Mind the (Tax) Gap

In recent years, the pharma industry has taken a pounding from a wave of federal whistle-blower lawsuits. These cases, focused largely on allegations of pricing improprieties, off-label marketing, kickbacks, and other Medicare fraud violations, have forced companies to pay $2.5 billion in settlements.

Erika A. Kelton

But that amount may pale in comparison to payments that could result from a little-noticed provision in the Tax Relief and Health Care Act. Enacted in December 2006, the legislation amended Section 7623 of the Internal Revenue Code to increase the size of whistle-blower rewards, provide whistle-blowers a process to challenge the size of the reward, and establish a whistle-blower office within the Internal Revenue Service to handle and track whistle-blower cases.

Congress decided it needed to up the ante to get more insider information about tax fraud in order to help close the "tax gap"—the difference between the amount companies and individuals owe in taxes and the amount actually paid. Like all US government agencies, the IRS has limited enforcement resources. And while the number of companies the IRS audits is growing, the odds of corporations getting caught for tax underpayments is still very low. In 2003, the IRS audited 7,125 large corporations (those with more than $10 million in assets). In 2006, that number grew to 10,591. However, Congress is counting on larger whistle-blower rewards and the new IRS whistle-blower office to increase the odds of catching tax scofflaws.

"One well-positioned whistle-blower could expose millions of dollars of fraud," said US Senator Charles Grassley (R-IA), who authored the new whistle-blower tax-fraud law. "It might take IRS auditors years to catch that much cheating on their own."

Whistle-blower 101

The new provision in the Tax Relief and Health Care Act follows a similar whistle-blowers' reward provision in the 1986 False Claims Act, which convinced thousands of insiders to report non-tax fraud against the government, particularly in the defense and health industries. The government has collected more than $11 billion as a result of these whistle-blower cases (also known as "qui tam") and has paid whistle-blowers rewards totaling more than $1.8 billion. However, the False Claims Act specifically exempted tax fraud from the kinds of cases covered under the statute.

These provisions for whistle-blowers in the Tax Relief and Health Care Act will offer a huge incentive to employees thinking about blowing the whistle—employees who can now hope to reap tens, if not hundreds, of millions in tax cases. Before the new tax law, the IRS rarely paid rewards to whistle-blowers. When it did, the reward was small—from 1 to 15 percent—and whistle-blowers had no recourse if they disagreed with the amount.

Under the new law, the IRS offers whistle-blowers 15 to 30 percent of the total amount it collects—including taxes, interest, and penalties—as a result of information given. The incentive is targeted to employees working at companies that have defrauded or underpaid the IRS by more than $2 million. What's more, whistle-blowers also may challenge the amount of their awards in federal Tax Court. Such judicial scrutiny will likely bring increased accountability and transparency to the IRS' whistle-blower program.

Finally, whistle-blowers don't have to be citizens of the United States—which thereby opens the reward to foreign employees of multinational companies. The IRS has pledged to keep the whistle-blower's identity confidential. This makes it even easier for whistle-blowers to report tax fraud without fear of retaliation or harassment from their employers.

Target Area: Transfer Pricing

The pharma industry's profitability has caught the IRS' attention—and made it a target. But what really puts the industry at risk is the global nature of the business. There are very large differentials in tax rates between countries, and this can create opportunities for improper tax reporting.

In its enforcement efforts, the IRS has placed transfer-pricing violations—the ability to shift reported income between affiliated companies—high on its enforcement agenda. Transfer-pricing laws require that intercompany transactions, particularly between foreign and domestic affiliates, are valued at "arm's length," so that company revenues are appropriately allocated between foreign and domestic entities. Misallocation of revenues may shift income that is taxable in the United States to a related foreign affiliate that is taxed in lower-rate jurisdictions. Billions of dollars in US taxes are lost to such transfer-pricing irregularities.

The complexity of many intercompany transactions and their relative lack of transparency make transfer-pricing compliance and enforcement particularly challenging—but the reward makes it a worthy pursuit. For example, GlaxoSmithKline paid $3.4 billion in September 2006 to settle a long-running transfer-pricing dispute with the Internal Revenue Service and agreed to abandon a refund claim for $1.8 billion. The controversy concerned intercompany transactions over the previous 17 years and charges that GlaxoSmithKline shifted profits from its US to its UK affiliate. The IRS contended that this resulted in the substantial underpayment of US taxes.

"We have consistently said that transfer pricing is one of the most significant challenges for us in the area of corporate tax administration," said Commissioner of Internal Revenue Mark Everson when he announced the Glaxo settlement.

Although the GlaxoSmithKline settlement predates the new tax whistle-blower law, the law's powerful financial incentives are likely to expose similar large underpayments or fraud schemes.

That was the case last February, when Merck paid $2.3 billion to settle its battles with the IRS over taxes relating to minority equity interest financing transactions and loans from a foreign subsidiary to Merck. The Wall Street Journal reported that Merck transferred valuable patents to a subsidiary in tax-favorable Bermuda, and then paid its subsidiary for use of the patents. This resulted in a reduction of $1.5 billion in US taxes over a 10-year period.

Among many other questionable practices are schemes involving mischaracterization of taxable gains in connection with asset sales or other divestiture transactions, abusive schemes involving the misuse of net operating losses, and mischaracterization of US source income of taxable entities.

Pharmaceutical companies may want to consider taking steps to minimize the potential whistle-blowers' need to go outside the company to report questionable tax practices. In many cases, whistle-blowers report the fraud to the government only after they've tried going through their supervisors and managers to stop the practices and have been retaliated against or fired for their efforts.

Take Action

Ensuring a vigorous and meaningful compliance structure specifically for tax compliance that covers the corporate parent and all foreign subsidiaries might be beneficial. This would include integrating measures that would allow for anonymous or confidential internal reporting and real guarantees by employers of nonretaliation. Independent board oversight of this internal reporting function at pharmaceutical companies could be important to ensure that tax compliance receives due consideration throughout the organization.

The new law is set to expose hidden tax-avoidance practices by corporate America—and pharma companies are high on the target list. In fact, the promise of big rewards has already persuaded industry insiders to provide information to the IRS that exposes tax-avoidance practices.

"They're coming in with big, fat piles of paper, and they have, at least on the surface...some credibility about the information they're bringing to us," said Stephen Whitlock, director of the new IRS whistle-blower office, in an interview last year.

Erika A. Kelton is a lawyer with Phillips & Cohen LLP. She can be reached at ekelton@phillipsandcohen.com