VideoOn the day in early January when talks over a long-running tax dispute between Glaxo SmithKline and the Internal Revenue Service broke off, Glaxo's share price fell nearly 2 percent. And no wonder. The IRS wants the U.K.-based pharmaceutical giant to cough up more than $5 billion in taxes, penalties, and interest, more than half of operating cash flow.
The dispute involves transfer pricing—specifically, the rate Glaxo charged for marketing services supplied by its U.S. affiliate from 1989 to 1996. The IRS maintains that the rate was far too low, and thus vastly understated Glaxo's income subject to U.S. tax during that period. Now the case is headed for the U.S. Tax Court, where hearings could begin as early as next year.
Corporate tax directors are taking a keen interest in the case—particularly at multinational enterprises, for which transfer pricing is the most important international tax issue. According to transfer-pricing experts, the IRS's decision to take Glaxo to court reflects new thinking on the part of the agency. They say the new thinking is enshrined in new regulations, proposed by the IRS last September. The rules would radically change how the U.S. tax authority treats services supplied to parent companies by affiliates in other tax jurisdictions (and vice versa)—including jurisdictions that offer enough tax incentives to be considered havens. "The new rules will allow the IRS to deal with this issue much more effectively," observes Deloris Wright, a principal in the Denver office of consulting firm The Analysis Group.
The proposed regulations have already spawned controversy, as was evident at an IRS hearing in mid-January. "Largely unworkable" was the judgment offered by Hank Wagner, senior counsel for the Mount Olive, New Jersey-based affiliate of German chemical maker BASF. Wagner's testimony cited the "enormous complexity" and "unreliability" of key provisions, which he said would impose compliance costs on multinational corporate taxpayers that would "exceed any benefit the new rule[s] will provide."
Others worry that the new rules could subject multinational companies to huge increases in U.S. taxes. The concern is particularly acute for midsize growth companies, says Jim Silvestri, director of worldwide taxes for Cognizant Technology Solutions Corp., a software developer based in Teaneck, New Jersey.
Heartburn for Multinationals
Under current tax rules, transfer pricing of services can be reported at cost as long as those services are deemed not integral to the business. Those that are integral must be priced as if they were offered by a third party, which usually amounts to cost plus a markup that would be appropriate in an arm's-length transaction. What's integral, of course, is subject to interpretation, as is the question of a suitable markup. And as Glaxo and other cases show, the IRS has had some difficulty getting the tax court to side with it.
The proposed new rules do away with the safe harbor for nonintegral services. Instead, they require those services to be priced, for starters, at cost-plus (called the simplified cost-based method). The markup must be demonstrably close to what is available from a third party. If the third-party markup exceeds 10 percent, a company would have to use one of five other methods (see "No Ports in This Storm," at the end of this article).
Certain services, such as insurance and research and development, are explicitly excluded from the simplified cost-based method, while others may not qualify because they fall into such broad but ambiguous categories as "valuable" or "unique" (see "More Fine Print," at the end of this article). Companies worry that even some low-margin back-office services won't qualify for cost-plus treatment.
Not surprisingly, the IRS contends that any additional tax burden for multinationals resulting from the new rules may be completely appropriate. To understand why, consider the Glaxo case, which focuses on the firm's popular ulcer drug, Zantac. Observers note that Glaxo depends heavily on marketing and distribution efforts in the United States for sales of Zantac in this country. Those services are performed through a U.S.-based affiliate. Meanwhile, Glaxo's R&D efforts for the drug are conducted in the United Kingdom.
According to the IRS, much more of Zantac's value is derived from marketing efforts than from R&D, because the drug is number two in the market. The IRS's position is that R&D may explain the success of a "pioneer" drug (that is, the first product to treat a given disease state); however, subsequent market entrants are successful primarily due to the marketing acumen of the company. But Glaxo's transfer pricing doesn't reflect that value. Glaxo contends that Zantac's value is largely produced by R&D, because the drug is different enough to make the U.K. patent that Glaxo holds on it the key to its value. "We expect to prevail in U.S. Tax Court," says a company spokesperson. The IRS declined comment.
Huge Stakes
How big are the stakes for companies that may face a similar challenge over their transfer pricing? Numbers are hard to come by, but The Analysis Group's Wright assumes that a typical multinational pharmaceutical company spends 4 percent of its revenues on corporatewide IT and other support services, and spends another 15 percent on marketing and distribution. Under current IRS rules, if those marketing and distribution activities took place in the United States, the U.S. taxpayer could be expected to earn a modest markup on these costs, typically between 5 and 10 percent.
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