Leprechaun Economics and Big Pharma

John Fitzgerald offers a lot of insights on the Irish GDP accounting issue:

The so called “patent cliff”. Because the pharmaceutical sector accounts for a substantial share of Gross Value Added (GVA), developments in the statistical treatment of the sector can have a significant impact on the national accounts: for example, if patents on major drugs produced in Ireland run out…multinational enterprises have grown in importance. When they operate in countries outside their home location, the profits earned by those companies in the foreign destination properly belong to the shareholders in the company, rather than to the residents of the country in which the profits are generated. This drives a wedge between GDP and GNI/GNP as the profits, net of tax, are remitted to the shareholder.

Let’s take three real world examples starting with Forest Laboratories:

Thirty million prescriptions were filed last year for the anti-depressant Lexapro, made by the U.S. pharmaceutical company Forest Labs. According to a story in Friday's Bloomberg Businessweek, most of the profits from that drug were transferred overseas, thus avoiding having to pay taxes in the United States. The news is shocking to Lexapro customers like Tyler Hurst, who buys the drug at a Phoenix pharmacy. "It does not say, 'The profits of this go outside the country,' anywhere," said Hurst as he looked at the drug bottle. "It is shady."

When the patent on Lexapro expired, these profits declined:

The makers of the popular antidepressant Lexapro (escitalopram) reported a net loss in sales resulting from expiration of the drug’s patent in March 2012. New York-based Forest Laboratories disclosed that it lost $153.6 million, or 58 cents per diluted share, in the fiscal quarter that ended in December 2012.Lexapro rose to popularity soon after its release in 2002, earning $13.8 billion for Forest Laboratories in the span of a decade. The antidepressant has routinely made up over half of Forest’s sales. It made almost $600 million in the quarter that ended in December 2011. Then, following the release of the generic version of escitalopram in March 2012, Lexapro’s sales plummeted 97 percent to $20.3 million in the third quarter ending in December 2012.

Lexapro was manufactured in Ireland for production costs near 25 percent of sales but sold to the U.S. at a transfer price near 70 percent, which left the U.S. distributor with low profits after selling expenses. The IRS did notice and argued that the transfer pricing should reflect only production costs plus a modest markup to cover the cost of capital on the Irish tangible assets. Clearly a lot of these profits before the expiration of the patent were due to intangible assets, which the IRS argued were U.S. owned. We see similar financials for medical device manufacturers such as Medtronic and Guidant. While I linked to the taxpayer’s petition to the Tax Court for the latter, let’s refrain from commenting on an ongoing litigation but rather note the Medtronic decision:

The U.S. Tax Court handed Medtronic Plc a victory in a $1.4 billion dispute with the Internal Revenue Service over how much of the medical device maker’s profits should be taxed by Puerto Rico and how much should face higher federal taxes instead…The case involved transfer pricing, or the rules that govern transactions between different arms of the same company. Corporations must make such transactions as if they were engaged in arm’s length deals between unrelated companies, and allocate income where it is earned, depending on which entity truly generates the profits. But those standards frequently lead to fact-intensive disputes with the IRS. In this case, the company and the government were arguing about the proper methods for determining how profits should be split between foreign and domestic operations.

Let’s put this in context with a simple example. Suppose that the U.S. parent sells $10 billion in products incurring $2 billion in selling costs, while the foreign (tax haven) manufacturer incurs $2 billion in production costs with overall profits being $6 billion. Let’s also assume that a distributor would be granted $500 in profits while a contract manufacturer would be granted another $500 million in profits. Transfer pricing geeks would say we have $5 billion in residual profits. The IRS thinks that the foreign manufacturer should pay a royalty equal to 50 percent of sales capturing all residual profits. The representatives for these highly profitable multinationals are arguing for royalty rates of only 20 percent of sales which would leave most of the profits with the tax haven even though the facts seems to be that all intangible assets were created in the U.S. Of course these profit margins pale in comparison to what Gilead receives on its new hit treatments:

A new investigative report finds that in the last two years Gilead Sciences has raked in billions in profits from exorbitantly priced hepatitis C medications that were developed with taxpayer dollars, and then shifted those profits to offshore tax havens where it dodges U.S. taxes….The report found Gilead’s sales and profits have soared since the drugs launched, while its tax rate has plummeted. Gilead’s worldwide revenues recently tripled—from $11.2 billion in 2013 to $32.6 billion in 2015. Corporate pre-tax profits soared even more: rising from $4.2 billion to $21.7 billion from 2013 to 2015, a five-fold increase. But, over the same period Gilead’s worldwide effective tax rate plummeted by 40%—dropping from 27.3% in 2013 to 16.4% in 2015.

This report accuses Gilead of tax dodging as it assumes the U.S. parent paid Pharmasset $11 billion for the phase II rights:

“For Gilead to give up effectively one-third of their value for an unproven asset still subject to significant ongoing clinical risk seems remarkable,” Porges, who is based in New York, wrote today in a research note. The company is “likely to be treated harshly by investors for apparently ‘top ticking’ the most visible asset in the market.”

This was a risky gamble that paid off. But my understanding is that the Irish affiliate purchased the phase II rights and then funded the remaining R&D. Regardless of who is right on the transfer pricing issue, the success of these Hepatitis C treatments represented a dramatic increase in value-added.