The New York Times recently reported on some of the loopholes pharmaceutical companies use to avoid paying U.S. taxes on their profits, even though the majority of their profits come from U.S. sales. In essence, the companies are able to shift accounted profits to overseas subsidiaries where they escape the reach of U.S. law. U.S. consumers, through higher drug costs, and U.S. taxpayers, though their subsidies for the research underlying patented drugs, are the losers here, but there is at least one proposal which may solve this problem.
- A description of the problem
- How to solve it and keep companies from gaming the system
First, a description of the pharmaceutical companies’ tactics from the article:
Though the companies stand behind their accounting, financial analysts and tax lawyers say that the drug makers’ claim defies reality and that their profits come mostly from sales in the United States. But the I.R.S. lacks the resources to challenge the companies effectively, the analysts and lawyers say. As a result, the six major companies - Pfizer, Johnson & Johnson, Merck, Bristol-Myers Squibb, Wyeth and Lilly - collectively pay a federal tax rate of less than 15 percent on their worldwide profits, with some companies paying much less. …
The major drug makers use a variety of complex but legal tactics to move profits from the United States to low-tax countries like Ireland and Singapore where they have large manufacturing operations, said H. David Rosenbloom, director for the international tax program at New York University Law School. …
The government can challenge the way the companies allocate their profits internally. But the companies have usually been able to defeat the I.R.S., Mr. Rosenbloom said.
“There’s a limit to what they can do, because these cases are huge. They’re very expensive,” Mr. Rosenbloom said of the I.R.S. …
The companies’ assertions that they are more profitable overseas than in the United States is hard to believe, said Dr. Alan Sager, director of the health reform program at the Boston University School of Health.
Prescription drug prices are far higher in the United States than in other industrialized countries, where prices are generally government-controlled. …
Wall Street analysts who follow the pharmaceutical industry also say most of the drug makers’ profits come from the United States.
David Moskowitz, an analyst at Friedman, Billings, Ramsey, estimated that at least 60 percent of the drug industry’s worldwide profits come from the United States. Higher American drug prices more than make up for higher marketing costs here, he said. Other analysts estimate that as much as 75 percent of the industry’s worldwide profits are generated in the United States.
But companies can hide those profits from the I.R.S. by moving their drug manufacturing overseas, said Martin A. Sullivan, contributing editor of Tax Notes, a nonprofit journal that examines tax issues. Companies transfer drug patents to their own foreign subsidiaries, he said.
The subsidiary then helps pay for research on the drug. If the medicine is approved for sale in the United States, the subsidiary manufactures the drug for a few cents a pill.
The pills are then shipped to the United States, where they are sold to a pharmacy or a wholesale company for several dollars each. But the parent company claims that almost all the profit should go to the subsidiary, not to the parent in the United States.
“Then the name of the game is to have that foreign subsidiary pay as little as possible back to the United States for the rights to all that income,” Mr. Sullivan said.
Sullivan gets at the exact problem: profits are far too easy to shift overseas as far as tax accounting is concerned. More than this, though, profits aren’t really what the U.S. should be taxing. The article makes one other point which shows why this is: of all the companies, Johnson and Johnson is the one least able to take advantage of this loophole, since more of its profits come from sales of physical goods like consumer products and medical devices. The greater the percentage of the good that’s intellectual property (IP), the easier it is to shift taxable profits to overseas divisions. This is absurd, since as the economy becomes more services and IP-based, and in particular as high-value services rely more and more on IP protections, it means the government’s tax base shrinks.
There is one factor which allows the drug companies to profit at the level they do in the U.S yet shift the profits overseas. That factor is the U.S. patent which gives them the exclusive right to sell the drug in the U.S. market. Imagine that in addition to taxing U.S. profits, the federal government taxed the value of U.S. patents. Since the patent protects the drug companies’ profits at the point of sale, not at the point of manufacture, it would be impossible for drug companies to avoid the tax burden by shifting manufacturing operations overseas. I’ve written more extensively on exactly this proposal in the current issue of Legal Affairs magazine, and I invite the reader to review that article for details of how such a tax could work and why everyone wins by adopting it.
An analogy to physical property may help. Patents are certainly not quite the same as physical property, but they do represent a claim on the intellectual property landscape in a particular national market. Yet intellectual and physical property are subject to entirely different tax regimes, and it is this difference that allows the drug companies to escape taxes the way they have. Take a company operating primarily in the physical domain, such as a clothier. In addition to whatever sales or income taxes it pays, it must also pay property tax on its retail location. Of all the taxes that it pays, property taxes are the least avoidable, precisely because it is a tax on the key factor of production without which the retailer cannot operate. In the case of drugs, the patent is the retail location — the grant of exclusive control over the sale of a particular brand of medicine. If that grant were taxed in line with its value, there would be no way for a drug company to avoid taxation, since that patent is the key factor driving the drug company’s profit.
Aside from making it harder for drug companies to avoid taxes, value taxes on patents have many positive effects in terms of reducing litigation costs, re-funding basic scientific research, and reducing the overall costs of innovation. Read the article and let me know what you think.