Lilly, others cut U.S. tax bills through transfer pricing

May 14, 2010

Over the past three years, Pfizer Inc. was an earner without profit in its own country.

The maker of cholesterol medication Lipitor, the world’s top-selling prescription drug, reported almost half its revenues in the United States for 2007 through 2009, while booking domestic pretax losses totaling $5.2 billion.

Abroad, it was another story. A Dutch subsidiary more than made up for New York-based Pfizer’s American losses. It reported pretax profits totaling $20.4 billion in 2007 and 2008—with a tax expense of 5 percent, a seventh of the top U.S. rate. Overseas tax savings increased the drugmaker’s net income by $1 billion last year, according to Robert Willens, a tax consultant in New York.

Pfizer is one of thousands of American companies that bolster their profits by attributing income to subsidiaries in countries with lower income tax rates, legally cutting their tax bills. Indianapolis based Eli Lilly and Co. and Oracle Corp. were among other big companies that helped drive a 70-percent increase in accumulated earnings abroad that weren’t taxed in the U.S. from 2006 to 2009, according to data compiled by Bloomberg.

“An inordinate concentration of profits in a low-tax country, way out of proportion to actual economic activity, is a sure sign of aggressive tax planning,” said Martin Sullivan, a tax economist who formerly worked for the U.S. Treasury and Arthur Andersen LLP.

Willens, the president of Robert Willens LLC, a consulting firm in New York that advises investors on tax issues, analyzed financial filings for last year by Pfizer, Lilly and Oracle and found:

— Pfizer increased net income by 13 percent compared with what it would have been without the tax benefit from foreign earnings. The company’s $8.6 billion in net income would have been $7.6 billion, Willens said.

— Lilly increased its 2009 net income by 21 percent to $4.3 billion from $3.6 billion, Willens found.

— Oracle reported $5.6 billion in net income last year, 14 percent more than it would have reported without foreign earnings taxed at lower rates, according to the analysis.

In each of the past seven years, Lilly has reported more than half its sales in the U.S. yet more than half its profits overseas. In 2007, a Swiss subsidiary booked pretax income of $3.2 billion—more than 80 percent of the $3.9 billion the parent company reported that year.

The Swiss holding company has an Irish manufacturing branch that produces drugs and sells them to affiliated companies, according to its annual report.

“Lilly takes great care to ensure that we have properly determined our income and assessed our tax obligations to each jurisdiction in which we do business,” said Mark E. Taylor, a company spokesman, in an e-mail. In some years, U.S. profits were reduced by merger-related costs, he said.

To be sure, each of those companies has actual sales abroad, although often in countries with tax rates similar to the U.S., which has an average combined state and federal corporate income tax rate of about 39 percent. Oracle, which reported 44 percent of its sales in the U.S., had 16 percent in Germany, Japan, Canada and France, countries with rates ranging from 30 percent to 39 percent last year.

Dozens of U.S. companies attributed income to foreign subsidiaries in 2008 that exceeded their share of actual sales abroad, according to offshore corporate records and U.S. securities filings compiled by Standard & Poor’s Capital IQ. In some cases, the foreign units employ few or no workers.

For pharmaceutical and technology companies it’s relatively easy to shift ownership of patents and other intellectual property abroad, said Sheldon S. Cohen, a former IRS commissioner who is now a director at the investment firm Farr, Miller & Washington LLC in Washington.

In a typical arrangement, a company will license the overseas rights for a patent developed in the U.S. to a subsidiary in a low-tax country, said Michael C. Durst, special counsel at Steptoe & Johnson LLP, in Washington. That permits income from foreign sales to be attributed to the low-tax country.

Treasury Department regulations require that prices paid between subsidiaries, such as licensing fees, be based on what unaffiliated companies would pay. Payments among Pfizer’s subsidiaries are supported by economic studies of similar third- party transactions, said Joan Campion, a company spokeswoman.

“All our transactions satisfy all arm’s-length requirements,” Campion said. Charges related to cost-cutting and mergers helped lower Pfizer’s U.S. income, she said. The company manufactures Lipitor in Ireland, among other countries.

An Irish subsidiary of Oracle that has no employees and paid no income tax in 2006 and 2007 was responsible for roughly a quarter of the parent’s pretax income of $10.8 billion in those years, according to Irish records and Oracle’s U.S. securities filings. The unit distributes products “primarily in the European market” that were developed by the Redwood City, California-based company and “jointly funded under a cost sharing arrangement,” according to its annual report from 2007, the most recent year available.

Ken Glueck, a senior vice president for Oracle, declined to answer questions about the company’s use of transfer pricing. In an e-mail, he compared transfer pricing to the mortgage-interest deduction that individuals can claim.

“Can someone please explain to me how following the tax laws of the United States became a reportable issue for Bloomberg News?” Glueck wrote.

U.S. companies amassed at least $1 trillion in foreign profits not taxed in the U.S. as of the end of last year, according to data compiled by Bloomberg. That cumulative total, based on filings by 135 companies, increased 70 percent over three years, from $590 billion in 2006.

While some of the offshore earnings reflect sales abroad, much of the growth results from expanding use of transfer pricing, said Sullivan.

The system allows for creating paper transactions between subsidiaries of the same company to allocate expenses and profits to selected countries. For instance, when technology firms license their patents to offshore subsidiaries in low-tax countries, profits from sales overseas are booked to the foreign units, not the U.S. parents. The tax savings add to profits.

“A very significant part of this accumulation of profits offshore is the artificial shifting of profits using transfer pricing,” said Sullivan, now a contributing editor to the trade publication Tax Notes. “There’s been a significant increase in its aggressiveness over the past decade.”

Transfer pricing lets companies legally avoid some income taxes by converting sales in one country to profits in another—on paper only, and often in places where they have few employees or actual sales.

After an economic bailout in which the U.S. government lent, spent or guaranteed as much as $12.8 trillion, the Obama administration faces a projected budget deficit of $1.5 trillion this year. In February, the administration said it would target some of the techniques companies use to shift profits offshore—part of a package intended to raise $12 billion a year over the coming decade.

That’s only about a fifth of the $60 billion in annual U.S. tax revenue lost to thousands of companies’ income shifting, according to a study published in December in the National Tax Journal by Kimberly A. Clausing, an economics professor at Reed College in Portland, Ore.

“Transfer pricing is the corporate equivalent of the secret offshore accounts of individual tax dodgers,” said Sen. Carl Levin, a Michigan Democrat and chairman of the Senate’s Permanent Subcommittee on Investigations, in a statement to Bloomberg News. Levin has overseen hearings on tax shelters including those sold to wealthy people by KPMG LLP. “Now that progress has been made in addressing offshore tax abuse by individuals, transfer pricing is an issue that deserves scrutiny.”

The anti-tax activists of the national Tea Party movement haven’t put transfer pricing on signs in their demonstrations, yet it deserves attention, said Mark Skoda, chairman and founder of the Memphis Tea Party.

“I find the issue of corporations paying no tax or little tax in the United States, when the majority of their operations are here, problematic,” Skoda said in an interview. “The problem is that this is sort of the level of micro that people don’t look at.”

On April 15, the deadline for Americans to file their personal tax returns, the Internal Revenue Service said it would add new agents, attorneys and economists to ensure companies are following the rules for transfer pricing. The United Nations set up a panel in October to devise guidelines for the practice in developing countries.

“If multinationals cannot be prevented from shifting profits to low-tax jurisdictions, then it becomes impossible to maintain the domestic corporate tax base,” said Reuven S. Avi-Yonah, director of the international tax program at the University of Michigan Law School in Ann Arbor. If that bleeding can’t be stanched, “we might as well abandon the income tax.”


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