How Multinational Corporations Avoid Paying Their Taxes

Rules of the Game
How Multinatioal Corporations Avoid Paying Their Taxes
By PETER ROST, MD
November 22, 2006

Drug companies and other multinational companies based in the U.S. systematically avoid paying tax in the U.S. on their profits. The companies elect to realize profits in low-tax countries and because of this the rest of us have to pay billions of unnecessary taxes to make up for the shortfall, writes Peter Rost, an ex-pharmaceutical executive.

The biggest tax scam on earth has a very innocent sounding name. It is called "transfer prices." That almost sounds boring. It is, however, anything but boring. Abuse of transfer prices is a key tool multinational corporations use to fool the U.S. and other jurisdictions to think that they have virtually no profit; hence, they shouldn't pay any taxes.

Corporations involved in this scam are "model corporate citizens," or so they would like us to believe. The truth is that they rob us all blind. The money we lose can be estimated in the tens of billions, or possibly hundreds of billions of dollars every year. We all end up paying higher taxes because rich corporations make sure they don't.

But don't take my word for this.

A few weeks ago U.K.-based GlaxoSmithKline (GSK), one of the largest pharmaceutical companies in the world, together with the Internal Revenue Service (IRS) announced that GSK will pay $3.4 billion to the IRS to settle a transfer pricing dispute dating back 17 years. The IRS alleges that GSK improperly shifted profits from their U.S. to the U.K. entity.

And U.K. pharmaceutical companies are not alone with these kinds of problems. Merck, one of the largest U.S. drug companies, also this month disclosed that they face four separate tax disputes in the U.S. and Canada with potential liabilities of $5.6 billion. Out of that amount, Merck disclosed that the Canada Revenue Agency issued the company a notice for $1.8 billion in back taxes and interest "related to certain inter-company pricing matters." And according to the IRS, one of the schemes Merck used to cheat American tax payers was by setting up a subsidiary in tax-friendly Bermuda. Merck then quietly transferred patents for several blockbuster drugs to the new subsidiary and then paid the subsidiary for use of the patents. The arrangement in effect allowed some of the profits to disappear into Merck's own "Bermuda triangle."

So what's going on here, how have multinational drug companies been able to gouge us for years selling expensive drugs and then avoid paying tax on their astronomical profits?

The answer is simple. For companies in certain businesses, such as pharmaceuticals, it is very easy to simply "invent" the price a company charges their U.S. business for buying the company's product which they manufacture in another country. And if they charge enough, poof; all the profit vanishes from the US, or Canada, or any other regular jurisdiction and end up in a corporate tax-haven. And that means American and Canadian tax payers don't get their fair share.

Many multinational corporations essentially have two sets of bookkeeping. One set, with artificially inflated transfer prices is what they use to prepare local tax returns, and show auditors in high-tax jurisdictions, and another set of books, in which management can see the true profit and lost statement, based on real cost of goods, are used for the executives to determine the actual performance of their various operations.

Of course, not every multinational industry can do this as easily as the drug industry. It would be difficult to motivate $6,000 toilet seats. But the drug industry, where real cost of goods to manufacture drugs is usually around 5% of selling price, has a lot of room to artificially increase that cost of goods to 50% or 75% of selling price. This money is then accumulated in corporate tax-havens where the drugs are manufactured, such as Puerto Rico and Ireland. Puerto Rico has for many years attracted lots of pharmaceutical plants and Ireland is the new destination for such facilities, not because of the skilled labor or the beautiful scenery or the great beer-but because of the low taxes. Ireland has, in fact, one of the world's lowest corporate tax rates with a maximum rate of 12.5 percent.

In Puerto Rico, over a quarter of the country's gross domestic product already comes from pharmaceutical manufacturing. That shouldn't be surprising. According to the U.S. Federal Tax Reform Act of 1976, manufacturers are permitted to repatriate profits from Puerto Rico to the U.S. free of U.S. federal taxes. And by the way, the Puerto Rico withholding tax is only 10%.

Of course, no company should have to pay more tax than they are legally obligated to, and they are entitled to locate to any low-tax jurisdiction. The problem starts when they use fraudulent transfer pricing and other tricks to artificially shift their income from the U.S. to a tax-haven. According to current OECD guidelines transfer prices should be based upon the arm's length principle ­ that means the transfer price should be the same as if the two companies involved were indeed two independents, not part of the same corporate structure. Reality is that standard operating procedure for multinationals is to consistently violate this rule. And why shouldn't they? After all, it takes 17 years for them to pay up, per the GSK example above, even when they get caught.

Another industry which successfully exploits overseas tax strategies to cheat us all is the hi-tech industry. In fact, Microsoft Corp. recently shaved at least $500 million from its annual tax bill using a similar strategy to the one the drug industry has used for so many years. Microsoft has set up a subsidiary in Ireland, called Round Island One Ltd. This company pays more than $300 million in taxes to this small island country with only 4 million inhabitants, and most of this comes from licensing fees for copyrighted software, originally developed in the U.S. Interesting thing is, at the same time, Round Island paid a total of just under $17 million in taxes to about 20 other countries, with more than 300 million people. The result of this was that Microsoft's world-wide tax rate plunged to 26 percent in 2004, from 33 percent the year before. Almost half of the drop was due to "foreign earnings taxed at lower rates," according to a Microsoft financial filing. And this is how Microsoft has radically reduced its corporate taxes in much of Europe and been able to shield billions of dollars from U.S. taxation.

But remember, this is only one example. Most of the other tech companies are doing the same thing. Google recently also set up an Irish operation that the firm credited in a SEC filing with reducing its tax rate.

Here's how this is done in the software industry and any other industry with valuable intellectual property. A company takes a great, patented, American product and then develops a new generation. Then, of course, the old product disappears. Some, or all, of the cost and development work for the new product takes place in Ireland, or at least, so the company claims. The ownership of the new generation product and all income from licensing can then legally be shared between the U.S. parent company and the offshore corporation or transferred outright to the tax-haven. The deal, to pass IRS scrutiny, has to be made using the "arms-length principle." Reality is that the IRS has no way of controlling all these transactions.

Unfortunately those of us working and paying tax in the U.S. can't relocate our jobs and our income to Ireland or another tax haven. So we have to make up the income shortfall. In the U.S. we have a highly educated society with a very qualified workforce, partly supported by our tax payers. This helps us generate breakthrough products. But once a company has a successful product, they have every incentive to move the second generation of a successful product overseas, to Ireland and a few other corporate tax havens.

There is only one problem for U.S. companies with this strategy, and that is that if they repatriate this money to the U.S. they have to pay full corporate taxes. In fact, according to BusinessWeek, U.S. multinational corporations have built up profits of as much as $750 billion overseas, much of it in tax havens such as the Ireland, Bahamas, and Singapore to avoid the stiff 35% levy they'd face if they repatriated the funds back into the U.S.

But of course, Congress, which is basically paid for by our multinational corporations, generously provided for a one-time provision in the corporate tax code, so that they could repatriate profits earned before 2003, and held in foreign subsidiaries, at an effective 5.25% tax rate.

And so the game goes on.

In the end, multinational corporations live in a global world which allows them to pretty much send their money to corporate tax havens at will, and then repatriate this money almost tax free, with the help of the U.S. Congress.

The people left holding the bag are you and me.

If you want to know learn more about the corruption in the drug industry, read my new book, The Whistleblower, Confessions of a Healthcare Hitman.

Peter Rost, M.D., is a former Vice President of Pfizer. He became well known in 2004 when he emerged as the first drug company executive to speak out in favor of reimportation of drugs. He is the author of "The Whistleblower, Confessions of a Healthcare Hitman." See: http://the-whistleblower-by-peter-rost.blogspot.com/