Doubts mount about Valeant Pharmaceuticals’ tax structures

MONTREAL – The disclosure by Valeant Pharmaceuticals International Inc. that it is under audit by the U.S. Internal Revenue Service is raising further doubts among tax specialists about the future of the Quebec-based drug company’s tax strategies.

Valeant estimates it has achieved US$2.5-billion in tax and other “corporate structure” savings since merging with Ontario’s Biovail Corp. in 2010. The company’s plan to save even more by buying California pharmaceutical firm Allergan Inc. has attracted the attention of a group of U.S. senators, who want the Federal Trade Commission and the Department of Justice to review Valeant’s US$50.9-billion stock-and-cash bid for the maker of Botox. Now, tax authorities have entered the picture.

‘I’ve seen many examples of companies moving some profits offshore to low-tax jurisdictions, but not to this extent’

“I’ve seen many examples of companies moving some profits offshore to low-tax jurisdictions,” said Stanley Abraham, director of U.S. taxation for Toronto-based accounting firm Zeifmans LLP. “But not to this extent.”

Valeant disclosed in an Aug.1 regulatory filing that the IRS has started an audit of its U.S. business for the 2011 and 2012 tax years. It is also under examination by the Canada Revenue Agency for the years 2010 and 2011.

Tax officials are looking at the periods before and after Valeant merged with Biovail, achieved through a so-called corporate inversion that reincorporated the combined company in Canada. The time frame is key because that is when Valeant reorganized its tax structure. It also subsequently picked up the pace and size of its acquisitions.

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While the Biovail deal was officially structured as Canada’s Biovail buying U.S.-based Valeant, the combined company kept the Valeant name and today, the offices of top management are clustered around a makeshift indoor basketball court in Madison, N.J. The building was formerly a YMCA.

One key advantage Valeant won in merging with Biovail was inheriting Biovail’s tax structure. According to Valeant, tax savings from the merger drove down the company’s cash tax rate to 3% in 2013 from 36% pre-merger.

Valeant benefits from Canada’s quasi-territorial tax system, which exempts from tax all income a company earns from affiliates abroad in countries with which Canada has a tax treaty. Canada has such agreements with some 90 countries, including major low-tax jurisdictions such as Ireland and Luxembourg.

Valeant also holds a significant portion of its corporate debt in the United States, benefitting from interest deductions on it.

Perhaps most important, however, the company moves its intellectual property offshore and uses transfer pricing to reduce taxable profit in higher rate jurisdictions, according to Dimitry Khmelnitsky, an investment analyst with Veritas Investment Research in Toronto who specializes in special situations and accounting issues. That’s the key factor driving the 3% tax rate, he said. Transfer pricing refers to the price one company division charges another division for goods and services transferred across borders.

“Valeant has not demonstrated nor disclosed sufficient details to assess why its off-shore tax structure and the related transfer pricing is sustainable,” Mr. Khmelnitsky said in a recent research note, adding that one major risk is that Valeant appears to have little in the way of business presence in its key offshore entities. “Instead, the company simply noted that its actions are similar to other IT companies, and that it is in compliance with all applicable laws.”

But even technology companies are subject to higher tax rates, Mr. Khmelnitsky said. Apple, branded a poster child of tax avoidance by U.S. lawmakers, pays a roughly 21% cash rate on its worldwide income and 87% of its taxes are paid in the United States, he noted. Meanwhile, Valeant pays “very little U.S. taxes,” he said, even though the country is its largest commercial market.

“We do everything by the book,” Valeant chief executive Mike Pearson said during a May 28 investor presentation. “In terms of our tax rate versus other companies, we are not a recently inverted company. We have been inverted for a number of years, and quite frankly, we just work harder.”

There’s another matter, tax specialists say: The shifting of intellectual property out of the U.S. itself and how Valeant has accounted for that.

“The bigger ticket issue which is going to pop right out [for the IRS] is how are they moving this offshore at little or no tax?” said Mr. Abraham, who has studied Valeant’s two most recent Form 10-K annual filings. “There’s only two ways out of it. If all [their] profits are in these low-tax jurisdictions, that means that they’re pushing most of the profits to the intellectual property itself as opposed to any other activity. And if it was pushed to the IP, how did you get the IP out without paying [significant tax]?”

Mr. Abraham cautioned he can’t be certain what the company is doing because it provides no meaningful disclosures on its offshore subsidiaries.

But he takes as an example Valeant’s purchase of U.S. speciality oral health company OraPharma Topco Holdings Inc. in 2012, as detailed in Valeant’s annual filing that year. According to the filing, OraPharma’s lead product is Arestin, an antibiotic for the treatment of periodontitis.

In its accounting of the acquisition, Valeant recognizes US$15.5-million as the fair value for the acquired IP and research and development for Arestin but US$466-million in “identifiable intangible assets,” which it specifies only as OraPharma’s “product brand” and “corporate brand.”

Mr. Abraham said Valeant is attributing little or no value to Arestin and to the intrinsic value of other patents. That suggests that it is the asset the company is transfering offshore, with little or no gain recognized on the transfer.

“You can’t have it both ways,” Mr. Abraham said. If the company states the value was in the other intangibles, namely the product and corporate brands of OraPharma, then the resulting profit should have followed the value and remained in the United States, he said. Alternatively, if the company says the value was in whatever assets were transferred offshore, then there should have been a rather significant tax assessed on the offshore transfer.

“Barring an abusive loophole, Valeant would have to pick its poison,” he said.

There is the possibility the assets Valeant transferred offshore are sheltered significantly by net operating losses or tax credits that might be carried forward. But Mr. Abraham said this is unlikely.

The IRS issued a notice in 2012 saying it recognized there are loopholes in the laws governing the transfer of intangible property by U.S. companies to foreign entities. The U.S. agency is expected to close the loopholes and issue new regulations retroactive to July 2012.

Valeant has added specific wording in the tax risks section of its annual filing to address possible reassessments by tax authorities. It states: “The final outcome of any audits by taxation authorities may differ from the estimates and assumptions that we may use in determining our consolidated tax provision and accruals. This could result in a material adverse effect in our consolidated income tax provision, financial condition and the net income for the period in which such determinations are made.”

Mr. Pearson has said that Valeant treats taxes like an operating expense, adding the company has world-class advisors in the area, including New York law firm Skadden, Arps, Slate, Meagher & Flom LLP as well as professional services firms Deloitte and PricewaterhouseCoopers.

But Mr. Abraham and Mr. Khmelnitsky as well as other accountants note that just because a company is advised by a well-known accounting firm doesn’t mean tax authorities won’t challenge the methodologies used to arrive at the transfer pricing and valuation practices or the assumptions used.

In that sense, the rules are more like a framework that’s subject to interpretation.

Merck & Co., Forest Laboratories Inc., Pfizer Inc,. and Eli Lilly & Co. have all been reassessed by the IRS in the past decade. British pharmaceutical giant GlaxoSmithKline plc, which also used PricewaterhouseCoopers as its auditor, settled with the IRS for US$3.3-billion in 2006 after the tax agency contested the transfer priced being charged to the drug maker’s U.S. subsidiary.

Asked about Valeant’s tax structure, company spokesperson Laurie Little offered no new details beyond previous answers and disclosures, repeating: “We book revenue where inventory and products are sold through inter-company agreements and distribution networks and record profit where earned and where each party earned an arm’s-length remuneration.”

Ms. Little said the drug maker is fully compliant with all local laws and treaty regulations as well as the rules governing transfer pricing.

Observers note that it’s impossible to say with certainty when Valeant’s tax probes will be resolved. Mr. Abraham said the IRS may want to have a longer 20/20 hindsight to see what cash flows result from Valeant’s offshore property transfers. That could take years.