Administrative Appeals Tribunal DECISION AND REASONS FOR DECISION [2008] AATA 639 ADMINISTRATIVE APPEALS TRIBUNAL No NT2005/7, NT2005/56 to 65 TAXATION APPEALS DIVISION ROCHE PRODUCTS PTY LIMITED Applicant COMMISSIONER OF TAXATION Respondent DECISION Tribunal Place Sydney Decision
The decision of the Commissioner of Taxation is set aside.
There is substituted a decision that Roche Products Pty Ltd had a tax loss of
$6,002,410 for the year ended 30 June 1993.
The matter is remitted to the Commissioner for further consideration, with a
direction that the Commissioner reassess in accordance with the reasons for
The decision of the Commissioner of Taxation is set aside.
There is substituted a decision that Roche Products Pty Ltd had a tax loss of
$5,346,138 for the year ended 30 June 1994.
The matter is remitted to the Commissioner for further consideration, with a
direction that the Commissioner reassess in accordance with the reasons for
The decision of the Commissioner of Taxation is set aside.
There is substituted a decision that the taxable income of Roche Products Pty
Ltd for the year ended 30 June 1995 is $14,114,666.
The matter is remitted to the Commissioner for further consideration, with a
direction that the Commissioner reassess in accordance with the reasons for
The decision of the Commissioner of Taxation is set aside.
There is substituted a decision that Roche Products Pty Ltd had a tax loss of
$2,205,879 for the year ended 30 June 1996.
The matter is remitted to the Commissioner for further consideration, with a
direction that the Commissioner reassess in accordance with the reasons for
The decision of the Commissioner of Taxation is affirmed.
The decision of the Commissioner of Taxation is set aside.
There is substituted a decision that the taxable income of Roche Products Pty
Ltd for the year ended 30 June 1998 is $8,573.
The matter is remitted to the Commissioner for further consideration, with a
direction that the Commissioner reassess in accordance with the reasons for
The decision of the Commissioner of Taxation is set aside.
There is substituted a decision that the taxable income of Roche Products Pty
Ltd for the year ended 30 June 1999 is $10,631,460.
The matter is remitted to the Commissioner for further consideration, with a
direction that the Commissioner reassess in accordance with the reasons for
The decision of the Commissioner of Taxation is set aside.
There is substituted a decision that the taxable income of Roche Products Pty
Ltd for the year ended 30 June 2000 is $972,633.
The matter is remitted to the Commissioner for further consideration, with a
direction that the Commissioner reassess in accordance with the reasons for
The decision of the Commissioner of Taxation is set aside.
There is substituted a decision that the taxable income of Roche Products Pty
Ltd for the year ended 30 June 2001 is $14,507,929.
The matter is remitted to the Commissioner for further consideration, with a
direction that the Commissioner reassess in accordance with the reasons for
The decision of the Commissioner of Taxation is set aside.
There is substituted a decision that the taxable income of Roche Products Pty
Ltd for the year ended 30 June 2002 is $20,760,681.
The matter is remitted to the Commissioner for further consideration, with a
direction that the Commissioner reassess in accordance with the reasons for
The decision of the Commissioner of Taxation is set aside.
There is substituted a decision that the taxable income of Roche Products Pty
Ltd for the year ended 30 June 2003 is $20,496,425.
The matter is remitted to the Commissioner for further consideration, with a
direction that the Commissioner reassess in accordance with the reasons for
CATCHWORDS TAXATION - income tax - transfer pricing – application of Division 13 of Part IIA, Income Tax Assessment Act 1936 (Cth) or international treaties – conferral of power by international treaties to impose tax – “arm’s length” prices for pharmaceutical products – transfer pricing methods – comparable transactions - conflicting expert opinions - assessment excessive – assessment set asideAdministrative Appeals Tribunal Act 1975 (Cth) s 43 (1)Income Tax Assessment Act 1936 (Cth)ss 136AD(3) and (4), 170 (2), (7), (9B), (9C), (14), 175A International Tax Agreements Act 1953 (Cth) Schedules 5,5A, 15
Patents Act 1952 (Cth)s 93(b)
Taxation Administration Act 1953 (Cth) ss 14ZYA, 14ZZ, 14ZZK, 14ZL(1)
Agreement Between Australia and Switzerland for the Avoidance of Double Taxation with Respect to Taxes on Income [1981] ATS 5 Article 9Agreement Between the Government of Australia and the Government of the Republic of Singapore for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income [1969] ATS 14 Article 6
Bayer AG v Minister for Health (1988) 96 FLR 50
Fletcher v Commissioner of Taxation (1988) 19 FCR 442 Green v Minister for Immigration and Citizenship [2008] FCA 125
Jones v Dunkel (1959) 101 CLR 298; [1959] ALR 367
McDonald v Director-General of Social Security (1984) 6 ALD 6
Shi v Migration Agents Registration Authority (2007) 158 FCR 525; (2007) 240 ALR 23; (2007) 95 ALD 260
Spencer v The Commonwealth (1907) 5 CLR 418
Stevenson v Commissioner of Taxation (1991) 29 FCR 282W R Carpenter Holdings Pty Ltd v Federal Commissioner of Taxation (2007) 161 FCR 1
REASONS FOR DECISION INTRODUCTION
This is a novel case which considers the circumstances in which transfer
prices, paid for acquisition of property by subsidiaries of multinational corporations,
can be adjusted for income tax purposes.
Roche Products Pty Ltd is a subsidiary of the multinational pharmaceutical
company, Roche Holdings Ltd of Basel, Switzerland. F Hoffman – La Roche
Limited, also of Basel, is the main operating company in the Roche Group.
The Roche Group carries on the business of selling and supplying prescription
pharmaceuticals, over the counter pharmaceuticals and diagnostic products
including diagnostic equipment and reagents. The prescription pharmaceutical
business is based upon research and development. The Roche Group has other
associated activities, but they are not relevant to these proceedings. Roche
Australia relevantly carries on business through three divisions, reflecting the
Like all multinational pharmaceutical companies the Roche Group largely
confines its sales of prescription pharmaceuticals to sales through its subsidiaries.
The same is also generally true of its other activities. As Roche Australia concedes,
these sales are not arm’s length sales.
The Commissioner of Taxation has assessed Roche Australia to income tax
on the basis that amounts paid by Roche Australia to Roche Basel were more than
the amounts which would be paid in arm’s length transactions. The issue in this
case is whether the Commissioner’s assessments are excessive. I have decided
that they were. I have substituted lower increases.
Testing whether the Commissioner’s assessments are excessive requires the
establishment of a benchmark for arm’s length sales against which the actual prices
can be tested. This is never an easy task. In this case it is particularly difficult.
Where there is a substantial free market for goods it will not usually be difficult
to find at least a range of prices for arm’s length transactions against which prices
paid by a subsidiary to its holding company can be measured. However, in the
present case, difficulties arise, because there is no substantial free market and
because it is difficult to find any comparable sales.
Pharmaceutical companies rarely sell their products through third parties.
That means that there is generally no free market in which the products in question
are sold. It also means that there is generally no free market for even potentially
comparable products. There are a few cases in which free markets for the same or
similar drugs can be found. However, these markets are generally very small.
Patent protection accrues to pharmaceutical products in their generic names.
However, the patent holders generally market their products under a brand name
which is different. The purpose for this is the legitimate business purpose of
developing goodwill or brand loyalty which attaches to the brand name and not to the
generic name. When the product is no longer protected by patent the patent owner
is able to extend its monopoly to some extent because no competitor entering the
market can use the established brand name. This object is assisted by the fact that
pharmaceutical products are generally not identifiable by appearance. The brand is
The task of a pharmaceutical company launching a new product is to bring its
therapeutic properties to the notice of the public and to the medical profession which
will prescribe the product. Companies seeking to enter the market to sell a
prescription pharmaceutical no longer covered by patent have different marketing
problems. Their product will not appear to be the same as, and will have a name
different to, the original product. The original product will be well known. The
newcomer will need to link the established product with their product. It will need to
attract pharmacists to recommend brand substitution to patients and to interest
medical practitioners in recommending or permitting brand substitution.
The result is that while the best method to determine the arm’s length price for
the sale of particular products would seem to be to determine what such products
are sold for elsewhere, this is a particularly difficult task with pharmaceutical
products. First, comparable sales are hard to find. Secondly, when they can be
found, they will generally relate to marketing processes linked to varying retail
THE TAXATION SCHEME
12. The Commissioner relies upon two alternative bases to support the
assessments. The first is found in the Income Tax Assessment Act 1936 (Cth). The
second is found in article 9 of the Agreement Between Australia and Switzerland for the Avoidance of Double Taxation with Respect to Taxes on Income [1981] ATS 5
and article 6 of the Agreement Between the Government of Australia and the Government of the Republic of Singapore for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with Respect to Taxes on Income [1969] ATS 14,
which are given effect to by the International Tax Agreements Act 1953 (Cth). The
Swiss Treaty is contained in schedule 15 of that Act, while the Singapore Treaty is
contained in schedules 5 and 5A. There is a question in this case, to which I will
come later, as to whether the double tax treaties confer power on the Commissioner
to assess income tax at all. For the present, however, I will assume that they do,
while I undertake an assessment of the operation of the relevant provisions. The
Singapore Double Tax Treaty is relevant because some goods were sold to Roche
Australia from Singapore. However, the parties accept that the Treaties are
Section 136AD of the Assessment Act applies to acquisitions of property and
operates where “the Commissioner… is satisfied that the parties to the agreement…
were not dealing at arm’s length with each other in relation to the acquisitions”
(s 136AD(3)(b)). In such circumstances, where the “consideration exceeded the
136AD(3)(c)), the Commissioner may apply the
section in which event “consideration equal to the arm’s-length consideration… shall
be deemed to be the consideration given… by the taxpayer” (s 136AD(3)).
Two relevant aspects of the operation of the section are that it applies to
“acquisitions” and that it employs a test which operates by reference to “arm’s-length
Article 9 of the Swiss Double Tax Treaty and article 6 of the Singapore Double
Tax Treaty operate when an “enterprise” in one country participates in the
“management, control or capital of an enterprise” in another country. In such a case,
where “conditions operate… which differ from those which might be expected to
operate between independent enterprises dealing wholly independently with one
another, then any profits which… might have been expected to accrue… may be
included in the profits of that enterprise and taxed accordingly”.
It can be seen that these tests differ in two significant respects from the tests
in s 136AD. First, the treaties are concerned with “profits” and not “acquisitions”.
Secondly, the treaty test refers to “independent enterprises dealing wholly
independently” rather than parties “dealing at arm’s-length”.
Nevertheless, the parties spent little time dealing with the words of either set
of provisions and effectively accepted that the same result would obtain whichever
was applied. It was pointed out that the concepts of “independence” and “arm’s-
length” are almost interchangeable and that variations in acquisition costs for goods
will have a direct effect on profits. This may mean that little point is served in my
determining whether the double tax treaties authorise the Commissioner to make
assessments of tax in accordance with their terms. For the present, I will deal with
the matter primarily on the basis that I am applying s 136AD.
METHOD OF ASSESSING TRANSFER PRICES
Because Roche Australia accepts that its relevant acquisitions were not at
arm’s length I can go straight to the question whether they exceeded arm’s length
The obvious starting point is to look for actual arm’s length transactions,
preferably for the same goods in the same market. Where there are no arm’s length
sales of the same goods in the same market it may be possible to find very similar
goods or a very similar market. Then, the question is whether the goods or markets
are sufficiently comparable and whether any, and if so, what, adjustments can be
accurately made to compensate for any differences. This approach is a common
one for valuers, particularly real estate valuers, and is described in the multitude of
cases following the decision of the High Court of Australia in Spencer v The
Dealing first with the prescription pharmaceuticals market, there are arm’s
length sales by Roche of some of the precise products which are under
consideration, but the sales were broadly made at the end of the period of patent
protection to generic wholesalers. The question is, whether these sales are
comparable. Can they be made more comparable by adjustment? There are also
arm’s length sales of a Roche product to a subsidiary of a rival pharmaceutical
company. These sales were early in the life of the drug and relate to a product
which needed to be established in the market. To that extent the sales are closer to
many of the sales in question here, but it is claimed that the drug in question is
atypical. Problems of this kind may require the employment of other methods to
arrive at arm’s length values. However, retreats to other methods, while avoiding
one problem, are prone to result in the substitution of other problems, possibly more
serious. In general terms, problems arising from comparables being atypical might
be met by looking at a greater number of potential comparables. This may even out
the differences. The problem with this approach, however, is that the very evenness
leads to an average which may not be a comparable at all. The legislation is
concerned with actual arm’s length consideration, not the averaging of a range.
These are just some of the problems which must be examined relating to the
Prescription Division. Different problems arise with respect to the Consumer Division
The history of a matter under review is usually irrelevant to its outcome.
However, that is not so in this case. The evidence cannot be understood without an
understanding of its history and the impact that it has had, right up to final
submissions, on the way the parties support their claims.
Of course, the taxpayer bears the burden of proving that the assessments are
excessive (s 14ZZK of the Taxation Administration Act 1953 (Cth). If the taxpayer
does not discharge this burden then the assessments will be affirmed. The focus
must accordingly be upon the evidence presented to the Tribunal and particularly the
taxpayer’s evidence. This is notwithstanding the decisions to the effect that the
concept of onus is a common law concept applicable to litigation and not to
administrative decision-making (see McDonald v Director-General of Social Security (1984) 6 ALD 6 and subsequent cases). The reality is that if the Tribunal, on appeal,
is not satisfied on the balance of probabilities that an assessment is excessive, the
appeal will fail. In considering this it will have regard to all of the evidence.
Attributing the consequence to a failure to satisfy a burden does not really add
This might be thought to make the evidence and the reasoning of the
Commissioner irrelevant on review. However, the evidence before the Tribunal in
the present case and the way the matter has previously been dealt with are so
inextricably linked that the history needs to be recounted.
On 2 September 1998 a Deputy Commissioner of Taxation wrote to Roche
Australia care of its accountants to inform it that the Australian Taxation Office was
intending to undertake a transfer pricing record review or audit of the company. The
audit took a substantial time, concluding with the issue of amended assessments for
Assessments issued in 2004. Amended assessments, giving effect to the objection
decisions, were issued in 2005 and 2006. In making the assessments the
Commissioner drew on material in an expert report prepared in December 2004 by
Dr Deloris Wright of Lakewood, Colorado in the United States of America.
26. In August 2006 an expert report was prepared for Roche Australia by
Dr Daniel Frisch of Washington, DC in the USA. In preparing this report Dr Frisch
had access to material which had not been available to Dr Wright. In particular, he
had access to material and calculations prepared for Roche Australia by Mr Murray
Hammond who had been retained by Roche Australia to advise and assist in dealing
with the transfer pricing issues. A statement containing material prepared by
Mr Hammond was filed in the proceedings. In his report, Dr Frisch was critical of
27. In 2007 a further report was furnished by Dr Wright which addressed
Dr Frisch’s report. In addition, Dr Brian Becker, also of Washington, DC, furnished
the Commissioner with a report addressing Dr Frisch’s report. Finally, Dr Frisch
prepared a further report responding to the second Wright report and the Becker
report. A final short report by Dr Frisch was presented at the hearing.
The significance of this chronology of events is that the reports were not
based on the same material. The later reports had regard to additional material,
particularly Mr Hammond’s material. The reports of Dr Frisch and Dr Becker
responded to this additional material by employing different methods to Dr Wright.
This process was compounded by the emergence of further material at the hearing
which caused the Commissioner, in his final submissions, to invite me primarily to
act on that material, so far as the Prescription Division case is concerned, and to
evaluate that material myself, although with some guidance from the methods
I will explain what this means in a little more detail. So far as the Prescription
Division is concerned, Dr Wright initially had no material relating to acquisitions
which could be assessed as comparable. Accordingly, she proceeded by looking for
companies with comparable activities and worked back from gross profit margins or
mark-ups of such companies to an appropriate adjustment of income. Dr Frisch had
access to material relating to the sales of some of Roche’s pharmaceutical products
to generic wholesalers. Dr Frisch and Dr Becker worked primarily from this material.
During the hearing the Commissioner sought to rely on material relating to Roche
Basel sales of a patented drug, Inhibace (cilazapril), for resale by the subsidiary of a
rival pharmaceutical company. Some material relating to this product was available
prior to the hearing, but there was further evidence about it during the hearing. The
experts were aware of the product prior to the hearing, certainly Dr Frisch was, but
Notwithstanding the way the evidence developed and the way it was relied on
changed, particularly by the Commissioner, I was never informed that the
Commissioner no longer relied on any part of the earlier evidence, though I enquired
Accordingly, the evidence of all the experts was before me. I was taken to the
evidence in the order in which it was prepared. The experts then gave short oral
evidence and were cross-examined in accordance with the order suggested by the
burden provision, namely Dr Frisch first, followed by Dr Becker and Dr Wright.
Approached from any perspective this is not a simple case. Approached from
many perspectives, which is how it was handled before me, it is a very complex
Transfer pricing issues relating to taxation are apparently highly sophisticated
and highly complex in the United States. Each of the experts is an economist
specialising in the field. Their approach to the issues before me must have been
coloured by their United States experience. At times I wondered why Australian
experts could not have approached this matter with just as much skill as the experts
from the United States but without some of the presumptions which their work must
have led to. Unfortunately, none of the experts were either asked to, or did, directly
address the provisions of either the double tax treaties or the Assessment Act. Had
they done so my task might have been easier. There was, however, a good deal of
reference to the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (1995) issued by the Organisation for Economic Co-operation and
Development of which Australia is a member. It may now be appropriate to turn
THE OECD TRANSFER PRICING GUIDELINES
The relevant tax treaty provisions relied upon before me are based on
Article 9 of the OECD Model Tax Convention. Like the tax treaty provisions the
Convention refers to “independent enterprises”. The Guidelines describe this as “the
arm’s-length principle” (Art 1.6). They equate arm’s-length dealings with the conduct
The Guidelines begin by explaining the importance of comparison (Art 1.15)
although material differences between what is compared should be taken into
account (Art 1.17). They begin by identifying “traditional transaction methods” of
which three types are identified (Art 2.1):
The name of the first method describes its content: comparing the controlled
price between related parties with an uncontrolled price between independent
parties. Various matters are to be addressed to ensure that the prices are
comparable. These are relatively obvious and may not add anything to the test itself.
For example, no differences between the transactions or enterprises should
materially affect price, unless accurate adjustments can be made.
The resale price method takes the resale price of the product acquired at a
controlled price and applies an appropriate gross margin to arrive at an arm’s length
The cost plus method begins with the costs incurred by the supplier selling at
a controlled price and applies an appropriate mark-up to arrive at an arm’s length
The Guidelines describe these methods as the most direct way of establishing
an arm’s length price. They state that they are preferable to other methods (Art
2.49). The evidence in this case leads me to suggest that, when it is available, the
use of comparables might be said to be preferable to the other traditional transaction
Other methods are covered by the Guidelines. They include profit based
methods. One of these is the profit split method by which total profits are divided
between holding company and subsidiary. An alternative is the transactional net
margin method. It is described as follows (Art 3.26):
“The transactional net margin method examines the net profit margin relative to an appropriate base (eg costs, sales, assets) that a taxpayer realizes from a controlled transaction (or transactions that are appropriate to aggregate…).”
The margin is ideally “established by reference to the net margin that the same
taxpayer earns in comparable uncontrolled transactions” (Art 3.26).
THE PRESCRIPTION PHARMACEUTICAL MARKET
The prescription pharmaceutical market is highly regulated. Prescription
pharmaceuticals cannot be marketed without approval from a Commonwealth
agency, the Therapeutic Goods Administration. New entrants into the market will be
subject to close scrutiny by this Authority as well as by its equivalents throughout the
world. Marketing permission will not be granted without significant evaluation
relating to safety and efficacy. This, in turn, requires animal trials, trials in healthy
human volunteers and, most importantly, significant clinical trials. Some clinical trials
are undertaken by Roche Australia although these have ceased to be relevant to
Most sales of prescription pharmaceuticals in Australia are made through the
Pharmaceutical Benefits Scheme. Under this scheme patients pay a fixed price for
drugs which are subsidised by additional payments to dispensing pharmacies under
the scheme. Approval to market a prescription pharmaceutical in Australia does not
automatically include it in the scheme. Two Commonwealth agencies are involved.
The Pharmaceutical Benefits Advisory Committee decides if the drug merits being
included and the Pharmaceutical Benefits Pricing Authority determines the price if it
does. Drug companies are free to market approved prescription pharmaceuticals
outside the scheme but, because the prices will generally substantially exceed the
subsidised prices of the scheme, they rarely do. Drugs dispensed in hospitals are,
One of the witnesses was Frederick Nadjarian. He has been the Managing
Director of Roche Australia for more than 20 years. Mr Nadjarian gave evidence,
which I accept, that, generally, two factors interact to determine the prices approved
by the Pricing Authority. First, the Authority generally allows a markup of about 30
percent over stated cost. Secondly, where products with similar therapeutic
properties were already on the market, it seeks to fix prices of new entrants at the
This is how the market operates for patented products during most of their
patent life. At the end of the patent life of successful products, and sometimes
before the end of that life, new companies enter the market with products containing
the same active ingredients as the successful products. These companies are
usually called generic companies because they cannot use the established brand
name and because they often sell the product by its generic name. Sometimes they
Pharmaceutical companies selling under patent need to develop a demand for
their product. In the case of a drug which has unique and positive therapeutic effects
this will be easier than with a drug whose properties are similar to those of an
existing drug. Consumer advertising is normally not permitted. Accordingly,
promotion centres around informing medical practitioners and the health industry
generally about the properties of the drug. This often involves direct marketing to
medical specialists and general practitioners. This is known as detailing.
46. The issue for generic companies is different. The drug may be well
established by its brand name. What is required is attracting medical practitioners
either to prescribe the drug by its generic name or to authorise brand substitution as
well as attracting pharmacies to dispense the generic preparation and to encourage
customers to accept the generic. Detailing may be some part of this process but it is
apparently primarily concerned with attracting pharmacists to dispense generics by
offering them incentives such as rebates, discounts and the supply of bonus stocks.
The entry of generics into the market place tends to drive prices down.
THE BUSINESS OF ROCHE AUSTRALIA
Generally speaking the business of Roche Australia is to establish, develop
and maintain marketing outlets in Australia for its Swiss parent. That part of the
business which is relevant to these proceedings is carried on through three divisions,
namely, the Prescription Division, which imports and sells Roche prescription
pharmaceuticals mainly through major drug wholesalers, the Consumer Division,
which sells over the counter products and the Diagnostics Division which sells
diagnostic equipment and products such as reagents.
THE PRESCRIPTION DIVISION
The most significant division in Roche Australia is the Prescription Division. It
markets Roche’s major prescription pharmaceutical products in Australia. Some of
the products are protected by patents. Others no longer have patent protection.
At the beginning of the period covered by the amended assessments Roche
Australia marketed a number of core products. They included Valium (a nerve
relaxant and sleeping tablet), Mogadon (a sleeping tablet), Bactrim (an antibiotic),
Rohypnol (a sleeping tablet) and Lexotan (for anxiety and tension). Newer products
were Roaccutane (isotretinoin) (for severe acne) and Hypnovel (an injectable
sedative). The newest products were Aurorix (moclobemide) (an anti depressant),
Rocephin (an injectable antibiotic) and Rocaltrol (calcitriol) (an osteoporosis
treatment). Aurorix was launched in Australia in 1992 at the beginning of the audit
period. It was protected by patent until 1997.
Roche Australia received the products in manufactured form. It did, however,
perform some secondary manufacturing and packaging in Australia. This was,
however, much greater in the Consumer Division than the Prescription Division.
Most prescription drugs were received in finished form ready to be distributed.
Prescription drugs are generally marketed by being prescribed by medical
practitioners. Sales representatives visit doctors and discuss three or four products
with them. However, the time of doctors is limited and sometimes the discussions
are superficial. Roche Australia, through Mr Nadjarian, developed a practice of
representatives focussing on one product. This practice began with Rocephin. It
was successful. Roaccutane, Aurorix and Rocaltrol were then included. The method
was more labour intensive and required a larger sales team. It was more expensive.
Between 1993 and 1995 sales of Aurorix, Rocaltrol and Rocephin more than
doubled and sales of Roaccutane grew by more than half. Thereafter, with the
approval of Roche Basel, Roche Australia developed a marketing strategy which
built on Mr Nadjarian’s strategy by identifying and concentrating on products with
THE CONSUMER DIVISION
The Consumer Division of Roche Australia sold medicines which did not
require prescriptions. They are often known as “over the counter” products. Many of
the products were imported although the local manufacture and packaging content
was greater than in the Prescription Division.
54. Included in the Consumer Division were products named Rennies
(indigestion), Interdens (oral hygiene), Aspro (headaches and pain), Aleve (pain
relief) and Elevit (multivitamins for pregnancy). These products were imported.
They were called in the proceedings “Category 1 products” and treated separately.
The significance of this was controversial. It seems that the Category 1 products
were identified for separate consideration during the audit period. Roche Australia
says, however, that there never was any agreement or arrangement that their
55. Other Consumer Division products in the Division included Berocca, a
multivitamin precursor of energy drinks which was very successful until its sales
began to be eroded by emerging energy drinks.
THE DIAGNOSTICS DIVISION
The Diagnostics Division sold diagnostic equipment and preparations, such as
reagents, for use with the equipment. These were products used by hospitals and
medical laboratories in providing pathology and other services.
Roche Australia followed the practice of selling or leasing its equipment at full
value while permitting purchasers to source preparations such as reagents
competitively. Other companies sold equipment at reduced prices upon condition
that all preparations and reagents were purchased from them.
58. Most of the Roche products were old during the reassessment period
although it also marketed Polymerase Chain Reaction technology which rapidly
copied genetic material and which it had acquired in 1991. This technology showed
The Diagnostics Division was never particularly successful. In 1994 Roche
Basel suggested that it be closed down. Mr Nadjarian decided against this course in
the belief that it would become successful and the hope that the Division could be
sold as part of a global sale of the Diagnostics Division. The Division was
restructured and began to show promise. By 1997 sales were twice what they had
been in 1993 although this was affected by equipment write downs. In 1998 Roche
acquired the Corange Group and transferred its Australian Diagnostics Division to
Boehringer Mannheim Australia Pty Ltd, which was part of that group.
THE EXPERTS’ EVIDENCE DR DELORIS WRIGHT
The first report of Dr Deloris Wright was prepared in December 2004 to assist
the Commissioner in determining the outcome of the objections. The report breaks
up the activities of Roche Australia into the three divisions identified above.
PRESCRIPTION DIVISION
Wright discussed the most appropriate method to employ. She
acknowledged that “the best way to determine arm’s length prices is always the
comparable uncontrolled price… method because these prices represent the price
that unrelated companies agreed upon under the same, or similar, circumstances
with each party negotiating at arm’s length and under no obligation to deal”.
However, she did not employ this method because she did not have access to any
relevant transactions. The best transactions were transactions with one party from
the Roche Group and the second best transactions were transactions between
parties unrelated to the Group. Neither were available.
Next Dr Wright referred to the resale price method and determined that this
was the most appropriate method to employ for the distribution and marketing
activities of the Prescription Division. As will appear, however, because of the lack
of information she had, she was not able to employ this method by reference to
actual sale prices. Dr Wright decided that the cost plus method was the most
suitable for the Prescription Division’s involvement in clinical trial management and
Dr Wright introduced her analysis with a reference to profit based methods
including the transactional net margin method. She noted that transactional based
methods were preferable to profit based methods. She said she used transactional
based methods to arrive at her results and then verified this with the use of profit
Wright divided the activities of the Prescription Division into three
components: clinical trials, secondary manufacturing and distribution and marketing.
I will outline the process she followed.
She first identified contract research organisations which specialise in the
management of clinical trials. She identified these through three companies
providing data bases on the internet for a fee. These threw up 591 companies. By a
process of analysis she discarded 580. She gave very few details of this process.
Eleven companies met her criteria. Five companies appear to have been added
from past searches. Fourteen of the companies were in the United Kingdom.
Material was collected relating to the markup for each of the years 1992 to
2002 for the sixteen companies. The results ranged from +24.8 percent for one
company in 2002 to -20.0 percent for another company in 1997. However these
outliers were discarded in favour of the interquartile range of 3.7 percent to
11.3 percent with a median of 7.9 percent. She concluded that a markup in this
It will be noted that not only does this method not use sales by Roche
companies it does not use sales at all. It uses calculations of markup from the
internet. The companies examined were companies whose business was providing
clinical trial services pursuant to contract. That is not, of course, what Roche
Australia did. Although Dr Wright attempted to find companies whose activities were
comparable to those of Roche Australia it must have been difficult to know precisely
how much was outsourced in each case she selected and whether it was
comparable to the work Roche Australia carried out. It also occurs to me that
different arm’s length results may be obtained in a company providing only one of a
group of services such as clinical trials, secondary manufacturing and distribution
and marketing, compared with a company providing all of those services. The one
service company may make a greater markup because it is a specialist while the
multi service company may make a greater markup because of the comprehensive
service it supplies. The important matter is not which one of these, or some other
alternative, is true, but simply that the availability of such considerations damages
Dr Wright then turned to secondary manufacturing. She made a similar
search with the same databases for companies providing secondary manufacturing
services to pharmaceutical companies or “Formulate, Fill, Finish” (FFF) services as
she called them. She examined 1,440 companies and rejected 1,438 of them. The
remaining two companies were a French company and a Canadian company. Only
the French company yielded markup figures for the whole period. The range was
from 2.6 percent to 30.2 percent with an interquartile range of 10.4 percent to
17.9 percent. The median was 12.6 percent. She concluded that a markup in the
Many of the observations I have already made apply equally to this analysis.
There is the added problem that the sample from which the range is taken is very
small. The range of 2.6 percent to 30.2 percent is the range for the French
company. Dr Wright accepts that company as a comparable. It follows that a very
large markup range can be found in a company operating at arm’s length.
Finally, Dr Wright examined the distribution and marketing function. She
began with the distribution function. This time she was seeking to apply the resale
price method. She first of all looked for comparable companies in Australia but failed
to find any. Next she looked at 17 other countries which she felt were comparable to
Australia. Again, she could not find companies which carried on functions sufficiently
comparable to the activities of Roche Australia, partly because they did not carry out
the detailing or direct marketing through medical practitioners. Dr Wright ultimately
decided to draw her figures for the distribution and marketing function from different
Starting with distribution Dr Wright looked at independent pharmaceutical
distributors who purchased from unrelated manufacturers. She first excluded
Australian companies as not useful. She then looked at the 17 countries she had
previously identified. She established that operating margins (interquartile of 0.9
percent to 2.3 percent for 1992 to 2002) across the countries involved did not show
significant variation. This satisfied her that she was on the right track.
Dr Wright next identified 1080 companies. All but 25 were rejected. However,
companies isolated in prior searches were added to make the total 49. The 49
companies yielded an interquartile gross margin range of 6.1 percent to 9.2 percent
with a median of 7.5 percent. The gross profit to selling, general and administrative
ratio (Berry ratio) was calculated. This indicated that markup on cost was fairly
Dr Wright then stated that an adjustment needed to be made for “carrying cost
of inventory and net accounts receivable”. She did not have the information to make
the adjustment but stated that it was usually small, although it could be quite large in
the present case due to the extended payment terms which Roche Basel gave to
Roche Australia. She also stated that adjustments needed to be made for functional
In the result Dr Wright arrived at adjusted gross margins of -7.7 percent to
13.4 percent an interquartile range of 7.6 percent to 9.2 percent and a median of
8.3 percent. Converted to operating margins the range was -14.3 percent to
6.8 percent, the interquartile range was 1.0 percent to 2.6 percent and the median
It is to be noted that Dr Wright said she was employing a cost plus method to
arrive at figures for clinical trial management and secondary manufacturing. Hence,
she uses markup figures. For distribution and marketing she used the resale price
method. Accordingly, she used operating profit. Nevertheless the operating profits
she determined were derived from the gross margins. It is difficult to see that there
is any real difference in the methods as applied by Dr Wright. Of course, the
methods would be quite different if actual transactions, rather than information taken
from financial records, were being used. The method used by Dr Wright is not really
a transaction method but rather a profit based method, with all their disadvantages,
marketing expense. She divided this role between
selling and marketing. Selling included the actual detailing; marketing was more
concerned with developing the market. She began with marketing. She chose
eighteen countries including Australia. From 265 companies she rejected 258,
leaving seven. Six of the companies were from the United States and one from
Canada. They included well known international advertising agencies. This process
yielded a markup range of 2.9 percent to 23 percent with an interquartile range of
9.0 percent to 15.9 percent and a median of 13.1 percent.
Next she turned to selling. She chose companies from a list of 1,069. They
were all United States companies. They provided various services to the
pharmaceutical industry including outsourced sales. These companies yielded a
markup range of -1.7 percent to 16.5 percent with an interquartile range of
3.3 percent to 10.3 percent and a median of 6.6 percent. Dr Wright ultimately chose
the top end of the range “because I believe that to be the appropriate mark up”.
Dr Wright then brought together the components she had identified in an
arm’s length gross margin range of 43.2 percent to 45.8 percent with a median of
44.4 percent. As a reality check she calculated the interquartile range of operating
margins which came out at 4.1 percent to 6.7 percent with a median of 5.4 percent.
CONSUMER DIVISION
Dr Wright then turned to the Consumer Division. She was only asked to deal
with the Category 1 products. She chose to use the resale price method. She
employed her usual method of identifying companies from commercial data bases.
She had already looked for independent companies carrying out distribution and
marketing of pharmaceutical products without success. She next searched for
independent distributors of fully finished unpatented products in Australia. Finding
none, she looked at the 17 countries to which she had previously had resort when
determining distribution margins in the Prescription Division. She determined to use
The results at which Dr Wright arrived are slightly different to her prior results
because she used the years 1992 to 2002 for her first set of calculations and 1994 to
2004 for the second set. The results are accordingly close to, but not identical with,
the figures she had obtained before. The unadjusted interquartile gross margin
range is 6.0 percent to 9.1 percent with a median of 7.5 percent and for operating
margins is 0.9 percent to 2.2 percent with a median of 1.6 percent. The adjusted
figures for gross margins appear to be 60.9 percent to 62.7 percent with a median of
61.7 percent and for operating margins are 3.9 percent to 6.9 percent with a median
of 5.6 percent. She acts on the operating margin percentages. I note that the
DIAGNOSTICS DIVISION
Wright dealt with the Diagnostics Division. As usual, she
commenced by searching for comparables in Australia. She looked for independent
distributors of diagnostic products. She found none. She went to the 17 countries.
She found none. However, 10 of the 47 distributors of pharmaceutical products also
distributed diagnostic products. She used the 47 distributors as her comparables.
82. The comparables yielded an adjusted overall gross margin range of
percent to 22.5 percent with an interquartile range of 16.5 percent to
18.1 percent and a median of 17.2 percent. The adjusted operating margin range
overall was -12.5 percent to 8.6 percent with an interquartile range of 2.6 percent to
4.2 percent and a median of 3.3 percent. These figures were finally adjusted to
gross margins of 59.2 percent to 63.7 percent with a median of 61.4 percent and
operating margins of 4.5 percent to 9.0 percent with a median of 6.7 percent which is
DR WRIGHT’S CONCLUSIONS
At the end of her 2004 report Dr Wright produced a table which showed the
effect of her conclusions on the revenue of Roche Australia. In simplified form it is
Prescription Division Distribution & Marketing Low Medium High Clinical Trials Secondary Manufacturing Consumer Health Division
Diagnostics Division Total Operating Profit $76,468,586 $103,131,231 $131,222,371 DR DANIEL FRISCH
Dr Daniel Frisch prepared his first report in August 2006. He had seen a copy
of Dr Wright’s report. He had considerable further information available to him which
came to form at least part of the statement of Mr Hammond. In particular, he had
access to information relating to sales by Roche Basel to Roche Australia and by
PRESCRIPTION DIVISION
Dr Frisch based his calculations on three products. Between 1996 and 2003
they were sold by Roche Basel to independent wholesalers in Australia. The
products are Rocaltrol (calcitriol) Roaccutane (isotretinoin) and Aurorix
(moclobemide). They were sold to Alphapharm Pty Ltd, Arrow Pharmaceuticals Ltd,
Hexal Australia Pty Ltd and Biochemie Australia Pty Ltd. They are all so-called
generic pharmaceutical companies. The patent for Aurorix expired in January 1997.
The patent for Roaccutane had expired in 1987. Rocaltrol had no Australian patent
Dr Frisch accordingly applied the comparable uncontrolled price method. The
drugs were identical in their active ingredients to the drugs sold by Roche Basel to
Roche Australia. Dr Frisch considered that the volumes sold were sufficient for the
sales to reflect arm’s length prices. However, some adjustments were necessary.
First, prices paid were not always in the same currency. These had to be converted.
Secondly, Roche Australia purchased the tablets in blister packs while the
independent parties purchased 30 kilogram drums. Roche Australia paid by the
pack; the independent parties paid by the kilogram. Thirdly, it was necessary to
adjust for packaging costs. Fourthly, the payment terms were different. Finally,
adjustment may have been necessary to account for any brand premium payable
under the Pharmaceutical Benefits Scheme.
87. Applying his method to sales of calcitriol, isotretinoin and moclobemide
Dr Frisch arrived at results which are included in Attachment 1. The results record
the final figures which Dr Frisch adopted. The attachment also shows comparative
figures for Dr Becker. The comparable is the highest price paid by the generic
For calcitriol the highest annualised price paid by the generics was higher
than the price paid by Roche Australia in every year. Dr Frisch concluded that the
price paid by Roche Australia was lower than the arm’s length price. The same
conclusions applied to the 10mg tablets of isotretinoin and the 300mg tablets of
moclobemide. It is to be noted, however, that figures were not available for generic
sales in every year. The figures covered every year from 1998 to 2003 for calcitriol
and from 1996 to 2003 for 20mg isotretinoin, but only from 2001 to 2003 for 300mg
moclobemide. The results were mixed for the other two products, namely 20mg
isotretinoin and 150mg moclobemide. The sale price to Roche Australia of 20mg
isotretinoin was less than the highest generic sale in 1996 to mid 2000, higher
between then and the end of 2002, but lower for 2003. For 150mg moclobemide the
sale price was lower in 1997 and 1998, higher from then to the end of 2002, but
When the figures are averaged Roche Basel overall paid less than the total
arm’s length prices for all the products surveyed. Dr Frisch argued that in complex
business dealings actual arm’s length prices will vary. He concluded that because
the prices paid by Roche Basel were predominantly less than arm’s length prices
“Roche Australia’s transfer prices for these products should be regarded as arm’s
length from Australia’s perspective”.
Rocaltrol, Roaccutane and Aurorix represented about 21.5 percent of Roche
Australia’s prescription sales. Dr Frisch calculated the gross margin percentage
earned by Roche Australia for the products and compared that with the gross margin
percentage for the other products. Dr Frisch found “no systematic difference
between the… prices” and concluded that his finding that the prices for the
comparable products were less than arm’s length should be applied to all products
Dr Frisch dealt separately with the income earned by Roche Australia for
conducting clinical research on behalf of Roche Basel. He agreed with the approach
taken by Dr Wright and relied on her determination and calculations. This shows
that from 2000, when Roche Basel increased its fee from 1.5 percent to 5.00 percent
the amount paid to Roche Australia was arm’s length. Since the average was also
within the range, Dr Frisch concluded that the fees paid overall were arm’s length.
CONSUMER DIVISION
considered that it was not appropriate to deal only with the
Category 1 products. This was because “a company that markets and distributes a
manufacturer’s products does not make decisions by considering each product or a
small group of products in isolation”. He concluded that the entire range of Roche
Australia’s products in the Consumer Division should be considered. He considered
that the correct question was whether “an arm’s length party [would] have been
satisfied with the profitability of Roche Australia[’s]… overall portfolio of products”?
Notwithstanding the logic of this approach I note that it does not seem to be
consistent with the essence of the enquiry which relates to acquisition prices for
Roche Australia’s Consumer Division had an overall operating profit margin of
8.1 percent measured as the ratio of earnings before interest and tax (EBIT) to sales.
Dr Frisch considered this to be a high rate of profit. He concluded that the overall
operations of the division were such that the prices for the products, as a whole,
were arm’s length. An arm’s length company, he said, would be prepared to carry
on business with the unprofitable prices paid provided it could continue to receive the
profitable lines at the same prices. Again, this does not seem to be the correct
question. Well it might. But the question is not whether it would continue but
whether the prices it was paying were arm’s length.
DIAGNOSTICS DIVISION
This Division was financially unsuccessful. The reasons were specific to
Roche Australia and apparently included the practice of permitting purchasers of
Roche equipment to source supplies of the products and reagents to be used with
the equipment from third parties. This might have been an advantage but apparently
Dr Frisch concluded that not only was it not profitable to use any of the
transaction based methods it was also not possible to use the profit based
transactional net margin method. In place of these conventional methods he simply
inquired “whether Roche Australia[’s]… management made decisions and took
actions that were consistent with what arm’s length parties might have done in the
same circumstances”. Dr Frisch concluded “that Roche Australia[’s]… experiences
and transfer prices during income years 1994 to 1999 may well have been consistent
with the experiences that an arm’s-length party would have had in the same
DR FRISCH’S CONCLUSIONS
Dr Frisch concluded that all of Roche Australia’s relevant activities were arm’s
DR BRIAN BECKER
Dr Brian Becker’s first report was prepared in August 2007. It commented on
the reports of both Dr Wright and Dr Frisch.
PRESCRIPTION DIVISION
Dr Becker adopted the same approach as Dr Frisch except that he confined
his analysis to the Alphapharm transactions and he excluded the sales of isotretinoin
20mg. These sales were excluded because they were relatively low. Alphapharm
generally had a market share of less than five per cent for this product. It generally
had the lowest market share of all of the preparations it purchased from Roche.
Nevertheless, the absolute quantities of isotretinoin 20mg which Alphapharm
purchased were much larger than the quantities of isotretinoin 10mg. The quantities
were at least 10 times greater and sometimes much greater than that. In 1999, for
example, Alphapharm purchased 7 kilograms of isotretinoin 10mg and 433 kilograms
of isotretinoin 20mg. Yet Dr Becker excluded the 20mg purchase and included the
With this exclusion, Dr Becker found that “Roche Australia did purchase the
presentations at prices consistent with those paid by the unrelated parties”.
However, the sales matching the comparables covered only eight of the years under
consideration and the comparables matched only some of Roche Australia’s
products. Dr Becker did not take the step of finding that a like conclusion could be
drawn with respect to the other products and years. He undertook a gross margin
100. Dr Becker found that Roche Australia earned a combined gross margin of
40.5 percent on the comparable sales in the eight years in which there were
comparable sales. He excluded the sales of isotretinoin 20mg. He found that the
gross margin on non-comparable products averaged 35.5 percent. The difference of
5.0 percent, when applied to the value of sales which were not used in the
comparables calculation, amounted to $65,530,000. Dr Becker then excluded
moclobemide from his comparables. This gave a gross margin of 46.1 percent.
Applying the different gross margin of 10.5 percent and making the same calculation,
the price adjustment increased to $138,075,000. After applying validating tests
Becker concluded that the appropriate amount was the adjustment of
101. Dr Becker could not find any comparable transaction to assist him with
assessing the clinical research activities of Roche Australia. He turned to
comparisons of profitability. He chose eleven companies. The middle 50 percent of
these, or the interquartile range, “earned an average mark-up on their costs (from
1992-2002) of approximately 5.0 percent to 11.8 percent with a median of
6.4 percent”. Dr Becker chose the median. Applying that to the actual mark-up by
Roche Australia he concluded that the clinical trial profit should be increased by
CONSUMER DIVISION
102. Dr Becker again employed a profitability approach because of the absence of
comparable transaction prices. He chose eleven companies. These were not the
same eleven as he had previously used. They reported operating profit margins with
an interquartile range of 1.2 percent to 2.7 percent with a median of 1.7 percent.
The figure for Roche Australia was -9.3 percent. Applying the differential of about
11.0 percent yielded an adjustment of $11,957,000.
DIAGNOSTICS DIVISION
Becker used the same approach again, this time identifying five
comparable companies. The interquartile range for the comparable companies was
1.2 percent to 4.7 percent with a median of 4.6 percent. Comparing this with the
Roche Australia figures he arrived at an arm’s length adjustment of $10,138,000.
DR BECKER’S CONCLUSIONS
104. Dr Becker summarised his adjustments (somewhat rounded) to $89.8 million
which would represent an overall arm’s length operating profit margin for Roche
MR MURRAY HAMMOND
105. Mr Murray Hammond also provided an expert report. However, Mr Hammond
was retained by Roche Australia to assist it in the preparation of its case.
Accordingly, the report was not the report of an independent expert. Nor was it the
report of an economist experienced in transfer pricing issues. It was the report of a
financial analyst. Nevertheless, the content of the report was little criticised and
cross examination on it was not extensive. The report does contain a collection of
primary material relating to the financial activities of Roche Australia. It also contains
a comparative analysis of the Alphapharm transactions. It compares product and
strength with like product of the same strength.
106. In line with the analysis of Dr Becker the analysis of Mr Hammond shows that
the Alphapharm purchases were largely for more than the purchases by Roche
Australia. It shows a period when isotretinoin 20mg was sold to Roche Australia for
more than the price to Alphapharm. It also shows a slight excess in the price to
Roche Australia for moclobemide 50mg. Similar analysis of sales to Arrow, Hexal
INHIBACE AND QUINODIS
107. One of the Roche Group’s products is the drug Inhibace (cilazapril). It also
108. In 1995 Inhibace was a new drug. Roche Basel was keen for it to be
launched. According to Mr Nadjarian, Roche Basel considered it to be a profit driver.
It thought it would be successful. The Roche Group annual report for 1993 said it
“showed strong sales growth”. This statement was replaced in the 1994 report with
a reference to “strong volume growth”. However, Mr Nadjarian did not wish to
market the drug in Australia. He did not think it would make money.
109. In March 1996 Roche Basel entered into an agreement with Bayer AG for
110. In April 2006 René Maier, the head of international pricing at Roche Basel,
sent an email to Mr Hammond commenting on the Inhibace agreement. He said that
the tablets were invoiced to Bayer AG in Swiss Francs “… at 40 percent of the
Australian wholesale price…”. This was in response to an email from Mr Hammond
suggesting that they were sold “at a rate that was 35 percent of the price to the
wholesaler giving them a 65 percent Gross Margin”. A spreadsheet prepared by
Mr Hammond supports a 65 percent gross margin. The agreement was a gross
margin contract under which it was expected that the margins would remain the
same. The wholesale price upon which it was based was the price paid by the
111. Mr Hammond did not make any calculations with respect to the Inhibace
agreement. He said “… we were not to use it…”. Dr Frisch was aware of the
Inhibace agreement, but he did not use it. He gave the following reasons for not
“[Roche] told me about the arm’s length transactions with Alphapharm, etcetera, and they said, By the way, there are these – there’s Inhibace, and they told me about another one, Quinodis I believe, and I said, Well, are those significant transactions or are they immaterial transactions and idiosyncratic one-off transactions? And it was clear to me that Inhibace was not – in no way could be thought of as, you know, a major drug… Fred didn’t even – Fred – Mr Nadjarian didn’t even want to bother with it. So I made the judgment that this was not going to be an important – no way was this expected to be an important drug for Australia or for Roche or for anyone, and instead it’s one of these isolated one-off transactions that, you know, I – I didn’t think was even worth pursuing as being representative of the important drugs that Roche Australia was carrying.”
While I do not doubt that this reflects what Dr Frisch was told, and appears to accord
with the views expressed by Mr Nadjarian in his evidence, it does not reflect Roche
112. In other parts of his evidence Dr Frisch said that it was his practice “to use
everything… It’s all arm’s length information, let’s use it all.” He also agreed that “it
is possible that Inhibace was comparable to some of the drugs that Roche Australia
QUINODIS
113. There is evidence that Quinodis was a drug which the Roche Group proposed
to market in Australia. In a letter in 1993 Mr Nadjarian said that Quinodis would
“hopefully be launched in 1994 but would not contribute a great deal to growth until
the year after”. The evidence suggests that there was a proposal that the drug
should be marketed by the Bayer Group, like Inhibace. However, no agreement was
produced; nor were any other records relating to the marketing of the drug. The drug
may never have been marketed in Australia.
THE CORRECT APPROACH THE PRESCRIPTION DIVISION
114. I can understand that, at a time when the Commissioner was conducting an
audit of Roche Australia, without financial data for what might be comparable sales,
he would seek expert advice based on general financial information from an expert
such as Dr Wright. However, that information will always be second best to
information relating to actual sales. After all Division 13 is concerned with costs of
acquisition of property. Even the double tax treaties, in a case such as the present,
will operate on sales although any adjustment will relate to profit. This is because
the costs of sales affects profit directly. It was not argued on the part of the
Commissioner that the double tax treaties justified some wider approach.
115. Apart from admitting to an intuitive belief that the way to evaluate transfer
prices is to look at comparable prices at arm’s length, rather than comparing
different aspects of the subject’s business to a range of other businesses, there
seem to me to be more concrete reasons why the evidence of Dr Wright relating to
the Prescription Division is no longer of particular assistance, given the presence of
other evidence based on actual transactions:
The method she used requires multiple subjective determinations which admit
The method requires the use of figures derived from the overall results of
companies assessed to be comparable, to determine profit components of
part of the activities of the subject. This is because adequate figures relating
to divisions of potentially comparable companies are not generally available.
This aspect admits the possibility of further error. The profitability of single
purpose companies will not necessarily accord with the profitability of
The method requires the drawing of profit figures from the results of many
companies. These produce statistical averages and not real or actual results.
116. During the hearing I was specifically informed on behalf of the Commissioner
that reliance continued to be placed on the first report of Dr Wright. This position
conflicts somewhat, at least so far as the Prescription Division is concerned, with the
following statement in the Commissioner’s final submissions:
“There now is direct evidence before the Tribunal which would enable it to decide whether the prices paid by the applicant to Roche Basel for products acquired by its [Prescription] Division were consistent with the correct arm’s length consideration. In respect of the [Prescription] Division it is submitted that the expert evidence now has only indirect relevance; it is but a ‘sanity check’ for any conclusion that is drawn from the direct evidence.”
The Commissioner’s position, at the time of submissions, was to rely upon the
Inhibace agreement as the only comparable product. This is the direct evidence
referred to. Dr Wright did not deal with Inhibace because she did not deal with any
direct comparable. Neither did Dr Frisch, although he was aware of the Inhibace
117. I have come to the conclusion that Dr Wright’s method is not of any real
assistance in dealing with the Prescription Division. In addition to the problems I
have found with her method, I also found problems with Dr Wright’s application of the
method. Part of this follows from the problems I find in the method. For example,
she was driven to use the profitability of advertising agents to determine a level of
profit for the marketing aspect of sales and marketing. She explained this on the
basis that 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”. 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. The advertising
agency may be dealing, for example, with a media advertising campaign for coffee.
That does not seem to me to be comparable to a pharmaceutical company
deliberating internally on how it might best train and equip a group of sales
representatives to make the best out of detailing its pharmaceutical products.
Wright separated sales from marketing and arrived at
cumulative profitability figures for both activities. I have difficulty in accepting that
such an approach may not overstate appropriate profitability when the subject
carried out both activities in-house and without any apparent internal division.
119. There was one aspect of Dr Wright’s evidence which particularly troubled me.
In addition to treating sales and marketing both separately and cumulatively,
Dr Wright applied the top of the interquartile range for selling expenses. She
accordingly chose 10.3 percent by contrast with the median of 6.6 percent. She
chose the median in other cases. The explanation she gave for this in her initial
report was “because I believe that to be the appropriate mark-up”.
120. In her evidence in chief Dr Wright was asked to explain further. She began by
saying that the figures her researchers had picked up were “very volatile”. Further
research showed that the companies were “entering new business”. This part of her
explanation only highlights the inherent problems in the method to which I have
“This is where my experience in the pharmaceutical industry came to bear. In the last 25 years I have been working for pharmaceutical companies. This is the only case I have had that has worked against the industry. There has not been a single time in that 25 years that I haven’t had at least one pharmaceutical company client and the analysis that you see in this report is the same analysis that I have done for those companies. Because I had access to the company resources I knew and know what kinds of contracts exist. I know how pharma companies deal with contract sales forces. I know what the results are likely to be. If you say with Quintiles [a company providing services to the pharmaceutical industry], you see that in the period ‘96 to ‘99 that the operating margin is in the 9 to 10 per cent range in each one of those years. I know that that is about right for the third party contracts that I have seen. So what I chose to do was to let that knowledge override the allocation of corporate overhead expenses that was creating the volatile operating margins.”
121. It is to be observed that Dr Wright was using companies which contracted with
the pharmaceutical industry as a means of determining the selling cost components
which would enable her to arrive at operating profit. Her method depends upon
finding proper comparables. Yet, here, she seems to have abandoned the exercise
in favour of anecdotal knowledge from dealing with pharmaceutical companies. She
gave no further details. This approach does not seem to me to be appropriate for an
expert such as Dr Wright. This is particularly so when it contradicts the figures which
have been derived from a complex process which should, by definition, be reliable.
Yet the figures were readily departed from without any proper, justified basis.
Dr Wright made no effort, for example, to collect or present the figures on which her
122. Dr Wright arrived at a median mark-up of 5.4 percent for Marketing and
Selling expenses. This is by far the largest component in the increased taxable
incomes leading to the amended assessments. The total amount flowing from
Dr Wright’s calculations for marketing and selling based on the median figures
(subject to the median for selling being shown as 10.3 percent) is $80,037,151 and
the figure applied was 5.4 percent. The proportion related to selling was 1.9 percent.
This is derived by taking 10.3 percent of the percentage of selling expenses to sales.
Had Dr Wright chosen the actual median of 6.6 percent the figure would have been
1.21 percent and the amount of $80,037,151 would have been reduced by
approximately $10,000,000. This is a substantial sum to depend upon anecdotal
123. In the result I do not gain any direct assistance in determining the ultimate
matters before me relating to the Prescription Division from either the method
employed by Dr Wright or her implementation of it.
124. That leaves me with the possibility of using comparable sales which, in any
event, all the experts, including Dr Wright, considered to be the preferred method.
125. The problem is identifying the comparable sales and making appropriate
adjustments. In the present case there do not seem to me to be any large issues
relating to adjustments. There was one issue as to whether the terms of payment
available to Roche Australia warranted an adjustment, but no other substantial
issues arise. The main issue is what are the appropriate comparables. The dispute
surfaced at two levels. First, were the generic sales of isotretinoin, moclobemide
and calcitriol comparable sales and was the Inhibace sale a comparable sale? The
parties adopted opposing positions. To Roche Australia, only the generic sales were
comparable. To the Commissioner, only the Inhibace sale was comparable.
Secondly, within the generic sales should any sales, such as isotretinoin 20mg, be
excluded? Before looking in detail at specific sales it seems sensible to look at the
126. There is a significant amount of evidence relating to what was called “the 30
per cent rule”. As described by Mr Nadjarian this was “an unwritten… rule that
everyone knows that when you try and list a product on the PBS if you have a
margin that is greater than 30 per cent, that can be one of the reasons… to reject
approval of the product at the price you requested”. It seems, however, that the
Pharmaceutical Benefits Scheme had to act on the applicant’s figures.
127. The evidence of both Mr Nadjarian and Mr Maier was that the prices which
Roche Basel required Roche Australia to pay were calculated from a gross profit
128. The agreements for the sales to the generic companies were negotiated to
realise a 40.0 percent gross margin. For example, Mr Nadjarian agreed that “what
happened in practice was that a contract with Alphapharm is negotiated, and if not
negotiated it has certainly been implemented after negotiations based upon a gross
129. There was ultimately no dispute over the figures presented to me. The
dispute concerned the way in which they should be used. A slight confusion does
arise because Roche Australia prepares its accounts on a calendar year and not a
Frisch’s figures are nearly the same as
Dr Becker’s, Dr Frisch refers to an income year and Dr Becker to the calendar year.
Accordingly, for example, the identical figures appear under 1995 for Dr Frisch and
1994 for Dr Becker. In addition, Dr Frisch did not include figures for income year
1993. This is because no detailed income statement was available for the 1992
calendar year. Dr Becker took the actual sales, assumed that costs and margins
were the same as in 1993 and made his calculations accordingly. By definition, he
arrived at the same margin for 1992 as he calculated for 1993. This leads to a slight
difference in margin expressed as a percentage between Dr Frisch and Dr Becker
for the total period under consideration.
130. A further confusion arose in relation to the inclusion of period costs in the
calculation of gross margins. Period costs are defined by Mr Hammond in his
statement as “balancing figures that make up the difference between the cost of
goods sold in Roche Australia’s product contribution report with the cost of goods
sold in the individual accounts.” Dr Becker observed that Dr Frisch, in calculating the
gross margins in his first report, did not consistently account for period costs.
Dr Becker pointed out that because period costs could not be assigned by product
for each year, Dr Frisch excluded these costs from his resale price analysis for the
years 1998 to 2002. Dr Frisch did not, however, exclude these costs for the years
1993 to 1997. This meant that Dr Frisch compared gross margins on comparable
products (without period costs) to gross margins on non-comparable products (with
period costs). Dr Frisch, in his second report, acknowledged this error, and ultimately
agreed with Dr Becker’s figures for the total sales and cost of goods sold by Roche
131. The average gross margin achieved by Roche Australia in its Prescription
Division was 37.54 percent (Dr Frisch) and 36.1 percent (Dr Becker). This margin
does not reflect clinical trials. The sole cause of the difference is the inclusion of
figures for calendar year 1992 by Dr Becker. The gross margin he arrived at for that
year was 36.6 percent which reproduces the agreed gross margin for calendar year
132. The gross margin figures for each year, subject to the above comments, are
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002
36.6% 36.6% 38.0% 31.0% 31.1% 33.8% 40.7% 36.7% 38.7% 34.5% 37.5%
133. The method employed by both Dr Frisch and Dr Becker was to compare the
profit margin earned with what they found to be a comparable arm’s length profit
margin. They took an average profit margin for all years as that comparator,
although asking themselves the question whether this was a fair approach. While
the approach may be reasonable for an expert considering whether there is evidence
of transfer pricing at other than arm’s length prices, I do not think that the
Commissioner or this Tribunal can ultimately act on that basis. This is because the
task of both the Commissioner and the Tribunal is to consider taxation assessments
for separate years. The focus must be on the separate prices in each of the years
under consideration. It accordingly seems to me to be necessary to look at each
year separately and to the gross profit margin in each year.
134. The controversial question is what products should be used as comparables.
The Commissioner primarily asserts that Inhibace should be the sole comparable. If
this approach were to be accepted the conclusion is simple. If Roche Australia
should have paid a price for its prescription drugs in each year which would return a
gross margin of 60 percent or 65 percent then in each year under consideration the
present assessments would be based on an understatement of Roche Australia’s
income. The assessments would plainly not be excessive.
135. The position becomes more complicated when the experts’ opinions are
addressed. It is to be remembered that none of the experts considered Inhibace.
Becker considered third party sales of isotretinoin,
136. The third parties who acquired the three drugs were Alphapharm, Arrow,
Hexal and Biochemie. Dr Frisch considered all strengths of the drugs sold to all of
these companies. He made adjustments to compensate for packaging and other
differences to enable comparison with the prices paid by Roche Australia. Dr Becker
undertook the same exercise except that he relied only on the sales to Alphapharm
and only on some of them. He made adjustments “which were essentially the same
as the adjustments performed in the FRISCH REPORT”.
137. Both Dr Frisch and Dr Becker prepared adjusted prices for the generic sales.
However, the adjusted results are little different although they slightly favour the case
of Roche Australia. The unadjusted prices appear in Attachment 1. There prices are
used for ease of comparison although I have also examined and compared the
adjusted prices. Where the figures for Dr Frisch show a range there was a price
138. The parties made no effort to resolve the differences between the experts’
figures. This was no doubt because the differences were not substantial and the
time and effort involved would not have been productive. The figures broadly lead to
139. The prices paid for the three drugs by Roche Australia were, on average, less
than the prices paid by the generics and they were less in most, but not all,
instances. A particular exception is isotretinoin 20mg in 2000 and 2001.
140. The technique chosen by both Dr Frisch and Dr Becker was to isolate
comparables, adjust them and then compare the comparables with the prices paid
by Roche Australia for the same drugs. Dr
comparables. Dr Becker primarily relied on all the Alphapharm purchases other than
141. Dr Frisch concluded that Roche’s purchases of the comparable drugs were at
arm’s length prices because the overall purchase prices for the comparable drugs
exceeded the prices Roche Australia paid overall, though not for every drug in every
year. In other words, the average prices they paid were less than the average prices
142. That left the prices paid for drugs for which there were no comparable drugs
to be assessed. Dr Frisch originally calculated that the average percentage gross
margin earned by Roche Australia on the drugs with comparable prices was
37.1 percent. The average percentage gross margin earned on the other drugs was
37.0 percent. Dr Frisch concluded that the difference was immaterial and it was
“valid to conclude that, since the transfer prices for the [comparable] products were
arm’s length, the transfer prices for the non-[comparable] products were arm’s length
143. Dr Becker raised issues relating to Dr Frisch’s calculations of 37.1 percent
and 37.0 percent, including the period costs. Dr Becker concluded that the actual
margins were 37.2 percent and 35.8 percent. Dr Frisch accepted the corrections
and the reasons for them, but said that they did not affect his conclusion.
144. Dr Becker undertook a similar exercise to Dr Frisch with the Alphapharm
drugs other than isotretinoin 20mg. This yielded comparisons of 40.5 percent and
35.5 percent for the gross margins for the comparable drugs and the non-
comparable drugs. The difference of 5 percent, applied to sales of the non-
comparable drugs of $1,309,246, lead to an uplift in profit of $65,530,000.
145. The comparative figures are set out in Attachment 2.
146. The approach of Dr Frisch was to include all generic sales of comparable
products. That seems to me to be a principled approach. It removes one area of
subjective decision-making. All arm’s length transactions are included. It is
accepted that Roche Australia had a wide range of products and market sizes.
There will be anomalous or atypical sales but the generic sales under consideration
do not seem to me to fall into that category.
147. I was troubled by Dr Becker’s excluding isotretinoin 20mg. He did this
because of the low market percentage which Alphapharm had with the product. He
equated this with “low volumes”, making it less appropriate to use the purchase as a
“pricing benchmark”. The reality is, however, that the absolute sales of isotretinoin
20mg were quite high. It is plain that the market for the 20mg presentation was
much greater than the market for the 10mg presentation. In 1999 Roche Australia
sold 5,520kgs of the former and 97kgs of the latter. Alphapharm purchased 433kgs
of the 20mg presentation and 7kgs of the 10mg presentation. It struck me as
surprising that acquisitions of 433kgs in one year would be excluded on the ground
that the volume is low while acquisitions of 7kgs would be included. I find it hard to
believe that one quantity should be included on the grounds of low volume although
a quantity 60 times as great was excluded. The argument that the market
percentage is what matters does not seem to me to be persuasive.
148. The issue of whether isotretinoin 20mg should be excluded is quite important
because it is one of the few drugs which Alphapharm was able, for a time, to acquire
more cheaply than Roche Australia. Excluding isotretinoin 20mg from the bases
changes the average profit margin of Roche Australia on the comparables from
149. I propose to explore the experts reasoning further without excluding
isotretinoin 20mg from the comparables to be considered. I do not think that a better
approach would be to exclude both isotretinoin presentations. I accept Dr Frisch’s
opinion that as many comparables should be included as possible. This is
particularly so in a case, such as this, in which comparables are hard to find. I
accept that atypical transactions should be excluded, but I do not find either
isotretinoin presentation to be in that category. Nor do I think that moclobemide
should be excluded, although Dr Becker has raised the possibility. In any event,
excluding both isotretinoin and moclobemide would unnecessarily reduce the base
from which the comparisons are to be made.
150. I accordingly prefer Dr Frisch’s method of dealing with the sales of isotretinoin,
moclobemide and calcitriol to that of Dr Becker, and accept that Roche Australia
earned a gross margin from those sales of 37.2 percent and a gross margin of
35.8 percent from the other sales. If there were nothing more, like Dr Frisch, I would
find that Roche Australia’s purchase of the comparable products were arm’s length
purchases and that, at most, the balance of sales required an uplift of 1.4 percent
151. However, my task is to arrive at a decision as to what were arm’s length
prices for the acquisitions in question. I will be guided by the words of the legislation
extracted above. The experts’ opinions will assist me, but they are not
determinative. I must arrive at my own decision. That may require me to look at
other matters, provided that they are relevant and probative.
152. The Commissioner relies particularly on two matters. The first is the Inhibace
sales. The second is the low level of profitability of Roche Australia generally. The
Commissioner says that the Inhibace profit margin should be taken as the sole
guide. I do not agree with that, but I do not think it can be dismissed. The general
profit level of Roche Australia is of less significance but I consider that I can refer to
it. It also seems to me that I can have regard to the evidence relating to the
structuring of the generic sales to Alphapharm, namely that they were generally
structured to yield a profit margin of 40 percent.
153. Dealing first with profitability, the evidence is that the gross profit margin for
the Roche Group’s Prescription Division was 75 percent. This is contrasted with
Roche Australia’s 36.1 percent. However, it is necessary to note what it is that the
parent division is marketing by comparison with the subsidiary. Roche Basel owned
the intellectual property associated with the drugs. It is the intellectual property
which is really the product, not the pill or capsule by which it is dispensed. The
intellectual property included patent rights. The intellectual property came from very
substantial expenditure on research and development, much of which would have
produced no results. The profits from the exploitation of the intellectual property
rights was something to which Roche Basel had a special claim even though the
profit would be collected for Australian sales by the Australian subsidiary. The
distinction between the two types of profits is discussed in the patent extension
cases such as Bayer AG v Minister for Health (1988) 96 FLR 50 where they are
referred to as “the profits of the patentee as such” (s 93(b) of the Patents Act 1952
(Cth)) and manufacturing or distributing profits (see p 69). In the absence of a
substantial market for arm’s length sales of prescription pharmaceuticals it is not
easy to determine how a subsidiary should be rewarded for its part in the marketing
of the intellectual property component of prescription pharmaceuticals.
154. The retail market for pharmaceuticals is quite unique. There are two
important factors which contribute to this. First, many drugs sold in the market are
patented. Accordingly, some participants are entitled to use monopolist conduct in
their marketing. However, not all drugs have this patent protection. Secondly, drugs
can only be sold to persons for whom they have been prescribed by a medical
practitioner. General media advertising is largely prohibited.
155. New patented drugs need to be launched and promoted. Although a
pharmaceutical company may have a monopoly, it does not follow that there are not
other drugs, also protected by patent, which are used to treat the same conditions.
Some drugs are destined to be successful because they involve a considerable
advance in heath care. Other drugs will need more promotion. Further clinical trials
are among the methods used to assist in establishing a reputation. Promoting drugs
through detailing them to medical practitioners is another practice.
156. The marketing of older drugs at the end of their patent life is different. No
doubt the patentee continues promotion through detailing. Medical practitioners are
likely to be encouraged to continue prescribing the established brand: Roaccutane
rather than isotretinoin; Aurorix rather than moclobemide; Rocaltrol rather than
calcitriol. However, independent generic companies, like Alphapharm, will be
entering the market either because the patent protection has expired or because the
patentee is prepared to wholesale the drug to give it some control over the wider
marketing of the drug near the end of its patent life in anticipation of other companies
157. Because the period covered by the assessments under consideration is
eleven years, the activities of Roche Australia cover the whole spectrum. Indeed, a
drug could go through the whole range during a period that long.
158. The comparable drugs selected by Dr Frisch and Dr Becker are within the
latter category. Indeed, one reason why there is data relating to comparable sales is
that Roche Australia was prepared to sell the drugs to the generics. That is unusual
for a drug with potential in its early life.
159. Inhibace is much more representative of the first category. It was covered by
patent. That suggests it might provide a balance to the comparable sales to the
generics. However, Roche Australia says Inhibace is atypical and should be
disregarded. Setting aside the fact that it yielded a much higher gross margin than
the comparable sales which Roche Australia wishes to rely on, what reasons do they
160. Mr Nadjarian says he did not want to market the drug in Australia. He thought
the market was oversupplied with competitors. He did not think it would be
profitable. He says that subsequent events bore this out because Bayer Australia
ceased to sell it. Nevertheless, Roche Basel thought it was a “profit driver” which
would be successful. An assessment of whether the price for which it was sold was
an arm’s length price will depend more upon whether the patentee thought it would
be successful than upon whether the patentee turned out to be correct. In any
event, the sale stands as a de facto arm’s length sale of a drug that was marketed in
Australia. Dr Frisch said that there may have been similar drugs in Roche Australia’s
portfolio. His approach of including everything might well have led him to including it
in his analysis had not Mr Nadjarian said that it should be disregarded.
161. It seems to me that Inhibace is a drug to which reference should be made.
However, I need to be very careful in its use because the evidence about it is limited
and because the experts did not deal with it. Nevertheless, there is a lot of evidence
in this case about the pharmaceutical market and the way it operates and there is
clear evidence of the gross margin basis upon which Inhibace was sold to Bayer.
162. In 1998 Roche Australia achieved a profit margin of 40.7 percent. In two other
years it achieved 38.0 percent or more. The time during which the gross margins for
the Prescription Division were at their highest was in 1998 and after. The year 1994
is an exception. There is evidence that after the audit commenced, Roche Basel
reduced its transfer prices to Roche Australia. The Taxation Department of Roche
Basel was involved. The evidence is that the prices for the sales to Alphapharm and
the other generic companies were negotiated around a predicted 40 percent gross
margin. The sales of Inhibace were made at a predicted gross margin of 60 percent
to 65 percent. All of this needs to be balanced with the average margins of 36.1
percent earned by Roche Australia from its prescription sales overall and its margin
of 37.2 percent in its sale of comparable products and 35.8 percent in its sale of non-
163. It was one thing for Dr Frisch to say that 37.1 percent and 37.0 percent were
not sufficiently distinguishable for a conclusion to be drawn that the sales that
yielded one were, and the sales that yielded the other were not, arm’s length.
However, it is another thing to come to the same conclusion about the difference of
1.4 percent between 35.8 percent and 37.2 percent. Small differences in gross
margin can reflect significant differences in price. In the present case an uplift of
1.4 percent would increase profit by more than $16,000,000 over the eleven year
164. I do not think that there is a rational basis for distinguishing between profit
margins earned by Roche Australia for comparable and non-comparable drugs. I
prefer not to calculate a gross margin for the drugs that have comparables and a
gross margin for those that do not, determine if the former is arm’s length and then
evaluate the latter. There is nothing in the evidence which suggests a different
process was adopted in pricing the drugs. It is unlikely that one group is arm’s
length and the other not. It also seems to me appropriate to have regard to the
whole of the evidence and not simply the material coming from the work of Dr Frisch
and Dr Becker. That necessarily precludes an approach which is limited to
comparing Roche prices paid for comparable drugs with prices paid for non-
comparable drugs. Whether there were comparable or non-comparable drugs is
largely a matter of accident. Using an arm’s length price for one group of drugs to
determine a profit margin for all other drugs when there is other useful evidence
does not seem to me to be appropriate. I do accept, however, that the evidence
does not permit determination of prices for individual drugs and that it is necessary to
165. When I take into account all these matters I conclude that an arm’s length
price for prescription pharmaceuticals would have yielded Roche Australia a gross
profit margin of at least 40.0 percent throughout its range. I base this conclusion on
a finding that 40.0 percent is the gross margin that arm’s length parties would
generally negotiate about. They might negotiate about a higher price. However, a
margin of 40.0 percent would still be arm’s length. This is what happened with the
generics. The Inhibace sale which, on one view, might be the closest comparable
was based on a gross profit margin of at least 60.0 percent. That might justify a
finding that the proper gross profit margin is of the order of 50.0 percent or higher.
However, I recognise that there must be a range. If all the evidence pointed to 40.0
percent it might be said that 38.0 percent was within the range. Adopting a very
cautious approach to Inhibace I find that it has the effect at least of putting 40.0
percent at the bottom of any range. I also note that the arm’s length price might not
yield the anticipated margin. Again, the Inhibace agreement leads me to conclude
that 40.0 percent remains the bottom of the appropriate range.
166. The 40.0 percent margin should be applied to each year. The resulting uplift
of profits would be as follows (figures in millions):
57,318 67,658 80,349 90,649 128,704 140,722
(36,347) (43,364) (51,603) (63,535) (82,291)
20,971 24,294 28,746 27,114 46,413 58,068 51,371 61,895
36.6% 35.9% 35.8% 29.9% 36.1% 41.3% 37.9% 39.6%
Total uplift 45,410
There should not be any adjustment for 1997 or 2000 because that would be the
same as proceeding from the averages. In any event, a generous arm’s length price
secured in one year should determine taxable income for that year and not a higher
arm’s length price attributed to other years.
CLINICAL TRIALS
167. Although the profits in this part of the Prescription Division were raised at an
earlier point in time and have been dealt with by the experts, the Commissioner no
longer relies on any aspect of these activities to support the assessment.
Accordingly, although a brief examination of this aspect of Roche Australia’s
activities was relevant to the context and background in which the matters before me
arose, I do not need to deal with them further.
THE CONSUMER DIVISION
168. The experts accept that no comparable sales are available. They are driven
169. The substantial issue between the parties is whether it is legitimate to isolate
a group of products for separate and individual treatment. Roche Australia says that
it is not legitimate to use the operating profits of chosen comparable organisations to
test the operating margins on particular products of the subject. It is argued that
individual products such as the Category 1 products cannot be separated out in this
170. The Consumer Division revenue returned an EBIT to sales percentage of
8.1 percent during the income years 1994 to 2002, which are the years in which the
Division was trading. Aspro was successful (4.2 percent) and Interdens was very
successful (40.7 percent) but Rennies (-56.6 percent) and Elevit (-55.2 percent) and
particularly Aleve (-317.9 percent) were unsuccessful.
171. Mr Nadjarian has given explanations for this situation. Interdens was very
profitable. Aspro was profitable but not as profitable. I need not trouble with what
Mr Nadjarian said about them. Much hope was apparently held for Rennies, but it
was not justified. It returned a gross profit of 44.6 percent on sales. A table
prepared by Dr Frisch, which I am not aware of having been challenged, shows the
figures. Admittedly, it covers the period as a whole. It does not isolate individual tax
years. However, it shows (the gross profit margins are mine):
172. One starts with the proposition, perhaps irrelevant, that the gross profit margin
for each drug (other than Aleve) is substantial. I say “perhaps irrelevant” because
neither the parties nor the experts appear to deal with the gross margins in this
aspect of the case. In a case in which the primary matter for concern is the cost of
acquisition of goods and not profits (subject to considerations relating to the different
tests in the double tax treaties and Division 13) this is surprising. I wonder whether
there was enough “standing back and looking at the canvas in this case” or whether
the case was too influenced by the ideas of US economists steeped in their traditions
of transfer pricing issues rather than the application of Australian legislation. In a
case involving very substantial sums with teams of two senior counsel and two junior
barristers on each side together with a hearing room containing up to 20 persons
instructing each side, with an average of not much less, on each of the 12 hearing
days, it is surprising that some of these fundamental matters were not addressed.
173. The basic reason why the experts did not address comparable purchases was
that none could be found. A second best method was chosen. However, I find it
difficult to see that addressing gross profit margins was not at least relevant,
particularly as not much time was spent dealing with operating margins in connection
174. The problem is compounded by the fact that a comparison of gross profit
margins and EBIT to sales for each of the products shows that it was the operating
expenses that caused potentially profitable operations to result in losses. This is
particularly so with Aleve and Elevit. Yet operating expenses were hardly
considered when Dr Frisch and Dr Becker were examining the Prescription Division.
175. The problems of the approach are highlighted in the submissions on behalf of
Becker ignored the overall operating margin of Roche
Australia’s Consumer Division of 8.1 percent and concentrated on the five
Category 1 products. His analysis of other companies led to the conclusion that an
operating margin of 1.7 percent would be arm’s length. He gleaned this from
undertaking a process not unlike that undertaken by Dr Wright to isolate comparable
company profits. As Roche Australia points out they were overall profits, not
profits on particular products. When the arm’s length profit of 1.7 percent is
applied to the Category 1 products an uplift of $11,957,000 is required, bringing an
EBIT of -$10,086,000 up to $1,872,000. This is to be contrasted with an uplift on the
part of Dr Wright to $6,087,904 representing an operating profit margin on EBIT to
sales of 5.6 percent if the median is taken.
176. The uplift is more than the total cost of goods sold for all of the Category 1
products except Aspro. Accepting that Aspro and Interdens both earned operating
profits which must be accepted as arm’s length the unavoidable conclusion of the
uplift proposed by Dr Wright is that the arm’s length market price for Rennies, Aleve
and Elevit should have been nothing, or, even worse, a negative price. This cannot
177. The only proper conclusion, accepting that the overall operating profit of the
Consumer Division is well in the arm’s length range, is that the acquisition prices for
the Category 1 products were arms length as well. There can be no doubt of that for
Interdens. The same must be true of Aspro. It showed a gross margin of
47.9 percent and EBIT to sales ratio of 4.2 percent, well above Dr Becker’s figure,
178. Elevit also showed a healthy gross margin of 43.0 percent. It is apparent that
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Administrative Appeals Tribunal