The Tax Cuts and Jobs Act (TCJA), passed in December of 2017, was aimed at dissuading U.S. companies from moving profits offshore. However, it may make shifting earnings to tax havens more beneficial for companies.
Before the TCJA, companies that offloaded profits linked to sales, research or production were taxed at a 35% rate when the profits were brought to the United States. The TCJA moved the country to a “territorial” system, which was meant to reduce or eliminate the incentive for companies to invert to avoid U.S. taxes on foreign income.
Corporate tax rate now 21%
Under a territorial tax system, U.S. multinational corporations no longer face an additional domestic tax on their foreign profits when those profits are repatriated to the United States. This system should make companies with foreign profits indifferent to the location of their headquarters.
AbbVie Inc. is one corporation that is taking advantage of the new system. Richard Gonzalez, the CEO, told investors earlier this year that, because of the change to a territorial system (where only profits reported by domestic subsidiaries face U.S. tax), the biopharmaceutical company expects its tax rate to fall from around 22% in recent years to 9% for 2018.
The company has historically reported its income in lower tax jurisdictions, which is possible in part because AbbVie holds most of the patents for its top-selling drug, Humira®, in Bermuda—a country with a zero-tax rate on corporate profits.
Despite recording over half its $28.2 billion in 2017 sales in the U.S. and basing most of its research facilities there, its annual reports show that the suburban Chicago company has never reported a profit in its home country.
In 2017, AbbVie reported foreign earnings before income tax of $10.4 billion on international revenue of only $9.97 billion. Yet, between 2013 and 2016, AbbVie had to pay around $1 billion a year of taxes in the United States, when it repatriated profits from its foreign subsidiaries to help cover expenses from its U.S. operations.
In the future, under the TCJA, it won’t have to pay such taxes. The authors of the law have said their bill would discourage the shifting of profits earned in the United States. However, the main anti–tax avoidance measures in the law still allow companies to benefit strongly from profit shifting by using patents.
AbbVie doesn’t address the patent locations on earnings conference calls or in its SEC filings.
Are “guardrails” preventing avoidance?
Critics of the TCJA’s new system say it doesn’t do enough to keep businesses from shifting profits. “If the guardrails in the new territorial system were meant to prevent companies from avoiding all taxes, AbbVie’s (tax rate) is a pretty clear signal that these guardrails may not be effective,” said Matthew Gardner, senior fellow with the Institute on Taxation and Economic Policy.
AbbVie is not the only U.S. company with big operations at home but which reports relatively few profits. Boston Scientific Corp., Expedia Group Inc., Microsoft Corp., Pfizer Inc. and Synopsys Inc. do the same. According to statements from their executives and their earnings from the most recent quarter, they are set to be big winners from the shift in the territorial system.
Democrats in Congress are examining how the tax law encourages companies to use patents to shift profits overseas, and Oregon Senator Ron Wyden plans to issue a report dealing in part with the issue later this summer.
“The U.S. shouldn’t get suckered into a race to the bottom with a bunch of no-tax, resort-lined islands to please the tax avoidance industry and their lobbyists,” said Wyden, the Senate Finance Committee Ranking Member.
The U.S. move away from worldwide taxation represents an adoption of modern tax orthodoxy. All the biggest Western economies operate a territorial tax system, but, conscious of the risk of profit shifting, they also have rules to tackle this risk. Typically, these rules allow governments to tax income reported in tax havens as though it arose in the home country.
The GILTI provision
Congress attached a provision such as those used in other countries to the TCJA. Under the Global Intangible Low Tax Income (GILTI) provision, if a company generates untaxed profits in a tax haven, it will be liable to have that profit taxed as though it arose in the United States.
However, the effective tax rate that will apply is 10.5%, half the U.S. corporate tax rate of 21%. And a reported loss in the United States can reduce the tax liability further.
AbbVie doesn’t disclose the exact mechanisms it uses to get its low tax rate. However, analysts and academics say corporate filings often show that drug companies frequently reduce their taxes by parking patents in a low-tax haven and then have their affiliates — which manufacture or market the drug — pay the tax haven subsidiary royalty fees for the right to use the patent.
This arrangement sees a drug sold into a target market, like the U.S., at a high price, with the U.S. distribution arm getting a sales margin as low as 5%.
The news service Reuters reviewed close to 90 patents on AbbVie’s Humira, most of which were cited by the company in lawsuits as protecting intellectual property. Around two-thirds of those patents were assigned to the Bermuda subsidiary, AbbVie Biotechnology Ltd. Most of those patents were developed by teams of researchers entirely or somewhat based in the U.S., according to details in patent filings.
Sometimes, the U.S. distribution profit is not enough to cover group costs incurred in the U.S. For example, many of AbbVie’s biggest costs — including $1 billion a year in interest charges and over $50 million in compensation for its top 5 executives — are covered by AbbVie’s U.S. entities, contributing to the U.S. loss, filings show.
That is why AbbVie can forecast a tax rate below the 10.5% GILTI rate, which some commentators have described as a new minimum tax rate. “There is an incentive to profit-shift,” noted Daniel Shaviro, a tax law professor at New York University.
For a no-obligation discussion on the possible impact and steps you should take now, contact Jason Sanders, our Tax Department Chair.