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Thursday, July 24, 2014

Fun and games with transfer pricing

ProGrowthLiberal in his comments on my last post and in his own post at EconoSpeak highlights the fact that drug-maker AbbVie already makes most of its profits outside the United States, about 87% in fact over 2011-2013 by his calculation. For PGL, then, AbbVie is not the best example of an inversion because the horse is already out of the barn in terms of escaped profits.

I see things a little differently on this, but the case is also highly illustrative of a principle we have discussed before, transfer pricing. Let's take a look at AbbVie's Form 10-K Annual Report, downloadable here, to see what I mean.

Pre-tax profits ($millions)    2013    2012    2011    3-year total

U.S.                                  -581      625     626     670
Foreign                             5913    5100    3042     14,055

Total                                 5332    5725    3668     14,725

Source: AbbVie Annual Report, p. 92

I actually calculate the foreign percentage for these three years as 95%, given that AbbVie claims to have lost money in the United States in 2013. In any event, this is a very strange division of the company's profits given where its sales were made.

Net sales ($billions)    2013    2012    2011

U.S.                           10.2     10.4     9.7
Foreign                        8.6       7.9     7.7

Total                          18.8     18.4    17.4

Source: AbbVie Annual Report, p. 40. Totals may not sum due to rounding.

As you can see, in each of the three years, over half of the company's sales were made in United States, but the company reports that only 5% of its profits are in this country. This is pretty funny math, if you like dark humor. Especially since Humira, AbbVie's biggest-selling drug by far, was developed in the United States. So with the patents in the U.S., and most of the sales in the U.S., the profits have to be in the U.S., right?

In reality, of course they are, but not in the Alice's Wonderland world of transfer pricing. In this byzantine world, the patent for Humira is almost certainly owned by a subsidiary in Ireland, where royalty payments are tax-free. How else could the company show a loss in the United States in 2013 when 54% of its sales are here? Despite this, the company reports paying about 39% of its worldwide income taxes ($226 million of $580 million worldwide, see p. 92), although we have seen that what companies report in taxes on their 10-K annual report is largely fiction

So what can we do? The answers remain simple, though as politically difficult as ever. First, require companies to publish what they pay, country-by-country. No more hiding behind consolidated accounts. Second, enact unitary taxation, using apportionment formulas to make transfer pricing irrelevant. Third, end the deferral of U.S. corporate income tax on foreign profits. Finally, despite what "everyone," including the President, says, don't reduce the corporate income tax rate. We've gone long enough with tax policies that exacerbate inequality; there's no reason to continue down that road when we have the world's largest economy.

Oh, and my tiny disagreement with ProGrowthLiberal: It seems to me that if a company is already draining giant chunks of its profits abroad, then allowing an inversion ratifies losing a bigger amount of tax money than it would for a company like Walgreen's that has not moved its profits offshore yet. But I imagine the IRS could still go after AbbVie post-inversion if it wanted to question its pre-inversion transfer prices, so this is a minor point indeed.

Cross-posted at Angry Bear.


  1. I worked for the UK subsidiary of AbbottLabs in the mid70s, when, s now, there was a transfer pricing issue. Abbott UK purchased the patented active raw materials for certain drugs from the Puerto Rico manufacturing plant - which happened to have low tax rates. What cost should the UK company use in its profit and tax returns? How do you decide the "market value" of a substance that, still under patent, is of no use to anybody else? Our FD answered that question by agreeing what he and our tax inspector decided was a reasonable amount of tax. In contrast, Roche UK paid its Swiss manufacturing company 40 times its cost for their range of tranquillizers. Equally patented, and equally useless to anybody else, although there had been some competition - from drugs that had a tendency to kill patients in overdoses. The eventual solution in the UK was to use Monopoly rules to fix the selling price of the Roche drugs, and hence substantially reduce Roche profits. Which was a perfectly fair result, as Roche had refused to give the UK any information, despite the very significant purchases made by the NHS.

    I conclude that there is no single satisfactory answer yet for this problem, but clearly there are very satisfactory financial structures for corporations.

    1. anonymous:

      Having worked for Baxter Travenol, Puerto Rico did not have low tax rates. The US put in place "Operation Bootstrap" with local government agencies in Puerto Rico which subsidized manufacturing ventures on the island.

      "The US government in Puerto Rico enticed US companies by providing labor at costs below those on the mainland, access to contiguous US markets without import duties, and profits that could transfer to the mainland free from federal taxation. The Administration of Economic Development invited investment of external capital, importing the raw materials, and exporting the finished products to the mainland. To entice participation, tax exemptions and differential rental rates were offered for industrial facilities. As a result, Puerto Rico's economy shifted labor from agriculture to manufacturing and tourism. The manufacturing sector has shifted from the original labor-intensive industries, such as the manufacturing of food, tobacco, leather, and apparel products, to more capital-intensive industries, such as pharmaceuticals, chemicals, machinery, and electronics. Through this project, a rural agricultural society was transformed into an industrial working class."

      Abbott Labs at that time also had similar operations in Puerto Rico as well as other medical manufacturers. Labor costs are not the issues in so much as Overhead costs. I am still curious as to how -$581 was arrived at on page 92 of their 2013 report. I am assuming they subtracted the higher costs of operations domestically as compared to other countries. As far as what they are making, I assumed it was Humira? A high selling drug to my knowledge.

    2. Abbott Labs was the owner of AbbVie. They also bought Guidant which had a Puerto Rico play which is currently being challenged by the IRS. The aggressiveness of these transfer pricing plays will be borne out in the litigation.

      Kenneth - I was trying to model out how AbbVie got its really nice situation. Even if one assumed all manufacturer and all IP were sourced in tax havens, the percent of profits that should have accrued to the US an allegedly mere distributor would have been more than 8% of worldwide profits. Could it be that the US incurs the R&D and a tax haven reaps the rewards? If the IRS can't challenge this - they might as well close the store.

  2. Well done! Big pharma has lots of examples of aggressive transfer pricing. Buy hey the Big Four accounting firms take their creative efforts to where the big money is. If only the IRS did the same!