IRS and GlaxoSmithKine Settle Transfer Pricing Dispute for $3.4 Billion

Significant Implications for Transfer Pricing of Intangibles

On September 11, the IRS reached settled its long-running transfer pricing dispute with GlaxoSmithKline, which agreed to pay the US Treasury $3.4 billion and to terminate its counter-suit against the IRS for rejecting its Advance Pricing Agreement (APA) application. While transfer pricing issues can be quite complex, the Glaxo-IRS dispute revolved around two fairly simple questions:

From the size of the settlement, it is clear that Glaxo's lawyers expected to lose on both counts. In other words, the effort that went into marketing Zantac in the United States was deemed to account for more of the value of the drug than did the research and development that took place in Europe. This precedent could force other companies with R&D operations outside of the U.S. that market their products to U.S. companies and consumers to re-evaluate their transfer pricing methodologies. Using a cost-based method might have been favorable if only research and production costs are considered, but what are the implications if marketing costs are factored into the value of the product?

This problem will be immediately apparent to other pharmaceutical companies, particularly those with both R&D and manufacturing facilities in low-tax jurisdictions like Ireland who market their drugs in the United States, but it could also affect software companies with a similar international structure. If under a cost-based method, most R&D and production costs are in a low-tax jurisdiction, the amount of income attributable to U.S. operations may be very low, but if marketing costs that are bourn in the U.S. and much of the value of the software is derived from the demand generated by those marketing efforts, the bulk of the worldwide profit could be taxable in the U.S. Under these circumstances, it may be wise to investigate other possible methodologies.

Even tangible goods whose value is affected by perceived characteristics created by a marketing campaign could be affected by this paradigm. For example, an MP3 player manufactured in China that retails for a higher price that similar players not backed by as extensive advertising campaings could be found to derive much of its value from marketing efforts in the U.S. Does this mean that Apple Computer will be sued by the IRS over its iPod profits any time soon? That depends on what costs they are reporting on their tax returns now and what method they use to justify those numbers.

The settlement may suggest to companies the value of entering into an Advance Pricing Agreement with the IRS to avoid the uncertainty of a future transfer pricing tax dispute. The rejection of Glaxo's APA application does reinforce the possibility of wasting time and effort on negotiating and APA only to be rejected by the IRS, but the benefits of reaching an APA may outweigh the burdens and uncertain outcome of the application process. Of course, the value of an APA to a given company will depend upon that company's circumstances, but it is likely that many companies that would benefit from the protection against significant additional tax exposure associated with entering to an APA have not availed themselves of the process.

Companies that derive a significant portion of their income from goods sold in the U.S. but whose taxable income is attributed to a large extent to activity outside the U.S. would be wise to consult a tax advisor about whether it makes sense for them to seek an Advance Pricing Agreement with the IRS.

Here are some additional articles that discuss the GlaxoSmithKline-IRS settlement:

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