canada formulated its ranitidine into finished ranitidine
products for sale to Kenral Inc. ("Kenral"), a corporation owned by
the Upjohn Company of Canada. The product sold under the Kenral label was
identical to Zantac, save for the brand name. According to Paul Lucas,
Senior Vice-President, Corporate Mobility for the appellant, this was the first
voluntary agreement Glaxo World had negotiated with a generic company and the
royalty of six percent payable by Kenral "was a much better deal"
than the four percent payable by the generic companies. Mr. J.W. Cuttle,
Marketing Management Kenral, said Kenral was created to compete in the generic
market as an ultrageneric. He defined an ultrageneric product as one that is
manufactured by the originating brand‑name pharmaceutical company but is
sold in the generic market segment at generic prices.
[43] A business plan for the appellant for the five-year
period 1991/92 to 1995/96 discussed various strategies to grow market share for
Zantac while protecting it "from competitive inroads" at a time when
Zantac's sales were declining due to the presence of the generics and the potential
competition from Omeprazole, a new anti-ulcer product that had recently entered
the market. Strategies included fragmenting the market with line extensions,
continued promotional efforts for Zantac's long‑term use on enhancing the
company image and support to physicians, pharmacists and consumers.
[44] By 1993 Zantac had lost significant market share to the
generics in Canada; the decision was made to cease
promotion of Zantac rather than to fight a losing cause. This was a uniquely
Canadian phenomenon. In the rest of the top ten markets, the central marketing
strategy of investing heavily in Zantac to expand the market was still in
effect as the patent had not expired.
Pricing
and Third Party agreements
[45] As stated, Glaxo
World's pricing strategy was to price their product at approximately a twenty
percent premium to Tagamet. In Canada, the United
Kingdom and the United States
there were no government controls restricting the price and Glaxo World was
free to determine the selling price of Zantac. However, in many countries the
retail price ("in-market price") was set by the local government,
often based on the cost of the API to the distributor or with reference to the
in-market price in other countries. In those countries, Glaxo World had to negotiate
price with government authorities. As a result, Glaxo World had an interest in
setting high transfer prices for the API because a higher transfer price paid
by the local Glaxo World distributor to Adechsa would often result in a higher
in-market price, both in that country and in others that may rely on it.
[46] In many of the European markets Glaxo World undertook
to promote and distribute Zantac through third-party distributors in addition
to its local subsidiaries. These third-party distributors were also referred to
during the testimony as foreign licensees and co-marketers. Dr. Gregory Bell,
an expert in the pharmaceutical industry and transfer pricing, explained that a
co-marketer is someone who sells the same chemical entity as the innovator, but
under a different brand name. The primary functions performed by the
third-party distributors were marketing, detailing and distribution. As was the
case with Glaxo Canada, third parties used marketing tools provided by Glaxo World
in the United Kingdom to promote to physicians the
clinical advantages of their ranitidine products over Tagamet.
[47] Glaxo World used
what is referred to as a resale-price method
to determine the transfer price of the API. Glaxo World and its distributors
agreed that a gross margin of 60 percent would be retained by the distributors
and the ranitidine was priced accordingly. To use a very simple example, if the
ranitidine product was sold for $10 in Italy, the transfer price would be $4; if the ranitidine
product was sold for $20 in France, the transfer price would be $8. Appellant's counsel
described the process as follows:
the starting
point for determining the price to the distributor was the in-market price for
the finished ranitidine product;
from that
in-market price the parties agreed, assuming specified conditions were
satisfied, a gross profit margin the be retained by the distributor
(approximately 60%); and
the remainder
would be remitted back to Glaxo Group in the form of transfer price,
royalties,[or both]. Where the distributor was to pay both transfer prices and
royalties, they would be considered together to determine the distributor's
gross profit margin after payment of the royalty.
[48] Mr. Fisk made it
clear that the price of the API had no connection to its manufacturing costs or
to the costs of the generic products. He explained that "the driver was
the in‑market price and, obviously, you know, Group's guidelines in terms
of what an appropriate level of gross margin would be". According to Mr. Hasnain,
a 60 percent gross margin was chosen because they determined that it would give
a sufficient return to the distributors to properly market the drug.
[49] According to Dr. J. Gregory Ballentine,
an economist who was qualified as an expert in transfer pricing, this pricing method allows for consistency of
returns for similar functions across similar markets, notwithstanding different
in‑market prices in different countries. However, the respondent contends
that the process is circular in that Glaxo World determines the transfer price
based on its target in-market price and the pricing authority determines the
approved in-market or reimbursement price based on the cost of the API.
[50] Contractual
arrangements varied from country to country. In some countries, there was a Licence
Agreement with Glaxo Group; in others, with the local Glaxo subsidiary. In most
countries intangibles, for example the right to use a Glaxo Group trademark and
the right to marketing support, were included in the purchase price of the
ranitidine and the royalty payment, if one was specified, was waived. This can
be contrasted with Canada, where there was a royalty payable to Glaxo Group
pursuant to the Licence Agreement. Under the terms of each Licence Agreement,
all local Glaxo distributors were required to purchase granulated ranitidine
from a Glaxo Group approved source and to sell the licensed product under a
trademark owned or controlled by Glaxo Group. This is similar to the appellant's
agreement.
[51] Dr. Ballentine explained that Glaxo entered into the
co-marketing agreements for various strategic reasons, including achieving a
higher in-market price, to obtain earlier product registration and to limit the
entry of other competitors. For example, in France and Italy Glaxo's
co-marketing agreements allowed it to negotiate a high reimbursement price from
the government. In Spain and Portugal the
government limited the number of brands or licenses for each product. Glaxo
World's goal was to protect the market from "pirates" who buy
ranitidine from non-approved sources by signing up the major players as co‑marketers
and thereby flood the market to limit the opportunities from other firms to buy
from non-approved sources and compete.
[52] A good illustration of why co-marketing agreements were
so important to Glaxo World is the marketing agreements with Menarini, an
Italian company. In Italy, the first country in which Zantac
was sold, all ranitidine products were reimbursed at the same price, which was
set by the government. The reasons for partnering with Menarini included the
weakness of patent protection in Italy, to take advantage of the influence Menarini had with the Italian health
authorities to obtain quick registration approval and the perceived advantage
of using an Italian-based company in order to obtain a high in-market price. On
cross‑examination, Mr. Fisk agreed that the fundamental element in
getting a high in-market price approved by the government was the high price of
the API to the distributors. Had Menarini been purchasing ranitidine for a
lower price, the approved in-market price for both its product and Glaxo's
product would have been lower.
[53] In a witness statement David John Richard Farrant,
Glaxo Group Developing Trade Areas Director from 1981 to 1988, explained that
Glaxo believed that the Italian owned company would be more likely than Glaxo
to negotiate a high price. As it turns out, this strategy worked "spectacularly
well", and they obtained an Italian price which was at a 44 percent
premium to the price of Tagamet, much higher than expected. Mr. Fisk testified
that securing a high in-market price in Italy was particularly important
because this was the first time the Glaxo World strategy of achieving a premium
price over Tagamet was tested and it was important to send a signal to the rest
of the operating companies that this was the strategy. The high in-market price
in Italy had an effect on the in‑market
price set in other countries as well, since many countries in Europe set their
prices by reference prices in the United Kingdom and in the first country where the product was launched.
[54] In addition to its co-marketing agreement in Italy,
Glaxo World had agreements in France, Austria,
Finland, Germany, Greece, Spain and Portugal. According to the appellant,
during the years in appeal the co-marketers paid between $962.20 and $2,641.69
per kilogram of ranitidine.
[55] During the years in appeal, there were many differences
between the Canadian market and the European markets. Unlike Canada, Glaxo had a monopoly in Austria, Finland, France, Germany and Italy that provided an opportunity to charge high prices for
ranitidine sales to third parties. Unlike Canada, price controls based on
ranitidine's selling price existed in these countries as well as in Greece, Spain and Portugal. Canada had generics on the market, whereas most of the European
markets did not and two of those that did (Greece and Spain) provided for generic ranitidine
products to be compensated for at the same price as the Glaxo products. In the
European markets there was no encouragement for the use of generics through
mandatory substitution rules.
[56] In 1993, a representative from Vitoria, one of the Spanish licensees,
wrote to Adechsa asking for a reduction in the transfer price:
As you know the price of the [ranitidine] supplied
by Adechsa hasn't been reviewed for many years and, actually, that price […]
represents nearly 12 to 13 times more than the current free market prices…
We beg you to grant us a significant decrease of
price for [ranitidine], in order to allow us to compete on equal basis with the
– competition and so, try to change the negative trend of the market share,
which we have been witnessing in the last years. For this purpose, please take
in consideration the relation between your price . . . and the free market
price above mentioned, where the competition gets their raw material.
[57] On cross-examination of Mr. Fisk, the respondent
established that Glaxo World had sold ranitidine to an Indian company called
Bio Tech Pharma for $225 (U.S.) per
kilogram starting in 1986. As of 1992, Glaxo World was selling ranitidine to a
Hungarian company called Biogal for $550 (U.S.) per kilogram and to an Egyptian company for $630 (U.S.) per kilogram. With respect to the price in Egypt,
Mr. Fisk explained that there were generic materials available there and Glaxo Egypt had to compete with the lower-priced
generics. When respondent's counsel asked Dr. Ballentine why Adechsa did not
sell ranitidine to Glaxo Canada at the
same price it was sold to the Indian company, he replied:
Because it can sell it to Glaxo Canada for
more than that…
What they pay for it to sell it in India is
completely irrelevant, because they are not selling it in India. They
are selling it in Canada. The price in Canada is different than the price in
India, and that is perfectly expected and understood.
[58] Mr. Fisk's cross-examination also revealed that the
prices disclosed by the appellant did not all take into account various
discounts and allowances given to the third party licensees by Glaxo and that
the adjusted transfer price was much lower in many cases. For example, in the
case of Austria, a promotional allowance was being
paid by Glaxo World into a Singapore bank account with no documentation
submitted to the Austrian government. This effectively reduced the transfer
price and would have resulted in a reduced in-market price had the government
been aware of it. The licensees in Italy, Portugal and Spain were all receiving various promotional
allowances, discounts, free goods and lump sump payments as well. Mr. Fisk also
admitted that he did not review the books and records of the French, Italian
and Finish licensees; instead he relied on various invoices and data from a
pharmaceutical data organization, IMS. IMS is an organization that collects
data such as prices and sales of particular drugs in various countries for use
by pharmaceutical companies, primarily to assess market conditions. While IMS
claims to have a high degree of accuracy in some countries, IMS will not
warrant the accuracy of its information and Glaxo Canada will not confirm or contest its
accuracy. IMS does not check its information with the drug manufacturer, but
instead relies on pharmacies or wholesalers to report their sales information.
IMS data does not include any discounts offered to manufacturers, any
discounts, promotions or free goods offered to pharmacists or wholesalers and IMS
does not always collect data from hospitals.
OECD CONVENTION AND COMMENTARY
[59] Subsection 69(2) of the Act is analogous to
Article 9(1) of the OECD Model Double Taxation Convention on Income and
Capital. The OECD issued a commentary on transfer pricing analysis in 1979.[12] The Canada Revenue Agency ("CRA")
relies on OECD Commentaries in assessing: Information Circular 87-2, International
Transfer Pricing and Other International Transactions, dated February 2,
1987. Information Circular 87-2 was replaced by IC 87-2R, International
Transfer Planning on September 27, 1999. The Federal Court of Appeal has
said that it is "common ground that the [OECD Commentary] inform or should
inform the interpretation and application of subsection 69(2)".[13]
[60] The OECD Commentary on Article 9(1) relies on the arm's
length principle to determine the prices that multinational enterprises ("MNEs")
would charge for goods and services sold from one jurisdiction to another. The
arm's length principle recognizes that independent enterprises would charge
prices according to market forces when dealing with each other. The Commentary
recognizes that transfers between MNEs do not necessarily represent the result
of free market forces, but may instead have been adopted for the convenience of
the MNE. Consequently, prices set by an MNE may differ significantly from the
prices agreed upon between unrelated parties engaged in the same or similar
transactions under the same or similar conditions.
[61] According to the OECD Commentary MNEs may adopt
transfer prices for reasons other than to minimize tax, but, regardless of the
reason, intra-group transfers which are not carried out at arm's length prices
will likely result in profits shifted from one country to another. The
Commentary also recognizes that in some MNEs the members have enough autonomy
so that they can bargain with each other in a manner similar to that of
independent entities.
[62] A hierarchy of methods that can be used to determine
transfer price is set out in the OECD Commentary. There are three "traditional
transaction methods": comparable uncontrolled price method, cost plus, and
resale price. The 1995 Commentary provides for two additional methods: the
profit-split method[14] and
the transaction net margin method, which are to be used if none of the other
three methods are not appropriate.
[63] The methods are defined by the OECD Commentary:
(a) The comparable uncontrolled price ("CUP")
method offers the most direct way to determining an arm's length price. The
transfer price is set by reference to comparable transactions between a buyer
and a seller who are not associated enterprises. Uncontrolled sales may include
sales by a member of an MNE to an unrelated party and sales to a member of an
MNE by an unrelated party as well as sales in which the parties are not related
to each other or to the MNE (though they may themselves be members of other
MNEs). Uncontrolled sales are, in short, sales in which at least one party to
the transaction is not a member of the taxpayer's affiliated group, but they
would include only bona fide transactions and not sales unrepresentative of the
market, for example made in a limited quantity at unrealistic prices to an
unrelated buyer, for the purpose of establishing an arm's length price on a
larger transaction. The method requires the uncontrolled transactions to be
carefully reviewed for comparability with controlled transactions.
(b) The cost-plus method of estimating an arm's length
price is based on the supplier's cost to which an appropriate profit-mark-up is
added. It is a method that raised problems both as regards assessing costs and
the appropriate mark-up for profit and its likely to be appropriate as a
deterring criterion mostly in specific situations, though it may also be useful
as a means of verifying provisionally acceptable prices after other methods
have been applied.
This method may be helpful in estimating an arm's length price, when
semi-finished products are sold…
(c) The resale price method ("RPM") begins
with the price at which a product which has been purchased from a related
seller is resold to an independent purchaser. This price is then reduced by an
appropriate mark-up representing the amount out of which the reseller would
seek to cover [its] costs and make a profit. What is left after subtracting the
mark-up can be regarded as an arm's length price of the original sale. This
method is probably most useful where it is applied to marketing operations.
(d) The transactional net margin method ("TNMM")
examines the net profit margin relative to an appropriate base (e.g. costs,
sales, assets) that a taxpayer realizes from a controlled transaction…
[64] Both parties called an expert witness to explain
transfer pricing and to testify as to the appropriate method of establishing
the transfer price between the appellant and Adechsa. Dr. J. Gregory Ballentine
testified for the appellant. Dr. Jack Mintz testified for the respondent.
Both experts agreed that the CUP method is the preferred method for determining
transfer prices.
[65] Only in the absence of useful evidence of an
uncontrolled transaction will it be necessary to use another method.[20] For example, because no
comparable transaction exists or because there are differences in the
transactions that cannot be taken into account. The other methods are also
useful in that they can be used as a check on each other.
PARTIES' POSITIONS
[66] Again, the issue in these appeals is whether the
prices paid by Glaxo Canada to Adechsa for ranitidine would
have been reasonable in the circumstances if the Glaxo Canada and Adechsa had
been dealing at arm's length.
[67] The respondent's position is that the generic
companies' purchases of ranitidine from arm's length manufacturers are
comparable transactions. She submits that the arm's length price the appellant
would have paid Adechsa is the same as the prices paid by Apotex and Novopharm
to their suppliers. To support its CUP analysis the respondent relies on the
cost-plus method.
[68] The appellant's position is that the generics are not
an appropriate comparator for two reasons: a) the appellant contends that its
actual business circumstances were wholly different from those of Apotex and
Novopharm, such that the transactions are not comparable within the meanings of
subsection 69(2) of the Act and the CUP method; and b) the ranitidine
purchased by the appellant from Adechsa was manufactured under Glaxo World's
standards of good manufacturing practices ("GMP"), granulated to
Glaxo World standards, and produced in accordance with Glaxo World's health,
safety and environmental standards ("HSE"). The appellant contends
that the ranitidine purchased by the generic companies is not a comparable good
because it is not manufactured to Glaxo World's standards.
[69] The appellant submits that the independent third party
licensees in Europe are the best comparator because
they purchased the same ranitidine under the same set of business circumstances
as the appellant. The appellant relies on the resale price method to confirm
its CUP analysis.
ANALYSIS
[70] There are three key differences among the parties.
These are (1) whether the Supply Agreement and the Licence Agreement should be
considered together to determine a reasonable transfer price; (2) the meaning
of the phrase "reasonable in the circumstances" in subsection 69(2) of
the Act; and (3) the impact of the differences in GMPs and HSEs on the
comparability of the ranitidine purchased by the appellant with that purchased
by the generic companies.
[71] The CUP method is the preferred method to use to
establish the arm's length transfer price. However, before any analysis of CUP,
each of the differences described in the preceding paragraph should be
considered.
Relevance of the Licence Agreement
[72] A major difference in the parties' approaches to
calculating the transfer price is whether the total cost of ranitidine to the
appellant, including royalties, should be considered or only the transaction
between Adechsa and the appellant for the purchase of ranitidine. The appellant
argued both the Supply Agreement with Adechsa and the Licence Agreement with
Glaxo Group should be considered. The respondent argues that the two agreements
are to be looked at separately and that the only transaction relevant to these
appeals is the Supply Agreement with Adechsa. The respondent relied on Singleton
v. Canada[21] for
the proposition that one must look at the transaction in issue and not the
surrounding circumstances, other transactions or other realities because in
order to give effect to the legal relations, one has to view the agreements
independently. The respondent points out that the two agreements covered
distinct subject matters, with all benefits or goods being provided by the
respective owner and that there was no tie-in between the Licence Agreement and
the Supply Agreement. In some of the contracts with the European licensees the
Supply Agreement referenced the Licence Agreement.
[73] The respondent also led evidence to establish that the
appellant acquired another API, salbutamol, from a third party. Salbutamol is a
product used in inhalers to help people with asthma. Pursuant to the Licence
Agreement with Glaxo Group, the appellant paid a royalty to Glaxo Group and
received all the intangible benefits pertaining to the drug as set out in
paragraph 14, above. There was a separate Supply Agreement between the
appellant and the third party for the purchase of the API. There was no
connection whatsoever between the two agreements. The respondent submits that
this is further evidence that the two agreements were independent from one
another.
[74] The appellant relies on two cases, Koffler Stores
Ltd v. M.N.R.
and GSW Appliances Limited v. M.N.R.,
to support its argument. Both these cases were decided prior to Singleton,
supra, and neither is particularly relevant. Koffler Stores involved
the purchase of two pharmacies and the consequent surrender of the leases to
the purchaser by the vendor. The Court determined that one contract was the
"genesis contract" (or principal contract) and the others were
contracts in implementation of the genesis contract and were "ancillary and
incidental" to it. The Court concluded that one should look at the
contracts together to determine the nature of the payments under one of them. I
have made no similar finding of fact. Both the Licence Agreement and the Supply
Agreement can stand alone; neither is ancillary to the other. GSW Appliances
involved the issue of inventory allowance where a particular company had
ceased to carry on business. The problem in that case was that there were two
agreements both purporting to transfer inventory on the same date, one to the
taxpayer's parent and another to a third party. The Court found the two
agreements were inconsistent with each other and it applied what is referred to
as the law of repugnancy and concluded that if you apply the law of repugnancy,
it is appropriate to look at one contract to understand the other. But there was
no suggestion in this current case that there is a repugnancy between the
license and the supply agreements.
[75] Appellant's counsel argued that the benefits available
under the Licence Agreement between it and Glaxo Group ". . . [were]
relevant in determining the proper price at which an arm's length party would
have been prepared to purchase ranitidine from Adechsa in the
circumstances." Dr. Ballentine characterized the issue as "what would
be the cost of selling ranitidine products in Canada?" and, in doing so,
he combined the royalty paid pursuant to the Licence Agreement with the
purchase price for ranitidine hydrochloride paid to Adechsa to arrive at a
bundle of goods and benefits received from the Glaxo World as a whole.
[76] Dr. Bell testified that both Glaxo Canada and Glaxo Group
were concerned about the "net transfer price", taking into account
both the cost of the API and the royalty. During his testimony he suggested
that we "abstract from issues of taxation" and focus on the profit.
He testified that as long as the innovator gets his 40 percent profit, how it
is earned does not matter, and it makes no difference whether the profit is
through a combination of the purchase price and a royalty or through the
purchase price or royalty alone. In his closing submissions appellant's counsel
referred to Dr. Bell's testimony and argued that the Court should respect the
legal structure designed by Glaxo World.
[77] By suggesting that the taxation issue be minimized,
Dr. Bell has demonstrated that he has a flawed understanding of a transfer
pricing inquiry. The purpose behind this exercise is to determine a reasonable
purchase price for the API and ultimately to determine the tax liability of the
appellant. Royalty payments in Canada are subject to withholding tax and the
profit will accrue to Glaxo Group and be taxed in the United Kingdom. The purchase price for ranitidine
is not subject to any withholding tax and the profit accrues in Switzerland, and ultimately in Singapore. To suggest that Glaxo Group does
not care whether its profits are in the form of royalty payments or purchase
price belittles the issue in these appeals.
CONSIDERATION OF SUBSECTION 69(2)
[79] The appellant submits that the
circumstances under which the appellant acquired ranitidine and the
circumstances under which the generic companies acquired ranitidine are not
comparable. The appellant argues that the price it paid to Adechsa for
ranitidine was "reasonable in the circumstances", within the meaning
of subsection 69(2) of the Act. The OECD Commentary explains that for
the prices of goods to be comparable, it is necessary to have economic
comparability, comparability of goods and for the goods to be sold at the same
point in the chain from produce to consumer. The 1995 Commentary adds the
following factors to the list of considerations: comparability of functions of
the enterprises, comparability of contractual terms and comparability of
business strategies.
[80] The appellant relies on the 1995 Commentary and submits
that its "actual business circumstances were wholly different from those
of the . . . [generic companies], but similar to those of the Glaxo Group's
independent licensees in a number of countries." In fact, this argument is
key to the appellant's argument, as was pointed out several times during the
trial. In appellant counsel's submissions, he lists the conditions or business
circumstances that in his view distinguish the appellant's transactions from
those of the generic companies:
(a) Glaxo Canada bought ranitidine from Adechsa using RPM, as did
the independent licensees. Apotex and Novopharm did not.
(b) Glaxo Canada had to buy ranitidine from sources approved by
Glaxo Group and could not freely determine its own sources. Glaxo Group's
independent licensees were similarly constrained. Apotex and Novopharm were
not.
(c) Glaxo Canada was required to conduct its business in
accordance with Glaxo Group's standards. In addition to having to purchase its
ranitidine from Glaxo-approved sources, these standards required that Zantac be
manufactured under Glaxo Group's standards of good manufacturing practices,
granulated to Glaxo Group standards, and produced in accordance with Glaxo
Group's health, safety and environmental standards; and
(d) Glaxo Canada received regulatory approval and marketing
assistance from Glaxo Group, as did the independent licensees. Apotex and
Novopharm did not.
(e) Glaxo Canada sold Glaxo Group ranitidine products under
trademarks owned by Glaxo Group, as did the independent licensees. Apotex and
Novopharm sold under their own trade marks.
(f) Glaxo Canada marketed and detailed to doctors using standard
pharmaceutical industry tools, as did the independent licensee. Apotex and
Novopharm did not market or detail to doctors.
(g) Glaxo Canada sold its ranitidine products at a price premium
to Tagamet, as did the independent licensee's. Apotex and Novopharm sold their
ranitidine products at a discount to Zantac.
(h) In marketing and detailing to doctors, Glaxo Canada's primary
focus was to promote the clinical advantages of Zantac (its ranitidine product)
over Tagamet (the brand name cimetidine product). The independent licensees had
a similar focus. By contrast, Apotex and Novopharm sold generic versions of
both ranitidine and cimetidine. Their primary focus was competing with each
other for pharmacy shelf space.
(i) The Glaxo Group manufacturer approved for Glaxo Canada during
the period under appeal, Glaxochem (Pte) Singapore, met Glaxo Group's standards
of GMP, granulation and environment. The generic suppliers to Apotex and
Novopharm did not.
[81] The appellant has also submitted that the evidence of
Dr. Mintz should be rejected, inter alia, because he ignored the unique
circumstances stemming from Glaxo Canada's business model when completing his transfer pricing analysis.
[82] The respondent's position is that since the 1995
Commentary came out after the period in appeal it ought not to be relied upon. This
is notwithstanding that respondent's counsel cited the 1995 Commentary in her
written submissions. Counsel also argued that the different business circumstances
are not relevant considerations in the transfer pricing analysis.
[83] The 1995 Commentary can assist me in considering
transfer pricing issues before me. Neither party pointed to any inconsistencies
between the 1995 and earlier Commentary. The 1995 Commentary is more detailed
and provides more examples than the earlier version. The preface to the 1995
Commentary sets out that they are "intended to be a revision and
compilation of previous reports by the [OECD] addressing transfer pricing . . .
The principal report is [the 1979 OECD Commentary]".[26] Both the 1979 and the 1995 Commentaries
have a role in the CUP analysis.
[84] Several examples of relevant business strategies are
suggested in the 1995 Commentary, including: "innovation and new product
development, degree of diversification, risk aversion, assessment of political
changes, input of existing and planned labour laws, [. . .] other factors
bearing upon the daily conduct of business…[and] market penetration schemes".[27] These are examples that one
would want to consider in any event absent the 1995 Commentary.
[85] The circumstance set out in paragraph 80(a) above,
that Glaxo Canada bought ranitidine from Adechsa using RPM is not relevant to
the issue of comparability. No one is really disputing the method that Glaxo World
used to arrive at the price of its ranitidine. The issue is whether that price
was reasonable.
[86] Several of the circumstances listed by the appellant
stem from contractual obligations in its 1988 Licence Agreement with Glaxo Group
or from Glaxo World's marketing and pricing strategies. For example, it was by
virtue of the Licence Agreement that the appellant was required to purchase its
ranitidine from Glaxo approved sources and adhere to Glaxo standards.
[87] The appellant's position is that the only authorized
sellers of Glaxo ranitidine were Adechsa and Glaxochem and if the appellant
wanted to sell Zantac it had to purchase from one of these suppliers. Because
Glaxo Group set the price, it could sell for whatever it wanted. This was the
testimony of Dr. Bell who said that the reason the appellant did not purchase
ranitidine for $225 (U.S.) like Glaxo India did was because Glaxo Group would
not allow it. Dr. Bell testified that what was scarce was the right to sell
Zantac and because of this scarcity, Glaxo Group could set the price it charged
for its ranitidine.
[88] The respondent does not argue that the appellant ought
to have purchased ranitidine from a different supplier. She says that the price
was not reasonable. The Crown looks at the prices the generic companies paid
for ranitidine to determine whether the price paid by the appellant was
reasonable.
[89] If the legislature intended that the phrase
"reasonable in the circumstances" in subsection 69(2) should include
all contractual terms there would be no purpose to subsection 69(2); any MNE
would be able to claim that its parent company would not allow it to purchase
from another supplier. No MNE would ever have its transfer prices measured
against arm's length prices, because all MNEs would allege that they could
purchase only from sources approved by the parent company. The controlling
corporation in a MNE would structure its relationships with its related
companies, and as between its related companies, in this manner or in some
similar manner. There is no question that the appellant was required to
purchase Glaxo approved ranitidine. The issue is whether a person in Canada dealing at arm's length with its
supplier would have accepted the conditions and paid the price the appellant
did.
[90] The circumstances set out in (f), (g) and (h) in
paragraph 80 relate to the fact that Zantac was priced at a premium to Tagamet
and that the appellant focused its marketing on selling to doctors. Again,
there is no dispute that the appellant's marketing and pricing strategies
differed from most, if not all, of the generic companies' strategies. However,
the issue at hand is the reasonable price to be paid for the purchase of
ranitidine, not Zantac. The evidence has established that it was the marketing
efforts of Glaxo Canada and the value of the Zantac brand
name that resulted in the price premium for Zantac. The evidence of Dr. Bell
and Mr. Hasnain was that the perception of the consumer was very important to
Zantac's success. There was no evidence that the price or value of the API had
any effect on the price of the finished product. In fact, Glaxo World did its
pricing the other way around, taking the price of the finished product and
determining the price of the API from what it would eventually fetch for the
final product. Any difference in business strategy between the appellant and
the generic companies relates to the end selling price of the finished product,
not the purchase price of the API.
[91] Finally, in (d) and (e) in paragraph 80, the appellant
says that it received regulatory approval and marketing assistance from Glaxo World
and that it sold its ranitidine product under trademarks owned by Glaxo World.
This is irrelevant because intangibles come from the Licence Agreement, which
is to be considered separately from the Supply Agreement.
[92] The 1995 Commentary states that business strategies
must be looked at to determine comparability. However in the appeals at bar,
the business circumstances and strategies that the appellant submits
distinguish it from the generic companies have no bearing on the transfer
pricing issue.
GOOD MANUFACTURING PRACTICE
[93] A point in dispute is the
impact of Glaxo's GMP. The appellant submits that the Glaxo ranitidine and that
purchased by generic companies are not comparable because of the differences in
GMP and HSE standards. The respondent agrees that there may be differences in
GMP and HSE but states that those differences are of no significance to either
safety or efficacy and therefore should have no bearing on the purchase price
of ranitidine.
[94] GMP is a term used for the control and
management of manufacturing and quality control testing of foods and pharmaceutical
products. The appellant's expert, Mr. William Ment, a senior regulatory
compliance consultant who was a branch director of the U.S. Food and Drug
Administration ("FDA") until 1999, described GMP as:
policies, practices, written procedures that
companies establish to ensure that the whole production process, which includes
manufacturing, testing and release, reduces as much as possible the risk to
that product having – being adulterated, having harmful impurities, et cetera,
in it.
[95] In the view of Clive Rogers, Glaxochem Limited's
purchasing manager between 1988 and 1994, GMP:
…means that you are running your site efficiently
with good housekeeping. You have trained personnel operating it. You are
keeping full and comprehensive records of all your manufacture, all your batch
records. You are doing proper chemical analysis on all the materials that you
buy in, that you use in process. You segregate materials that are rejected that
you bought in and only use good ones, and you can track a manufacturer right
the way through from beginning to end and you know who has done what to it at
what time and did it comply with a manufacturing process that was registered.
[96] A total of five science
experts were called, all of whom attempted to put their testimony in layman's
terms, to varying degrees of success. With respect to these issues the
following facts are clear:
(a) During the years
in appeal, Canada did not conduct inspections of or have GMP
requirements for API manufacturers. The responsibility for ensuring the quality
of the API was placed on the dosage form manufactures.
(b) Canada required the dosage form (secondary) manufacturers
to manufacture their finished products in accordance with GMP;
(c) Generic ranitidine
was chemically equivalent and bioequivalent to Glaxo's ranitidine and was
approved for sale by HPB; and
(d) Glaxo Group had GMPs for the primary manufacture of the API;
the generic suppliers did not.
[97] The appellant argued that Glaxo's
standards differed from those of the generic API manufacturers in that Glaxo World
required that its ranitidine be (1) manufactured under Glaxo's GMP standards
(2) produced in accordance with HSE and (3) granulated to Glaxo World standards. The suppliers to the generic
companies did not manufacture ranitidine according to Glaxo standards.
[98] When Mr. Ment was asked "[t]o what extent can
test methods be developed to detect adventitious contamination,
cross-contamination or all and any kind of chemical that may be found in a
batch?" he replied, "[i]t would be extremely difficult, if not impossible,
to do that with a battery of tests that companies typically run for batch
release testing. They are not designed to detect and to identify adventitious
contamination, except to a very limited extent."[29]
[99] A similar sentiment was expressed by Dr. Ian Keith Winterborn,
the appellant's science nominee at discovery who also testified at the trial of
these appeals. He said "[i]t is impossible to design – well, it is not
impossible, but it would be onerous to try to design analytical tests which
could detect and quantify any and all potential contaminants that might occur
during manufacture, if the conditions under which the material is manufactured
are not known and not understood."
[100] Mr. Ment said laboratory testing was aimed at
detecting the most likely contaminants (based on the process used) and
cross-contaminants (based on the other chemicals present in a multi-product
facility) but even with such testing, he said that some contaminants might
still slip through undetected.
[101] Appellant's counsel has not argued that his client's
ranitidine was superior to the ranitidine used by the generic companies. He
argued that Glaxo GMPs were superior and that this reduced the risk of
contamination during manufacture. The respondent's expert, Dr. Leslie Benet,
saw things differently. Dr. Benet, a professor of biopharmaceutical sciences at
the University of California, San Francisco, was qualified as an expert in pharmaceutical
sciences, pharmacology, bioequivalency, chemical equivalence and other
scientific aspects of drug-related issues. He emphasized that the real issue is
not contamination per se (which goes to quality) but harmful
contamination (which goes to safety). According to Dr. Benet, for example,
cross-contamination with Atenolol, a beta‑blocker used for lowering blood
pressure, would not be a concern because it has a very wide therapeutic index.
Cross-contamination with penicillin, on the other hand, would be a concern
because people have allergic reactions to penicillin.[31] He testified that any differences in
GMP and HSE are irrelevant. In his view companies may establish whatever
internal standards they like but drug products are approved based on the
regulatory standards in each country. The only issue, according to Dr. Benet,
is whether the API met the Canadian standard. The appellant has admitted that
the generic ranitidine was bioequivalent and chemically equivalent to Glaxo's
ranitidine. This is the standard used by HPB to determine whether a Notice of
Compliance for a New Drug Submission will be granted. In Dr. Benet's
view this is enough to end the inquiry.
[102] The appellant has suggested that both the Zantac
brand and Glaxo's reputation would be impacted if harmful contaminants were
ingested by the ultimate consumer. The appellant's view, therefore, is that
Glaxo World has an incentive to do more than just meet the basic regulatory
requirements. To reduce the risk of contamination it was not unreasonable for
the appellant, for its comfort and that of the Glaxo World, to purchase
ranitidine produced under good manufacturing practices for a marginally higher
price than one would pay for ranitidine that lacked GMP.
[103] The Therapeutic Products Directorate of the Health
Products and Food Branch of Health Canada is the Canadian authority that regulates pharmaceuticals and medical
devices for human use. The respondent's witness, Mr. Sultan Ghani, became the
director of the Bureau of Pharmaceutical Sciences of the TPD in 2002. He was
qualified as an expert in good manufacturing practices of the pharmaceutical
industry in general, the drug approval process, quality assurance and GMP in
the pharmaceutical industry in Canada.
[104] Mr. Ghani explained that, during the years in issue and
right up to the time of his testimony, Canadian regulations placed the
responsibility for the quality of the active pharmaceutical ingredient on the
dosage form (or secondary) manufacturer, and that this was where Health Canada
considered the responsibility to rest as well. However, this practice will soon
change due to international efforts to bring GMP standards to API manufacturers.
[105] Mr. Ghani also said the number of GMP problems
associated with API manufacturing was very, very small compared with the number
of GMP problems associated with dosage form or secondary manufacturing and this
was why Health Canada did not concern itself with API manufacturers. He also
admitted that cross‑contamination is a concern everywhere, including the
API manufacturers, if proper cleaning and other precautions are not taken. In
re‑examination, Mr. Ghani acknowledged that there are limits to
end-product testing and that GMPs do reduce the risk of contamination as much
as possible.
[106] During the years in appeal, the FDA was the only
government regulator in the world to inspect API manufacturers. Routine FDA
re-inspections of Glaxo's Singapore site
were conducted on April 17-18, 1989 and February 21‑23, 1994.
The FDA found only minor deficiencies and concluded the facility was in general
compliance with then current GMPs. Uquifa
was also found to be an 'approvable' source of ranitidine hydrochloride for the
U.S. market during, but not necessarily
throughout, the period in question. This is evidenced by the FDA's Center for
Drug Evaluation and Research ("CDER") acronym 'AE' (meaning approvable)
found on the FDA reporting forms for the inspections of Uquifa conducted in
1987, 1990 and 1993. Deficiencies were identified in each of the inspections
but those deficiencies were all later rectified.
[107] Of particular significance is the fact that the FDA
reporting form for the August 22, 1995 inspection of Uquifa still used the CDER
acronym AE, for approvable, and the associated endorsement page signed on
November 11, 1995 and December 8, 1995 clearly says: "FOLLOW-UP
Recommend approval of both applications". Thus, although Uquifa may have
been an 'approvable' source of ranitidine hydrochloride, it was not yet an FDA
'approved' source.
[108] The subtle difference between the words 'approved' and
'approvable' seems to have caused problems for witnesses of both parties. The
following exchange occurred on cross-examination of Dr. Benet:
Q. Have you seen any approval, final
approval? [referring to the FDA approval of Uquifa]
A. Yes. It is in this document. Let's go
on to the next couple of pages.
Q. At the date of this audit, it was not
approved; right?
A. It was approved in January -- when
they reviewed this data. Can we go on to the next pages?
. . .
Q. If you turn to page 13, it says:
"No response has been received from the firm. Recommend firm be considered
an acceptable source." That is February 1991?
A. Right.
Q. That is a recommendation. Have you
seen the approval?
A. Yes. It is down in the bottom of
the document I have, but you don't see it there. The document I have has
the approval on it, which we got from the FDA by Treaty.
. . .
this was the FDA approval of the product, and it is
ranked – you can get the document that shows it is approved, approvable.
MR. RHEAULT:
Q. Approved or approvable?
A. "Approvable" is the word they
use. See, this document only has the reporting district. You need to
see the document that is the next page that says what the action is, and that
is not on this document. Maybe it is not in your document, but I was shown --
my counsel, when I asked to see 505438, was able to show me that. That is it,
"District decision, AE." That is approvable.
[109] Dr. Benet appears to have equated 'approvable' with
'approved'. On cross-examination, he stated that Uquifa was GMP approved by the
FDA in 1990, when in fact, it appears that it was not. I do not know to what
extent this assumption impacted Dr. Benet's conclusion that Glaxo's GMPs did
not lead to any differences in quality, safety or efficacy of Glaxo's API
compared to the generic API.
[110] Dr. Chris Baker, who became a director of logistics
within Glaxo's pharmaceutical arm around 1990 and 1991, also seems to have
equated 'approvable' with 'approved'. In response to questioning, he said that
he was aware that Uquifa had been approved by the FDA, but that the
deficiencies listed in the FDA Form 483s showed that they were still having
problems as late as 1995.
[111] It appears that the
non-active ingredients in a dosage form (pill, tablet. . .) may not
have been manufactured according to GMP. The appellant's science nominee, Dr.
Winterborn, said in examination in chief:
Glaxo had other requirements in
addition to simply testing a sample to a specification. One of those main
requirements was that all actives [meaning active pharmaceutical ingredients or
APIs] had to be made in accordance with good manufacturing practices.
I
infer from this that Glaxo did not require its non-active ingredients to be
manufactured in accordance with GMPs.
[112] Furthermore, the respondent's expert,
Mr. Ghani, said:
…recently, even there has been
some discussion of having GMP for the excipients [the 'glue' that holds the
tablet together], which means non-active pharmaceuticals, because they think
that [the] majority of your tablets or capsules, the amount of the excipient is
higher. You have a 25-milligram tablet, you have a 25-milligram active drug,
but you may add [to] it about more than a gram of non-active [ingredients] into
that one. There are organizations, right now, that have developed the GMP
quality standards for excipients, but I am sure that [over the] next few years
this will become a topic for regulatory bodies to address…
[113] I accept Mr.
Ghani's testimony that GMP standards for excipients are a relatively recent
phenomenon. As such, it is perhaps not surprising that the appellant did not
have GMPs for the excipients; nevertheless, it is open to question why the
appellant would go to such lengths to avoid contaminants entering the final
product via non-GMP APIs when they were willing to accept the risk of contaminants
entering the final product via non-GMP excipients.
[114] With respect to HSEs, the appellant also argued that the
ranitidine purchased by the generic companies was not manufactured in dedicated
(i.e. single product) facilities, the reason being that multi-product
facilities have a greater risk of cross-contamination. What is interesting
about this argument it that Glaxo manufactured ranitidine hydrochloride in two
facilities, Singapore (a single product facility) and Montrose U.K. (a multi product facility). The appellant never
suggested that the API manufactured in Singapore was superior to the API manufactured in Montrose. In fact, Dr. Chris
Baker described the Glaxo Group Primary Production Policies and Procedures as
internal standards intended to ensure that the safety and security of Glaxo's
processes and products were consistently maintained around the world.
Consistency, he said, "implies how you manufacture and, therefore, if you
manufacture, you have to manufacture in the same way, in the same process, in
the same locations around the world. . . . Because allowing
variations from market to market means the patient could, in consequence, get a
different quality of product." Therefore, as far as the appellant is
concerned, an API that comes out of a Glaxo multi‑product facility is no
different from an API manufactured in a dedicated facility; Glaxo standards are
the same. There was no evidence to support the appellant's claim that a
multi-product facility of a generic supplier, by its very nature, is inferior
to a dedicated facility.
[115] Mr. Tomas Barrera was qualified to give evidence on
behalf of the appellant on whether Uquifa met Spanish environmental regulatory
standards with respect to waste water discharges, hazardous waste and air
emissions in the years in question. He was also qualified to give opinion
evidence as to whether Uquifa met Glaxo's waste water discharge standards in
the same period, but he was not qualified to speak to marketing issues.
[116] I place little, if any, reliance on Mr. Barrera's
evidence because:
(a) he
used information from Spanish regulatory authorities to assess Uquifa but
relied on information provided by Glaxo to assess the Singapore site. (The environmental record of
Glaxo Spain is wholly irrelevant because APIs
were not produced there.);
(b) he
admitted that Uquifa and the Singapore plant
both exceeded waste water limits with the permission of their respective
regulatory authorities; and,
(c) he
admitted that he did not know whether Uquifa's 1988 to 1990 exemption with
respect to waste water limits had been extended.
[117] Any difference between Uquifa's and Singapore's environmental compliance is not
significant for the purpose of these appeals. Dr. Chris Baker said
"the normal policy in Glaxo was to hold quite significant stocks of API,
because the value of carrying the stock is relatively small [compared] to the
impact of not being able to supply the market." This would have mitigated
any security of supply concerns the appellant might have had about buying APIs
from Uquifa, especially since there were a number of potential suppliers
available. And since Apotex and Novopharm also purchased product from Uquifa,
none of them would have been in a position to secure a competitive advantage if
environmental problems had surfaced at Uquifa.
[118] Appellant's counsel argued that Glaxo's adherence to GMPs meant that its
ranitidine was not comparable to that used by the generic companies. I do not
accept this argument. Glaxo's
GMP and HSE standards do not change the nature of the good. As Mr. Winterborn
stated, "Ranitidine is ranitidine is ranitidine". Bernard Sherman,
the Chairman of Apotex, insisted that the Glaxo ranitidine molecule and the
generic ranitidine molecule are identical. The appellant has admitted that the
generic ranatinde was chemically equivalent and bioequivalent as required by
HPB. Thus, were it not for the Licence Agreement and Glaxo World's self-imposed
standards, the appellant could have purchased ranitidine from the generic suppliers,
packaged it as Zantac and sold it for the same price it was selling the Zantac
which contained Glaxo-manufactured ranitidine. However, I do accept that GMPs
may confer a certain degree of comfort that the good has minimal impurities and
is manufactured in a responsible manner. Granted, this has some value but it
does not affect its comparability with the ranitidine used by the generic
companies.
COMPARABLE UNCONTROLLED PRICE
METHOD ("CUP")
[119] The 1979 and 1995 OECD Commentaries
apply the following criteria in analyzing the CUP method: economic
comparability, comparability of goods, comparability of point in the chain
where goods are sold, comparability of functions of the enterprises,
comparability of contractual terms and comparability of business strategies[35]. I shall review each.
I. Economic Comparability
[120] The OECD Commentary explains that geographically
different markets differ so that it is rarely possible to directly determine an
arm's length price in one country on the basis of market prices in another
country. Geographically different markets therefore can be satisfactorily
compared only if the economic conditions are the same or differences in
conditions can be easily eliminated.[36] The
1995 Commentary elaborates on this point by noting several other circumstances
that may be relevant to determining market comparability. These include, inter
alia, the size of the markets, the extent of competition in the markets and
the relative competitive positions of the buyers and sellers, the availability of
substitute goods and services, and the nature and extent of government
regulation of the market.[37]
[121] There is no question that the generics and the appellant
were operating in the same geographic market. They both sold their ranitidine
products throughout Canada during the period in appeal.
Similarly, both the generics and the appellant were operating in the same
market, taking into account the additional circumstances set out in the 1995
Commentary. All three companies were engaged in the sale of prescription
pharmaceutical products in Canada. The
three companies were comparable in size, were subject to the same government
regulations and were competing with each other and other ulcer medications for
market share.
[122] In his report Dr. Ballentine concluded that there were
at least two markets for ranitidine in Canada: the branded pharmaceutical market and the generic pharmaceutical market.
He based this conclusion on the fact that the appellant and the generics sold
their finished ranitidine products at different prices. He also noted that the
generics had different marketing strategies, economic circumstances and
business strategies than the appellant. Throughout the trial, the appellant's
witnesses maintained that the appellant did not view the generic companies as
their competitors. In its view, its competition was Tagamet and other brand
name ulcer medications.
[123] The respondent's expert in pharmaceutical marketing, Dr.
Charles King III addressed Dr. Ballentine's argument in his rebuttal expert
report. Dr. King concluded that there is only one ranitidine market in Canada. He explained that economists
define markets based on the analysis of substitutability and that products do
not need to be identical in order to be substitutes. In his testimony
Dr. King gave the example of butter and margarine, which are not identical
goods but which operate in the same market. He noted that generic ranitidine is
a substitute for Zantac and that the market for Zantac was not independent of
the market for generic ranitidine. After generic ranitidine was introduced at a
lower price than Zantac, many consumers changed from Zantac to a generic
product. The fact that Glaxo Canada did not lower the price of Zantac does not
mean that the generics were not competitors in the same market.
[124] At trial, Dr. Ballentine noted that his "use of the
term 'markets' has caused some controversy. It doesn't matter to me what term
is used. I will use, in my discussion here; there are two segments to the
ranitidine tablet market in Canada." At
trial, Dr. King agreed that it was acceptable to refer to two segments that
carry different prices, so long as it was understood that both segments were
competing in one economic market.
[125] There is no question in my mind that the generic corporations
and the appellant were competing in the same economic market. The appellant
itself acknowledged that it was losing market share to the generics and it came
up with a marketing strategy specifically to fight the generic companies. The
fact that the appellant and the generic companies charged different prices for
their respective ranitidine products is not relevant to this question.
II. Comparability of goods
[126] In order for goods to be comparable, they should be as
nearly as possible physically identical but if the differences are important a
useful comparison may still be possible so long as appropriate adjustments can
reasonably be made to the uncontrolled price to take account of the
differences. The OECD Commentary notes that even in seemingly homogeneous
products, such as steel for example, quality differences are an important
determinant of price and this has to be taken into account. Nevertheless, in
general it is fair to say that the less standardized the goods the less easy it
will be to find comparable uncontrolled prices.[38]
[127] The appellant has argued that the ranitidine it
purchased from Adechsa was not comparable to the ranitidine purchased by the
generics because the ranitidine purchased by the appellant was manufactured
under Glaxo World's standards of GMP, granulated to Glaxo World standards, and
produced in accordance with Glaxo World's HSE standards, while the ranitidine
purchased by the generics was not. I have previously concluded that Glaxo World's
GMP and HSE standards do not change the nature of the ranitidine. If there is a
difference, it is in only in possible reduction of contaminants; there is no
difference in substance.
III. Comparability of point in the chain where goods are
sold
[128] For prices to be readily comparable it is necessary to
compare goods sold at the same point in the chain from producer to consumer or
to be able to quantify easily the different points in the chain. The appellant
and the generic companies both purchased ranitidine at the wholesale level. The
parties agreed that this factor is comparable.
IV. Functional Analysis
[129] The 1995 Commentary states that comparison of the
functions taken on by the parties is necessary as it seeks to identify and
compare the economically significant activities and responsibilities undertaken
by the independent and associate enterprises.[39]
Functions identified include design, manufacture, advertising, marketing, and
distribution, among others. It is also necessary to consider the risks assumed
by the respective parties. Adjustments should be made for any material
differences.
[130] The appellant and the generic companies performed
similar functions, namely secondary manufacture, sales and distribution, and
research and development. All three companies had regulatory affairs divisions
whose purpose was to obtain approval for their respective drugs from the HPB.
All three companies have, as the ultimate purchasers of their drugs, Canadian
consumers. More specifically, with respect to ranitidine, the appellant and the
generic companies all performed very similar functions in terms of purchasing
bulk ranitidine from primary manufacturers, conducting secondary manufacturing
in Canada and undertaking marketing
activities and distribution. That the generic companies had a different
strategy when it came to marketing their products does not mean that they had
different functions than the appellant.
V. Comparability of contractual terms
[131] The contracts between the generic companies and their
suppliers were not put into evidence. Dr. Sherman testified that Apotex's
contract with its suppliers was for ranitidine only and did not include any
assistance with marketing or secondary manufacturing, nor did it include
exclusivity or the right to purchase future drugs. There is no evidence that the
appellant's Supply Agreement with Adechsa was any different from the generic
companies' agreements with their suppliers; the contract was for the simple
purchase and sale of ranitidine.
VI. Are the European licensees comparators using the CUP
method?
[132] The appellant relies on the testimony and expert report
of Dr. Ballentine to support its argument that the prices paid by Glaxo's European
licensees are appropriate comparators. The appellant submits that the European
licensees were similar to Glaxo Canada in that they were selling ranitidine products in the local markets under
license from the Glaxo World on the basis of the price premium to Tagamet. The
licensees were subject to the same types of restrictions as Glaxo Canada, including restrictions as to the
use of the trademark owned or controlled by the Glaxo Group and the requirement
to buy ranitidine from a Glaxo approved source.
[133] The respondent disagrees with the appellant's
submissions and argues that the European licensees are not appropriate
comparators for six reasons. First, Glaxo World's trading arrangements were set
up specifically because it was not possible to compare prices between markets.
Second, it is not possible to make adjustments to compensate for the
differences between the different markets. Third, the transactions with the
foreign licensees differ from the transactions between Glaxo Canada and Adechsa in material respects
that cannot be quantified (intangibles, different functions). Fourth, the
purchase prices of the licensees were arrived at as a result of a negotiation
for gross profit margin and not on price. Fifth, Glaxo Canada has not established the transfer
price to the European licensees. Last, Glaxo Canada ignores other potential comparators for no valid reasons.
[134] I do not intend to review each of the respondent's
submissions. Suffice to say that I agree with the respondent that the European
licensees are not good comparators. The European markets and the European
transactions differed significantly from the Canadian market and the Canadian
transactions and it is not possible to compensate for those differences. The
evidence was that in marketing and selling a product one takes into account
that each country is different and even parts of the same country may differ. I
also reject the appellant's argument because it has not satisfactorily
established the transfer price to the European licensees and has ignored other
potential comparators which had lower transfer prices.
VII. Economic circumstance not comparable
[135] The OECD Commentary cautions against using comparators
in different jurisdictions:
. . . The
progressive liberalization of international trade which has taken place during
the last decades has certainly facilitated access to new markets, but it has
not led, even in the countries where this liberalization is the most extensive,
to the constitution of one single market where transactions would be made
always and everywhere under the same conditions. Only in very few cases is
it possible to determine directly an arm's length price in one country on the
basis of market prices in another country. Geographically different markets
therefore can be satisfactorily compared only if the economic conditions are
the same or differences in conditions can be easily eliminated. The variety
of economic and social structures, of geographical situations and of consumers'
habits means that supply and demand of the same product may vary considerably
from one country to another. In practice, market prices do vary from one
country to another or even within one country and in addition different country
policies in many spheres (for example, value of currency, taxes, competition
policy, price or exchange control, size and efficiency of market and degree of
concentration) are likely to influence price levels. On the other hand, an
enterprise enjoying a monopoly or other dominant position in the market can,
and often will charge uniform prices to all its unrelated customers or to all
of them in particular areas, or uniform prices modified only by identifiable
market specific factors such as import duties.
[Emphasis added.]
[136] During the years in appeal, there were significant
differences between the Canadian markets and the European markets as set out in
paragraph 55 of these reasons. Dr. Ballentine attempted to partially
adjust for the selling price differentials by making certain changes to the
transfer prices of the licensees. He stated that the purpose of the adjustments
was:
[to
incorporate] the effects of compulsory licensing in Canada, maybe reference
pricing in France, whatever pricing mechanism was followed in Spain. In my
view, it doesn't matter what legislative, regulatory or administrative process
is used to influence tablet prices. Those factors may have a material effect on
tablet prices . . . that is what [Table 7] shows. I incorporate the various
differences that have a material impact on tablet prices in their impact on
ranitidine by making that adjustment.
[137] Dr. Mintz stated that it was very difficult to make
adjustments and generally not possible to take into account the differences in
markets; also, he did not understand the logic behind Dr. Ballentine's
adjustments. Dr. Ballentine did not adjust for the monopoly situations in
Europe as opposed to the competition amongst vendors to Canada or the price competition amongst
the Canadian ranitidine sellers.
VIII. Contractual terms not comparable
[138] The transactions between Glaxo Canada and Adechsa were for a kilogram of
ranitidine with no intangibles included in the purchase price. The transactions
with the European licensees between 1990 and 1993 generally included the
ranitidine and a variety of intangibles for a single consideration. This makes
the Glaxo Canada transaction fundamentally different from the transactions
involving the European licensees and makes comparisons between the two
inappropriate. Transfer pricing policies differed between Glaxo Canada and European distributors as well.
Special incentives like promotional goods were applied to European
distributors, unlike Glaxo Canada.
[139] Dr. Ballentine attempted to adjust for the differences
in the contracts by re-characterizing the issue to be one of what Glaxo Canada
was required to pay to sell Zantac in Canada. In so doing, he bundled the
royalty payment that the appellant paid to Glaxo Group with the transfer price
it paid to Adechsa; this permitted him to attempt to compare the two Glaxo Canada transactions undertaken by the
European licensees. Again, the issue in these appeals is not what is a
reasonable price for Glaxo Canada to pay to
sell Zantac in Canada; it is what is a reasonable price for Glaxo Canada to have paid for a kilogram of
ranitidine. Dr. Ballentine's CUP analysis does not address the latter issue.
IX. Other differences: functional analysis
[140] Furthermore, if one accepts Dr. Ballentine's
characterization of the issue as being broader than simply identifying a
reasonable transfer price for a kilogram of ranitidine, then one should
consider all the functions that Glaxo Canada has to undertake on behalf of its
parent company – including research and development, registration of materials
with the local health authorities, secondary manufacturing for arm's length
parties (Kenral), financing activities and assistance with marketing strategies
– and look for comparables with similar functions. As Dr. Mintz indicated,
Dr. Ballentine was selective in choosing what to bundle and what to ignore.
None of the European licensees undertook any of the foregoing activities,
making them inappropriate comparators. Certain European licensees, including France, Portugal and Spain, had much less risk than Glaxo Canada. The licensees in those countries
were guaranteed a gross profit margin of approximately 60 percent. Glaxo Canada had no similar profit guarantee.
This is also something that would require adjustment; if possible.
[141] A better example of a CUP for Glaxo ranitidine is the
sale by Adechsa to Biotech Pharma in India. Biotech Pharma was a third party that acquired only ranitidine for
onward sale to a Glaxo-related company. There were no intangibles associated
with the ranitidine, making it a near perfect comparator to transactions with
the appellant. The sale price was $225 (U.S.) per kilogram in 1986. Another example not considered by Dr. Ballentine
was the sale to Glaxo Egypt, then owned by a third party, for $630 (U.S.) in 1992. The price at which Glaxo Group sold
ranitidine to Glaxo Egypt was stated to be due to the need
to compete with generic ranitidine. The circumstances of these countries were
more similar to the circumstances of Glaxo Canada.
[142] Even if one accepts the appellant's submission that the
European co‑marketers are the most appropriate comparators, the appellant
has not established to my satisfaction the transfer price they paid. As stated
earlier in these reasons, the appellant did not disclose various promotional
allowances paid by Glaxo World to the third party licensees. These payments
effectively reduced the transfer price. Without complete records from the
licensees, it is not possible to accurately estimate the net transfer price.
X. Is the Kenral transaction a comparator using the CUP
method?
[143] Dr. Ballentine agreed that the Kenral transaction was
not a good comparator, albeit for different reasons than the respondent. Kenral
was competing in the same geographic market as the appellant and, like the
appellant, used Glaxo approved ranitidine in its tablets. However, the
transactions differed significantly taking into account functions, risk and
contractual terms. Kenral purchased completed packages of ranitidine tablets
from Glaxo Canada. Kenral received a guaranteed 25
percent gross profit and consequently bore little risk, unlike the appellant who
bore all the costs and risks for product approval by HPB, secondary
manufacturing, post launch research and development and marketing. Finally,
Kenral received intangibles and other benefits in consideration for the
purchase price: the ability to have HPB access the Glaxo Canada registration
materials rather than prepare its own, secondary manufacturing, marketing
assistance, including free goods, and Glaxo Canada paid the royalty of six percent to Glaxo Group in respect of ranitidine
sales to Kenral. There is no evidence to establish what Kenral would have paid
only for a kilogram of ranitidine without all the intangibles and other
benefits.
[144] The appellant argued that if there was no comparator
under the CUP method, the resale price method using the European licensees as
comparators should apply. The appellant relied on the transactional net margin
method ("TNMM") and the respondent relied on the cost plus method to
confirm the reasonableness of their respective methods. However, all agree that
the cost-plus and resale price methods are secondary methods to be used when
the CUP method is not appropriate and that the TNMM is another alternative when
cost plus and RPM are not appropriate.
XI. The Resale Price Method
[145] The RPM compares gross margins,
which is computed as net sales less cost of goods sold divided by net sales. RPM
is most reliable when it measures the return of only one function, is isolated
to a particular product and there is a high degree of similarity in functions
and risks between the companies being compared. The OECD Commentary states that
RPM is particularly useful where it is applied to marketing functions. Like the
CUP method, it is difficult to compare transactions in different geographic
locations using RPM. As Dr. Mintz explained, this is because expenses below the
gross profit margin line will vary considerably depending on geography. Dr.
Mintz gave the examples of taxes and marketing expenses. A licensee in a
country with low marketing expenses or low taxes may be willing to accept a
lower gross profit margin than a licensee in a high marketing expense or high
tax jurisdictions. Thus, what may be a reasonable gross profit margin in one
country will not be a reasonable gross profit margin in another.
[146] Dr. Ballentine compared the gross margins earned by the
European licensees with the resale margins earned by Glaxo Canada on the sales of their respective
ranitidine tablets. Dr. Ballentine calculated cost of goods sold in two steps.
First he calculated the transfer price for ranitidine including the royalty, if
any. Second, he calculated the secondary manufacturing costs. In calculating
the cost of goods sold to the European licensees, Dr. Ballentine used the secondary
manufacturing cost to Glaxo Canada. He
acknowledged that there may be some differences in local labour costs and in
the amount of overhead, but he concluded that the differences would be
relatively small. His conclusions showed that in the period from 1990 to 1993,
gross margins earned by the European distributors were between 45.8 percent and
82.4 percent, with nine of the 13 licensees having gross margins between 61.5
percent and 64.4 percent and the median gross margin earned was 62.0 percent,
while Glaxo Canada's gross margin for the period was
61.7 percent. He concluded that the prices paid by Glaxo Canada for the purchase of ranitidine
were not in excess of arm's length prices.
[147] The respondent questioned Dr. Ballentine's analysis.
First, the respondent argued that Dr. Ballentine did not use accurate financial
data. Instead of using financial data from the licensees themselves, which
apparently were not provided to him, Dr. Ballentine relied on IMS data. Second,
the respondent submits that Dr. Ballentine should not have estimated secondary
manufacturing costs based on Glaxo Canada's standard costs. Dr.
Ballentine also relied on the transfer price figures provided to him by Glaxo Canada which were changed several times
and did not reflect a variety of other incentives. The appellant has not established
the costs to the licensees needed to calculate gross margins.
[148] Even if one accepts the gross profit margins Dr.
Ballentine estimated, there are a number of reasons that the results are not
helpful. Dr. Ballentine's figures establish that the gross profit margins
varied between 45.8 percent and 82.4 percent, with the two Portuguese licensees
having the largest gross profit and the Austrian licensee at the bottom. The
four Spanish licensees all had average gross profits of 61.5 to 62.0 percent. The
two Finnish licensees had average gross profits of 61.8 to 62.0 percent.
According to Dr. Mintz, this wide range undermines the reliability of the
analysis. From the data, Dr. Mintz concluded that local conditions greatly
influenced the gross profit margins that the licensees were earning; it was no
accident that the gross profit margins earned by licensees located in the same
country were similar and the gross profits earned by the licensees located in
different countries are different. He concluded that there are other factors
that influence the pricing of ranitidine that need to be taken into account,
such as the kind of pressures that would be faced in a particular market, or
the kind of functions that would be undertaken by the third‑party
distributor, or even the effort that is taken at advertising and marketing in
each of the countries.
[149] Dr. Ballentine also excluded the results from
co-marketers in Japan and Korea, which both showed higher margins than the
median 62 percent, on the basis that they were related parties. However, Glaxo Canada had admitted that all three
entities were owned 50 percent by third parties and that was the same criteria
that Dr. Ballentine used to include the data from Cascan, a German company. He
provided no reason for excluding the Glaxo Korea gross profit margin of 75
percent, although that too was an admitted fact. He also dismissed the gross
profit margins earned by the two Portuguese licensees of 76.8 percent and 80.0
percent as anomalies. Dr. Mintz explained that when one is only dealing with
13 comparators, two data points cannot be ignored. Two of thirteen is
statistically relevant. When the Glaxo Korea data is factored in, this makes
three of fourteen. Therefore, Dr. Mintz disagreed with Dr. Ballentine
characterizing the Portuguese licensees as anomalies and said he would want to
look at what was causing the difference. Two of the known differences between Portugal and the other European countries
are that non‑Glaxo ranitidine was available for sale in Portugal at one twelfth of the Glaxo price.
Also, while Glaxo Portugal and the two Glaxo licensees' ranitidine products all
sold at about a single price, generic ranitidine in Portugal was selling at a discount. The
circumstances in Canada were similar, which might suggest
that the appellant should have a similar gross profit to that of the Portuguese
licensees.
[150] For many of the same reasons that the European licensees
were not good comparators for the CUP analysis, they are also not good
comparators for the RPM. Glaxo Canada performed
many more functions and assumed more obligations than the European licensees.
These factors should have justified a lower transfer price or a higher gross
profit margin to Glaxo Canada. With
respect to the differences in functions, the fact that the European licensees
were targeted to receive 60 percent gross profit margin for the marketing
function may suggest that this is what the marketing function alone was worth.
If this is so, then Glaxo Canada,
performing many more functions, should have received a much higher gross profit
margin than 60 percent, one that would compensate it for all the additional
activities it undertook and one that recognized that Glaxo Canada incurred more
risk than the European licensees because it lacked a guarantee.
[151] The appellant submits that Ford Motor Co. of Canada
v. Ontario Municipal Employees Retirement Board
is authority for the reasonableness of RPM. However, respondent's counsel
pointed out that she was not disputing that RPM was a valid method; her
argument was that RPM is a secondary method which is appropriate to use when
the CUP method is not suitable. The circumstances in Ford were such that
there were no comparable transactions under the CUP method. Moreover, Ford can
be further distinguished on the basis that the dealers in Ford were
buying and selling the finished car. Their only functions were marketing and
distribution. This can be contrasted with the appellant who performed more
functions, again suggesting that RPM is not an appropriate method.
XII. Transactional Net Margin Method
[152] Dr. Ballentine used the TNMM as a reasonableness check
on the price the appellant paid for ranitidine. This method compares net
profits between companies. To apply this method, Dr. Ballentine compared the
appellant's rate of return after research and development costs with those of
independent companies involved in preparing and selling pharmaceutical
products. Dr. Ballentine eliminated any companies that (1) that did not have
sales in all four years from 1990 – 1993, (2) had less than $50 (U.S.) million
in annual sales and (3), had an average research and development to sales ratio
greater than three percent, because these latter companies might own
significant technological intangible assets.
[153] The appellant spent more than three percent of sales on
research and development during the years in question[43] but Dr. Ballentine thought it was
appropriate to use the three percent comparison because the appellant had spent
substantially less than that for many years prior to the years in question:
Since the
process of taking a drug from discovery and development through marketing
approval can take 10 to 12 years, if not longer, current spending on
pharmaceutical research and development, even if it is ultimately successful,
may not be expected to result in a commercialized product until perhaps 10 or
12 years later. Even though Glaxo Canada's research and development spending in
1990 through 1993 was greater than 3 percent, that spending could not have
resulted in sales of new drugs during 1990 - 1993. As a result, it is
appropriate to compare Glaxo Canada to firms that spent less than 3 percent.
[154] Thus, Dr. Ballentine concluded that the appellant's
profitability was higher than the profitability of the independent companies.
[155] In his rebuttal expert report,
Dr. Mintz declared that:
[I]t is far from clear that these are suitable companies for comparison
without taking into account research and development costs, manufacturing,
marketing practices, investment policies and other attributes that would affect
margins. I cannot reach a conclusion that the comparisons made are valid at
all.
[156] I cannot accept Dr. Ballentine's analysis on this issue.
His reasoning for excluding the companies with higher research and development
to sales ratios is not reasonable. There is insufficient evidence of other
functions undertaken by the comparators.
XIII. Cost plus method
[157] The respondent relies on the cost plus to support the
reasonableness of its CUP analysis. In applying the cost-plus method, Dr. Mintz
looked at the cost of manufacturing ranitidine and added to it a suitable
profit margin. He ignored Adechsa and considered only the Singapore manufacturer because Adechsa
actually incurred losses on its sales of ranitidine to the appellant once
transfer prices and royalties paid to Glaxo Group are considered.
[158] During the years in appeal, the Singapore manufacturer had cost-plus margins
ranging between 766 and 1059 percent. This can be contrasted with Glaxochem UK
(Montrose) which had cost-plus margins between four and 16 percent during
the same period and CKD Korea, which manufactured ranitidine due to an import
ban in Korea, which had a mark-up of 25 percent by agreement with Glaxo Group Dr.
Mintz then calculated the Singapore manufacturer's cost-plus margin using the
transfer prices substituted by the Minister and found them to range from 62 to
159 percent, which is still much larger than the other manufacturers' margins.
[159] Dr. Mintz concluded that a reasonable mark-up would be
25 percent for the Singapore manufacturer and four percent for
Adechsa (as agreed upon with the Swiss government). Using the cost-plus method
to calculate the transfer price, Dr. Mintz found that the total reassessments
of Glaxo Canada's profits would be 93 percent of
the actual reassessments. He concluded that after the CUP adjustments for
research and development, granulation costs and other factors, the total
reassessments would be virtually identical to the CRA reassessments.
[160] The appellant did not call a witness to rebut Dr. Mintz's
conclusions regarding the cost-plus method and his conclusions went largely
unchallenged on cross-examination. At no point did the appellant challenge Dr.
Mintz's figures, calculations or conclusions on this issue. The appellant's
thrust was that Dr. Mintz was not experienced in the pharmaceutical industry. The
appellant did establish that Glaxo Group had not used the cost-plus method to set
the price of ranitidine. As I have stated several times, the method that Glaxo
used to set its prices is not relevant to the issue of whether the price is
reasonable.
Part I Assessments: Conclusion
[161] CUP is the preferred method and the generic companies in Canada are an appropriate comparator
using the CUP method. The appellant acquired granulated ranitidine from Adechsa
at an amount in excess of the fair market value of ranitidine, and pursuant to
subsection 69(2) of the Act the appellant is deemed to acquire it
at a reasonable amount. The price that would have been reasonable in the
circumstances for Glaxo Canada to pay
Adechsa for a kilogram of ranitidine is the highest price the generic companies
paid for a kilogram of ranitidine. However, to this amount I would add $25 per
kilogram as this was the approximate cost to Singapore for granulation. The ranitidine purchased by the generic
companies was not granulated. The GMP performed by a Singapore may have
increased the value of its ranitidine but only to the extent that, as stated earlier
in these reasons, it gave some degree of comfort to the appellant that the
product would probably have less impurities and contaminants than that of its
generic competition. No submissions were made as to what this extra
consideration should be. There is no evidence before me to consider what
increase I might add to the generic price per kilogram of ranitidine on account
of GMP. It would appear to be modest in any event. The evidence does not
suggest any addition to the price of the ranitidine due to any HSE by Singapore. The appellant, in computing its
income for a particular year, may not deduct the excess amount it paid to
Adechsa. For example, if the appellant paid Adechsa $1,300 per kilogram for
ranitidine and the highest price the generic companies paid for ranitidine was
$380 per kilogram, the appellant would be permitted to deduct the amount of
$380 per kilogram plus $25 per kilogram for granulation, a total of $405. The
excess amount, $895, is not deductible in computing the appellant's income.
PART XIII ASSESSMENTS
[162] The excess amount, in the
example, $895, has been paid by or transferred from Glaxo Canada to Adechsa. The Minister also has
assessed the appellant for tax under Part XIII of the Act on the basis
that its parent corporation, Glaxo Group in the United Kingdom, directed or concurred with the payment or transfer of the
excess amount to Adechsa as a benefit that Glaxo Group desired to confer on Adechsa.
According to subsection 56(2) of the Act:
|
A payment or transfer of property made pursuant to the
direction of, or with the concurrence of, a taxpayer to some other person for
the benefit of the taxpayer or as a benefit that the taxpayer desired to have
conferred on the other person (other than by an assignment of any portion of a
retirement pension pursuant to section 65.1 of the Canada Pension Plan or
a comparable provision of a provincial pension plan as defined in section 3
of that Act or of a prescribed provincial pension plan) shall be included in
computing the taxpayer's income to the extent that it would be if the payment
or transfer had been made to the taxpayer.
|
Tout paiement ou transfert de biens fait, suivant les instructions ou
avec l'accord d'un contribuable, à toute autre personne au profit du
contribuable ou à titre d'avantage que le contribuable désirait voir accorder
à l'autre personne – sauf la cession d'une partie d'une pension de retraite
conformément à l'article 65.1 du Régime de pensions du Canada ou à une
disposition comparable d'un régime provincial de pensions au sens de
l'article 3 de cette loi ou d'un régime provincial de pensions visé par
règlement – doit être inclus dans le calcul du revenu du contribuable dans la
mesure où il le serait si ce paiement ou transfert avait été fait au
contribuable.
|
[163] In her Reply to the Notice of Appeal the respondent stated
that in assessing, the Minister assumed that Glaxo Group directed, or concurred
with, the payment or transfer of the excess amount for its benefit. In her
Amended Reply to the Amended Notice of Appeal, the respondent alleged that the
transfer was for the benefit of Adechsa and it is on this basis that these
appeals were heard. As a result of the Crown altering the basis of the
assessments, the Crown had the onus of proof that the intended beneficiary of
the excess payments was Adechsa. This onus was satisfied.
[164] For the purposes of subsection
56(2) of the Act, the respondent submits that Glaxo Group is the
taxpayer, Adechsa was the person upon whom the benefit was conferred and the
appellant was the source of the benefit. In McClurg v. M.N.R, Dickson
C.J explained that the purpose of subsection 56(2) was to "ensure that
payments which otherwise would have been received by the taxpayer are not
diverted to a third party as an anti-avoidance technique." An amount will be included
in the income of a taxpayer who has not received the income directly when the
following four conditions are met:
1. There is a payment or transfer of
property to a person other than the taxpayer;
2. The payment or transfer is
pursuant to the direction of or with the concurrence of the taxpayer;
3. The payment or transfer must be
for the taxpayer's own benefit or for the benefit of some other person on whom
the taxpayer desired to have the benefit conferred; and
4. The payment or transfer would have
been included in computing the taxpayer's income if it had received it
directly.
[165] Conditions one and
two are met. Glaxo Canada overpaid Adechsa for the purchase of the ranitidine
and Glaxo Group concurred with the transfer price. With respect to condition
three, the appellant argued that there was no intent to confer a benefit on
Adechsa. Alternatively, the appellant argued that there was no benefit because a
benefit cannot exceed the net profit earned by Adechsa in respect of the sales.
Appellant's counsel explained that because Adechsa took a loss on the sale of
ranitidine to the appellant, there can be no benefit. He also stated that
condition four is not satisfied because Glaxo Group had no entitlement to any
of the payments made to Adechsa.
[166] Counsel for
the appellant stressed that one of the essential conditions for the application
of subsection 56(2) is that the taxpayer must have desired to confer a benefit
on the other party. Counsel argued that this condition, which has been
recognized in numerous judgments,
was not met in the circumstances of this case. I cannot agree with counsel's
assessment of the evidence in this regard.
By 1990 Glaxo Group knew that the appellant was purchasing ranitidine for about
five times more than what other companies in Canada were paying. Glaxo Group
did not have a mistaken belief that the price the appellant was paying for
ranitidine was reasonable. As set out in paragraph 13 of these reasons, Glaxo
Group's taxation strategy was to minimize tax by shifting its profits to Singapore via Switzerland.
Part of the strategy included using Adechsa as a distributor and funneling the
excess amounts through it. The corporate structure of Glaxo World was, in part,
designed to minimize income in high tax jurisdictions by diverting income to
low tax jurisdiction.
[167] I also reject the
appellant's alternative argument. Appellant's counsel has mistakenly equated
benefit with profit; they are not the same. Had the appellant purchased
ranitidine from Adechsa at the same prices the generic companies were paying,
Adechsa would have taken a much larger loss. In short, Adechsa got something
for nothing. This is still a benefit even if it involves a smaller loss and not
a profit.
[168] Finally, appellant's
counsel argued that condition four was not met because Glaxo Group had no
entitlement to any of the payments made to Adechsa. Appellant's counsel relies
on Smith v. The Queen,
wherein Mahoney J.A. cited with approval from Winter et al. v. The Queen:
. . . [Winter] has added another precondition to the application
of subsection 56(2), which seems to me to be relevant in the circumstances.
It was held in Winter, at p. 6684,
that the validity of an assessment under subsection 56(2) of the
Act when the taxpayer had himself no entitlement to the payment made or the
property transferred is subject to an implied condition, namely that the payee
not be subject to tax on the benefit he received.
Mahoney
J.A. concluded that "Being 'subject to tax on the benefit received' means
that the value of the benefit is required to be included in the calculation of
the recipient's taxable income."
[169] Neuman v. Canada,
a decision of the Supreme Court of Canada also considered subsection 56(2) of
the Act. The excerpt cited from Winter in Smith is obiter
based on the Federal Court of Appeal decision in McClurg v. Canada
(F.C.A.),
which was affirmed by the Supreme Court of Canada after Winter was
decided. McClurg stands for the proposition that subsection 56(2) generally
does not apply to dividend income because the reassessed taxpayer would not
have received that money had it not been paid to the shareholder. Winter
is summarized at paragraphs 51-53 of Neuman:
In Winter, the majority
shareholder in an investment company caused the corporation to sell some of its
shares to his son-in-law, who was also a shareholder in the corporation, for a
price of $100 per share. The Minister calculated the fair market value of the
shares at approximately $1,000 per share and reassessed the majority
shareholder under s. 56(2) by adding as income the difference between what the
son-in-law paid for the shares and their market value.
Marceau J.A., writing for the
court, held that the fact that the taxpayer had no direct entitlement to the
shares did not preclude attribution since there was no indication that s. 56(2)
was intended to be so confined. Marceau J.A. concluded (at p. 593) that:
when the doctrine of
"constructive receipt" is not clearly involved, because the taxpayer
had no entitlement to the payment being made or the property being transferred,
it is fair to infer that subsection 56(2) may receive application only if the
benefit conferred is not directly taxable in the hands of the transferee.
Marceau J.A. distinguished the
Federal Court of Appeal's ruling in McClurg where Urie J. held that s.
56(2) does not apply to dividend income, which holding was affirmed by this
Court, as follows (at pp. 591-92):
the McClurg decision was
concerned with a declaration of dividend in accordance (in the views of the
majority) with the powers conferred by the share structure of the corporation, and
I do not see it as having authority beyond the particular type of situation
with which it was dealing.
I agree with
Marceau J.A.: Winter concerned the conferral of a benefit which was not in the
form of dividend income. The application of s. 56(2) to non-dividend income was
not before this Court in McClurg and it is not before this Court in the
present case. But the entitlement requirement implicitly read into the fourth
precondition of s. 56(2) in McClurg clearly applies to dividend income.
[Emphasis added.]
[170] Neuman was heard after Smith but did not refer to Smith.
The benefit to Adechsa was not in the form of dividend income; the entitlement
requirement does not apply to the appeals at bar.
[171] That the
entitlement requirement does not apply to these facts is found in the interplay
between subsection 56(2) and paragraph 214(3)(a) of the Act. The
latter provision deems an indirect payment to be a dividend in situations
involving a non-resident taxpayer. The Act provides a complete scheme
for the treatment of the excess amounts transferred to Adechsa and no recourse
to the entitlement requirement is necessary.
[172] In transfer pricing
cases, the goal of the MNE is to divert profits to a low tax jurisdiction. The
amounts will be included in calculating the income of the recipient to whom
they were diverted (in this case Adechsa), with the result being a lower rate
of tax and more profits left for distribution to the parent company. The goal
of the entitlement requirement, as set out in Winter, is to prevent the
tax authority from choosing between potential taxpayers. In the case at bar,
there is only one potential taxpayer and consequently the entitlement
requirement cannot apply. Indeed, in a transfer pricing case the application of
the entitlement requirement may allow a multinational enterprise to avoid tax
altogether on income earned in a jurisdiction.
[173] Even if the
entitlement requirement did apply to the case at bar, it was satisfied based on
the facts. Pursuant to subsection 69(2) the reasonable amounts for the appellant to have paid Adechsa for the
purchase of ranitidine are the highest amounts paid at the time for ranitidine
by the generic companies. The amounts in excess of the reasonable amount(s)
($895 per kilogram in our example) that were transferred to Adechsa were not paid
in consideration for ranitidine. Adechsa did not provide any other goods or
services to the appellant and as such was not entitled to the excess amounts.
The question is whether Glaxo Group was entitled to the excess amounts.
[174] Appellant's counsel did not offer an explanation as to
whom he believed was entitled to the excess amounts. He stated it was not Glaxo
Group. If not Glaxo Group, then who? It was Glaxo Group who was entitled to the
excess amounts. But for the direction of Glaxo Holdings and the concurrence of
Glaxo Group in setting the transfer price, the appellant would not have
transferred the excess amounts to Adechsa. The excess amounts would have
remained in the hands of the appellant and at some point in time all or part would
have been distributed to Glaxo Group in the form of dividends. Glaxo World's
tax strategy was to divert profits to Singapore before being
paid to Glaxo Group as dividends. Ultimately, the amounts were indeed received
by Glaxo Group.
[175] Subsection 212(2) of the Act imposes a 25 percent withholding
tax on dividends paid to non-residents. This amount is reduced to ten percent
under Article 10(1)(a) of the Canada-United
Kingdom Tax Convention(1978). Glaxo Canada was required to withhold the ten percent by virtue of
subsection 215(1) and is liable for tax for failing to withhold the amounts
under subsection 215(6).
[176] The Part XIII
assessments are essentially correct. However, the deemed dividend and,
consequently, the withholding tax assessed are to be reduced in recognition of
the increase in the value of a kilogram of ranitidine by $25 for granulation.
CONCLUSION
[177] The
appeals from the assessments made under the Income Tax Act for the 1990,
1991, 1992 and 1993 taxation years and assessments made under Part XIII of the Act with
respect to the alleged failure of the appellant to withhold tax on dividends
deemed to be paid to a shareholder in 1990, 1991, 1991 and 1993 are allowed and the matters are referred back to the
Minister of National Revenue for reconsideration and reassessments only to decrease
the excess amounts paid by the appellant for ranitidine by $25 per kilogram and
to adjust the amounts of withholding tax accordingly.
[178] Costs shall be paid by the appellant; the parties may
make representations as to the quantum of costs.
Signed at Ottawa, Canada, this 30th day of May 2008.
"Gerald J. Rip"
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