A recent ruling on an obscure, 20-year-old tax dispute between Ottawa and GlaxoSmithKline Inc. is being hailed by tax lawyers as a victory that creates an important precedent for multinational clients in fights with the Canada Revenue Agency.
At issue is the use by multinationals of "transfer pricing" to minimize their tax bills, a practice that has long been a headache for tax authorities around the world - including Canada's, which has hired extra auditors in recent years to beef up its enforcement.
The concept is simple. Say the Canadian subsidiary of a global company imports raw materials, from which it manufactures, packages and sells a product. If it inflates the amount it pays its corporate parent for those raw materials, it can move some of its Canadian profits out of the grasp of Ottawa, preferably transferring them somewhere where taxes are lower. This is why tax rules demand that affiliated companies pay the same prices in transactions as an "arm's length" business would.
For the years 1990 to 1993, Canadian tax officials accused British-based GlaxoSmithKline PLC's Canadian arm of overpaying a Swiss-based Glaxo affiliate for the key ingredient in the stomach-ulcer drug Zantac, which Glaxo Canada packaged and sold in the Canadian market. In 2008, a judge in Canada's Tax Court agreed, adding $51-million to the company's revenue figures for those years.
But late last month, the Federal Court of Appeal overturned that ruling, saying the judge failed to take into account the "economic reality" when calculating what a fair price for the drug would have been had the deal taken place between arm's-length companies. The decision sends the case back to the Tax Court for reconsideration.
"I think it's a win for the taxpayer," said Claire Kennedy, a tax lawyer with Bennett Jones LLP in Toronto who specializes in transfer pricing. "But we have to wait and see what the real story is after the Tax Court looks again at the case."
Transfer pricing has become big business for lawyers and accountants, who advise multinationals how to set up and justify their internal prices. Big companies are naturally eager to minimize their tax bills, while avoiding unwelcome attention from tax collectors. But they must also ensure they avoid paying tax twice, in two different countries, on the same revenue.
Lots of money is at stake. The Canada Revenue Agency estimated in 2005 that more than 16,000 Canadian corporate taxpayers reported foreign transactions with related parties, such as parent companies or affiliates, worth more than $1.5-trillion.
In 2007, Canada's auditor-general said the Canada Revenue Agency had assessed $729-million in additional tax on the international transactions of large corporations the previous year. The number of cases that actually go to court, however, is very small. Most transfer pricing disputes are dealt with by an international arbitration process between the tax authorities involved.
In the Glaxo case, Canadian tax officials took issue with the price the multinational's Canadian arm paid for ranitidine, the active ingredient in Zantac. Glaxo Canada paid a Swiss-based affiliated company between $1,512 and $1,651 a kilogram for the ingredient. But two Canadian generic drug companies paid just $194 to $304 a kilogram for a similar substance.
The 2008 Tax Court ruling said Glaxo's was an unreasonable price that would not have been handed over by an "arm's length" business. But Glaxo argued, and the Federal Court of Appeal's three-judge panel agreed, that the Tax Court judge was wrong to ignore the licensing agreement between Glaxo and its parent.
Under this deal, Glaxo's Canadian arm, which had healthy profit margins, was obligated to get its ranitidine from its corporate affiliate, in order to have the right to market it as Zantac, a brand-name drug sold at a much higher price than its generic competitors. The agreement also allowed it access to all of Glaxo's other drugs. The Federal Court of Appeal said the search for a useful comparable price should not take place in a "fictitious business world" where these facts were ignored.
Whatever the final outcome, the Glaxo case will likely be waved around by tax lawyers working for multinationals in future fights with the Canada Revenue Agency, as many saw the original 2008 Tax Court decision as heavy-handed.
"This will be definitely relevant to a large number of transfer pricing cases," said Alan Kenigsberg of Stikeman Elliott LLP's Toronto office, who advises corporate clients on transfer pricing and other tax issues, including those facing audits from the Canada Revenue Agency.
"Any case where the Canada Revenue Agency has cherry-picked a specific issue, any time they don't look at the big picture and they are picking on a specific single entry, that's times when you can throw this out there," Mr. Kenigsberg said. "I have at least one or two situations where this case will be incredibly useful."
But Ms. Kennedy stresses that the ruling by no means opens a loophole in Canada's transfer-pricing rules.
"Are there opportunities for planning and transfer pricing and will companies take advantage of them? Absolutely. They are entitled to do so," she said. "But it's not like this decision has driven a truck through transfer-pricing regulations. Far from it."
She said transfer-pricing disputes will remain on the front burner, partly because the math is getting more complicated. So much of the value of products in the modern economy is based on "intangibles," such as a brand-name or intellectual property, she said. And these are hard things for companies and tax collectors to appraise.
But Canada's declining corporate tax rates, at least relative to the U.S. and some European countries, may put the transfer pricing shoe on the other foot, said lawyer Dale Hill of Gowlings Lafleur Henderson LLP's Ottawa office, who spent 16 years working for the Canadian Revenue Agency negotiating transfer-pricing agreements.
"It won't be so attractive to have more profits in the U.S., as opposed to Canada," Mr. Hill said. "You may see a slight shift, as more companies try to put money in Canada."