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Drug Firms Move Profits to Save Billions

Posted on August 7, 2006 by Martin A. Sullivan
      Tax issues associated with the transfer of intangibles outside the United States have been a high risk compliance concern for us and have seen a significant increase in recent years. Taxpayers, especially in the high technology and pharmaceutical industries, are shifting profits offshore.
                              — IRS Commissioner Mark Everson
                              June 13, 2006
Moving profits from the United States to low-tax jurisdictions is the way prosperous U.S. pharmaceutical companies keep their taxes low. And that domestic-to-foreign shift has clearly accelerated in recent years. By Tax Analysts' calculations, in 1999 foreign profits accounted for 39.2 percent of worldwide profits of large U.S. drug companies. By 2005 that percentage had jumped to 69.9 percent.

Corporate tax directors strive to reduce effective tax rates to bolster reported profits and stock prices. So it was bad news when Congress began in 1996 a 10-year phaseout of tax benefits for drug company operations in Puerto Rico. As a result of the phaseout, drug company possessions tax credits declined from $2.1 billion in 1994 to $500 million in 2003 (the latest year for which data are available). That should have increased the companies' taxes. But the self-help provided by profit shifting more than offset the effect of the cut in credits. In 1999 the effective tax rate on drug company profits was 27.2 percent. By 2005 the rate had dropped to 23 percent.

The rising share of foreign profits relative to total profits for the companies is shown in Figure 1. Their declining effective tax rate is shown in Figure 2. The data in the figures are from the annual reports of the nine U.S. pharmaceutical companies in the Fortune 500: Pfizer ($51 billion in revenue and number 31 on the Fortune list in 2006), Johnson & Johnson ($51 billion, 32nd), Abbott Laboratories, ($22 billion, 93rd), Merck ($22 billion, 95th), Bristol-Myers Squibb ($20 billion, 110th), Wyeth ($19 billion, 119th), Eli Lilly, ($15 billion, 148th), Amgen ($12 billion, 181st), and Schering Plough ($9.5 billion, 250th).

It's Simple

When one affiliate of a multinational corporation makes a sale or loan to another affiliate, profits are shifted. When the terms of the transactions are set so that affiliates in low-tax countries get the better deals, the low-tax affiliates get larger shares of the profits and the multinational group reduces its overall income tax burden.

Pharmaceutical companies own a lot of marketing intangibles and patents that are developed in one or just a few locations and then used worldwide. Determining fair terms for interaffiliate transactions involving intangible assets involves a great deal of subjective judgment, so those determinations are a constant source of conflict between drug companies and the IRS.

The data strongly suggest the IRS is losing the battle.

How much is the IRS losing? Determining where profits belong is never a clear-cut call, but profits generally track the location of value-creating economic activity. Sales and long-term assets, segmented by geographic location, are two measures of economic activity that are available from company annual reports. As shown in Figure 3 (on page 474), foreign assets on average accounted for 41 percent of worldwide assets and foreign sales accounted for 44 percent of worldwide assets from 2003 to 2005. If we use those measures as profit indicators, foreign profits should be roughly 43 percent of the worldwide total instead of the actual figure of 66 percent. The difference — 23 percent — is the amount of worldwide profit that arguably should be reassigned to the United States.

The nine largest drug companies had total pretax profits of $42.6 billion in 2005. If 23 percent of that number, or $9.8 billion, were shifted back to the United States and taxed at an average rate of 30 percent, the treasury would take in an additional $2.9 billion — in just one year, from just nine companies.


Figure 1. Foreign Profits as a Percentage of Total Profits,
Six U.S. Pharmaceutical Firms, 1994-2005




Source
: Annual reports from Pfizer, Johnson & Johnson, Merck,
Bristol-Myers Squibb, Abbott Laboratories, and Schering Plough.

Figure 2. Adjusted Effedctive Tax Rates
Of U.S. Pharmaceutical Companies




Source
: Annual reports of Pfizer, Johnson & Johnson, Merck,
Bristol-Myers Squibb, Abbott Laboratories, Wyeth, Eli Lilly, and
Schering Plough. All figures are unweighted averages. Averages
exclude a few reported effective tax rates that are aberrations due
to large one-time financial events or large losses that severely
distort tax rates. Figures are adjusted to remove the effects of the
repatriation provisions of the American Jobs Creation Act of 2004.


Although economists dispute the magnitude of the disparity, drug prices are generally considered to be higher in the United States than in other countries. To the extent that is true, one can make a good argument that domestic profits should be even larger and that the annual revenue loss from inappropriate transfer pricing is greater than $2.9 billion.

Now you know why transfer pricing consultants make so much money — and why Everson is so concerned.


Notes


For Figure 1, the amount of foreign and domestic income was explicitly reported by Pfizer, Johnson & Johnson, Bristol-Myers Squibb, Abbot Laboratories, and Schering Plough. For Merck, it was estimated as follows: First, worldwide income was estimated by dividing reported total tax liability by the worldwide effective tax rate. Second, domestic and foreign shares (which were reported in percentages) were multiplied by estimated worldwide income to arrive at the dollar amounts of domestic and foreign income.

Figure 3. Foreign Profits, Sales, and Assets
as a Percentage of Worldwide Totals,
Six U.S. Pharmaceutical Firms, 2003-2005 Average




Source
: Annual reports of Pfizer, Johnson & Johnson, Merck,
Bristol-Myers Squibb, Abbott Laboratories, and Schering Plough.

In Figure 2, reported effective tax rates were omitted for some companies in some years. That occurred in nine instances. Pfizer reported effective tax rates of 49.7 percent in 2003 and 35.4 percent in 2000. In both cases the reported tax rates were the result of large and extraordinary one-time costs. In 2003 large merger-related costs were incurred in connection with Pfizer's acquisition of Pharmacia. In 2000 Pfizer indicated that its reported effective tax rate of 35.4 percent would have been 23.1 percent but for the extraordinary cost. For 1998 Merck reported an unusually high 35.5 percent effective tax rate that would have been 31.5 percent without one-time costs associated with acquired research. Because of large losses in 2002, Amgen reported a -103.3 percent effective tax rate. And for the years 2003 to 2005, Schering Plough did not report an effective tax rate because, given low profits in those years, mechanical application of the effective tax rate formula would yield meaningless results.

Repatriations under provisions of the American Jobs Creation Act of 2004 require drug companies to recognize large one-time tax expenses. Companies reported those effects, and the tax rates shown in Figure 2 for 2004 and 2005 have been adjusted to remove the effects. For example, in 2005 Pfizer reported an effective tax rate of 29.7 percent. It also reported that repatriations increased the effective tax rate by 14.4 percentage points in that year. So the adjusted effective tax rate used in the calculations presented here is 15.3 percent.