Billionaire Eugene Melnyk: I’m a ‘whistleblower’ on tax allegations against Valeant

MONTREAL • Eugene Melnyk, the billionaire owner of the Ottawa Senators and founder of drug maker Biovail Corp., is waging war against the company that now controls his one-time business.

Mr. Melnyk alleges that Valeant Pharmaceuticals International Inc. is masquerading as a Canadian company to make use of this country’s international fiscal treaties and dodge U.S. taxes. He predicts it will all eventually implode if American authorities claw back the taxes he believes Valeant may owe.

The Canadian businessman confirmed that he and three other individuals formed a group that made a formal presentation in 2012 to U.S. regulatory authorities, notably those in charge of taxation, denouncing Valeant’s tax strategy. In an interview this week, he called himself an “official whistleblower.”

The group alleges that Valeant’s merger with Canada’s Biovail in 2010 — which the group, among others, claim was more like California-based Valeant taking over Biovail — was a deceitful transaction whose sole purpose was to win Biovail’s international tax advantages. And the group says Valeant, now headquartered in Laval, Que., is casting itself as a Canadian company only to keep those benefits going.

“You know the phrase if it walks and talks like a duck it is a duck?” Mr. Melnyk said of Valeant. “Well guys, you are an American company. Who are you trying to fool?”

Valeant executives say their drug and health products company is doing nothing wrong and follows all the rules of jurisdictions where it operates.

Mr. Melnyk founded Biovail and led it as chairman and chief executive for more than a decade before losing a fight to take the medicine maker, built on developing slow-release pills, private. At the time Biovail merged with Valeant, he was no longer involved with the company and declared that he had sold his remaining stock.

The crux of Mr. Melnyk’s allegation against Valeant is that the company’s income is not being taxed in the United States even though its corporate leadership resides in that country. In that sense, he believes the company is infringing U.S. tax law. He says Valeant will eventually spin into a “death spiral” when authorities force the company to pay back the taxes owed, which will trigger debt covenants with lenders.

When it comes crashing down, it’s going to happen so fast and so hard that people are going to lose fortunes

“It’s a house of cards,” he said. “It’s going to come crashing down on them, I’m telling you. And when it comes crashing down, it’s going to happen so fast and so hard that people are going to lose fortunes.”

By taking advantage of Canadian tax treaties with Barbados and, more recently, other countries in Europe and elsewhere, Valeant is further reducing its tax bill while its main decision-making happens in the United States, Mr. Melnyk alleges. Unlike the United States, Canada allows companies to shift their intellectual property centres to lower-tax jurisdictions while repatriating the profits without incurring more tax.

The situation has allowed Valeant to pay a tax rate under 5% and save tons of money, contributing to an aggressive growth-by-acquisitions strategy that gives it, in theory, more firepower than U.S.-based rivals in takeover situations. Many U.S.-based companies are subject to a tax rate north of 30%. Allergan, the Irvine, Calif.-based company currently fighting off a takeover bid from Valeant, paid a tax rate of about 26% in 2013.

Valeant is incorporated in British Columbia and headquartered in the Montreal suburb of Laval, Que. where its head office employs 186 people. Its chairman and chief executive, Canadian native J. Michael Pearson, works from an office at Valeant’s U.S. headquarters in Bridgewater, N.J., where about 400 people are based. Mr. Pearson spends more than half his time travelling globally, a company spokesperson said. Valeant’s Chief Financial Officer Howard Schiller works in New Jersey as well.

Two of Valeant’s 10 board members live in Canada. Roughly half the company’s revenue last year was generated in the United States.

Valeant made three senior executives available to respond to Mr. Melnyk’s statements, including Mr. Pearson, Mr. Schiller, and Jeremy Lipshy, who leads the company’s tax planning.

“Mr. Melnyk is obviously entitled to an opinion,” Mr. Lipshy said. “But the fact is that under the rules of both Canada and the United States, we’re a Canadian company following all the rules and regulations as they’re currently proposed, both in spirit and in terms of the written rules.”

Valeant’s intellectual property is owned in multiple jurisdictions including Mexico, Poland, Luxembourg, Ireland, Canada, Australia and South Africa, Mr. Lipshy said.

“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,” he said. “Each entity is resident in their country of their incorporation and we’re compliant with all local laws as well as the laws of the relevant treaties between each party.”

In a quarterly filing with the U.S. Securities and Exchange Commission on August 1, Valeant disclosed that during this year’s second quarter, the U.S. Internal Revenue Service started an audit of the company for the years 2011 and 2012.

Valeant also disclosed that it is “under examination” by the Canada Revenue Agency for its 2005 to 2008 and 2010 to 2011 tax years. The company said it received updated reassessments last year for the first four-year period, relating mainly to the CRA’s denial of deductions for legal and consulting fees. The 2010–2011 examination is in its preliminary phase and no reassessments have been issued, the company said.

Certain Valeant affiliates in other regions outside Canada and the United States are also under examination by tax authorities, the company said, “and all necessary accruals have been recorded, including uncertain tax benefits.”

Valeant spokesperson Renee Soto said the IRS investigation was a standard audit.

“The company is regularly subject to audits as are most companies of Valeant’s size,” Ms. Soto said. “Getting audited is nothing new or concerning. We have no knowledge of any exposures or issues other than those disclosed or for which reserves have been established.”

At the centre of Mr. Melnyk’s group’s complaint against Valeant is a test in international tax law known as “mind and management.” Established by the 1906 case of De Beers Consolidated Mines Ltd. versus Howe, it holds that the residency of a corporation is determined by the jurisdiction where, in an English court’s words, its “central management and control” lies.

A century ago, that English court found that although De Beers was incorporated in South Africa and did all of its mining there, executive decisions were being made from London. Today, Mr. Melnyk says Valeant is being steered by Mr. Pearson, a former consultant with McKinsey & Co., from the United States, where he enjoys a larger-than-life reputation in some quarters of Wall Street.

Still, the “mind and management” concept is a common law test and not necessarily a clear-cut, bright-line rule.

One factor a Canadian court would consider to establish residency is where the corporate board meets, said Sunita Doobay, a cross-border Canada-U.S. tax lawyer with Toronto-based TaxChambers LLP. Valeant says it holds most of its board meetings in Canada.

Mr. Melnyk’s argument goes further than that, however.

He argues that because Valeant is taking advantage of Biovail’s former off-shore international tax structure, it should adhere to the same operating principles that Biovail did. Chiefly, that means having a decision-making, mind-and-management presence in its main offshore intellectual property centre.

Mr. Melnyk says he decided early on in Biovail’s history to take advantage of Canada’s tax treaty with Barbados, which applied a 1% tax on companies for annual revenue over $2-million. Under the treaty, after Biovail paid taxes in Barbados it would transfer the rest of its after-tax profits to its Canadian parent through a tax-free dividend.

As Biovail’s former chief financial officer, Brian Crombie, explains in an academic paper on the subject written in 2010, the key to making the setup work was that veritable control over the company’s research and development, product and acquisition decisions had to be in Barbados, not back in Canada.

On Feb.15, 1991, even before Biovail started generating significant revenues, Mr. Melnyk personally relocated to Barbados and hired a team of local staff to help him. He established a Biovail subsidiary that owned all of the intellectual property for the company’s products. Biovail Barbados also contracted for all the research R&D done for the company globally, arranged for all the manufacturing, supplied all the products to other subsidiaries and lent money to other Biovail units, according to Mr. Crombie’s paper.

Mr. Melnyk was in charge of the company and he was in Barbados. Biovail’s other key staff, including those from the corporate parent office in Mississauga, Ont., came to him, flying to the island for important meetings at least once a quarter.

“I often joked to people that all they needed to do was look at my BlackBerry and they’d know based on all the emails from one person in Barbados where mind and management was,” Mr. Crombie wrote in the paper. “Biovail lived the tax structure. When I met other off-shore executives that were mere functionaries, that just were a conduit for documents and not true decision makers, golfing every day and dining every night, I got concerned.”

Canadian auditors paid Biovail a visit in Barbados but were satisfied by the arrangement.

Valeant initially said it planned to maintain the setup. A June 21, 2010 press release outlining the terms of the Valeant-Biovail merger stated that Mr. Pearson would become the combined company’s new CEO, “residing in Barbados.” Today however, the company is no longer run out of the Barbados and Mr. Pearson works from New Jersey.

Finally, Mr. Melnyk takes aim at the Biovail merger itself in his denunciation of Valeant. He argues that the merger’s sole purpose was to allow then U.S.-based Valeant to benefit from Ontario-based Biovail’s international tax structure and evade U.S. tax.

To remain a Canadian company, Valeant had to figure out a way to be acquired by Biovail even though Valeant was the bigger entity, Mr. Melnyk says. There were therefore several unusual steps taken to consummate the merger, he says. Among them, Valeant issued debt to help pay for a $1.8-billion special dividend for Valeant shareholders. It also paid a 15% premium to Biovail shareholders in the deal, even though Biovail was the acquiring company.

Mr. Melnyk alleges there was no commercial purpose to these moves other than to artificially depress the value of Valeant and make Biovail a plausible buyer. In the end, Valeant announced that Biovail stockholders would own about 50.5% of the shares of the combined company. According to Mr. Melnyk, one telling detail is that Biovail executives received “change of control” termination payments despite the fact that it was Biovail, on paper, that took control of the combined company.

Valeant insists the biggest driver for the merger was cost savings, not tax, and that its current business model is not dependent on tax rates. “Obviously tax was a benefit of it but it was not the primary motivation for the deal,” Mr. Pearson said.

The merger mechanics, Mr. Melnyk alleges, were the work of an aggressive investment banker who had pitched his Biovail management team the same game plan when Mr. Melnyk wanted to merge with U.S.-based Watson Pharmaceuticals years earlier. At the time, Watson had a bigger market value than Biovail. Mr. Melnyk sought the advice of both lawyers and accountants and rejected the plan as unworkable and legally questionable.

Today, he says he believes he’s watching Valeant build on the results of that same banker’s playbook. And it frustrates him.

Asked about his motivation for approaching U.S. authorities, he answers: “You know why? Because you see a wrong happening right in front of you. And you know it’s wrong.”

Mr. Pearson has a different view: “It’s been a long time since Mr. Melnyk’s had any visibility really, into our company.