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Pharmaceutical industry: A dose of reality

Pharmaceutical industry: A dose of reality

23 March 2016

Khadija Sharife*

FOR years, African countries have paid exorbitant amounts for pharmaceuticals developed in the US, including drugs such as AZT, which is used to treat Aids. The reasoning was always that it cost pharmaceutical companies upwards of US$1bn to create these drugs — and these costs must be recouped.But a new investigation of the murky tax breaks used by the industry tell another story entirely.

Take the case of Puerto Rico, a small island in the Caribbean which is officially a US territory. It may seem unlikely, but in the late 1990s and early 2000s, Puerto Rico became a destination for drug companies seeking to make use of its status as a tax haven. There, one of the small coastal towns, called Barceloneta, was even dubbed “Ciudad Viagra”, as it churned out 100m of Pfizer’s little blue pills.

In 2000, there were 77 pharmaceutical companies in Puerto Rico, and by 2004, 19 of the world’s top 25 prescription drugs were manufactured on the island.

The reason: multinationals keen to avoid corporate taxes could fully repatriate their profits back to the US mainland. Puerto Rico also had a rather generous regime in which companies could make tax-free income generated by intangible assets, such as pharmaceutical patents.

It worked: for an island with a population of only 3.5m people, it was providing about 170,000 manufacturing jobs by the 1990s.

American lawmakers began to get antsy, and by 1994 the US Government Accountability Office said the laws which made it possible for multinationals to set up shop in Puerto Rico were costing $3.9bn/year.
So the US gradually phased out those laws, closing the taps completely in 2006. It hardly mattered, as Big Pharma simply routed their profits through new safe harbours, and their profits remain barely taxed.
Puerto Rico still provides incentives to companies like Pfizer, including an exemption from income, property, municipal and other taxes (where a tax is levied, such as an excise, it is just 1%). These tax exemptions don’t expire until 2029.

But when repatriation benefits changed, so did Pfizer’s corporate structure, transferring both drug production and patent ownership elsewhere.

Between 1996 and 2014, the number of manufacturing jobs in Puerto Rico fell by about half.
An analysis of the public disclosures of nine pharmaceutical companies show they ducked paying about $140bn in taxes by holding more than $405bn of their income offshore. Pfizer led the pack with $25.9bn in avoided tax, followed by Merck ($21bn) and Johnson & Johnson ($18.6bn).

The true cost of developing drugs is intentionally opaque, but it’s clear that pharmaceutical companies rely on intangible assets such as patents and trademarks, which are often financed, subsidised and developed by public institutions.

This analysis reveals a fundamental truth about the global economy: land and other genuinely scarce items are no longer the most valuable assets in the world. Instead, about 80% of corporate market value is located in intellectual property, which is considered an intangible asset.

For companies that are heavily dependent on intangibles, such as Pfizer — with a market cap of $191bn — the company’s actual book value, with intangibles stripped out, is about $5.9bn in the red.
Bristol-Myers Squibb and Eli Lilly show similarly high market caps — $105bn and $85bn respectively — as compared to their net assets of only $6bn and $10.7bn.

In fact, by 2009, just 7% of an estimated $27.3trillion in corporate intangible capital was disclosed to governments and investors on financial statements, according to Brand Finance, a valuation consultancy.
Of course, the financial accounting process for patents is trickier than for other assets.
In practice, pharmaceutical giants develop patents, which they can then shift multiple times to a subsidiary in any country, depending on the tax planning structure devised by the company’s accountants. Legally, patents aren’t constrained to the jurisdiction where they were developed.

Again, consider Viagra: in July 1999, the Viagra patent was logged under the ownership of an entity called Pfizer Research & Development, which was based in Ireland and Belgium. Ireland at the time offered 0% tax within certain structures, while Belgium provided an 80% tax deduction from patent incomes.
The actual drug ingredients are manufactured in Ireland’s Ringaskiddy hub, but it was in the Isle of Man, a UK tax haven, that Pfizer’s Ringaskiddy Production Company was incorporated (later dissolved). Later, two holding companies based in the US state of Delaware were created as conduits for income from Pfizer’s intangible assets such as patents to flow back to the US.

Effectively, the company is able to use the patent owner, such as Pfizer Ireland, to charge its other subsidiaries royalties, which can then be remitted to any bank account of its choice. This strategy reduces the pretax profits by creating artificial expenses.

The bottom line is that income is siphoned to offshore entities, while any debts or costs are registered in nontax haven jurisdictions, including the US.
Presumably for the same reason, Pfizer Ireland is also the proud owner of other blockbuster drugs such as the cholesterol medicine Lipitor (atorvastatin).

Generating $10.7bn in revenue in 2010 and more than $140bn since its creation, Lipitor was developed by Warner-Lambert, a company purchased by Pfizer in 2000 for $90bn.
Pfizer’s intangible assets, listed at $35bn, disclose only those assets such as Lipitor that are acquired from other companies. Pfizer does not disclose the value of those intangible assets internally developed, such as Viagra.
In what is the accounting world’s biggest blind spot, these assets are also not disclosed in annual reports. Brand Finance acknowledges: “Most high-value, internally generated, intangible assets never appear in conventional balance sheets.”
Internally developed intangibles are the assets most prone to financial fudging as the value is wholly determined by the company.

In all, Pfizer maintains about $74bn in offshore capital, using more than 200 entities based in tax havens, chiefly those specialising in shifting profit from intangible assets around places like Delaware, the Netherlands, Luxembourg and Ireland.

The reasons are simple: In the Netherlands, taxes on intangible assets are just 5%. In Luxembourg, taxes are reduced by 80% if transactions occur within subsidiaries of the same parent company, and Delaware, the mothership of intangible asset fudging, boasts a complete exemption for intangible assets provided money dances around holding companies engaged in “management”.
(Pfizer had not responded to questions at the time of publication, while Merck, Abbott, AbbVie, Amgen, Eli Lilly and BMS declined or failed to respond to interview requests.)
Pfizer’s $25.9bn tax scheme, though the largest, was not the only one.
Research suggests that other pharmaceutical companies make similar savings through these mechanisms. These include:
• Merck ($21bn);
• Novartis ($19.2bn);
• Johnson & Johnson ($18.6bn);
• Amgen ($10.5bn);
• Bristol-Myers Squibb ($8.4bn);
• Eli Lilly ($8.2bn);
• AbbVie ($8bn);
• Abbott ($8bn);
• Gilead ($5.5bn);
• Baxter ($4.2bn);
• Celgene ($2.3bn); and
• McKesson ($1.4bn).
This means 13 pharmaceutical companies have avoided paying over $140bn in taxes by offshoring $405bn in assets. Each company used similar language to justify this.

This is Merck: “At December 31 2014, foreign earnings of $60bn have been retained indefinitely by subsidiary companies for reinvestment; therefore, no provision has been made for income taxes that would be payable upon the distribution of such earnings.”

Bristol-Myers Squibb says its effective tax rate is “lower than the US statutory rate of 35% primarily attributable to undistributed earnings of certain foreign subsidiaries … US taxes have not been provided on approximately $24bn of undistributed earnings of foreign subsidiaries as of December 2014 ”.

These disclosures — albeit in very fine print — are public. This is because the use of multiple tax havens for complementary purposes, ranging from manufacturing of drugs to spiriting of funds, is legal.
What is kept hidden, however, are two layers of transactions. The first is the annual income, loans, expenses and services between subsidiaries of the same parent company; the second is the financial dealings involving internally developed intangible assets, which are shielded from public scrutiny and entirely self-regulated.
Now, Pfizer is seeking to invert or reincorporate headquarters entirely to Ireland’s Allergan. The way it works is that a company can acquire or merge with a smaller foreign company and change its corporate billing address to eliminate US federal and state taxes.

In 2014, Pfizer unsuccessfully tried to merge the UK’s AstraZeneca using inversion — but it was a practice labelled by US president Barack Obama as legal but “wrong”.
These pharmaceutical giants are still making a killing on their actual sales.
American consumers account for about half of the pharmaceutical industry’s global sales — about $400bn annually — in prescription drugs. Last year, the top 25 prescription drugs catering to various forms of aches and pains churned out $145bn in sales.

Notoriously, a few years back, Bayer’s CEO, Marijn Dekkers, railed at India’s efforts to force it to license its cancer drug Nexavar in the country, saying: “We did not develop this medicine for Indians … We developed it for Western patients who can afford it.”
Nexavar is big money, costing patients about $5,400/month in the US, where there is no price ceiling on medicines.
The implication is that the pharmaceutical giants see the US’s lack of price restrictions as necessary to generate the revenue needed for innovation. The rest of the world, then, is free-riding on America’s high health-care costs.
The drug giants argue that these kinds of numbers are necessary to compensate for the high research and development costs of these drugs.

But the numbers suggest otherwise: Past studies show just 1.3% of net sales in the US is reinvested in research.
In reality, it is taxes — not pharmaceutical profits — which subsidise the majority of research funding for new drug development. From 2006 to 2009, 84% of the research funding for 48 new drug innovations in the US came from public sources such as the National Institutes of Health (NIH), according to scholars such as medical sociologist Donald Light.
European countries such as France, Italy, Germany and the UK are no less innovative, despite mandating capped prices at levels affordable to citizens. Studies show European countries, which account for 28% of global pharmaceutical sales and 36% of global R&D, produce 32% of new molecular entities.
So, how much does it cost to develop a new, innovative drug — something that adds original value or advances the existing treatment of cancer or other illnesses?
About a decade ago, a study produced by the Tufts Center for the Study of Drug Development pegged the figure at $1bn.
Titled “The Price of Innovation” and published in the Journal of Health Economics, the study examined R&D expenditure for 68 randomly selected drugs through a survey of 10 large pharmaceutical companies.
The study found the average cost of drug development was $802m each, a figure that increases to between $1.6bn and $1.8bn with inflation.

(There were problems with the study, however. For one thing, the Tufts Center neglected to mention that pharmaceutical companies provided about 65% of its finances, and there was no way to verify the quality of information, as the names of the companies as well as the names and types of drugs were confidential.)
The Tufts study said that from 1996 to 2005, Big Pharma generated $558bn in profits, produced from $288bn in R&D and $739bn in marketing and administration (which excludes executive salaries).

But the breakdown of R&D costs reveals some fuzzy maths, particularly when it comes to “capitalised costs”, explained by the Tufts authors as “the expected return that investors forgo during development when they invest in pharmaceutical R&D instead of an equally risky portfolio of financial securities”.
Marcia Angell, former editor-in-chief of The New England Journal of Medicine and senior lecturer at Harvard Medical School, says the “Tufts consultants simply tacked it onto the industry’s out-of-pocket costs. That accounting manoeuvre nearly doubled the $403m to $802m”.

The US Office of Technology Assessment also pointed out that “the net cost of every dollar spent on research must be reduced by the amount of tax avoided by that expenditure” — tax savings of between 30% and 39% of R&D costs.
As Light and economist Rebecca Warburton have determined, the combined effect of taxpayer subsidies and credits reduces the overall costs of developing a drug from $403m to $201m — a far cry from the original $1bn claim.
Another important point is that more than a quarter of Big Pharma’s products are developed external to their companies — most often by cash-strapped public institutions, universities and small companies.

Here, government funding is often provided to these public institutions to develop products.
Take Burroughs Wellcome — a company that congratulated itself on the discovery of azidothymidine (AZT), used to prevent and treat HIV/Aids, lauding its own scientists for having discovered the formula.
This irked Samuel Broder, a scientist with the NHI and his colleagues from Duke University, who wrote a public letter to The New York Times disputing this claim.

Broder said Burroughs Wellcome “did not develop or provide the first application. Nor did it develop the technology to determine at what concentration such an effect might be achieved in humans … [it] was not first to administer AZT to a human being with Aids, nor did it perform the first clinical pharmacology studies in patients … nor immunological and virological studies necessary to infer that the drug might work”.

In fact, he said, all of this was done by the NHI staff, working with Duke University.
Indeed, Broder said the company “did not work with live Aids virus, nor wish to receive samples from Aids patients.”
Wellcome, later integrated into pharmaceutical giant GlaxoSmithKline, priced its AZT at $10,000/year. The revenues generated were described in the US senate as “staggering”.

While there are legitimate reasons to reward pharmaceutical companies for investing in research, their tax record suggests the current system is broken. For both the tax holes the companies create and the life-saving medicines they license, it’s the public that ends up stuck with the tab.

• This investigation was supported by the Fund for Investigative Journalism and the International Center for Journalists
* Khadija Sharife is an investigative journalist with African Network of Centers for Investigative reporting

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