Roche Products Pty Limited v The Commissioner of Taxation: A bitter pill to swallow, but for whom?

A preliminary decision was handed down on 2 April 2008 by Mr Justice Downes of the Administrative Appeals Tribunal (AAT). The issue involved the transfer prices for pharmaceutical products acquired by Roche Products Pty Limited ("Roche Australia") from its parent company Roche Holdings Limited of Switzerland and other group companies (referred collectively here as Roche Basel).

This is a novel case disputing the exercise of the Commissioner's discretion in determining arm's length consideration. Consequently the preliminary decision is of significant interest to multinationals in the pharmaceutical industry and multinationals generally, in terms of how the economic determination of prices by both the ATO and taxpayers in practice is considered in light of the specific transfer pricing legislative provisions.

Background

The audit period covered the income tax years 1993 to 2003. After conducting a transfer pricing review and audit, the ATO raised amended assessments in relation to the transfer prices of three of Roche Australia's four divisions. The bulk of the adjustment related to the Ethical Pharmaceutical Division, which imported and resold prescription drugs. This division also performed secondary manufacturing (Formulate, Fill and Finish or FFF) as well as undertaking clinical trials to support the local registration of drugs.

Adjustments were also proposed to the transfer prices of "over the counter" medicines acquired by Roche Australia's Consumer Division from other group companies and the Diagnostics Division, which imported and resold diagnostic equipment and preparations for use with that equipment.

In calculating the transfer price adjustments in the amended assessments, the ATO used a Transactional Net Margin method (TNMM). The ATO acknowledged that there was an absence of good comparables in the Australian market to support the transfer prices of product acquired by Roche Australia from its overseas group companies. In quantifying the adjustments in the amended assessments, the ATO considered the functions being performed by Roche Australia in respect of the resale of the products in Australia and sought to benchmark their profit against the profit earned by independent companies from similar activities. The ATO aggregated the returns from the various functional components to calculate an appropriate gross margin. Applying the TNMM resulted in the ATO issuing revised assessments, increasing Roche Australia's taxable income over the audit period by approximately $130 million.

Roche Australia argued that the assessments were excessive. In the Ethical Pharmaceutical Division, between 1996 and 2003 a number of the products were sold by Roche Basel to independent wholesalers of generic pharmaceutical products in Australia, such as Alphapharm Pty Limited. Roche Australia used a Comparable Uncontrolled Price (CUP) method to demonstrate that the prices paid by Roche Australia for the product were comparable to the price paid by the Australian independent wholesalers. Roche Australia used the gross margin on the products for which it had a CUP to benchmark the gross margin of its other products for which it had no direct price comparison (non-CUP products). Roche Australia argued that because the gross margin on its CUP products approximated the gross margin on its non-CUP products, no adjustment to transfer prices in the Ethical Pharmaceutical Division was warranted.

In relation to the Consumer Division, the ATO looked to adjust only the prices of fully finished products acquired by Roche Australia from overseas group companies. Roche Australia argued that the transfer prices of these products should not be looked at in isolation but should be looked at in light of the performance of the Consumer Division as a whole, and that when transfer prices were analysed at the divisional level, no adjustments were warranted.

In relation to the Diagnostics Division, the ATO applied TNMM to the results of the division as a whole. Roche Australia argued that the losses of this division were not due to excessive transfer pricing of products acquired from overseas group companies, but were a result of local market conditions. Roche Australia argued that no adjustments were warranted.

Independent US transfer pricing experts were used by both parties to support their respective positions: Dr Daniel Frisch for Roche Australia, Dr Deloris Wright and Dr Brian Becker for the Commissioner.

In his preliminary decision, Mr Justice Downes found that Roche Australia had overpaid approximately $59 million for its ethical pharmaceutical products over the period and that Roche Australia's taxable income should be increased accordingly. No adjustments were proposed to the Consumer Division or Diagnostics Division.

In calculating the adjustments to the ethical pharmaceutical products, Mr Justice Downes concluded that an arm's length price for pharmaceuticals would have yielded Roche Australia a gross margin of at least 40 percent throughout its product range. This conclusion was based on Mr Justice Downes's finding that the prices for the generic sales to Alphapharm Pty Limited were generally negotiated to yield a gross profit margin of 40 percent to Alphapharm Pty Limited

PwC commentary

In an area renowned for its complexity and subjectivity, the preliminary decision in this case probably raises more questions than it answers. However, as this is a novel case in Australia where a judge has had to consider whether the economic process used to set or review transfer prices is in accordance with the provisions of Division 13 of the 1936 Income Tax Assessment Act, the decision has significant implications for taxpayers and the ATO. Being a preliminary decision, any conclusions drawn from the judicial comment must be considered with this in mind.

We have commented below on the significant implications for corporations arising out of the decision.

The taxation scheme

Dealing at arm's length

Transfer pricing methodologies

Separate years

Losses