Vantage point – Pfizer bid ignites tax debate but fixes are distant

Analysis

Pfizer's attempt to buy AstraZeneca to trim its tax rate by establishing a UK home could well prove to be an inflection point in a debate about tax avoidance that has been rumbling on for years. If it succeeds it would be by far the largest "inversion" of a US pharma group in the ongoing rush of companies to tax-friendly countries – deals that have triggered policymakers to intensify their scrutiny.

Law change, eventually, is likely. In the US, for example, every leading corporate tax reform proposal seeks to limit companies' ability to move intellectual property to overseas subsidiaries as a tax-avoidance strategy. But with the political cycle where it is in the US, reforms are some way away.

Policymakers worldwide are showing growing concern about the consequences of shifting corporate allegiances, which many believe choke national finances and threaten domestic investments.

“It does seem absurd now that we're seeing gigantic deals like this driven by taxes rather than by more fundamentally sound economic reasons,” says John Christensen, the UK-based director of the non-partisan Tax Justice Network. “As a means of creating jobs and creating real productive investment, this is not a particularly useful strategy.”

As a strategy to boost earnings and share prices, however, investors consider it sound economics. Companies like Perrigo, Endo International and Actavis all acquired Irish-domiciled companies in 2013, seeking legal shelter through so-called inversion transactions in the jurisdiction with the lowest corporate tax rate of all the industrialised countries, at 12.5%.

Investors have backed these buyouts with significantly increased share prices; given the fiduciary duty of top executives to generate returns on investment, the incentives are clear (JP Morgan Healthcare Conference 2014 – Valeant’s success sees others copy the tax trick, January 17, 2014).

Widespread interest

In the US, several big legislative packages have been drafted that could limit the ability of pharma and biotech groups to find a new corporate home. President Barack Obama has proposed raising the hurdles to the type of inversion transaction that Pfizer is keen to achieve.

Passage of such legislation is not widely expected this year, although the proposed Pfizer-Astra deal – in which Pfizer would retain its New York headquarters even though its taxation home would be London – has triggered renewed calls from advocates who want greater controls.

“Pfizer has gotten billions in tax subsidies for research and experimentation, so the government has long supported them,” says Rebecca Wilkins, senior counsel for federal tax policy with the Washington-based lobby group Citizens for Tax Justice. “Even though they want to take advantage of all the things that the US economy, banking and capital structure offer them, they’re not willing to pay for it.”

Pfizer is not alone. Despite the US having the highest 2013 corporate tax rate of all the countries in the Organisation for Economic Co-operation and Development (OECD) at 35% – actually 39.1% if state and local taxes are included – revenue as a share of US GDP is not out of line with the rest of the OECD. In 2011, that share was 2.3%, to a 3% average across the OECD and surprisingly below the 2.5% of low-tax Ireland.

In other words, US-based groups have become very savvy in legal tax avoidance. And it is worth quite a lot: JP Morgan analyst Chris Schott estimated in January that Endo, Perrigo and Actavis would trim their corporate tax rates from 31%, 25% and 34% in 2012 to 18%, 7% and 16% respectively, post-inversion.

Alone among the leading corporate tax reform advocates in positions of power, Mr Obama is seeking to make it more difficult for US companies to do these inversions. A provision in his budget plan would require that former shareholders of the foreign company would need to own at least 50% of the combined entity.

Such a requirement would prevent a transaction like Pfizer-Astra at anything like a realistic valuation. As the deal currently stands Astra shareholders will only hold about 27% of the equity in the new company. That would meet the current law’s threshold of 20%, and the perceived threat to this thresholding rising could well have contributed to Pfizer's decision to act now.

What is income?

Inversion is just one means by which US companies can seek overseas shelter. An arguably cheaper but more sophisticated approach involves moving the effective home of individual products to overseas subsidiaries.

It makes perfect sense for pharma companies to have facilities in many countries, and a benefit of this international presence is the ability to give a product a new home in a foreign subsidiary. In the case of drugs, for example, it is the intellectual property (IP) that gets transferred to the ownership of subsidiaries as an “intangible” asset.

“It needs to be noted that all of these (IP transfer) transactions are borne of business need,” says Karen Holden, principal in international tax services for the consulting firm Ernst & Young. "For example, drug products to be sold in the (European Union) must be released by an EU company."

To execute, there needs to be access to the underlying IP – which is why companies 'transfer' IP from the US," she said. "Changes which increase the tax cost of executing on these business strategies would have a significant impact on US company's ability to compete in the global marketplace."

That may be so, but it is also clear that this strategy can have a huge impact on the profitability of the whole company. Look no further than the example of California-based Gilead Sciences. The IP for its record-shattering hepatitis C drug Sovaldi – an intangible for the purposes of corporate accounting – has been domiciled in Ireland, thanks to the group’s R&D and manufacturing facilities in Cork.

The effective tax rate for Gilead is currently 24.6%, as reported on its first-quarter 2014 earnings statement.

Because of Sovaldi’s domicile, the company has estimated that its effective tax rate will decline about one percentage point for every $1bn in sales from its hepatitis C franchise. ISI Group analyst Mark Schoenebaum has forecast that an effective tax rate of 15% could be achieved under current forecast scenarios.

How they do it

To take advantage of this ability to get around taxes legally, of course, a company needs an overseas location and the know-how to manipulate the complex revenue flows from multiple subsidiaries. Ireland has become a haven first because of its low rates and second because its “territorial” basis for taxation means that income booked outside its borders might not be taxed at all.

For example, an Ireland corporate subsidiary can then, through its own subsidiary, become resident in an even lower-tax jurisdiction like Bermuda and escape even Ireland’s low rates. Sales are booked in the non-Irish subsidiary's location and returned as royalty payments to its Irish parent. For purposes of Ireland law they are viewed as an expense deductible from taxation.

Unlike the “territorial” tax system applied by most jurisdictions, the US technically taxes on a worldwide basis, with deductions for, among other factors, taxes paid in foreign countries. However, certain rules allow US-based multinational corporations to exempt this type of revenue, which goes untaxed by foreign jurisdictions, from also being subject to US taxes.

These arrangements are something that can be achieved more easily by science-based companies that can describe income as licensing royalties, than by industrial companies selling durable goods like automobiles, for example.

“This income shifting works for companies that have intellectual property – pharmaceuticals and technology are the two big ones,” says Eric Toder, fellow and co-director of the Urban Institute/Brookings Institution Tax Policy Centre in Washington. 

Because manufacturers of durable goods cannot as easily take advantage of IP transfers, they also cannot use this technique to reduce their taxes, putting them at a competitive disadvatage, Mr Toder adds. “That's got to be a political issue in the corporate sector.”

Just wait ‘til next year – or 2017

No significant tax reform is expected to pass Congress and be delivered to Mr Obama before congressional elections in November. But the fact that Mr Obama and the chairman of both the tax-writing committees in the House and Senate have offered significant corporate tax reform proposals in the past few months suggests that these issues will not go away.

While Mr Obama has not suggested a wholesale corporate tax overhaul, his fiscal 2015 budget plan proposed to raise $12.6bn in the five years between 2015 and 2019 by taxing “excess” profits resulting from offshore transfers of intangible assets like IP.

This is part of some tax proposals that have existed since 2011, suggesting that it will appear in future budgets if it is not enacted. The current plan defines as “excess” profits the net revenues related to intangible assets, with a credit for taxes paid to any foreign jurisdiction at above a 10% rate.

In Congress, the chairmen of both the Senate Finance Committee and House Ways and Means Committee have both drafted corporate tax reform proposals that would similarly seek to put levies on currently little-taxed income generated by transfers of intangible assets. Given that the Senate is controlled by Mr Obama’s Democratic allies and the House by opposition Republicans, it is fair to say that there is significant interest across the political spectrum for closing this loophole.

This year is, however, a congressional election year, making it unlikely that such massive and controversial proposals could pass Congress – and some would suggest that because 2015 begins a presidential election cycle this will be difficult to achieve until at least 2017.

An opportunity

What is moving in Congress is legislation to extend expiring tax provisions – one of which exempts from US taxation those earnings that pass between majority-owned foreign corporate subsidiaries established in various countries. It would not be inconceivable for a transaction as high-profile as the proposed Pfizer-Astra deal to put such exemptions under the spotlight and disrupt progress of this “extenders” legislation – or theoretically, become a bargaining chip in a bid to change the anti-inversion rules that Pfizer intends to exploit.

These big inversion transactions “have long attracted attention”, says Barbara Angus, a principal in international tax consulting for Ernst & Young. “Many policymakers on Capitol Hill view these developments as reinforcement of the need for comprehensive tax reform that would yield a US corporate and international tax system that allows global businesses to operate and invest in the US competitively.” 

Internationally, the complexity of multinational corporations and national laws has caused some to call for a scrapping of the traditional approach to taxation and turn to apportionment-based levies, in which companies pay based on their economic activity. Advocates of this concept argue that such a design would reflect the fact, among other things, that a corporation’s legal structure has little to do with management decisions, not to mention serve as a counterweight to multinational corporations’ fiduciary duty to maximise profits.

As long as that fiduciary duty exists, corporations will look for ways to reduce their tax burden, which means that without reform these practices will continue.

Seeking a level playing field could even be in big pharma’s best interest. Transactions like Pfizer’s proposed takeout of Astra might make sense financially, but many believe that they hold little merit on other measures. If such short-term financial engineering were not possible and therefore demanded by investors, management could be freed to think more strategically about deals to support the long-term health of the drug development sector.

To contact the writer of this story email Jonathan Gardner in London at jonathang@epvantage.com or follow @JonEPVantage on Twitter

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