THE CASE OF GLAXO SMITHKILNE

When the two British rivals Glaxo Wellcome and Smithkline Beecham merged with a whopping
valuation of $74 billion, it was declared the second largest pharmaceuticals company that
existed. It took the world by storm, with an annual sale of $24.9 billion and a market share of
7.3%, it was reaching new heights of prosperity.
SLAMMED BY THE INTERNAL REVENUE SERVICE (IRS)
GSK was claimed to have forged a tax claim of 2.7 billion. This claim was constituted to the
Glaxo Wellcomes activities during the period of 1989-1996 which meant that the Glaxo
Smithkline pharmaceuticals were not yet formed. IRS even went to claim that with the interest
that was left to be added the company would be paying an additional amount of $2.5 billion in
the form of interest. IRS claimed that the US subsidiary of Glaxo Wellcome had escaped from
paying taxes in the US. It went on record saying that the subsidiary in the US transferred its
profit to its parent company in the U.K. There was a basic reason why the US subsidiary
company would do that. The low tax rate in the parent company and high tax rate in the
subsidiary or in this case US, is the reason for the IRSs claim.
This issue went on being a long one. The IRS was involved in the audit of Glaxo accounts since
1992, the claim was asked for the period of 1989-1996. Hence, GSK were also expecting a tax
claim for the period of 1997-1999. There were medicines that were sold in such a large amount
and were so popular that it accounted for half the revenue of Glaxo at one point in time. One
such medicine was for the anti-ulcer, named, Zantac. Here, with the sales of such huge amount it
was evident that IRS would believe that the profits were transferred to the parent company in the
U.K. Other drugs that the IRS believed the profits were transferred for were Zofran- an antinausea drug, Ceftin- an antibiotic, Serevent- an anti-asthamatics and Imitrex- which eased
migraines. All these drugs were among the top 50 selling drugs worldwide.
There are argumentative points when it comes to discussion about drugs. It is often believed that
the research and development cost relating to drugs are higher than the manufacturing cost. In
this very case, the parent company took to accounts the research and the development work
while its subsidiary was involved in the sales and marketing of the drugs. IRS opined that Glaxo
was over estimating the research and development cost in the U.K and lowering its share of
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profit in the U.S. When a company does that, it is illegal. It is considered that the company is
undergoing a malpractice and this is when the government intervenes.

(EXCESSIVE)
PAYMENTS

GLAXO AMERICA
(SALES AND
MARKETING)

PROFITS

GLAXO U.K
(RESEARCH AND
DEVELOPMENT)

DRUG

This was such an issue of controversy that GSK had to give a statement to the media that stated
Disagreements with and between revenue authorities as to tax allocations between related
companies in different tax jurisdictions are inevitable for a global business such as GSK
This statement sure kept the controversy out of the limelight for some point of time. But there
were high profile individuals who felt free to comment on the ongoing tug of war between GSK
and the IRS. This case is in regards to the manufacturing industry hence, the case involves the
question as to what value is created. Glaxos lawyer John Magee had an opinion that sounded
pretty relevant. He stated that When it comes to the drug industry, cost of raw materials is often
regarded negligible whereas the value of research, marketing and other overheads were much
higher. He stated that these things are subjective in nature.
Various institutions came to their rescue; there were organizations that said they were being
victimized because they were creating a subsidiary company in the third world countries. That
was creating an employment opportunity there and had good market prospects in those countries.
Glaxo even appealed the parent company in the U.K. to relieve them from double taxation. The
U.K. government was taking this appeal on a positive stride but few discussions and
deliberations between the two countries led to a fall down and that proposal was cancelled.
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The controversy obviously led to the two parties to settle their disputes inside the court. Glaxo
Company in the U.S could not deliver enough evidence as to why they had transferred that
amount to the parent company in the U.K. Hence, that led to Glaxo Company paying a sum of
$3.4 billion to the IRS authority which meant that IRS won their claim.

THE CASE OF SEAGATE TECHNOLOGY

Seagate Technology Inc., a worldwide leading industry in designing, manufacturing and
marketing of hard disk drives was founded in 1979 in Scott's Valley, California. It was also called
Seagate US. Despite of manufacturing hard disk drives, Seagate also manufactured disk drives
components until it established its subsidiary in Singapore as Seagate Singapore.

Then, Seagate US started buying disk drives components and also some portion of hard disk
drives, of its total sales. The diagram above shows, how the transfer pricing was done and the
way profit was shifted to the subsidiary (low tax in this case) company. Then while practicing it,
there occurred some issues of transfer pricing. IRS claimed that transactions between Seagate US
and Seagate Singapore were not at the arms length and that they were practicing transfer
mispricing. It revolved around the issues of royalty payments made by Singapore Subsidiary to
its parent company, payments made by parent company to the subsidiary on purchase of
component parts, payments made by parent company to the subsidiary on purchase of disk
drives.

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The royalty issue occurred because of the subsidiary company not paying enough royalty to the
host company for the use of its know-how; know- how is the use of companys logo, trademark,
method of operation, engineering techniques, etc. According to IRS, Seagate Singapore should
have paid Seagate US at least 3% of royalty on the total sales for the use of its know-how. This
would value the benefit of the royalty arrangement at arms length. But the issue arose since;
Seagate Singapore only paid 1% royalty to its host country. Seagate US argued on this issue by
keeping its point that the need of additional 2% royalty did not exist because of the relative
insignificance of trade names and trademarks in the disk drive industry and because of the other
issue shown in the reason in a diagram given below;
Seagate US Argument on Royalty Issue

So on the basis of the given argument made by Seagate US about not having the necessity of
paying the additional royalty, it settled to receiving 1% royalty from its subsidiary as it did
before.
The second issue that occurred was related to pricing component parts, at first, Seagate US used
its own standard costs as the transfer price for buying components and disk drives from Seagate
Singapore. Later, it changed to the standard costs of Seagate Singapore plus a markup of 25%
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and they did not adjust for difference between actual and standard costs. So the setting of price
was very uncertain and unclear. Seagate Singapore also sold some components to the unrelated
disk manufacturers, one of them was Bull Peripherals, and to evaluate this issue, the data
related to this unrelated party was taken into account and comparison was made.
With the help of the profit earned by Seagate Singapore on its sale to Bull Peripherals and on its
overall transactions, it was found that there was no significant difference between the profit rates
(as shown in the figure), so the practice of transfer pricing was found to be on the arms length.

The third issue was related to pricing disk drives. Seagate US purchased disk drives from
Seagate Singapore and resold them to third parties. It also offered 12-18 months warranty of
these products. IRS believed that with a motive of shifting profits to Singapore, it paid its
subsidiary excessive prices for the disk drives. Seagate US put forward data regarding Seagate
Singapores transactions with other unrelated parties. Based on the weighted average sale price
for these sales, contended that as per the CUP method of determination of transfer prices, the
dealings with its subsidiary had been done at arms length. Court remained skeptical of the
similarity between circumstances involving the uncontrolled sales and controlled sales, like;
volume of sales, level of market, geographic market, and timing of sales. Court was doubtful if
the usage of the weighted average sale price could be used as comparable price for controlled
transactions. Timing of sale mattered. Seagate USs contention that its transfer prices were
reasonable based on the CUP method, was turned down.
THE BIG ISSUE OF TRANSFER PRICING:
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In todays competitive world the practice of transfer pricing has increased trend. With the
increment in cross border transaction there is no room for transfer pricing to stay unattempted.
Recent surveys show that transfer pricing is amongst the most important international tax issue
that multinational companies face. Multinational companies managers point out the fact that
introspection inside the companies and auditing their files are becoming a rule rather than an
exception.
In the past recent years government authorities have taken actions on the fiscal issues caused by
transfer pricing. Government are aware of the fact that multinational companies use transfer
pricing techniques to avoid paying income and other tax and they also know that it would
involve a huge risk for the government .
So government authorities have issued certain rules and policies within which the mechanism of
transfer pricing is acceptable. These set of guidelines usually use the notion of arms length
pricing. The concept of arms length has been discussed in the starting of this case but just to
recall, it is the price that would be agreed upon by unrelated parties. But then one fact that must
be kept in mind while using the concept of transfer pricing is that the arms length price must be
similar to the transfer price.
BENEFITS OF TRANSFER PRICING:
There are certain important benefits that multinational companies face while practicing transfer
pricing across borders. Firstly it helps to lower tariffs by shipping goods into high tariff countries
at minimal transfer prices so that duty base and duty to be paid are low. When good are imported
to high tariff countries, the holding company shows that the subsidiary company is purchasing at
a lower price and the subsidiary companies show that they are buying the goods at a lower price
because of which they avoid paying high tariffs and get a tax advantage.
The second one is transfer pricing helps to reduce income taxes in high-tax countries by
overpricing goods transferred to units in such countries; profits are eliminated and shifted to lowtax countries and the next is it enhances a company's competitive position in local as well as
international market.
CHALLENGES OF TRANSFER PRICING:
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Transfer pricing can cause internal as well as well as external problems for any organization.
The first issue is performance measurement. Manipulations in the prices between the firms make
it difficult to know the actual profit and performance of the individual companies. Another
challenge faced by transfer pricing is that Tax and regulatory jurisdictions contribute to transfer
pricing problems. Pricing that is justified and reasonable in the home country may not be
perceived as such in the host country.
Thus, we can see that with a smart phone in every pocket and access to internet from virtually
everywhere 21st century companies are in constant contact with customers, suppliers and
business partners in almost any country in the world. Products fabricated or purchased in one
jurisdiction may be stored in another jurisdiction and sold to customers in a third jurisdiction.
Any business may enter into a partnership or joint venture in any other country. Support
functions like accounting, marketing or research and development, may be located in one place
but provide services throughout the organization in any of its branches.
The challenge for such global businesses is how to determine the amount of profit earned in any
given jurisdiction and how to protect the company from aggressive tax authorities that may
challenge the prices set for the sale of goods or services between businesses. This is where the
process of transfer pricing plays its role.
So now if you think transfer pricing illegal then you must know the fact that transfer pricing is
not, in itself, illegal or necessarily abusive. What is illegal or abusive is transfer mispricing, also
known as transfer pricing manipulation or abusive transfer pricing.

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