Pharma Industry – Transfer pricing Perspective Sanjay Tolia December 12, 2008

1. Pharma Industry – Transfer pricing Perspective Sanjay Tolia December 12, 2008 PwC

2. Content • Transfer pricing Environment in India • Pharma Transfer Pricing Issues • Select Global Case Laws • Dispute Resolution • Legislative & Regulatory Development • Way Forward

3. Transfer Pricing Environment in India

4. Transfer Pricing Environment in India • Fourth round of TP audit completed • Enhanced team • Increased information sharing and awareness • High volume of cases with limited time-frame • Aggressive positions adopted • Favorable ITAT rulings

5. Current Emerging • Manufacturing • Distribution • Marketing • Services • Business Restructuring • Marketing Intangibles • Intellectual Property Transfers • Permanent Establishments • Convergence with Customs • Guarantees Transfer Pricing Environment in India Shift in Focus

6. Pharma TP Issues

7. Pharma TP issues • Comparability of Active Pharmaceutical Ingredients (API’s) • Comparability with: • generic API; and • same/similar API’s imported by third parties, available on customs databases • Clinical Trial Services • Role may vary from mere facilitation/co-ordination v/s responsibility for the completion of the trials • Difficulties arise in identifying appropriate comparable companies

8. Pharma TP issues • Contract R&D and Contract manufacturing services • Relatively high mark-ups insisted by the revenue • Difficulty in identifying appropriate comparable companies; • Contract research vs. co-developing drugs with foreign partners based on revenue sharing models • Publicly available information databases do not provide results of companies purely engaged in contract research activities • Difficult to ascertain whether potential comparables are engaged in contract research, or are co-developing drugs with foreign partners based on revenue sharing models.

9. Pharma TP issues • Other Issues • Product Analysis vis-à-vis basket of products approach • Drugs Prices Control Order (DPCO). • Price control under the DPCO may cause product margins of pharmaceutical companies to come under pressure • Where the pricing of raw material inputs procured from associated enterprises is sought to be reviewed by the application of profit based transfer pricing methods, the identification of comparable companies entails challenges • Distribution • Start-up losses • Use of profit level indicator (Gross margin vs net margin)

10. Other TP issues • Business Restructuring • Involvement of operational teams to document local rationale for change • TP documentation to address transition aspects • Any disposal of intangible assets reflecting the migration from a full risk function to a lower risk business • Valuation of intangibles, exit charge, pre-transition planning • Possible creation of Permanent Establishment (PE)

11. Other TP Issues • Guarantee Fees • TP issues when parent company guarantees its subsidiary’s external borrowings • Benefit test required before an inter-company fee can be paid to the parent, for issuing the corporate guarantee • Arm’s length profit element to be earned on guarantee transactions • Thin capitalization

12. Select Global Case Laws

13. Select Global Case LawsGlaxo, USA • Relevant known facts: • UK parent with subsidiaries in several locations including the US • UK parent conducted breakthrough R&D and developed the “heritage products” including Zantac • UK parent owns patents on heritage products • Heritage products all introduced in markets outside the US before US introduction • UK parent is apparently the legal owner of global trademark rights to the heritage products

14. Select Global Case LawsGlaxo, USA • Relevant known facts: • Bulk chemical produced by non-US affiliate of Glaxo UK (Singapore) • Glaxo US licenses product intangibles from Glaxo UK, initially for a royalty equal to 10% of sales • Glaxo US performs fill / finish and market and distributes the heritage products in the US • Glaxo US performs some R&D. Apparently some US R&D involves clinical trials related to heritage products including Zantac. Glaxo UK reimburses for some US R&D • Glaxo US asserts that marketing plans, materials etc. developed in the UK and used in other markets before use in US

15. Select Global Case LawsGlaxo, USA • Relevant known facts: • When introduced in US, Zantac has a direct competitor (Tagamet) which is well established in the market and is the world’s largest selling pharmaceutical product. • Zantac has therapeutic advantages over Tagamet • Zantac replaces Tagamet as the ulcer treatment of choice within two years of US introduction and becomes the world’s largest selling pharmaceutical product, a status it holds for several years • When it becomes clear Zantac is a blockbuster, royalty rate paid by Glaxo US is increased

16. Select Global Case LawsGlaxo, USA • IRS Theory • In economic substance, Glaxo US is the owner of the relevant trademarks and marketing intangibles • Royalties paid by Glaxo US should be capped at their original level and cannot subsequently be increased • Amount of the deficiency should be treated as a loan to Glaxo UK from Glaxo US and interest income should be imputed on that loan at market rates • Reported settlement terms • Glaxo agrees to pay tax and interest of $3.4 billion • Resolves all transfer pricing controversy regarding the heritage products through 2005

17. Select Global Case LawsRoche, Australia • Relevant known facts • Roche Products Pty Ltd (‘Roche Australia’) is the Australian subsidiary of the multinational pharmaceutical company, Roche Holdings in Switzerland (‘Roche Switzerland’) Reported settlement terms. • Audit period covered 11 income tax years 1993 to 2003 • Australian Tax Office (‘ATO’) increased Roche Australia’s taxable income over the audit period by A$ 130 million. • Independent US transfer pricing experts were used by Roche and ATO to support their positions

18. Select Global Case LawsRoche, Australia • Relevant known facts • ATO’s Approach • Application of TNMM: Identified return for each function • Arm’s length mark-up- Aggregation and consolidation arrived at by Built up approach

19. Select Global Case LawsRoche, Australia • Roche Australia argued • CUP was the most appropriate • Identified internal comparable transactions during assessment and made adjustments for the following differences: • Currency • Payment terms • Packaging • Demonstrated based on CUP Analysis, that Roche Australia had paid less than the ALP • Thus no adjustment was warranted

20. Select Global Case LawsRoche, Australia • Decision • TNMM & Build up approach of the ATO disliked and rejected by the Judge • Roche Australia’s methodology of internal GM comparability not appreciated by the Judge • The Judge after considering comparable gross margins was most persuaded by evidence of negotiation with third parties which was 40% • Increase in taxable income was A$ 45 million as against the adjustment made by the ATO

21. Dispute Resolution

22. Dispute Resolution - Global • Audits, tax adjustments, Advanced Pricing Arrangement (APA’s), Mutual Agreement Procedure (MAP) cases and arbitration proceedings appear to be on the rise around the world • Fundamental international tax principles (such as the arm’s length standard) are under attack • Taxpayers are increasingly confronted with substantial tax risks and uncertain tax positions worldwide • Pressure is growing on traditional and new dispute resolution techniques (eg: mandatory binding arbitration) • As the volume of APA and MAP cases increases, competent authorities worldwide appear to face difficult and complex challenges – resulting in backlog of cases that are substantial and increasing.

23. Dispute Resolution – Indian Scenario • Mutual Agreement Procedure (MAP) • A remedy available under the DTAA, independent of remedies available under domestic tax law to resolve tax disputes • Decision not binding on taxpayer • Can be simultaneously pursued with domestic appeals • Demand stayed till dispute resolved (US & UK)Advanced Pricing Arrangement (APA) regime • A committee has been formed to study best practices in APA’s and make suggestions for an APA model to be introduced in India • Views sought from tax consultants, multinational corporations, industry representatives, etc

24. Legislative & Regulatory Developments

25. Legislative and Regulatory Developments • United States • Cost Sharing Regulations to be issued by end of year • Global Dealing and Services Regulations to follow • Organization for Economic Cooperation and Development • Transfer Pricing Aspects of Business Restructurings (Discussion Draft) • Germany • Ordinance on Business Restructurings • China • Documentation rules expected to be issue by end of year

26. Way Forward Corporates must: • Proactive – not reactive • Adopt Coordinated and centralized approach. • Involve operational teams in tax and TP planning and documentation process • Holistic solutions – not fragmented responses • Global awareness and vision – not myopic • Harmonize TP documentation with other regulatory requirements

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