I. Introduction
There are two things in life that are certain: death and taxes.
Corporations have successfully cheated the former by achieving
perpetual life. And, from their births, it seems like corporations
have also been doing their darndest to avoid the latter. Offshore
affiliates have become a popular corporate technique for avoiding
income tax.[1] Recently, Merck has been investigated for putting its
own unique spin on the traditional offshore affiliate.
II. Analysis
In 1993, Merck in conjunction with a British bank entered into a
Bermuda partnership whose assets were substantially comprised of the
soon-to-be-valuable patents behind cholesterol-lowering medications
Zocor and Mevacor.[2] In creatinig this partnership, Merck engaged in
a practice called "inversion:" a method of reorganization wherein a
domestic corporation reorganizes itself to become a subsidiary of a
foreign parent entity, thereby rendering any profits generated by the
foreign business operations outside of the reach of the federal income
tax.[3] In other words, "the arrangement . . . allowed some of the
profits to disappear into a kind of Bermuda triangle between different
tax jurisdictions."[4]
In order for such a reorganization to pass IRS muster, it must
have independent "economic substance," meaning that there must be some
economically colorable justification for the reorg other than tax
avoidance.[5] Merck offers that the partnership, whose existence was
never previously publicly disclosed, was simply a way of raising
financing for its 1993 acquisition of a pharmacy benefits firm:
Medco.[6] Presumably, Merck's argument would go as follows:in order to
incentivize investment by the British bank (the other partner), they
had to secure the investment with a sure thing, like their Zocor
patents. Similar facts were seen in a recent Second Circuit case where
the court held that the foreign banks in a GE deal were not "bonafide
equity partners" and on this basis found no economic substance in the
transaction.[7] While the IRS has not disclosed the basis upon which
it will pursue Merck for back taxes, a similar fate may await the drug
company.
III. Conclusion
In light of the constant struggle that exists between
corporate efficiency and preservation of the tax base, consider for a
moment tax arbitrage as a matter of theory. Does tax avoidance differ
substantially from other things that corporations do on regular
basis? In what way is shopping around for favorable tax treatment in
different jurisdictions different from, say, shopping around for
favorable labor laws for the purpose of minimizing a manufacturer's
overhead? Or from shopping around for favorable management laws upon
incorporation? Doesn't tax avoidance, on a very rudimentary logic
level, have very valuable economic substance all its very own? This is
not to say that there aren't valid policy reasons for obligating
corporations to behave in this counter-capitalist manner. It is all
but undeniable that the corporate tax base has the potential
to be a if not the most valuable source of tax revenue for the federal
government. However, it is at very least debatable as to whether the
corporate tax comes even near to that potential in practice given the
many creative tax arrangements engineered for corporations.[8] Given
that the value pouring out of the corporate tax base is most likely far
less than it could be, is it possible that the funds recouped through
investigation and prosecution are not worth the dollars that the
government spends in the process? This author does not know the answer
to that question. However, it seems possible that trying to reach
funds that have been merely shopped around on the international tax
market costs more than it is worth to this government, and that aiming
to keep corporations from taking advantage of lower tax rates elsewhere
is a losing battle not worth fighting.
[1] See, e.g. James Poterba, Program Report: Public Economics, The National bureau of Economic research Reporter, available at www.nber.org/reporter/winter06.
[2] Merck Evading Taxes?, The Red Herring, Sept. 28, 2006, available at www.redherring.com/Article.aspx?a=18859&hed=Merck+Evading+Taxes%3F+.
[3] See id., see also Corporate Inversions, The Tax Prophet, at www.taxprophet.com/hot_topic/August03.shtml.
[4] Jesse Drucker, How Merck saved $1.5 billion paying itself for drug patents, The Wall Street Journal, Sept. 28, 2006, available at www.post-gazette.com/pg/06271/725846-28.stm.
[5] Donald R. Korb, Remarks at the 2005 University of Southern
California Tax Institute: The Economic Substance Doctrine in the
Current Tax Shelter Environment (Jan. 25, 2005), available at www.irs.gov/pub/irs-utl/economic_substance_(01_25_05).pdf.
[6] Supra note 4.
[7] Id.
[8] See, e.g. George K. Yin, How Much Tax Do Large Corporations Pay? Estimating the Effective Tax Rates of the S&P 500, virginia law review, forthcoming, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=390260.