With a swipe of his debit card in a Phoenix pharmacy, Tyler Hurst bought a $99 bottle of Lexapro and kicked off a 9,400-mile odyssey of international corporate tax avoidance. Each stop along the way—an industrial park in Dublin, a skyscraper in Amsterdam, a palm-shaded law office in Bermuda—helps the medicine's maker, Forest Laboratories (FRX), cut its income tax bill. Although all of Forest's Lexapro sales are in the U.S., the company moves profits generated by the world's third-best-selling antidepressant from subsidiary to subsidiary overseas, exploiting tax advantages in multiple countries. The technique, known as transfer pricing, reduced Forest's net U.S. tax bill by more than a third in 2009, according to the company's annual report.
Forest declined to discuss its transfer-pricing techniques. Nor would it say how much it made from the $99 that the Phoenix customer paid for his month's supply of Lexapro. For top-selling prescription drugs, the retailer would keep about $12, and $2 would go to a wholesaler, says Helene Wolk, an analyst at Sanford C. Bernstein in New York. The remaining $85, she says, would go to Forest. Since its debut in 2002, Lexapro has generated $13.8 billion in sales for Forest, according to analyst Gary Nachman of Leerink Swann in New York. The drug accounted for 58 percent of Forest's sales for the fiscal year that ended on Mar. 31.
Thousands of other companies, from Oracle (ORCL) to Eli Lilly (LLY) to Pfizer (PFE), also legally avoid some income taxes by using transfer pricing, typically converting sales in one country to paper profits in another, often a place where they have few employees or actual sales. GlaxoSmithKline (GSK), the U.K.'s largest drugmaker, settled a transfer-pricing case with the U.S. in 2006 for $3.4 billion. Since December, the IRS and the Justice Dept. have lost two such cases against Silicon Valley companies: a $24.3 million dispute with chipmaker Xilinx (XLNX) and a $545 million battle with software maker Symantec (SYMC).
In February the Obama Administration, which faces a projected budget deficit of $1.5 trillion this year, said it would target some transfer-pricing techniques as part of a crackdown intended to raise $12 billion a year over the coming decade. That's one-fifth of the estimated $60 billion in U.S. tax revenue lost to transfer pricing each year, according to a study by Kimberly A. Clausing, an economics professor at Reed College in Portland, Ore. By 2009, U.S. companies amassed at least $1 trillion in foreign profits not taxed in the U.S., according to data compiled by Bloomberg. That cumulative figure, based on filings by 135 companies, has increased from $590 billion in 2006, up 70 percent. Part of the increase is the result of growing sales abroad; much of it springs from expanded use of transfer pricing, says Martin Sullivan, a tax economist and writer who has worked for the Treasury Dept. and Arthur Andersen.
Senator Carl Levin (D-Mich.), the chairman of the Senate Permanent Subcommittee on Investigations, calls transfer pricing "the corporate equivalent of the secret offshore accounts of individual tax dodgers." Senator Byron Dorgan (D-N.D.) calls for scrapping the IRS rules that allow this "unbelievable scandal." Enforcement of these rules, according to Dorgan, is impossible. "It's the equivalent of asking the Internal Revenue Service to connect the ends of two different plates of spaghetti."
It's about 2,100 miles from Phoenix to Forest's corporate headquarters on Third Avenue in New York. Those headquarters are the first stop for the estimated $85 the company took in from that Lexapro purchase in Phoenix, though definitely not the last. Next the money moves 3,200 miles east to Ireland, where workers in lab coats and goggles make and test Lexapro in a low-slung factory near a soccer field on Dublin's north side. A rock the size of a smart car rests beside the parking lot, inscribed with one word in bright blue letters: Forest.
This subsidiary—called Forest Laboratories Ireland—sells Lexapro to its U.S. parent, according to Dan L. Goldwasser, a Forest board member and attorney with Vedder Price in New York. This transaction is at the heart of transfer pricing. With each tablet Forest buys from its Irish subsidiary, it shifts profits to Ireland, where corporate income is taxed at rates of 10 percent to 12.5 percent, compared with 35 percent in the U.S. "Part of the object is to generate some of the profit in Ireland," Goldwasser says. The company won't disclose what it pays the Irish subsidiary for Lexapro or other medications made there.
Forest's Irish operation employs about 5 percent of the company's 5,200 workers, yet it reported $2.5 billion in sales during fiscal 2009—equal to about 70 percent of Forest's $3.6 billion in net sales. Lexapro alone generated $2.3 billion in revenue in 2009, according to company filings. Scores of U.S. pharma and tech companies have set up similar operations in Ireland, lured by an educated workforce, access to European markets, and low taxes, says Alan Mahon, a spokesman for the Irish Finance Dept. "Ireland's 12.5 percent corporation tax rate has become an international 'brand,' " he says.
In 2007 the IRS challenged Forest's transfer pricing, claiming the company didn't adequately value its U.S. marketing operations and thus allocated too much profit to its low-tax Irish subsidiary, according to a person familiar with the matter who asked not to be identified because he wasn't authorized to discuss it publicly. The dispute involved profits from another antidepressant, Celexa, in 2002 and 2003, according to the person and SEC filings by Forest. The IRS sought an additional $206.7 million in taxes, according to the company's disclosures. In November, Forest said it had agreed to pay an undisclosed amount that "did not have a material impact" on its results.
By the time the IRS went after Forest for its tax treatment of Celexa, the company had found a way to further reduce its Irish income taxes—by sending most of its profits on a 3,200-mile trip from Ireland to Bermuda.
On advice from Ernst & Young, Forest Laboratories Ireland reorganized in 2005, dropping Ireland from its name. The newly dubbed Forest Laboratories Holdings established a registered office in Hamilton, Bermuda, and declared the island as its tax residence. This unit took control of licensing the patents.
A second Irish subsidiary inherited the old name. It handled the manufacturing and sublicensed the rights to the patents, according to a corporate disclosure and an internal Forest flow chart tracing the arrangement that was reviewed by Bloomberg News. International tax planners have a nickname for this type of structure: the Double Irish. The structure helped Forest's Irish subsidiary cut its effective tax rate to 2.4 percent from 10.3 percent the year before the reorganization, according to its annual reports. It did so by deducting from its taxable income the fees that went to Bermuda, which has no corporate income tax. Ernst & Young declined to comment on its work for Forest.
Forest's profits, however, don't fly directly from Ireland to Bermuda. To avoid yet another Irish tax, they first make a 470-mile detour to Amsterdam.
Fees paid to the Bermuda unit pass through another subsidiary, Forest Finance BV in the Netherlands, according to the internal Forest document, Dutch corporate records, and a person familiar with the transaction. That route bypasses a 20 percent Irish withholding tax on certain royalties for patents, according to Richard Murphy, director of Tax Research, a British forensic accounting and research firm, who has worked on similar transactions. The structure takes advantage of an exemption on that tax if payments go to a company in another European Union member state.
Forest established its Dutch company in July 2005, two months before its Irish subsidiary got permission from Bermuda regulators to conduct business. The Amsterdam unit operates largely as a conduit, records show. In 2007, Forest Finance collected $1.19 billion in licensing income and paid out 99.6 percent of it in licensing expense, according to its annual report. The company lists its office at an Amsterdam building used by Fortis Bank Nederland, a lender nationalized in 2008 by the Dutch government. Forest has no employees there, said a receptionist at Intertrust, a business that manages financial records for companies. The receptionist wouldn't give her name. Intertrust was sold in January by Fortis Bank to a private equity firm.
The Netherlands has more than 13,000 such entities "established by foreign multinational corporations for the purpose of channeling financial assets from one country to another," according to reports by the Dutch Central Bank. More than 12.3 trillion euros ($15.5 trillion) flowed in and out of them during 2008, the Dutch Central Bank said.
Forest's income tax savings from international operations almost doubled after its 2005 reorganization. In fiscal year 2007 its effective tax rate dropped by 21.8 percentage points, or $155 million, because of the effect of foreign operations, according to U.S. securities filings. In 2009 the international tax benefits lopped $183 million off Forest's federal income tax bill, and helped drive its effective tax rate down to 20.9 percent, compared to the federal statutory rate of 35 percent. The benefits boosted Forest's net income in 2009 by 31 percent, according to an analysis of its tax footnotes by Robert Willens, president of a consulting firm that advises investors on tax issues.
Although Forest described its Bermuda office as the Irish subsidiary's "principal place of business" in a 2008 court filing, it has no employees on the island. The closest it comes to a presence is its registered office at Milner House, a beige building nestled among the pastel structures of Hamilton, the island's main commercial area. There, Coson Corporate Services, part of law firm Cox Hallett Wilkinson, provides "corporate administrative services" for Forest Laboratories Holdings, according to Jeannette Monk, the firm's corporate administrator. Asked whether Forest had any employees there, she said, "This is a law firm."
It's also the final port of call for about two-thirds of the profits Forest derived from sales of Lexapro and its other drugs in 2009. U.S. corporations can avoid taxes on such overseas profits indefinitely, unless they decide to bring the earnings back home.
The potential tax liability doesn't count against income in reports to shareholders, says Michelle Hanlon, an associate professor of accounting at Massachusetts Institute of Technology's Sloan School of Management. So lower taxes from earnings kept overseas go straight to the bottom line, she says, and U.S. companies rarely repatriate significant portions of that income. They are permitted to use the income in overseas operations or in certain investments, or to simply let it sit as cash in a bank account, says Hanlon.
An exception came in 2004 when Congress enacted a one-time break allowing companies to bring back their earnings at an effective tax rate of 5.25 percent, less than one-sixth the top corporate rate. As a result, 843 corporations brought $362 billion to the U.S., with $312 billion qualifying for the tax break, according to the IRS. Under the provision, Forest returned $1.2 billion to the U.S.
U.S. tax laws have sought to regulate various forms of transfer pricing since 1921. The Treasury Dept. issued regulations limiting it in 1968, and thousands of pages have followed in the years since. The tax code was amended in 1986 because of concern that companies were shifting profits from the U.S. None of it eliminated aggressive transfer pricing.
For U.S. regulators, the key questions are whether the parent pays too much to its offshore subsidiary and whether the subsidiary in turn pays too little to its U.S. parent. Treasury regulations require "arm's length" prices, or amounts that would be paid between unrelated parties.
Those rules are "based on a fiction," says Michael C. Durst, special counsel at Steptoe & Johnson in Washington, who advised companies on transfer pricing for 15 years and has emerged as a vocal critic of the system. Many of the transactions between a U.S. parent and its offshore units would never take place between unrelated parties, Durst says. "As a result of resting on this basic fallacy," says Durst, "transfer-pricing rules have for many years been unenforceable."
On Apr. 15 the IRS said it would add new agents, attorneys, and economists to ensure that companies are following the rules for transfer pricing. It is difficult to say whether the offensive will have any effect on Forest. The IRS's goal is to flood the zone on a handful of big corporations—it's not clear which. For now, at least, every time an American walks out of a pharmacy with a bottle of Lexapro, Forest launches another perfectly legal transatlantic journey of tax avoidance.
"If multinationals cannot be prevented from shifting profits to low-tax jurisdictions, then it becomes impossible to maintain the domestic corporate tax base," says Reuven S. Avi-Yonah, director of the international tax program at the University of Michigan Law School. If that bleeding can't be stanched, he says, "we might as well abandon the income tax."
With Phillip Cruz, Dara Doyle, Fred Pals, Lisa Rapaport, Marybeth Sandell, Carey Sargent, Shelby Siegel, and Martijn van der Starre