Billions of dollars in taxes hang in balance at top court

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A nearly 20-year battle between global drug giant GlaxoSmithKline Inc. and the Canada Revenue Agency, now being weighed by the Supreme Court of Canada, could end up rewriting the rules that allow multinationals to shift some of their profits out of Ottawa's reach.

The case marks the first time the Supreme Court has taken on the corporate tax issue known as "transfer pricing." And the court's decision, which has yet to be released, could lay down new ground rules that could make a multibillion-dollar difference to the tug-of-war between Canada's tax collectors and multinational companies.

Tax lawyers, who collectively make millions advising companies on transfer pricing strategies, are watching the case closely. They say it is just the latest in a round of similar tax fights not just in Canada, but around the world, as cash-strapped governments look to squeeze corporations that use transfer pricing to move profits where taxes are lowest.

Tax lawyer Vern Krishna, a professor at the University of Ottawa and counsel with Borden Ladner Gervais LLP, says the issue is both "hugely complex" and "hugely important" to big companies: "Transfer pricing is one of the last remaining tax avoidance arrangements that multinationals engage in."

Transfer pricing works like this: A Canadian subsidiary of a foreign multinational must declare, for tax purposes, how much it pays to its parent, or other affiliates, for the products it imports for sale here. If it inflates the price that it pays, it lowers its profit figure in Canada and effectively shifts money outside this country's borders.

Under Canadian law, and according to Organization for Economic Co-operation and Development guidelines, the transfer price must be within the range of what an "arm's length" company would pay for the product in the similar circumstances.

It's this "arm's length" question that is central to the GlaxoSmithKline case. From 1990 to 1993, the Canadian subsidiary of British-based Glaxo Group Ltd. told Ottawa that it had paid a Swiss affiliate between $1,512 and $1,651 a kilogram for the active ingredient ranitidine, which it packaged as the stomach ulcer drug Zantac.

The price for the powder inside those pills, however, was five times the cost paid by generic producers, for almost exactly the same substance. This difference attracted Ottawa's attention, and it reassessed the company for $51-million in unpaid taxes, starting a complex and lengthy legal battle. Glaxo beat back the reassessment at the Federal Court of Appeal. The case then went before the Supreme Court in January.

Glaxo's lawyers, led by Al Meghji of Osler Hoskin & Harcourt LLP, argued before the top court that it's not fair to compare the brand-name price to that paid by generic suppliers, since Zantac sells for much more than the no-name drugs. Plus, they argued, the local subsidiary, for merely packaging and selling the drug, was still making, and declaring, a 60-per-cent profit margin.

By agreeing to this arrangement, which naturally forbids the local subsidiary from buying powder from generic suppliers, the Canadian subsidiary also gets exclusive access to Glaxo's catalogue of drugs, and future drugs. The company's lawyers argued that any arm's-length business person would make the same deal.

But lawyers for the government argued that tax laws, and the OECD's rules, mean only the comparable generic price must be taken into account for this crucial "arm's length" test – not all of the other provisions of the subsidiary's arrangements with its corporate parent.

Claire Kennedy, a tax partner with Bennett Jones LLP in Toronto, was in the courtroom for the January hearing as an observer. She said the tax bar is eagerly awaiting the decision, which she expects to clarify the definition of "arm's length."

Ms. Kennedy said the government's argument in this case, that only the generic price should be used, was narrow and "was not met sympathetically" by the justices.

"I think what the government was arguing was a very artificial approach," she said, arguing that other facts, such as the benefits of the subsidiary's affiliation with its global parent and the higher retail price of the drug, have be taken into account.

It is not just a question of corporations trying to minimize the tax they pay. With the tax authorities of all countries vying for the same multinationals' profits, companies need to sort out which income will taxed where in order to avoid being forced to pay twice.

Mr. Meghji, who wouldn't speak in detail about his case, said whatever the result, more transfer pricing cases are on the way.

"We're on the cusp of significant transfer pricing litigation over the next number of years, where the courts will have to set the rules of the game," Mr. Meghji said. "How do we interpret the transfer pricing provisions to ensure that the system works well, works efficiently, and allows the right amount of income to be taxed in the right country?"