Purchase price of generic unpatented APIs from associated enterprises can be benchmarked against the price of same APIs sold by other independent producers despite difference in quality
The Mumbai bench of the Income Tax Appellate Tribunal (Tribunal) recently pronounced its ruling in the case of Serdia Pharmaceuticals India Private Limited (Taxpayer), on transfer pricing issues arising from the import of Active Pharmaceutical Ingredients (API) from its Associated enterprises (AEs) for production of drugs in finished dosage forms (FDFs). The Tribunal upheld the order of the Commissioner of Income-tax (Appeal) stating that the arm?s length price of generic APIs can be computed using the Controlled Uncontrolled Price Method (CUP) as long as comparables for application of CUP are available.
Serdia Pharmaceuticals India Private Limited, a wholly owned subsidiary of Servier International BV, Netherlands and Serdia (Mauritius) Limited, Mauritius is engaged in the manufacture and marketing of pharmaceutical drugs mainly in the field of anti-hypertension and metabolism. They manufacture and market pharmaceutical drugs in Finished Dosage Forms (FDFs) for use by the end consumers. The FDFs may be in the form of tablet, liquid or gel.
The Taxpayer imported APIs from its AEs (Servier France and Servier Egypt) in the process of manufacturing the FDFs in Assessment Years (AY) 2002-03, 2003-04 and 2004-05. An API contains all the medicinal properties and is a key element and ingredient in a pharmaceutical drug. An API may be patented or generic in nature. A patented API allows the patent holder to sell the API at a premium price, allowing the company to recoup the cost involved in the course of research and development of the drug. Once the patent on an API expires in a particular geographic location, any other pharmaceutical manufacturing company can manufacture and market that API. The API then becomes generic in nature thereby ending the monopoly of the patent holder.
For the purpose of computation of arm?s length price and compliance of Indian transfer pricing regulations, the transfer pricing report was prepared and Transactional Net Margin Method (TNMM) was used as the most appropriate method. As the operating margin of the Taxpayer was more than the mean operating margin of comparable companies, the transactions with the AEs were considered to be at arm?s length.
In the course of proceedings before the Transfer Pricing Officer (TPO), the Taxpayer mentioned that the import price of the APIs is determined by the overseas entity and the Taxpayer?s judgment as regards its ability to manufacture and market the finished formulations in India using the imported raw material to generate revenues and reasonable profits. Further, the Taxpayer submitted that the AEs do not sell the APIs to any independent enterprises in India. During the course of the transfer pricing assessment, the Taxpayer had also furnished information regarding the product details of its competitors. Based on the inputs from the Taxpayer, the TPO collected information on the prices at which these APIs are purchased by other manufacturers of the competing FDFs. The TPO observed that the prices at which other manufacturers are purchasing these APIs is much lower than the price paid by the Taxpayer to its AEs for purchase of similar APIs.
The Taxpayer contended that the quality of one of the APIs i.e. Trimetazidine which is imported from AEs is of much superior quality, has higher purity levels has a longer shelf life and has been launched after clinical trials as compared to its comparables which are manufactured by competitors in India which justified the higher price paid to the AE.
The TPO was of the view that the APIs purchased by the Taxpayer from its AEs abroad was not unique in nature and similar APIs were being purchased by competitor pharmaceutical companies although from different vendors. Hence, having regard to the nature of goods and after doing certain economic adjustment for difference in quality and purity standards, the TPO considered the prices at which other producers were purchasing as Comparable Uncontrolled Price and suggested an equal to the difference in prices.
With regard to the adoption of TNMM a the „most appropriate method? (MAM) , the TPO was of the considered view that TNMM should be applied only as a method of last resort since this method is unreliable as the profits are affected by so many other aspects besides the product prices. Based on the above reasoning, TPO chose CUP over TNMM as the most appropriate method to compute the arm?s length price.
Being aggrieved by the TPO?s order, the Taxpayer filed an appeal before the Commissioner of Income Tax (Appeals) (CIT(A)). On appeal, the CIT(A) upheld the TPO?s order.
Aggrieved by the stand taken by the CIT (A), the Taxpayer filed an appeal before the Tribunal. The Taxpayer?s contentions were as follows:
• The TPO cannot reject TNMM and adopt CUP solely on the ground that CUP is the most direct and reliable method. The Revenue had not provided any logical reason for non- acceptance of TNMM method.
• APIs manufactured by the Taxpayer?s AEs, which being an innovator drug cannot be compared with the generic APIs manufactured by other enterprises. APIs manufactured by the Taxpayer?s AEs undergo extensive research and development and bear the burden of proving the safety and efficacy of the drugs through clinical trials before being used by end customers.
• The product efficacy of the FDFs manufactured by the Taxpayer is better than the FDFs manufactured using APIs produced by other enterprises. The API?s purchased by the Taxpayer from the AEs were guaranteed for quality and the AEs also provided product liability cover in respect of FDFs produced from such APIs.
• The Taxpayer also received certain technical assistance with respect to marketing FDFs in India from its AEs. Therefore, the import price also constitutes the technical services.
• The import prices paid by the Taxpayer to its AEs for import of APIs is lower than the price at which the AEs sold the APIs to third parties in other countries like Japan, Portugal etc.
• The import price of the APIs has been agreed and accepted by the Custom department in India. Therefore, the import price cannot be disregarded by another wing of the Government.
Ruling of the Tribunal
The salient aspects of the Tribunal?s order are as follows:-
• In a situation if the TPO finds that the selection of MAM is not appropriate to all the relevant factors and the facts of the case, he has the power to reject the method adopted by the Taxpayer in determining the arm?s length price with logical reasoning.
• The selection of MAM is not on the unfettered discretion of the Taxpayer and the selection should be exercised based on the Indian transfer pricing guidelines set out in section 92C(1) and read with Rule 10 C(1) of the Income Tax Act 1961.
• As per the Indian transfer pricing regulations, there is no hierarchy for the selection of methods. However, the traditional transactional methods (CUP, Re-Sale Price Method and Cost-Plus Method) have an edge over traditional profit method (Profit Split Method and TNMM). In case, both the methods can be applied in an equally reliable manner, the traditional transactional methods should be preferred over traditional profit method. The revised OECD guidelines (OECD Transfer Pricing Guidelines 2010) also support the same approach.
• The APIs imported by the Taxpayer from their AEs were not patent protected during the years under consideration and hence attributing higher price to cost and process of developing a new drug is not a cogent justification for importing the APIs at a higher price. Therefore, FDFs manufactured by the Taxpayer in the post patent period are expected to compete with the FDFs manufactured by the generic drugs manufacturers based on the selling prices and market demand.
• The good manufacturing practices and high quality standards followed by the Taxpayer?s AEs provide some degree of comfort; however, the same does not affect the comparability with similar generic APIs.
• The Taxpayer?s reliance on the Federal Court of Appeals of Canada?s ruling in the case of GIaxo Canada was not accepted by the Tribunal. In the case of Glaxo Canada the comparison of generic API prices with the API produced by the innovator of the drug was not considered appropriate on the basis of commercial compulsions contained in the “license agreement” under which Glaxo Canada was under an obligation to purchase APIs at a higher price and also enjoyed the benefits of use of brand name and access to portfolio of other patented and trademark products. This was a distinguishing factor as compared to the Taxpayer?s case. However, the observations of the Federal Court of Appeal that business realities like the necessity to import the API from a particular company for the right to use the brand name (in the instant case “Zantac”) etc. seems not to have been dealt with by the Tribunal.
•The overseas judicial pronouncements although are not legally binding, deserve utmost consideration as they are given by eminent judges after detailed analysis.
• Acceptance of the import price by the Custom department does not justify that the import price is accepted to be at arm?s length from the transfer pricing perspective and the onus lies on the Taxpayer to justify the arm?s length price by following the mechanism prescribed as per the transfer pricing regulations.
• The prices at which the APIs were sold by the AEs to third parties in other countries cannot be compared due to certain geographical differences and non-furnishing of adequate supporting information.
• The Taxpayer had not made out a claim for higher adjustment than those allowed by the TPO on account of differences in quality and purity. The Taxpayer may make a claim for higher economic adjustments on account of differences in quality etc. after proper justification in future.
Conclusion:- Apart from the direct bearing on the transfer pricing approach of the pharma companies that import APIs from their AEs, the ruling provides guidance on several important aspects of transfer pricing jurisprudence: preference of CUP over TNMM, irrelevance of customs valuation, persuasive value of foreign rulings, economic importance of an intangible like patent and the requirement to select the most appropriate method under the relevant rules.