The Walgreens Inversion

Good news - Max Sawicky has returned to blogging:

The Gov needs money. I’m as entertained as anyone else by speculations about how to improve the tax code. It certainly could be improved. But there is a much simpler way to increase collections — enforce the tax code we already have. About one in six dollars owed is not paid on time, or ever. The solution is simple: give the over-burdened Internal Revenue Service more money.

Bad news – American corporations are back to the inversion game:

Walgreens, our country’s biggest pharmacy chain, is trying to dodge paying its fair share of taxes. It may soon shift its corporate address from Illinois to Switzerland, a tax haven. After it completes a planned merger with Alliance Boots, a Swiss pharmacy chain, Walgreens can take advantage of a tax loophole to reincorporate itself offshore. This may let the company avoid $4 billion in U.S. taxes over the next five years, leaving the rest of us to pick up the tab. Walgreens would still be controlled from the U.S. It would still benefit from our roads, bridges and infrastructure, and it would will still have more than $70 billion in annual U.S. sales.

Walgreens does tend to sell around $72 billion a year in products but mostly to U.S. customers. Its profits tend to be around $4 billion a year yielding a 5.5% operating margin. When I first read this story, I was puzzled how simply being tax domiciled in Switzerland would impact the U.S. tax obligations for what is essentially a purely domestic enterprise. Ben Hallman offers two possible explanations:

The tax savings of moving a corporate address abroad can be enormous. Companies are no longer on the hook for paying U.S. taxes on profits earned abroad, potentially a huge benefit for companies with big overseas sales. Walgreens, because its stores are located primarily in the U.S., would likely realize big tax savings in a different way: By shifting large amounts of debt from its foreign operation to its domestic operation in order to offset profit, said Frank Clemente, the executive director of Americans for Tax Justice.

Walgreens has virtually no third party debt right now. I’m not an expert on whether or not one can just have a U.S. affiliate pay interest expenses on debt generated by a foreign affiliate so if any of you are international tax law experts – feel free to comment. But it is this second scenario where I would like to comment:

One common way U.S. companies exploit such shell companies is by transferring patents or trademarks abroad, and then paying their subsidiary licensing fees for the right to use those patents, thus reducing domestic profit.

We need to do what the tax attorneys call a section 367(d) analysis. Let’s assume that the 5.5% operating margin being generated by these Walgreens stores can be decomposed into a 3% routine return versus a 2.5% royalty rate for the use of various intangibles (patents, trademarks, etc.). Hallman is suggesting that the Swiss affiliate could charge $1.8 billion per year in royalties. But under section 367(d), the Swiss affiliate would have to pay the U.S. affiliate the fair market value for the transferred intangible assets. What is a reasonable estimate of this fair market value? Is it closer to $20 billion or to $2 billion? I’m sure Walgreens could get some hack who pretends to be a valuation expert to argue for the lower figure. But if one looked at the balance sheet as well as the current market value for the equity of Walgreens and tried to deduce the market’s valuation of its intangibles, this figure would be closer to $40 billion. But as Max notes – we note a properly funded IRS to make the argument.