The high court endorsed an appeals court ruling about "transfer pricing," which allows multinationals to charge their subsidiaries high prices for ingredient costs in order to reduce Canadian profits.
The Department of National Revenue had challenged Glaxo Canada's use of a licence agreement that allowed it to pay Glaxo Swiss subsidiary Adechsa between $1,512 and $1,651 per kilogram for the purchase of ranitidine, the active ingredient in the anti-ulcer drug Zantac. Glaxo also paid parent company Glaxo Group a six per cent royalty on net sales of Zantac.
The price of ranitidine exceeded the $194 to $304 per kilogram charged to Canadian generic pharmaceutical companies Apotex Inc. and Novopharm Inc. by arm's-length suppliers.
The government successfully argued in Tax Court that applying the "reasonable" charges to Glaxo Canada would have increased the subsidiary's net income for 1990 to 1993 by $51 million.
But the Federal Court of Appeal in July 2010 overturned the Tax Court's decision and rejected the Department's argument that fair market value paid by generics was the relevant measure. It sent the calculation back to the Tax Court for a redetermination.
Writing for the Supreme Court, Justice Marshall Rothstein said in a ruling released Thursday that the Tax Court "erred in refusing to take account of the licence agreement."
"The generic comparators do not reflect the economy and business reality of Glaxo Canada and, at least without adjustment, do no indicate the price that would be reasonable in the circumstance, had Glaxo Canada and Adechsa been dealing at arm's length."
The court declined to say whether the price paid by Glaxo Canada was fair and referred it back to the Tax Court for a recalculation.
One of the relevant issues of the licence agreement not considered by the Tax Court was that Glaxo Group owned the intellectual property rights of Zantac, which commanded a premium over generics. Without the agreement, Glaxo wouldn't have had access to the Zantac trademark or the parent company's other products.
GlaxoSmithKline welcomed the court ruling even though the Tax Court could still establish prices that boost its reported Canadian income and taxes.
"We are pleased that the Supreme Court of Canada has agreed with the Federal Court of Appeal on the main appeal. As the case is still before the courts, we are not in a position to comment further," spokeswoman Anna Robinson said in an email.
Queen’s University tax law expert Art Cockfield said the ruling is a win for Glaxo and could prompt others to adopt sophisticated cross-border tax structures to shift profits to low-tax jurisdictions.
"There's massive flows going back and forth and companies have an incentive to game the system by shifting profits always to the lowest tax country," he said in an interview from Kingston, Ont.
"It's negative for Canada because it supports aggressive international tax planning that sends revenues outside of the country."
Canada's lower corporate tax rate than the United States could, however, insulate it from such profit shifts between companies with operations on both sides of the border, Cockfield added.
Two-thirds of the $2 billion of daily trade between Canada and the United States is between related companies.
The Department of National Revenue didn't return calls seeking comment or estimates of how the Supreme Court's ruling could potentially impact tax revenues.
The Supreme Court's ruling applies to a section of the tax code that was changed in the late 1990s. Consequently, Cockfield said it's not clear whether other courts will use the ruling as a precedent for the principles that should apply in the new law.