Valeant and the IRS | FT Alphaville

Valeant and the IRS

Buried in page 27 of Valeant’s recent quarterly regulatory filing was some potentially significant news: the pharmaceutical company, currently pursuing a $53bn hostile takeover of Allergan, is under investigation by the Internal Revenue Service.

According to people familiar with the situation a number of individuals, including former senior executives, have raised concerns with the IRS, which has been holding an inquiry into the company for the last two years. The probe by the Large Business and International division of the agency has included an examination of Valeant’s tax arrangements following the 2010 merger with Canadian Biovail, a so-called “inversion” deal that enabled the former US company to dramatically reduce its tax bill.

Before the merger Valeant profits were largely subject to the US federal income tax rate of 35 per cent. Biovail, by comparison, reported an effective tax rate as low as 7 per cent. For the last three years Valeant has paid an effective tax rate of between 3 and 5 per cent, even though last year around half of the group’s revenues came from the US, the world’s largest drug market.

The IRS notified the company in the second quarter of this year that it has commenced an audit of the Valeant US consolidated group for its 2011 and 2012 tax years, according the filing. Valeant said “all standard audits are disclosed in our SEC filings. We are not aware of any other investigations.”

The examination comes as political opposition to attempts by companies to reincorporate overseas has grown, following moves by other pharmaceutical groups to lower their tax payments by buying foreign competitors.

A negotiated resolution is typical in corporate tax cases, although the IRS has the power to bring criminal and civil suits. For instance, in 2006 the agency struck a $3.4bn settlement with UK based GlaxoSmithKline to resolve a long running transfer pricing dispute. The IRS does not comment on investigations and will not disclose the existence of an inquiry in progress or one that leads to no action.

The audit highlights questions surrounding the way in which the Biovail-Valeant deal was structured, the sustainability of tax arrangements put in place by the Canadian company, and the pricing of intellectual property rights.

Canadian, but with a Caribbean arrangement

Biovail was founded by Eugene Melnyk in Mississauga, Ontario, at the end of the 1980s. The Canadian company specialised in developing slow release versions of other drugmaker’s products under licence — for instance a once-a-day version of the anti-depressant Wellbutrin.

Early on Mr Melnyk relocated to Barbados, establishing a subsidiary that owned intellectual property for the group. The location allowed Biovail to benefit from the Caribbean island’s very low tax rate of 1 per cent on annual profits over $2m, as well as a Canadian-Barbadian tax treaty which allowed cash to be transferred to the Canadian holding company without incurring a further tax liability.

The chief executive moved to the Caribbean because one issue related to international tax law is the question of mind and management. An important test case was the 1906 case De Beers Consolidated Mines Ltd vs Howe, where an English court found that the “central management and control” of the South African incorporated diamond miner was in the UK, rendering it liable for UK taxes.

Canadian courts have also looked to De Beers as precedent. On at least two occasions Biovail passed Canadian audits of its tax arrangements, according to people familiar with the company.

In the 2000s inversion deals were pitched to Biovail, those people said, including transactions where a larger US company would be acquired. In the proposed scenario, as with the eventual Valeant deal, the US company would raise debt and pay a special dividend to lower the value of its stock ahead of any transaction, allowing Biovail to be portrayed as the acquirer.

However, people familiar with the company said that two legal opinions and one from the accounting firm E&Y concluded that an attempt to artificially lower the value of an acquired company, or portraying Biovail as the buyer in a deal that valued the two companies close to a 50:50 ratio, would be improper. The conclusion of those opinions, according to people familiar with them, was that for Biovail to buy a US peer and retain its international tax structure, it would have to be the bigger company.

Mr Melnyk stood down as chairman and chief executive in 2007.

The inversion

In 2010 Biovail and Valeant merged, both exchanging stock for shares in the new entity. The Canadian company was described as the buyer, even though in market capitalisation terms it was the smaller entity when negotiations began, approximately $2.5bn to Valeant’s $3.7bn. Both had made sales the previous year of just over $800m.

Ahead of the transaction Valeant borrowed $2.8bn and proposed to pay its shareholders $1.8bn as a special dividend, conditional on their approval of the merger.

Unusually, shareholders in Biovail, the company said to be the buyer, received a 15 per cent premium for their stock. Biovail executives also benefitted from a triggering of change in control provisions, while after the deal completed the company’s name was changed to Valeant, retaining the stock ticker of the US company. The announcement said:

Upon the completion of the merger, which is expected to occur before the end of the year, Biovail stockholders will own approximately 50.5 percent and Valeant stockholders will own approximately 49.5 percent of the shares of the combined company on a fully diluted basis

The structure of the deal to ensure that Valeant shareholders retained less than 50 per cent of the new entity meant that it was not a taxable event for US investors. This is a factor which does not appear to be important for US companies considering more recent inversion deals, according to US tax attorneys.

Analysts focused on the possibilities of the Barbados tax structure, what many saw as the underlying reason for the deal as Biovail’s products did not overlap with Valeant’s and key drugs such as Wellbutrin XL faced competition from generic drugs and declining sales.

The plan for the new management structure of the group, meanwhile, was laid out with the merger terms (with our emphasis):

J. Michael Pearson, currently Chairman and Chief Executive Officer of Valeant, will serve as the new Valeant’s Chief Executive Officer, residing in Barbados, and Bill Wells, currently Chief Executive Officer of Biovail, will be the non-executive Chairman. The new Valeant’s Board of Directors will consist of 11 members, including five Biovail representatives, five Valeant representatives and one additional independent Canadian resident director to be identified.

However, the Canadian influence did not last long, as The Globe and Mail later described:

Wells and other Biovail executives were gone less than three months after the merger closed in September, 2010. The company uprooted the headquarters from Mississauga to Montreal (thanks to Quebec government incentives), but the brain trust largely works out of New Jersey offices near Pearson’s home.

Peggy Mulligan, the chief financial officer residing in Canada, also left the company within months of the merger closing. Of the current directors, Kate Stevenson and Ron Farmer are Canadian residents, and board meetings are held in Canada.

New Valeant

Under Mike Pearson the new Valeant went on an an acquisition spree. The former McKinsey consultant’s approach was to invest in pharmaceutical deals, rather than research and development for new drugs, stripping costs out of the companies he buys. The deals were funded with debt, raised mainly in the US, which has the effect of depressing taxable US profits because borrowing costs are tax deductible.

Such an approach raises a question about the sustainability of Valeant’s low tax rate. At some point the company’s debt burden, currently $17bn, will decline, reducing the size of that tax shield. Debt also shields US taxes only insofar as it is raised for US purposes. A person familiar with the company described the IRS audit as standard, and suggested that the difference in Valeant and Biovail’s tax rates may simply reflect the basis on which they were calculated.

A second question is the location of Mr Pearson and his management team when important decisions about each of those deals were made. Mr Melnyk was careful to ensure that meetings were held, decisions taken and documents signed in the appropriate jurisdiction. Brian Crombie, a former Biovail chief financial officer, described the careful arrangements in a paper on international taxation.

The Barbados subsidiary would also have quarterly meetings, mostly taken in Barbados, where the pipeline of products was presented, debated, valued and decisions on continued funding taken on them. These meetings would include representatives from the corporate parent office, the operating subsidiaries, the R&D facilities and would be chaired by the President of the Barbados Subsidiary, who also happened to be Chairman of The Board and the largest single shareholder in the Company. On a regular basis consultants would be hired to analyse different product opportunities and these arrangements would be with the Barbados subsidiary.

The flight time from New Jersey to Barbados is about five hours, although it may be shorter in a Gulfstream G650, one of the private jets owned by Valeant. A person familiar with the company said that while Mr Melnyk and Mr Wells ran both the company and the Barbados entity, living there, new Valeant split the responsibilities. Rich Masterson was appointed to run the Barbados entity, retiring when Valeant left the country.

Mr Crombie’s paper also described the process by which prices were set for the transfer of goods through the Barbados subsidiary, where most of the company’s profits were booked.

Because Biovail had outside licensees, developers and manufacturers, establishing and proving third party based transfer pricing was so much easier than for a company that has to try to create it from scratch.

Such transfer pricing was at the heart of the dispute between the IRS and GlaxoSmithKline. A potential issue for a company making acquisitions is the price at which intellectual property is transferred to entities in other low tax jurisdictions.

According to its 10K regulatory filing, Valeant rejigged its structure two years after the Biovail merger.

The Company effected an internal reorganization in July 2012 to streamline certain aspects of its operations. As part of this internal reorganization, the Company migrated certain of its intellectual property from Barbados to Bermuda and moved certain of its operational and managerial functions from Barbados to certain European jurisdictions (including Ireland).

Bermuda also has a tax treaty with Canada, as well as being closer to New Jersey. However Valeant then moved its intellectual property again the following year to Luxembourg, a jurisdiction favoured by lenders due to the ease of enforcing collateral rights in any bankruptcy proceedings. A person familiar with the company said that Valeant is no longer located in Barbados or Bermuda.

The tax authorities

Corporate tax disputes are common, and can remain unresolved for many years. For instance, Valeant has said in regulatory filings that it has open tax issues with Canada for the years 2005 to 2012, and that some disputes with tax authorities may remain open indefinitely.

The IRS is required to keep secret the nature and existence of any investigation by law. An inquiry into a company’s tax returns will be followed by an audit, if necessary. Following that the agency may detail “proposed adjustments” that the company can accept, appeal or challenge. Possible routes to do so include going through the US Tax Court, or the Federal Circuit courts.

An alternative

There is another consideration when assessing Valeant’s low tax rate. The low level of taxes may simply reflect a very low level of profits. Audited accounts for the company have shown growing losses in recent years, numbers the company has suggested investors disregard in favour of adjusted measures of underlying profitability. Given that the company has $17bn in debt, however, that explanation might suggest that it is not the sustainability of the tax rate which investors should be pondering.