Target Area: Transfer Pricing

The pharma industry's profitability has caught the IRS' attention—and made it a target. But what really puts the industry at risk is the global nature of the business. There are very large differentials in tax rates between countries, and this can create opportunities for improper tax reporting.

In its enforcement efforts, the IRS has placed transfer-pricing violations—the ability to shift reported income between affiliated companies—high on its enforcement agenda. Transfer-pricing laws require that intercompany transactions, particularly between foreign and domestic affiliates, are valued at "arm's length," so that company revenues are appropriately allocated between foreign and domestic entities. Misallocation of revenues may shift income that is taxable in the United States to a related foreign affiliate that is taxed in lower-rate jurisdictions. Billions of dollars in US taxes are lost to such transfer-pricing irregularities.

"We have consistently said that transfer pricing is one of the most significant challenges for us in the area of corporate tax administration," said Commissioner of Internal Revenue Mark Everson when he announced the Glaxo settlement.

Although the GlaxoSmithKline settlement predates the new tax whistle-blower law, the law's powerful financial incentives are likely to expose similar large underpayments or fraud schemes.

That was the case last February, when Merck paid $2.3 billion to settle its battles with the IRS over taxes relating to minority equity interest financing transactions and loans from a foreign subsidiary to Merck. The Wall Street Journal reported that Merck transferred valuable patents to a subsidiary in tax-favorable Bermuda, and then paid its subsidiary for use of the patents. This resulted in a reduction of $1.5 billion in US taxes over a 10-year period.

Among many other questionable practices are schemes involving mischaracterization of taxable gains in connection with asset sales or other divestiture transactions, abusive schemes involving the misuse of net operating losses, and mischaracterization of US source income of taxable entities.

Pharmaceutical companies may want to consider taking steps to minimize the potential whistle-blowers' need to go outside the company to report questionable tax practices. In many cases, whistle-blowers report the fraud to the government only after they've tried going through their supervisors and managers to stop the practices and have been retaliated against or fired for their efforts.

Take Action

Ensuring a vigorous and meaningful compliance structure specifically for tax compliance that covers the corporate parent and all foreign subsidiaries might be beneficial. This would include integrating measures that would allow for anonymous or confidential internal reporting and real guarantees by employers of nonretaliation. Independent board oversight of this internal reporting function at pharmaceutical companies could be important to ensure that tax compliance receives due consideration throughout the organization.

The new law is set to expose hidden tax-avoidance practices by corporate America—and pharma companies are high on the target list. In fact, the promise of big rewards has already persuaded industry insiders to provide information to the IRS that exposes tax-avoidance practices.

"They're coming in with big, fat piles of paper, and they have, at least on the surface...some credibility about the information they're bringing to us," said Stephen Whitlock, director of the new IRS whistle-blower office, in an interview last year.

Erika A. Kelton is a lawyer with Phillips & Cohen LLP. She can be reached at ekelton@phillipsandcohen.com