When the U.K. is a Tax Haven: Pfizer’s Medicine to Reduce the Tax Bill

Marco Guerra, LLM University of Milan; LLM Student, King’s College 

In one of her articles on this blog Christy Burzio focused on the AstraZeneca (potential) deal. She analysed the issue from a commercial point of view and its implications. In one passage, reporting what was expressed by the shareholders of the company, she noted that the deal was rejected “namely on the basis that it was motivated by tax avoidance and cuts to research jobs”[1].

The New York Times’ Deal Book quantified those tax benefits: “Pfizer paid a 27.4 per cent rate in the United States; AstraZeneca paid about 21.3 per cent in Britain. Those six percentage points could turn into an annual windfall of more than $1 billion”[2].

This operation involves the so-called “corporate inversion”. It means the process of incorporating a multinational company set in a high-tax country in another (low-tax) country by altering the citizenship and tax liability[3]. Recently, several US Senators have introduced bills in the Senate and House that would crack down on this tax-avoidance strategy.

In the first part of this work I will provide a brief description of this tool and its use in some of the most important acquisitions of the last decades. Then I will analyse the proposal made by the Democratic Party in the U.S. Consequentially, I will outline a possible (and reasonable) solution in the light of the concept of residence for tax purposes. In particular, I will focus on the concept of residence for tax purpose as provided by select legislation, identifying their weaknesses and potential solutions.

The corporate inversion as a tax planning tool

In recent years we have seen a growth in the number of inversions from both the U.S. and the U.K. This type of tax planning is especially popular for pharmaceutical and biotechnology companies, where most of the value of the company is found in mobile intangible assets that can be shifted geographically. Initially, companies like Helen of Troy, a Texas-based beauty-supply firm that was an inversion pioneer in 1994, would move offshore by forming a new company based in Bermuda. Similarly Valeant Pharmaceuticals, also domiciled in Bermuda, has made a strategy of buying companies (such as Bausch & Lomb) and moving them to its lower-tax domicile. Ireland is another popular haven: the pharmaceutical company Actavis moved to Ireland by way of merger with Warner Chilcott, and the acquisition of Questcor Pharmaceuticals by Mallinckrodt moved another U.S. company to a lower tax rate. But this is not the only business where companies adopt this tax strategy: last March Chiquita Brands announced a merger with Fyffes, a Dublin, Ireland-based food distributor.

But what is it and how does it work?

The U.S. Treasury defines corporate inversions as “a transaction through which the corporate structure of a U.S. based multinational group is altered so that a new foreign corporation, typically located in a low or no-tax country, replaces the existing U.S. parent corporation as the parent of the corporate group”[4].

As known, the U.S. has one of the world’s highest corporate tax rate (35 per cent[5])[6]. Moreover, the U.S. tax treatment of foreign income is based on two features. At first, (i) American corporations must pay tax on worldwide income, not just on U.S. income, but (ii) they may defer tax on most income from foreign sources until the income is repatriated to the United States[7].

With an inversion, the U.S. corporation reincorporates in a new country with a lower tax rate maintaining its headquarters in U.S.[8]. Furthermore, this transaction is structured to be tax-free to the corporation under International Revenue Code 368 (a)(1)(B)[9] and taxable to the shareholders.

American companies have legally exploited this loophole by acquiring foreign firms and transferring their official address to the foreign lower-tax-rate country. Under current U.S. tax law, if the American company transfers at least 20 per cent of its shares to the foreign firm, it can avoid paying the 35 per cent U.S. corporate rate.

With reference to their foreign incomes, American companies have two roads:

1. They can leave those earnings overseas, taxed at local rates (if any) but untaxed from a US perspective[10]. Moreover, the existence of a new foreign parent may enable the U.S. group to reduce taxes on U.S.-source income by paying deductible interest or royalties and by manipulating transfer pricing[11]. In this case the capital is largely unproductive, as it outstrips local investment needs and can’t be used for dividends[12].

2. On the other hand they can bring the profits back home, paying the difference between what they paid abroad and the U.S. rate (i.e. credit method).

The U.S. proposal

Several lawmakers have long been concerned about corporate inversions. Senator Charles E. Grassley (R-IA) said in 2002: “These expatriations aren’t illegal. But they’re sure immoral […] So they’ll take tax dollars, but they aren’t willing to pay their share”[13].

The first attempt to stop this phenomenon is contained into the American Jobs Creation Act of 2004 (still in force). It provides that the new foreign domicile of the company will be ignored, and it will be taxed as if it is a domestic U.S. corporation if:

(i)                the former shareholders of the US corporation own at least 80% of the new foreign corporation; and

(ii)             the expanded affiliate group of the new company does not have substantial business activities in the country of its incorporation compared to the total business activities of the expanded affiliate group.

This law prevents many corporate inversions, but it still leaves the door open for Pfizer-AstraZeneca-like mergers. In fact in the past few years, as the world has become more global and other countries have cut their corporate rates, a new exodus wave has started. In particular, the American Jobs Creation Act put a stop to the most egregious inversions where the foreign corporation acquiring the U.S. business is little more than a shell company. However, this may not be enough to stop the transaction that Pfizer was contemplating.

This is the reason why, while Pfizer’s bid for AstraZeneca was still alive, Senator Carl Levin and Congressman Sander M. Levin proposed a change in the inversion rules[14]. Under their proposal, a company could not move offshore by taking over a foreign company unless the foreign holders own a majority of the new company and the company gets new management[15]. The Levin proposal curtails this strategy by raising the threshold from 20 to 50 per cent. In other words, foreign shareholders must own the majority of shares of the new entity for it to avoid U.S. taxes. In addition, if management and control of the company remain in the United States, it must pay the U.S. corporate tax.

Residence of the company and allocation of income

The U.S. uses a purely formal approach to company residence for tax purposes. All corporations organised under the laws of the U.S. or one of the federal states is treated as domestic. All other corporations are “foreign”, even if all their commercial and economic activities are linked to the U.S.[16]. Similarly, the tax liability of companies incorporated in the U.K. is determined by the place of incorporation and not any factual enquiry as to where or how it conducts its business[17].

The identification of the residence of the company for tax purposes, as well as with reference to the location of the registered office and place of management, can also be determined in relation to the location of its main business. Several countries (such as Italy) adopt the “main business” test in addition to the tests of incorporation or central management.

Briefly, in order to identify the main business of a company it is necessary to direct attention to the activities carried out for the achievement of company purpose and proceed with the acquisition of data and information regarding:

(i)                            activities carried on by the company;

(ii)                         places where those activities are carried;

(iii)                       places where contracts are concluded;

(iv)                        economic and financial relations with third parties;

(v)                          main markets in which the company operates;

(vi)                        place of management of bank accounts and where the financial resources are available.

In 2011 the EU Commission presented a proposal of the Directive on a common consolidated corporate tax base (hereinafter, the “CCCTB”). The CCCTB proposal involves a revolutionary change: this is the switch of the method for allocation of income to a formula apportionment method. The CCCTB is based on the following factors: labour, capital, sales[18]. Also in this case the main goal is to allocate the income, and accordingly the taxing right, where it was effectively realised according to factual, and not formal, features.

It is really important to stress that the CCCTB will not affect tax rates. It seeks to harmonise the tax base and not the tax rates. In other words, the CCCTB determines the portion of the consolidated tax base that belongs to a Member State. Member States will be entitled to tax the income apportioned to them as they wish[19].

Conclusion

Presently the U.S. debate on how to stop corporate inversions is polarized on two contrasting positions.

Democrats[20] focus their effort to erect barriers that make sure that companies don’t acquire other firms just to take advantage of a lower tax rate[21].

On the other hand Senator Orrin Hatch (and the Republican Party) suggests that “The [best] way is to make the United States a more desirable location (i.e. with a lower corporate taxation) to headquarter one’s business”[22].

But, as it was observed[23], if done incorrectly, tax reform could become little more than a race to the bottom to cut corporate taxes as much as possible. In this case any country could be considered as a mere tax planning tool. As the U.K. in the potential Pfizer-AstraZeneca merger stated “Do we really want a jewel in the crown of British industry, our second-biggest pharmaceutical firm, to basically be seen as an instrument of tax planning?” asked Chucka Umunna, the Labour Party’s shadow business secretary[24]. To avoid this risk, ensuring sovereign taxing powers, I think that the recent U.S. debate is not focused on the relevant issue.

As it was observed, if residence-based corporate taxation becomes impossible (or leads to unfair results), the only way to continue to tax multinationals is on the basis of the source[25]. In other word the tax base should be determined considering how and where[26] a good or a service has been produced (labour and capital factors), and where it has generated a profit (place of selling/purchase).

In the light of the brief considerations I have outlined, I endorse this approach for two reasons:

(i)                it guarantees that incomes are taxed where they are actually realised independently from any formal way to determine the residence of a company;

(ii)             a low-tax rate can no longer be used as a tool of harmful competition, but as an expression of a well-balanced management of public resources of the States. They do not have to work on their fiscal policy to attract sterile capital but genuine economic investments that permit an expansion of their tax base.