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Mother of all tax settlements
November 13, 2006
On November 9, GlaxoSmithKline (GSK) and the Internal Revenue Service of the United States announced that the GSK will pay $3.4 billion to the IRS to settle a transfer pricing dispute dating back 17 years.
The pharmaceutical giant shall also abandon its discrimination claim of $1.7 billion against the IRS for rejecting its advance pricing agreement (APA) request (an APA mechanism enables the taxpayer and revenue to reach an agreement on the transfer pricing methodology and at times the price, ahead of the transaction).
The settlement has far reaching impact on global transfer pricing disputes in general and implications on India in particular.
Background: The case revolved around the question -- Where did the value lie? Was the true value in the drug (Zantac) sold in the US, derived from marketing efforts of GSK US, or the research and development (R&D) undertaken by GSK UK?
Depending upon where substantial value was created, the revenue authority of either jurisdiction would have the right to tax substantial portion of income from the sale.
The IRS alleged that GSK improperly shifted profits from the US to the UK entity. In its view, a greater portion of income was allocable to the trademark developed by the US entity through its marketing efforts.
The face-off: According to the IRS, Zantac was a marginal improvement over its predecessor (Tagamet). It implied that the intensive marketing efforts of the sales team of Glaxo US were the driving force behind its phenomenal performance.
On the other hand, GSK showcased Zantac as a pilot drug requiring fewer doses with lesser side effects. In GSK's view, the stupendous sales performance was attributable to the fact that Zantac was a pioneer drug, which resulted from intensive R&D undertaken by GSK UK.
Whereas the IRS co-related the success to increase in the number of sales employees, GSK focused on its R&D function entailing fewer specialists.
The IRS referred to the contractual terms that guaranteed GSK UK a fixed rate of return thereby shifting the risk and high returns to Glaxo US. On the other hand, GSK contended that R&D in itself constituted a significantly valuable component.
The settlement has put an end to the debate and speculation amongst experts as to what would have been the outcome in a court. With the settlement representing more than 60 per cent of sums at stake, it is being viewed as victory for the IRS. Certainly, a big price for GSK to buy peace with the taxman!
Global impact: Given the magnitude of tax involved, the legal-economic questions in issue and involvement of the US (with its transfer pricing jurisprudence), the controversy has global significance. Astounding sales of a drug may no longer be seen as a result of scientific breakthrough alone. Revenue authorities worldwide shall keenly assess the role of marketing efforts in value generation.
Indian law: Indian judiciary since pre-Independence has been grappling with the question -- Where does value lie? In Ahmedbhai Umarbhai's case, a similar question arose though in a different form -- How much profits were attributable to manufacturing operations undertaken in Hyderabad State as against the sale of oil in British India.
The Supreme Court held that profit or loss had to be apportioned between the two activities according to well established principles of accountancy.
Further, Indian transfer pricing regulations stress on functions performed (taking into account the assets employed and the risks assumed) for allocating returns from any business. The Indian revenue is within its powers to re-allocate income between activities based on functions performed.
The GlaxoSmithKline case highlights the need to understand how value generation takes place in the entire gamut of business operations.
Impact on MNCs: Needless to mention, the relative importance of marketing and R&D activity is to be judged on the facts of each case. As research would vouch, it is not possible to force medicine down the throat, if it does not have curative value.
However, this does not imply that a commensurate return should not be allocated for marketing operations. This is particularly true of branded generic drugs, which are primarily driven by aggressive marketing.
The possibility of revenue getting pro-active to identify and tax income attributable to marketing efforts can not be ruled out. Since India is a high tax jurisdiction, it may imply increase in the overall tax burden for MNCs, should greater value be attributed to marketing.
For the pharmaceutical industry in particular, a reverse trend may be observed. Ease in availability of skilled manpower makes India an attractive destination for outsourcing of R&D activity. Not surprisingly, in the past few years India has emerged as a hub for contract R&D. There may be tendency on part of foreign tax administrators to attribute profits to marketing efforts in foreign jurisdictions.
Typically, an APA may settle the question of allocation in a manner acceptable to the taxpayer and revenue. However, in the Indian context, the difficulty is compounded by absence of an APA mechanism.
Competent Authority process under the treaty may be looked as an alternative resolution mechanism, though it suffers from excessive delay and uncertainty of outcome (the failure of talks between Competent Authorities of US and UK in GSK case does not bode well for similar cases in other jurisdictions).
From a tax planning perspective, the key for MNCs in India is to recognise that if marketing is more complex than basic distribution, it should command a higher return. This factor needs to be considered in advance while structuring cross-border operations from a tax efficiency perspective and avoiding tax conflicts.
Such an approach would save MNCs from protracted litigation and not upset effective tax rate calculations and cost arbitrage India offers for R&D. The return attributable to marketing activity may be determined by analysing comparables.
Quantitative information may be supplemented with qualitative data such as information on the market, impact of advertising on consumer choice, characteristics of the good sold etc.
The author is a partner with BMR & Associates. The views expressed herein are his own.
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