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
The Commissioner relied upon on two alternative bases to support the assessments – Division 13 of the Income Tax Assessment Act and Article 9 of the Double Tax Agreement (DTA) between Australia and Switzerland. In his preliminary decision, Mr Justice Downes acknowledged that both parties accepted that Division 13 and the relevant Article of the DTA achieved the same result. Consequently he was not required to consider whether the Associated Enterprise Article in the Double Tax Treaties confers power on the Commissioner to assess income tax. Nevertheless, Mr Justice Downes proceeded to comment to the effect that, in his view, a Double Tax Treaty does not impose a right to tax. This is consistent with the approach of the full Federal Court in recent cases.
Dealing at arm’s length
The application of Division 13 (the transfer pricing provisions) requires that the parties were not dealing at arm’s length [para 136AD(1)(b) or para 136AD(2)(b)].
Roche Australia accepted that it was not dealing at arm’s length with Roche Basel in relation to the acquisition of product and so there was no need for there to be evidence introduced nor for Mr Justice Downes to decide the issue.
Transfer pricing methodologies
Mr Justice Downes reinforced the difficulties in finding appropriate comparables in the Australian market. He commented that he believed the analytical approaches undertaken by the expert economists were “coloured by their United States experience”. Mr Justice Downes was particularly concerned to note that none of the experts had been asked to address the specific provisions of the Income Tax Assessment Act nor the Article of the relevant Double Tax Treaty. In considering Mr Justice Downes’ summation of the evidence of the experts, it is clear that Mr Justice Downes has a preference for the transactional methods over a profit method such as TNMM, even though he applies the same gross margin to all of Roche Australia’s pharmaceutical products to arrive at the final adjustment. In particular, his comments in respect of Dr Wright’s application of TNMM suggest that he does not consider a range of profit outcomes calculated from a number of broad comparables to be persuasive in supporting an arm’s length price of a product.
For the ATO and most taxpayers, the TNMM has evolved as the transfer pricing method of choice over the years. Based on the preliminary decision in this case, taxpayers will be well reminded of the need to look for and analyse whether internal comparables exist within the global group, as this evidence is likely to carry more weight in an Australian Court of Law than a TNMM analysis based on a number of atypical comparables.
It has also been the practice of the ATO to use comparables in different industries, due to the lack of comparables in the same or similar industry to the tested party. It is understood that the ATO argues that functionality is paramount such that if the functional profile is the same, this overrides any difference in industry dynamics of either the tested party or the comparable that potentially could influence the profit outcome. However, Mr Justice Downes casts doubt on this approach in his comments, criticising the approach of Dr Wright who used advertising agents as comparables for the marketing aspect of the sales and marketing function of Roche Australia’s pharma division. Mr Justice Downes referred to Dr Wright’s explanation for her approach: ”she was trying to value the marketing functioning…. And you do that by reference to companies that employ such individuals and render creative marketing as their core business, and that is an ad agency.” Mr Justice Downes commented that “I do not think that this explanation justifies using the profitability of international advertising agencies, as comparable to internal marketing deliberations of a pharmaceutical company.”
Separate years
Mr Justice Downes makes it clear that the focus in determining arm’s length prices must be on the separate prices in each of the years under consideration. Mr Justice Downes concluded that “It accordingly seems to me to be necessary to look at each year separately and to the gross profit margin for each year.” Based on this comment, it could be concluded that taking an average over a three or five year period is not in accordance with the application of Division 13. However it is noted that Mr Justice Downes decision is based on determining a gross margin of 40% for all ethical pharmaceutical products and applying it across all years in dispute.
A further point to note arising under this heading is that when calculating the ultimate adjustment, where the gross margin of Roche Australia exceeded 40% in a year (as it did for Roche Australia in the 1998 year) the excess was not offset against the adjustment in the years when the gross margin was less than 40% gross margin.
Although a 40% gross margin was found to be an arm’s length gross margin in this case, it should not be seen as providing a benchmark for the broader pharmaceutical industry. However, corporates should investigate closely possible internal comparables and review their gross margins in light of any dealings with third parties.
Losses
Mr Justice Downes recommended “standing back and looking at the canvas” when looking at transfer prices. Just because a transfer price results in a loss does not necessarily mean that the transfer price is not arm’s length. This was particularly important in relation to the Diagnostic Division, where Mr Justice Downes was satisfied that the poor operating results of the division were a result of commercial factors, not transfer prices. In particular, Mr Justice Downes was clearly concerned that one of the problems of TNMM is that in analysing the performance of a division or company “it inevitably attributes any loss to the pricing. After all it is certainly true that there are companies that make losses for reasons other than the prices for which they acquire their stock. The Australian operations for multinational companies are not necessarily excluded from this”. Again this is an important reminder to taxpayers of the importance of documenting contemporaneously the commercial reasons for losses or low profitability in their transfer pricing analysis.
These comments could also cause the ATO some hesitation in immediately presuming that losses incurred by a company with cross-border intercompany transactions are due to transfer pricing practices that are not arm’s length.
Conclusion
The judicial comment of Mr Justice Downes will be studied by the ATO and corporations seeking to glean an insight into his decision-making process that will help them ensure that the consideration for overseas related-party transactions is arm’s length. However, similar to the application of the concept of ‘the arm’s length principle’, conclusions drawn from the Roche case will be discussed and disputed.
The preliminary decision appears to reinforce the view that Australia’s transfer pricing legislation is transactional and that profit methods such as TNMM do not sit as comfortably with the legislation as they do with DTAs. It is probably too early to determine whether this decision will result in amendments to Australia’s transfer pricing legislation. It will not be until there is further judicial comment either on appeal of the Roche case or a new case dealing with Division 13 that the application of Mr Justice Downes’ comments will become clearer.
