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On April 4, 2004 GlaxoSmithKline Holdings (Americas) Inc. (“taxpayer”) filed a petition in Tax Court. This petition followed failed negotiations between the US and UK tax authorities. 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. Based on the Tax Court Petition, the IRS appears to be claiming that the taxpayer understated its income over an 8 _ year period by $7.75 billion. The taxpayer, in turn, is claiming that it overstated its income during that time period by $2.89 billion. The total profits to split appear to be about $12.7 billion.

In general, the IRS has 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 License Agreement). 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 (ii) 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. 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.

Commensurate with Income

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 value of the patent license. 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 such an increase.

Developer-Assister Rules

The IRS has asserted under the Developer-Assister rules that the taxpayer is not entitled to deduct royalties that it paid to its UK parent for trademarks and other marketing intangibles because the US taxpayer assisted in developing those intangibles.

Pursuant to the Developer-Assister rules, if another controlled taxpayer provides assistance to the owner in connection with the development or enhancement of an intangible, such person may be entitled to receive consideration with respect to such assistance. The regulations further state that the developer is ordinarily the taxpayer that bears “the largest portion of the direct and indirect costs of developing the intangible, including the provision, without adequate compensation, of property or services likely to contribute substantially to developing the intangible.” The taxpayer asserts that the IRS must demonstrate that it spent an “inordinate” amount of money on advertising and marketing and “did far more” advertising and marketing for many years than an average distributor of pharmaceutical products.

Inconsistent Treatment

The taxpayer further asserts that it has a right to be treated consistently with other taxpayers who are similarly situated. This claim is based on the assertion that the IRS executed an Advanced Pricing Agreement (“APA”) with SmithKline, an industry competitor, in June of 1993 based on a resale price method. An APA permits a taxpayer to obtain a prospective legal determination from the IRS that the taxpayer’s transfer pricing methodology and application of that methodology satisfies the arm’s length standard set forth in IRC section 482. In the SmithKline APA, the IRS determined that a specific gross margin provided an arm’s length return for selling and marketing activities related to the drug Tagamet. The taxpayer claimed that it requested a similar APA from the IRS in June of 1994, but the IRS refused to act on the application and that such refusal was discriminatory. Since Glaxo subsequently acquired SmithKline, it has all of the information that ordinarily would be confidential concerning this matter.

Assessment of the Case

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.

From a cursory review of the economics of the drug industry, however, it appears that a significant portion of the “monopoly profits” of a patented drug are attributable to the patent and thus the IRS may be in error in this case. Publicly available reports discussing the impact of the introduction of generic drugs on the market share and pricing of branded drugs suggest that the large profits of a patented drug are simply not attributable to extraordinary marketing intangibles, because the marketing intangibles cannot sustain the large profits once patent protection is lost. For example, a study prepared in 2000 and presented to the National Bureau of Economic Research discusses the impact of the loss of US patent protection in 1997 on the Glaxo drug Zantac. The authors conclude that after the loss of patent protection Glaxo maintained its pricing policies, but lost “very substantial market share”. The authors also report that by June of 1999 sales of prescription Zantac had dropped to 8% of their peak levels in 1994-95 and “fell dramatically” immediately after the loss of patent protection. These reports suggest that a taxpayer would have paid substantial amounts to avoid the early loss of patent protection and that marketing intangibles, in fact, cannot sustain the large market share of a high priced drug.

Glaxo also introduced Zantac 75 in 1996, an over the counter product, to compete with similar products while maintaining sales of its prescription drug. Presumably, this introduction allowed further exploitation of the Zantac name. However, by 1999, reports indicate that the price of Zantac 75 was about one third of the price of prescription Zantac for equal therapy, and sales of Zantac 75 were about 3 to 4 times those of prescription Zantac for equal therapy. Thus, again, marketing intangibles alone cannot maintain both a large market and high prices.

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 since 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. Moreover, the Competent Authority process available under Treaty is designed to avoid double taxation in these cases. It is disappointing that the US and UK Competent Authority could not reach agreement in this case. Their failure does not bode well for taxpayers if similar issues arise with other jurisdictions. It is time for the IRS to reassess its position in this case.

 

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