Transfer Pricing Aspects of Taxing the Pharmaceutical Sector

Changes to tax laws are often seen as the primary solution to curb profit shifting from the United States. The 2017 “Tax Cuts and Jobs Act” attempted to do so by reducing the incentive to shift income outside of the US. The incoming Biden Administration is considering various proposals because the 2017 initiatives have been seen as largely unsuccessful.

In reality, however, changes to tax laws are notoriously hard to enact because they are subject to political whims. As we saw with the 2017 changes, it is also difficult to predict their effectiveness. In contrast, the arm’s length standard is a known commodity already etched into the tax code, so in practical terms, it seems prudent to analyze whether its proper enforcement could provide a more primmediate solution.

The United States and the Pharmaceutical Sector

The US relationship with the pharmaceutical sector comes up frequently in terms of both healthcare and tax policy. Because the US pharmaceutical drug market is less regulated than other countries, pharmaceutical companies are able to charge higher prices and subsequently book as much as half of their worldwide revenue there.

Brad Setser wrote in a February 2020 piece for the Council on Foreign Relations:

Ireland, Switzerland and Singapore account for 40% of the dollar value of U.S. pharmaceutical imports ... These tax games appear to have only gotten more intense after the U.S. tax reform. The U.S. trade deficit in pharmaceuticals is one track to go from just over $50 billion dollars at the end of 2016 to close to $100 billion by the end this year.

This post references a prior discussion of transfer pricing:

The United States, thanks to pharmaceutical prices that are systematically higher than in other advanced economies, is by far the most profitable market for most pharmaceutical companies. So many pharmaceutical firms, through transfer pricing games, often try (and often succeed) to shift a portion of their U.S. profit to a low tax jurisdiction.

He describes the transfer pricing strategy as having the intangibles transferred to a tax haven, which employs a foreign manufacturing affiliate to produce the drugs, which are sold to distribution affiliates at very high prices. Forest Laboratories for example produced Lexapro in Ireland, which was sold to U.S. customers. Most of its consolidated profits were sourced to a Bermuda affiliate.

Thomas Horst recently weighed in on these tax policy issues citing certain financial information for the five largest U.S. based pharmaceutical multinationals. Table 1 provides some of his key information for these five companies. 

Table 1: Select Financial Ratios Noted by Thomas Horst

Abbvie, Bristol-Myers Squipp, and Merck report very modest if not negative ratios of U.S. profits relative to worldwide profits even though the ratio of U.S. sales relative to worldwide sales is much higher. The allocation of profits more closely matches the allocation of sales for Pfizer. Johnson & Johnson represents an intermediate case with 20% of worldwide profits sourced to the U.S. parent, while just over half of its sales were to U.S. customers.

One would not necessarily expect profits to be allocated among affiliates in the same fashion as sales are because even under arm’s length pricing the allocation of profits depends on where the product is produced and, even more importantly, which affiliate owns the product and process intangibles. These financials for Abbvie, Bristol-Myers Squibb and Merck are so stark, however, that there is a general view that its transfer pricing policies may be difficult to defend in terms of arm’s length pricing.

Horst illustrates how various proposals to tax these multinationals would work using a transfer pricing example that does not resemble most pharmaceutical operations. He considers three alternative tax regimes:

(1) the current U.S. tax treatment, including the GILTI provisions; (2) treating the income as subpart F income rather than tested income for GILTI; and (3) disallowing the U.S. affiliate’s tax deduction for the portion of its intercompany import costs that represents its foreign affiliate’s pretax profit.

Horst advocates the third proposal as a means for addresses profit shifting and encouraging U.S. parents to source production in the U.S. rather than in foreign jurisdictions.

We will not address these issues in terms of the optimal policy, but we will discuss Horst’s transfer pricing illustration. Table 2 considers an Irish manufacturer with a U.S. distribution affiliate.

Table 2: Horst Transfer Pricing Example

The fact that the Irish manufacturer retains $20 million in profits is not evidence of income shifting as one could reasonably argue that the U.S. distribution affiliate’s 100% return to operating expenses is quite generous. One could argue that the U.S. affiliate owns valuable marketing intangibles, but if the Irish affiliate owned the product intangibles, then this split of profits is not necessarily unreasonable.

Of course, the Lexapro case involved a U.S. parent owning both the product intangibles as well as the marketing intangibles. Even in this case, the Irish affiliate deserves at least a routine return to manufacturing. The Horst proposal would set foreign profits at zero, which assuredly would create double taxation tensions with foreign tax authorities.

A Transfer Pricing Model

The oddest aspect of Horst’s example is that the assumed financials more resemble what one would expect from the export of Irish whiskey than branded pharmaceuticals. For many pharmaceuticals, the cost of production relative to sales is less than half of the 60% assumption in Horst’s example. The cost of sales and marketing is often greater than the cost of production.

Table 3 presents a more detailed and realistic example for the transfer pricing of a life science multinational. It is only loosely based on the aggregate financials for Johnson & Johnson as it assumes worldwide sales = $80 billion with half of those sales in the U.S. Our presentation assumes four affiliates:

A U.S. distribution affiliate with selling costs = 30% of U.S. sales.

A foreign distribution affiliate with selling costs = 30% of foreign sales.

A manufacturing affiliate with production costs = 30% of worldwide sales.

A principal affiliate that incurs ongoing R&D expenses = 10% of sales.

Consolidated operating profits = 30% of sales and are allocated among these affiliates according to the transfer pricing policies.

This simple example diverges from the actual business of Johnson & Johnson for many reasons, including the fact that Johnson & Johnson has a wide variety of products in not only the pharmaceutical line of business but also the medical device and consumer products line of business. Johnson & Johnson not only sells its array of products to customers in many nations but also has nearly 100 manufacturing facilities in many jurisdictions, including several U.S. manufacturing facilities. While our example cannot be seen as a description of Johnson & Johnson’s many transfer pricing issues, the hope is that it can assist in understanding some of the key transfer pricing issues facing pharmaceutical multinationals.

Table 3: Transfer Pricing Where Distributors and Manufacturers Receive Routine Returns.

Table 3 is based on transfer pricing policies that grant the distribution and manufacturing affiliates with routine returns as established by a Transactional Net Margin Method (TNMM) or Comparable Profits Method analysis. The principal pays the manufacturing affiliate intercompany (I/C) price 1, which equals 35% of sales covering its production costs and providing profits = 5% of sales. Intercompany price 1 represents the principal affiliate’s inbound price.  The principal charges the distribution affiliate I/C price 2, which equals 65% of sales. Intercompany price 1 represents the principal affiliate’s outbound price. The distribution affiliates receive a 35% gross margin and a 5% operating margin. Both policies are defended by an analysis based on TNMM.

The principal’s spread on these intercompany prices represents 30% of sales or $24 billion. The principal also incurs the $8 billion in ongoing R&D costs, so it nets $16 billion in operating profits. The justification for the fact that the principal retains two-thirds of worldwide profits is the assertion that the principal owns all of the valuable intangible assets. Note also that the manufacturing affiliate retains only one-sixth of worldwide profits with the remaining profits allocated to the distribution affiliates.

The impact of a multinational’s transfer pricing policies depends on the tax rates faced by each of its affiliates. Table 3 makes a simplifying assumption that the principal affiliate faces a zero-tax rate while all operating affiliates face a 30% tax rate. Under these transfer pricing policies, the multinational pays only $2.4 billion in taxes so its effective tax rate = 10%.

A Potential Arm’s-Length Transfer Pricing Model

Tax authorities can suggest several objections to this particular set of transfer pricing policies. Even if the principal affiliate rightfully owns all product and process intangibles, a recurring theme in transfer pricing disputes in the life science sector revolves around the upfront market expenses, which have often been borne by the local distribution affiliates.

Table 4 models the effect of lowering I/C price 2 to 60% of sales, which increases the gross margin for the distribution affiliates to 40% thereby granting them with a 10% operating margin. The premise is that the distribution affiliates not only deserve a 5% routine return for selling activities but also an additional 5% return as the profits attributable to marketing intangibles.

Table 4: Transfer Pricing When Distribution Affiliate Capture a Portion of Residual Profits

Under this alternative transfer pricing policy, the global distribution affiliates collectively capture a third of worldwide income while the share of worldwide income accruing to the principal affiliate declines to 50%. In our illustration, this alternative transfer pricing policy increases the effective tax rate from 10% to 15%.

Transfer Pricing Issues

The tax authorities for the manufacturing affiliates might question why these affiliates only receive the routine return for allegedly being contract manufacturers. If the manufacturing affiliates own either valuable process intangibles or product intangibles, then the arm’s length value of I/C price 1 should be raised in order to compensate the manufacturing affiliate for any valuable intangible assets that they own. If I/C price 1 is raised from 28% of sales to 32% of sales, the manufacturing affiliates capture a third of worldwide profits. If I/C price 2 has also been lowered to 48% of sales, then the principal captures only one-third of worldwide profits and the effective tax rate increases to 20%.

The financial statistics reported by Horst for Johnson & Johnson noted that the U.S. share of worldwide income was 20%, while half of its worldwide sales are to U.S. customers. This observation would be no surprise if the only function performed in the U.S. was selling activities. We also noted that distribution affiliates might be entitled to a portion of residual profits if they have historically created marketing intangibles. Johnson & Johnson also has several manufacturing affiliates in the U.S. An additional transfer pricing question would be whether these affiliates were merely contract manufacturers or do they own a portion of the intangible assets.

The information provided in most 10-K filings is insufficient for a complete understanding of the transfer pricing issues for a life science multinational with multiple products and its various functions globally dispersed. The goal of Base Erosion and Profit Shifting Action 13 is to improve the disclosure of key information needed to evaluate the transfer pricing issues for such multinationals. Properly prepared Master Files and Country-by-Country Reports would provide more detailed financial data as well as a description of how the multinational’s valuable intangible assets were created.

We have seen a myriad of proposals for altering U.S. tax law with respect to multinationals and the allocation of worldwide income. These proposals are motivated by a concern that multinationals are shifting income to tax havens. Rather than some set of new complicated rules, we humbly suggest that we try a proper enforcement of the arm’s length standard.

References

“Tax Games: Big Pharma Versus Big Tech”, Brad Setser, February 12, 2020, www.cfr.org.

“Effective Tax Rates for the 10 Largest Pharma MNEs And Their Implications for U.S. International Tax Reform”, Tax Notes International, December 21, 2020.