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.
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.
Under the new rules, the company would have to add a markup based on its estimate of what it would pay a third party for those services, recognizing the value created by the services. But the company would have to prove that such a markup was appropriate, based on market prices or “comparables.” If it couldn’t do so within a margin of error that grows increasingly narrow as the markup rises, tax could very well be owed according to the affiliate’s share of the profits earned in the U.S. market, based on its value added; that is, the value of the marketing relative to R&D. In the case of the average multinational drug company, says Wright, if it has a gross margin of 80 percent, such a profit split could mean the U.S. company should earn a significant chunk of the gross profit, or as much as 30 or 40 percent of revenue. That’s as much as eight times what the company would report under current IRS rules.