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Transfer pricing goes beyond putting percentile value
November, 23rd 2006
The recent Glaxo Smithkline Holdings case in the US creates additional uncertainty about transfer pricing methodology.

The mammoth $5.2 billion tax dispute between Glaxo Smithkline Holdings in the US and the Internal Revenue Service (IRS) was decided in the first fortnight of September in favour of the IRS. The issue of transfer pricing mandates multinational companies to conduct business between the related group companies on an "arm's length" basis, that is, any transaction between two entities of the same MNC must be priced as if the transaction was conducted between two unrelated parties.

The main issue in the case concerns the appropriate transfer price between the taxpayer and its UK parent (Glaxo UK) with respect to certain Glaxo Heritage Products (principally Zantac) discovered and patented by Glaxo UK. In general, the IRS reduced the amount paid by the taxpayer for drugs (to that paid by a contract manufacturer) and reduced the royalty the taxpayer paid for the right to sell drugs (to the rates set forth in an Initial Licence Agreement).

IRS methodology

The IRS has, in effect, transferred most of the profit from the sale of these drugs to the taxpayer under a residual profit transfer pricing methodology. The most significant element of the IRS methodology is probably the determination that the initial patent royalty rate is arm's length throughout the entire audit period.

The IRS is also arguing that the taxpayer (i) owns all of the economic rights in the US trademarks, (ii) developed those trademarks, and (iii) need not pay a royalty to Glaxo UK for them. In the alternative, the IRS argues that the taxpayer assisted Glaxo UK develop those marks and should be compensated for doing so.

Attribution of income

Even if the primary IRS argument is right, it is far from clear how much income should be attributable to the marks as opposed to the patents. The taxpayer asserted that the royalty paid in connection with the drug patent was commensurate with the income earned as set forth in Internal Revenue Code Section 482 and that IRS improperly applied this standard to the royalties at issue.

Pursuant to the "commensurate with the income standard" applicable to such transactions, a royalty rate needs to be evaluated each year to determine whether an adjustment is necessary to reflect market conditions. Pursuant to this rule, the taxpayer apparently increased the royalty rate over time to reflect actual performance and increased the value of the patent licence.

The IRS disallowed these increases in royalty rates stating that the initial royalty rate reflected an arm's length charge and that there was no increase in the value of the licensed patents to justify it.

Even though Glaxo had paid taxes on its profits in the UK, and although there is a "double-taxation" agreement between the UK and the US which means that a company should not have to pay tax on the same profits in both countries the IRS decided that much of this profit had, in fact, been made in the US.

As the huge amount of taxes at stake in this case confirms, attempting to allocate the profits of Glaxo between (i) UK developed patents and UK developed marketing intangibles on the one hand and (ii) US distribution activities, including the possible further development of marketing intangibles on the other hand, is problematic.

The Glaxo case creates additional uncertainty about transfer pricing methodology in situations involving valuable intangibles. Not only do other foreign-based companies face similar issues, but as transfer pricing is a "two-way street", foreign tax authorities can follow the lead of the IRS and attempt to tax more of the distribution profits of US-based multinationals. India has had transfer pricing laws for about four years now.

The first set of assessments for the reports filed initially are just about being done.

While "cost+" seems to be a popular choice, the fact that this has yet to be tested at higher jurisdictional levels would appear to suggest that its popularity is subject to scrutiny.

As the afore-discussed case reflects, the law of transfer pricing goes beyond just putting a percentile value to reflect the transfer price. Strategic decisions would have to be made keeping the transfer price in mind.

Mohan R. Lavi
(The author is a Hyderbad-based chartered accountant.)

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