Pfizer Wants To Decrease Its Taxes By Moving To Britain

I am reading the following headline at Bloomberg Businessweek: “Pfizer’s $99 Billion Bid for AstraZeneca Is a Tax Shelter.”

No, it is not. This is a tax shelter the same way I am Floyd Mayweather Jr.’s next opponent.

It is sign of a problem, though.

Pfizer is based in New York City. AstraZeneca is based in London. Pfizer has proposed the deal, but AstraZeneca has not yet accepted. The deal may fall yet fall through. There are any number of reasons why a drug company would buy another drug company, but this one would move one of the largest U.S. multinationals to London. The term for this is “inversion.”

Mind you: the Pfizer executives are not moving. They will remain in New York, and Pfizer research facilities will remain in Connecticut. Pfizer will however go from being a U.S.-based multinational to a U.K.-based one. How? There will be a new parent company, and that parent will be based in London. Voila!

Inversions are more complicated than they used to be. In 2004 Congress passed IRC Section 7874, which denies tax benefits to an inversion unless certain thresholds are met. For example,

·       If the former shareholders of the former U.S. parent own 80% or more of the foreign corporation after the inversion, then the inverted company will continue to be considered – and taxed – as a U.S. company.

You can quickly assume that new – and non-U.S. shareholders – will own more than 20% of the new Pfizer parent.

What if you own Pfizer stock? In addition to owning less than 80% of the new parent, code Section 367 is going to tax you when Pfizer inverts. This is considered an “outbound” transaction, and there is a “toll” tax on the outbound. What does that tell you? It tells you that there has to be cash in the deal, otherwise you are voting against it. There has to be at least enough cash for the U.S. shareholders to pay the toll.

Let’s say the deal happens. Then what?

I cannot speak about the drug pipeline and clinical trials and so forth. I can speak about the tax part of the deal, however.

As a U.S. multinational, Pfizer has to pay taxes on its worldwide income. This means that that it pays U.S. taxes on profits earned in Kansas City, as well as in Bonn, Cairo, Mumbai and Sydney. To the extent that a competitor in Germany, Egypt, India or Australia has lower tax rates, Pfizer is at an immediate disadvantage. In the short term, Pfizer would be less profitable than its overseas competitor. In the long term, Pfizer would move overseas. Congress realized this and allowed tax breaks on these overseas profits. Pfizer doesn’t have to pay taxes until it brings the profits back to the United States, for example. Clever tax planners learned quickly how to bend, pull and stretch that requirement, so Congress passed additional rules saying that certain types of income (referred to as “Subpart F” income) would be immediately taxed, irrespective of whether the income was ever returned to the United States. The planners responded to that, and the IRS to them, and we now have an almost incomprehensible area of tax Code.

Take a moment, though, and consider what Congress did. If you made your bones overseas, you could delay paying taxes until you brought the money back to the U.S. Then you would have to pay tax – but at a higher rate than your competitor in Germany, Egypt, India or Australia. You delayed the pain, but you did not avert it. In the end, your competitor is still better off than you, as he/she got to keep more of his/her profit.

What do you do? Well, one thing you cannot do is ever return the profit to the United States. You will expand your overseas location, establish new markets, perhaps buy another – and foreign – company. What you will not do is ship the money home.

How much money has Pfizer stashed overseas? I have read different amounts, but $70 billion seems to be a common estimate.

When Pfizer inverts, it may be able to repatriate that money to the U.S. without paying the inbound toll. That is a lot of money to free up. I could use it.

The U.S. also has one of the highest – in truth, maybe the highest – corporate tax rate in the world. The U.K. taxes corporate profits at 20%, compared to the U.S. 35%. The U.K. also taxes profits on U.K. patents at 10%, an even lower rate. This is a pharmaceutical company, folks. They have more patents than Reese’s has pieces. And the U.K. taxes only the profits generated in the U.K., which is a 180 degree turn from Washington’s insistence that it can tax profits of an American company anywhere on the planet.

Now, Pfizer does not get to avoid U.S. taxes altogether. It will still pay U.S. tax on profits from its U.S. sales and activities. The difference is that it will not pay U.S. taxes on sales and activities occurring outside the United States.

Since 2012 approximately 15 large U.S. companies have moved or announced plans to move offshore. Granted, there are numerous reasons why, but a significant – and common – reason has to be the benighted policy of U.S. multinational taxation. What has the White House proposed to stem the tide? Increase the ownership threshold from 20% to 50% before the company will be deemed based outside the U.S.

Brilliant.  To think that Washington at one time pulled off the Manhattan Project, Hoover Dam and landing a man on the moon. How far the apple has fallen.

The issue of corporate inversion has been swept up as part of the larger discussion on tax reform. That discussion is all but dead, unfortunately, although perhaps it may resurrect after the Congressional elections. The Camp tax proposal wants to move the U.S. to a territorial tax system rather than the existing worldwide system, which is an acknowledgement of the problem and a very good first step. It will not stop Pfizer, but we may able to stop the next company to follow.

The 6707A Tax Penalty Is Outrageous

I have attached a penalty notice to this blog. Take a look . The IRS is assessing $14,385 for the 2008 tax year, and the description given is a “Section 6707A” penalty.

This is one of the most abusive penalties the IRS wields, in my opinion. As too often happens, it may have been hatched for legitimate reasons, but it has degenerated into something else altogether.

Let’s time travel back to the early aughts. The IRS was taking a new direction in its efforts against tax shelters: mandatory disclosure.  There was a time when tax shelters involved oil and gas or real estate and were mostly visible above the water line, but the 1986 changes to the tax Code had greatly limited those schemes. In their place were more sophisticated – and very hard to understand – tax constructions. The planners were using obscure tax rules to separate wealth from its tax basis, for example, with the intent of using the orphaned basis to create losses. 

The IRS promulgated disclosure Regulations under Section 6011. At first, they applied only to corporations, but by 2004 they were expanded to include individual taxpayers. The IRS wanted taxpayers to disclose transactions that, in the IRS’ view, were potentially abusive. The IRS quickly recognized that many if not most taxpayers were choosing not to report. There were several reasons for this, including:

·       Taxpayers could consider a number of factors in determining whether a transaction was reportable

·       The gauzy definition of key terms and concepts

·       The lack of a uniform penalty structure for noncompliance

The IRS brought this matter to Congress’ attention, and Congress eventually gave them a new shiny tax penalty in the 2004 American Jobs Creation Act. It was Section 6707A.

One of the things that the IRS did was to disassociate the penalty from the taxpayer’s intent or purpose for entering the transaction. The IRS published broad classes of transactions that it considered suspicious, and, if you were in one, you were mandated to disclose. The transactions were sometimes described in broad brush and were difficult to decipher. Additionally, the transactions were published in obscure tax corners and publications. No matter, if the IRS published some transaction in the Botswana Evening Cuspidor, it simply assumed that practitioners – and, by extrapolation, their clients – were clued-in.

If the IRS decided that your transaction made the list, then you were required to disclose the transaction on every tax return that included a tax benefit therefrom. If the IRS listed the transaction after you filed a tax return but before the statute of limitations expired, then you had to file disclosure with your next tax return. You had to file the disclosure with two different offices of the IRS, which was just an accident waiting to happen. And the disclosure had to be correct and complete. If the IRS determined that it was not, such as if you could not make heads or tails of their instructions for example, the IRS could consider that the same as not filing at all. There were no brownie points for having tried.

There’s more.

The penalty applied regardless of whether taxpayer’s underlying tax treatment was ultimately sustained. In fact, the IRS was publishing reportable transactions BEFORE proving in Court that any of the transactions were illegal or abusive. If you took the IRS to Court and won, the IRS said it could still apply the penalty. There was no exception to the imposition of the penalty, even if you could demonstrate reasonable cause and good faith.  

But there was some mercy. Although you could not take the penalty to Court, you could request the IRS Commissioner for rescission if it would “promote compliance … and effective tax administration.” Oh please.

Can this get worse? You bet.

Let’s decouple the penalty from any possible tax benefit you may have gotten. If the transaction was particularly suspicious (termed “listed’), the penalty was $100,000. Double that if you were a company. What if the transaction occurred in your S corporation and then on your personal income tax return because of the K-1 pass-through? Well, add $200,000 plus $100,000 for a penalty of $300,000. Per year. What if the tax benefit was a fraction of that amount? Tough. 

This was a fast lane to Tax Court. Wait, the penalty could not be appealed. Think about that for a moment. The IRS has a penalty that cannot be appealed. What if the system failed and the IRS assessed the penalty abusively or erroneously?  Too bad.  

The Taxpayer Advocate publicly stated that the 6707A penalty should be changed as it “raises significant constitutional concerns, including possible violations of the Eight Amendment’s prohibition against excessive government fines and due process protections.”

In response to public clamor and pressure from Congress, the IRS issued moratoriums on 6707A enforcement actions. It wound up reducing the penalty for years after 2006 to 75% of the decrease in tax resulting from the transaction. There was finally some governor on this runaway car.

My client walked into Section 6707A long before I ever met him/her. How? By using a retirement plan.

Yep, a retirement plan.

The plan is referred to as a 412(i), for the Code section that applies. A company would set up a retirement plan and fund it with life insurance. Certain rules relaxed once one used life insurance, as it was considered a more reliable investment than the stock market. I was a fan of these plans, and I once presented a 412(i) plan to a former client who is (still) a sports commentator at ESPN.

Then you had the promoters who had to ruin 412(i)) plans for everyone else. For example, here is what I presented to the ESPN person. We would set up a company, and the company would have one employee and one retirement plan. The plan would be funded with life insurance. The plan would have to exist for several years (at least five), and - being a pension plan - would have to be funded every year. Because life insurance generally has a lower rate of return than the stock market, the IRS would allow one to “over” fund the plan. After five years or more, we would terminate the plan and transfer the cash value of the insurance to an IRA.

The promoters made this a tax shelter by introducing “springing” life insurance. They were hustling products that would have minimal cash value for a while – oh, let’s say … the first five years. That is about the time I wanted to close the plan and transfer to an IRA. Somehow, perhaps by magic, all that cash value that did not previously exist would “spring” to life, resulting in a very tidy IRA for someone. Even better, if there was a tax consequence when the plan terminated, the cost would be cheap because the cash value would not “spring” until after that point in time.

I thought a 412(i) plan to be an attractive option for a late-career high-income individual, and it was until the promoters polluted the waters with springing insurance nonsense. It then became a tax shelter, triggering Section 6707A.

My client got into a 412(i). From what I can tell, he/she got into it with minimal understanding of what was going on, other than he/she was relying on a professional who otherwise seemed educated, sophisticated and impartial. The plan of course blew up, and now he/she is facing 6707A penalties – for multiple tax years.

And right there is my frustration with penalties of this ilk. Perhaps it makes sense if one is dealing with the billionaires out there, but I am not. I am dealing with businesspeople in Cincinnati who have earned or accumulated some wealth in life, in most cases by their effort and grit, but nowhere near enough to have teams of attorneys and accountants to monitor every fiat the government decides to put out. To say that there is no reasonable cause for my client is itself abusive. He/she could no more describe the tax underpinnings of this transaction any more than he/she could land a man on the moon.

What alternative remains to him/her? To petition the Commissioner for “rescission?” Are you kidding me? That is like asking a bully to stop bullying you. I have ten dollars on how that exercise will turn out.