Healthy Skepticism Library item: 17333

Warning: This library includes all items relevant to health product marketing that we are aware of regardless of quality. Often we do not agree with all or part of the contents.

Publication type: Electronic Source

Edwards J
Big Pharma's Secret Tax Problem: As Drug Patents Expire, the IRS Wants Its Pound of Flesh
BNet 2010 Mar 1
http://industry.bnet.com/pharma/10006936/big-pharmas-secret-tax-problem-as-drugs-patents-expire-the-irs-wants-its-pound-of-flesh/

Full text:

Big Pharma’s wave of patent expirations – in which blockbusters such as the cholesterol drug Lipitor lose their exclusivity and face generic competition over the next few years – contains a hidden tax hit, according to Sanford Bernstein analyst Tim Anderson.

Until recently, drug companies’ tax exposure has been something of a secret, Anderson wrote in a note to investors, as companies hide from taxes in foreign countries using a process called “tax arbitrage.” None of the companies he surveyed gave details on where their drugs were actually made or how loss of exclusive rights to sell them will change the taxes they pay. He said:

… the level of company disclosure on this topic is very low.

… the companies we cover were in almost all cases not willing to share specifics such as where patents are held and where bulk active ingredient is manufactured.

Nonetheless, the hidden tax cost of patent expirations will be in billions of dollars. The companies most exposed are Eli Lilly (LLY), Pfizer (PFE), Bristol-Myers Squibb (BMY), Merck (MRK), GlaxoSmithKline (GSK) and Novartis (NOV), Anderson says.

In general, companies with these qualities will be affected:

companies with lowest effective tax rates
companies with highest degrees of generic exposure
companies that are least diversfied
companies that are based in the U.S.
Companies often register their drugs with foreign corporations in countries with low taxes. Merck’s Zocor, for instance, was registered in Bermuda, which has a corporate tax rate of zero. As the exclusive rights to make a drug expire, the revenues from that drug decline. With that decline, the tax advantage of those foreign locations disappears also. Overall, companies’ effective tax rates will go up, as U.S. tax rates come to dominate the remaining business mix, Anderson argues.

Pfizer and Lilly are already seeing increasing tax rates eat up their profits. Pfizer warned that its effective tax rate would suddenly jump from 22 percent in 2008 to 30 percent in 2012. That could cost Pfizer an extra $2 billion in tax, as its overall revenues remain subject to higher U.S. taxes.

Lilly also disclosed its tax rate was going up. In the company’s earnings call for Q4 2009, CFO Derica Rice said:

Our tax rate increased by about two percentage points.

Anderson says Lilly’s tax rate is now 25 percent.

Here’s how drug company “tax arbitrage” works: Once a drug is discovered, the U.S. company sells a patent license to a foreign subsidiary. The foreign company then makes the bulk chemical in each pill. It sells the chemical back to the U.S. company, which finishes the manufacturing process and puts the pill in a pretty box. The U.S. company then pays royalties to the foreign company on each sale made.

When the foreign company sells the chemical to the U.S. company, it does so at “a massive mark-up,” which the company ensures by reverse-engineering a set of prices after the transfer has been made, Anderson says:

This causes most of the profits from the new drug to be generated in the low tax jurisdiction, and the net result is a lower overall effective tax rate for the company.

As best we can tell, many if not most major drugs are handled this way, …

It all comes to an end when cheap generics hit the market. About $140 billion in exclusive revenues will be lost through 2016. Not only will the tax-free revenues of blockbusters disappear, but as the U.S. side of their business comes to dominate the revenue mix, so will the U.S. statutory corporate tax rate of 35 percent.