and the IRS Finally Find Relief with Zantac
Longstanding Dispute over Transfer Pricing
Sharon Burnett and Darlene Pulliam
JUNE 2008 - When
it comes to transfer pricing, even the most seasoned tax professionals
can find themselves with a stomachache. Transfer pricing is at the
heart of a long-running dispute between the IRS and a corporate
taxpayer, which resulted in the largest settlement in IRS history.
For 14 years, GlaxoSmithKline (GSK) and its predecessor companies
had disagreed with the IRS about the transfer prices the U.S. subsidiary
of GSK paid its U.K. parent for several different drugs. The dispute
primarily involved the appropriate pricing method for GSK’s
Zantac, a product designed to treat stomach ailments and ulcers.
On September 11, 2006, GSK and the IRS agreed to a $3.4 billion
settlement, the largest in IRS history.
its magnitude, the settlement, did little to help multinational
companies with setting inbound transfer prices when intangible
assets are involved. The settlement does send a strong message
that the IRS is very serious about taxpayers complying with transfer
pricing rules. A closer look at the 14-year disagreement between
GSK and the IRS may be instructive for taxpayers in similar situations.
issue in the GSK case was the transfer price at which the U.K.
parent, GlaxoSmithKline PLC, sold drugs (primarily Zantac) to
its U.S. subsidiary. In a parent-subsidiary transaction such as
this, the transfer price does not affect the overall profit of
the group, but it does affect the overall taxes paid by the group.
price should be equal to the price that would be charged in an
arm’s- length transaction. This arm’s-length amount
must be determined using one of the following methods:
- The comparable
uncontrolled price method (Treasury Regulations section 1.482-3);
- The resale
price method (section 1.482-3);
- The cost
plus method (section 1.482-3);
- The comparable
profits method (section 1.482-5); or
- The profit
split method (section 1.482-6).
price method is approved by the IRS when a tangible product is
involved. The resale price method is ordinarily used in cases
involving the purchase and resale of tangible property in which
the reseller does not add substantial value to goods that are
distributed by physically altering them before resale. Packaging,
repackaging, labeling, or minor assembly are ordinarily not considered
physical alteration. The arm’s- length character of a controlled
transaction is tested against the gross profit margin realized
in comparable uncontrolled transactions. The resale price method
measures the value of functions performed. Ordinarily, it should
not be used if the controlled taxpayer uses its intangible property
to add substantial value to the tangible goods [Treasury Regulations
price is determined by subtracting the appropriate gross profit
from the applicable resale price for the property involved in
the controlled transaction. The applicable resale price is equal
to either the resale price of the property involved or the price
at which contemporaneous resales of the same property are made.
The appropriate gross profit is computed by multiplying the applicable
resale price by the gross profit margin earned in comparable uncontrolled
transactions [Treasury Regulations section 1.482-3(c)(2)].
Pricing Agreement Between IRS and SmithKline Beecham
information is available from the various advance pricing agreements
executed by the IRS. The SmithKline Beecham advanced pricing agreement,
which was obtained by Tax Analysts (Tax Notes Today,
Sept. 18, 2006), was a major factor in the recently settled litigation
between GSK (the successor entity) and the IRS.
advance pricing agreement (APA) agreed to by the IRS and SmithKline
Beecham governed intragroup sales of the drugs Tagamet and Dyazide.
The document established a pricing method that the parties agreed
was “consistent with the arm’s length standard”
and achieved a result that “clearly reflects income.”
In the APA, the company agreed to price Tagamet using the resale
price method and the IRC section 936 cost-sharing payment. The
resale price was to be calculated by reducing the company’s
net trade sales for a 28% marketing commission and another 8%
for the Tagamet trademark and the company’s trade name.
As a result, the transfer price for Tagamet sold to U.S. parent
SmithKline Beecham by SmithKline Beecham Pharmaceuticals Co. (LabCo.),
a manufacturing concern in Puerto Rico owned by an SmithKline
Beecham Corp. subsidiary, would be 64% of net trade sales. The
agreement defined net trade sales as sales minus returned items,
allowances, and any cash discounts that do not exceed 2% of sales
(Tax Notes Today, Sept. 18, 2006).
Transfer Pricing Example
a drug and getting it to market involves numerous different costs,
such as research and development (including patents), government
approval, labor, raw materials, shipping, and marketing. The first
two costs occur over numerous years and can be very difficult
to track because companies are generally developing several drugs
at a time. Exhibit
1 contains a possible breakdown of the costs (as a percentage
of sales) of an inbound product with intangible components. The
percentages in the example are loosely based on the APA between
SmithKline Beecham and the IRS for Tagamet. The resale price method
was used, and the APA was based on an outbound transfer price
2 for a glossary of terms).
Hanbury Ltd., a U.K. research and development subsidiary of U.K.
parent Glaxo, developed an ulcer drug during the late 1970s. Zantac
was available for sale by 1981. A competitor, SmithKline, was
able to get a similar ulcer drug, Tagamet, to market a couple
of years earlier. In 1992, the IRS began an audit of Glaxo’s
tax returns for 1989 and 1990. In 1994, Glaxo and the IRS attempted
to resolve the dispute through the APA process (see the timeline
At this time,
the APA process was relatively new. It was difficult to imagine
an agreement on a transfer price before a transaction actually
occurred. Even though the purpose of an APA is to resolve transfer
pricing issues before they arise during an audit, taxpayers and
the IRS had already encountered numerous problems in agreeing
on a transfer price after the transaction had occurred (e.g.,
Eli Lilly and Bausch & Lomb). The first APA was signed in
1991, and by 1994, a total of 45 had been completed. About half
involved a foreign taxing authority. Taxpayers, most foreign taxing
authorities, and the IRS were eager to agree on a solution to
a transfer price. Between 1991 and 1994, about 49% of the received
applications were executed. From 1995 to 1999, the rate increased
to 61% (APA statistics from Announcement 2000-35, 2000-1 CB 922).
The IRS has now reached the first APA with China (News Release
Glaxo and the IRS were not able to come to an agreement in 1994.
By 1999, GlaxoWellcome (GW) and the U.K. taxing authorities had
reached an agreement on transfer pricing. In December 1999, GW
requested relief from double taxation through the U.S.–U.K.
Convention for the Avoidance of Double Taxation, commonly known
as the “competent authority process.” (The transfer
prices were important to determine taxable income in both countries.)
fundamental issue that remained after the competent authority
process, the one needed to determine the inbound transfer price,
was as follows: Which was more valuable, the research and development
process completed in the United Kingdom or the advertising and
marketing efforts in the United States?
The IRS asserted
that the advertising and marketing were more valuable, because
Zantac was the second ulcer drug to enter the market. GW and the
U.K. taxing authorities believed a high transfer price was reasonable
because the R&D was more valuable, and the U.S. GW subsidiary
did not own any drugs. Ordinarily, taxing authorities, particularly
the United States and the United Kingdom, are able to negotiate
their differences. However, in this case a very large amount of
disputed taxes was at stake—up to $5 billion.
2000, GW merged with SmithKline Beecham Corp. (SKB) to become
GlaxoSmithKline (GSK). This merger was important because SKB had
been able to reach an agreement with the IRS over the outbound
transfer price for Tagamet in 1993. As noted above, when the terms
of the APA were made public, it was revealed that the outbound
transfer price for Tagamet was 64% of the net trade sales (defined
as sales less returned items, allowances, and any cash discounts
up to 2% of sales). The 36% reduction from the net trade sales
amount consists of 28% as a marketing commission, 5% for the Tagamet
trademark, and 3% for the SKB trade name.
In May 2001,
GSK and the IRS filed a joint motion to allow depositions—GlaxoSmithKline
Holdings (Americas) Inc. v. Comm’r (117 TC 1). The
IRS had not yet filed a notice of deficiency, so no case had yet
been filed with the Tax Court. However, both GSK and the IRS wanted
to obtain depositions from two key former GSK executives—Sir
Paul Girolami and Sir David Jack—who had intimate knowledge
of the company’s financial and R&D workings over several
decades. If one person could be credited for inventing a particular
drug, Jack was the inventor of Zantac. The Tax Court approved
the joint motion based on the two executives’ advanced ages
and the fact that their testimony was vital to a case that was
likely to be filed. Although it was not specifically mentioned
in the tax case, the documentation trail for the development and
ownership of Zantac was apparently lacking, making the testimony
of the two executives invaluable (“U.S. Marketing Intangibles
Stance in Glaxo: Wave of the Future?” Tax Management
Transfer Pricing Report, Vol. 12, No. 21, March 17, 2004).
GSK sued the IRS, claiming it had erred in increasing GSK’s
income by $7.8 billion ($4.5 billion for cost of goods sold, $1.9
billion for royalties, and $1.4 billion for interest income) for
intercompany transactions involving Zantac, Ventolin, Ceftin,
Zonfran, Imitrex, and Serevent. GSK later added a claim for a
$1 billion refund based on a charge of discriminatory practices
in the APA process. This charge stemmed from the SKB APA for Tagamat,
to which GSK had access after the 2000 merger. The IRS was criticized
for handling inbound and outbound transfer pricing differently.
2006, the case was finally scheduled to go to trial in February
2007 after a delay based on claims of GSK withholding documents
and a flood that destroyed some of the litigation information
stored on IRS servers. On Sept. 11, 2006, the IRS and GSK announced
a settlement concerning the transfer-pricing dispute for the tax
years 1989 to 2000 and an agreement concerning the tax years 2001
to 2005. Under the settlement, GSK will pay the IRS $3.4 billion
(or 60% of the total amount contested) and will drop its claim
for a $1.8 billion refund. This represents the largest settlement
IRS history (News Release IR-2006-142, 09/11/2006).
The IRS is
serious about transfer pricing. Then–IRS Commissioner Mark
W. Everson made the following statement concerning the GSK settlement:
“We have consistently said that transfer pricing is one
of the most significant challenges for us in the area of corporate
tax administration. The settlement of this case is an important
development and sends a strong message of our resolve to continue
to deal with this issue going forward.”
Counsel Donald Korb reiterated the IRS’s commitment to settling
transfer pricing disputes and said this about the settlement:
“Our decision to accept GSK’s settlement offer reflects
our commitment to resolving transfer pricing controversies without
litigation, provided that our ultimate goal of compliance is not
compromised.” The lawsuit’s 14-year duration backs
up both statements.
is just as important for intangible assets as tangible ones. GSK
might have been able to support its argument concerning the value
of R&D if it had been able to prove how much had actually
been spent in R&D. In particular, keeping track of the costs
in the pharmaceutical R&D can be challenging. Few drugs are
researched or developed in isolation. Not only are other drugs
involved, but over the years many different entities may also
be involved (for instance, different researchers, laboratories,
and acquired projects). On the other hand, it is also difficult
to document the value added by a company’s marketing efforts.
Market studies and other documented efforts of a company’s
marketing department should be helpful.
The APA process
usually works, but it is not perfect. In 2006, 82 APAs were executed,
of which 40 were bilateral agreements with other tax treaty countries.
Revenue Procedure 2004-4 favors bilateral APAs; it requires that
a request for a unilateral APA covering transactions with a related
entity in a jurisdiction with which the United States has an income
tax treaty must include “an explanation of why the request
is not bilateral.” The GSK experience is an example of an
unsuccessful multijurisdictional APA application.
Burnett, PhD, CPA, is a lecturer in accounting at Oklahoma
State University, Stillwater, Okla.
Darlene Pulliam, PhD, CPA, is the McCray Professor
of Accounting at West Texas A&M University, Canyon, Texas.