A transfer price is a price agreed between two related persons or taxpayers when selling to, buying from, or hiring resources. For example, if John's Co manufactures goods in Country X and sells them to its foreign affiliate, Abbot Co, organised in Country Y, the price at which that sale takes place is called a transfer price.
A transfer price is distinguishable from a market price, which is the price set in the marketplace for transfers of goods and services between unrelated persons. Transfer prices are used by multinational companies for sales and other transfers of goods and services within their corporate group. These inter-company prices are the most important category of transfer prices. Individuals dealing with corporations or other entities also use transfer prices. This method is also used by persons dealing with close family members.
Related persons engaged in cross-border transactions can avoid the income taxes of a country through their manipulation of transfer prices unless prevented from doing so. For example, a company John's Co may avoid income tax payments in Country X by fixing a price on the sale of its manufactured goods to Y Co that results in its earning little or no profit. In case the effective tax rate in Country X is lower than the effective tax rate in Country Y, then the total tax burden of the affiliated companies John's Co and Abbot Co stands reduced by using inappropriate transfer prices. If Country X is a tax haven, in that case the affiliated companies would pay less or no tax on their combined profits.
The tax authorities should have the power to adjust, in a well-designed income tax system, in appropriate cases, the transfer prices set by related persons. This power should include the power to allocate gross income, deductions, credits, and other allowances among related persons so that the country collects its fair share of tax revenue from economic activities conducted within its borders. In order to further clarify this complex issue in the following paragraphs, a well know US case (Glaxo-IRS) is being discussed to explain this complicated taxation issue with a view to illustrating how a tax administration can benefit while applying transfer price rules.
The Glaxo-IRS issue is centred around what makes a product successful through marketing or R&D,1 and this fact brought with it implications for Asian countries where MNCs are currently shifting a part of their value chain.
Several multinational companies as well as tax administrations around the world were eagerly awaiting the decision of the Glaxo-IRS case in the ongoing transfer pricing dispute between the Internal Revenue Service or IRS (of the US) and pharmaceutical giant Glaxo SmithKline Holdings (Americas) Inc and Subsidiaries (GSK). The dispute started in the 1980s. Apart from the magnitude of the proposed income tax adjustment that was at stake, the issue raised in this case dealt with a fundamental question of valuing marketing activities in a company's commercial success. And as a consequence of this dispute on September 11, 2006, the IRS found itself richer by $5.2 billion. After years of failed negotiations and settlement discussions, GSK agreed to settle the matter by agreeing to pay the IRS approximately $3.4 billion in addition to abandoning its claim seeking a refund of $1.8 billion in overpaid income taxes. The settlement brings to conclusion a dispute involving adjustments to GSK's tax years from 1989 through 2000. As a part of the settlement (the terms of which are confidential), GSK and the IRS have also reached an agreement for tax years 2001 through 2005 with respect to the transfer pricing issues arising in those years.
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 transfer pricing dispute between the IRS and GSK focused on the issue of an "arm's length" payment due to GSK's US subsidiary for its role in marketing GSK's drugs in the US.
These drugs were discovered in GSK's research facility in the UK. One of its drugs, soon went on to become one of the largest selling drugs in the world. The IRS argued that the commercial success of that drug (as well as the other drugs) was driven by the innovative and effective marketing strategy developed and implemented by its US subsidiary. GSK counter-argued against this proposition and attributed the success of these drugs to the patented molecules, which were developed and held by its UK entity. Accordingly, most of the profits from the sale of these heritage products in the US, including that drug, were "transferred" to the UK in the form of payment for the underlying drug molecules.
The transfer pricing issue highlighted in the course of this dispute raises a fundamental valuation issue that may be relevant for not only pharmaceutical companies, but also other research-oriented companies. Specifically, it raises the question - what drives the success of an innovative product, R&D or marketing? A vertically integrated MNC performs a range of activities within its organisational structure. When product development or R&D is conducted by one entity and marketing strategy is developed by another, tax administrations will now be tempted to determine which of these activities drive the ultimate success of the product. It will now become harder to dismiss the role of marketing activities in explaining the commercial success of a product. Though the actual arguments and counter-arguments are not within the public domain, it appears that the stance taken by GSK has been that the uniqueness and efficacy properties of its products were of paramount importance; the marketing team simply communicated these properties to the end-customer.
The IRS rebutted this line of argument citing the presence of other drugs that were equally effective and hence attributed the commercial success of the products to a well-conceived and effective marketing strategy that was put in place. The settlement of this dispute suggests that GSK ultimately agreed to give some credence to the IRS' arguments, thereby validating the importance of marketing intangibles.
The impact of the GSK case is likely to have a bearing in the Asian context as well. The transfer pricing regulations in Asian countries have been in force since long, and are founded on the same principles as the "arm's length" principle prevalent in the US regulations. The various transfer pricing methods that are listed in the Asian regulations are also similar to the prescribed methods in the US regulations. This common interface makes it likely that Asian tax administrations will look to the US in drawing parallels that can be implemented in the Asian context. Consequently, the decisions by the US courts or out of court settlement outcomes would have persuasive value in Asia, particularly when very few cases have reached even the level of Income Tax Appellate Tribunal.
The outcome of GSK's case is likely to bring the issue of marketing intangibles to the forefront of transfer pricing analysis in Asia. Several MNCs have now located a portion of their company's overall value chain in Asian countries. The gamut of activities performed by the Asian entities is wide-ranging. Some render services, some perform distribution activities and some are engaged in manufacturing. In light of the outcome in the GSK case, it will now become imperative for the Asian companies to properly document and value their role in either performing marketing or research activities.
However, a word of caution is in order here. The ratio of the GSK's case in the Asian context cannot be applied in every case. It is neither necessary nor sufficient for marketing intangibles to exist when an entity undertakes marketing activities. Arguably, marketing intangibles have a value when the market conditions are competitive. Moreover, creation of marketing intangibles should be ascertained only when the entity undertakes expenses that are significantly higher than other routine players in the industry. Finally, the practical implications of inferring too much from the GSK case is that tax authorities of a developing country need to strike a balance between revenue gain and business loss. In the Asian perspective it needs to be appreciated that MNCs choose Asia as a preferred locational choice to avail of the cost advantages that it offers. Equating locational advantage in the same scale as assistance in developing intangibles would deter foreign investment and attended benefits of expanding employment base, service industry and so on.
(The writer is an advocate and is currently working as an associate with Azim-ud-Din Law Associates.)
1. The issue came up before US Supreme Court in the case of Boeing Co et al v US 537 US 1 (2003), and the court disapproved Boeing's method of allocating R&D because it resulted in the disappearance of the relevant cost.