Pharmaceuticals Are Heavily Outsourced. Can the U.S. Make More of it Here?

The pharmaceutical industry is a global powerhouse and its sales are right up there with oil, autos, and semiconductors as the most traded items traveling the globe every day. In the U.S., pharma is consistently a top two item the U.S. exports, and imports. It is a big contributor to our deficit – meaning we import much more than we export. Last year, every American heard about the shortages of baby formula, made by one drug lab – Abbott Labs. Some might be aware of shortages of Adderall and the critical drug amoxicillin, used to fight pneumonia. One of the reasons for those shortages is that the U.S. is heavily dependent on imports. The U.S. has only one lab that makes amoxicillin, USAntibiotics in Tennessee. The FDA has listed this drug as an essential medicine, often in short supply. Yet, we only have one lab that makes it.

In some cases, such as in generic medication, importing from low-cost nations like India is one reason why the U.S. generic drug-making footprint has shrunk. But that is not the main reason why.

The U.S. gets a lot of its drugs, both branded medication, and generics, from Europe. Europe is hardly a low-labor, low-regulation economy. But it can be, surprisingly, a low-tax economy. The tax avoidance schemes that big pharma companies use, all allowed by Washington, make offshoring the production of medicines more rewarding financially than making it at home.

What can be done to favor domestic production of medicine? This is not to say the U.S. should not import drugs. But what could be done to bring this trade in balance, rather than being completely out of whack, and favoring imports over domestic producers?

Brad Setser, once a USTR advisor who left to join the Council on Foreign Relations last year, wrote on his Twitter feed on January 20 that U.S.-based pharmaceutical companies are masters at tax avoidance. This has benefited the offshoring of pharmaceutical production throughout Europe, led by Ireland.

If the U.S. finds a way to stop the tax gaming, companies might more readily decide to produce the drugs in facilities in both North America and Europe. For now, saying that the jurisdiction that houses the IP is where the product revenue comes, and should be the basis for taxation, is not illegal, but it is gaming the system in a way that favors global pharma companies at the expense of domestic ones.

The profit from these sales would not exist without the market where it comes from. Other nations control how much they pay for different drugs.  The lackadaisical U.S. valuation of who owns the intellectual property for taxation purposes has led people to question if the system is just a shell game of lowering tax costs by moving profits and production away from the United States.

Here is where U.S. pharmaceuticals come from when looking at the countries that allow for tax schemes favorable to globe-trotting drug makers. Notice the trend.

This chart above shows that U.S. pharmaceutical companies are saying their profits all come from abroad and therefore they should be paying taxes to the Irish government instead of the American government. The problem is that few of their sales really occur there.

Looking at this chart below, it appears as if the top five global pharmaceutical companies with headquarters here are mostly selling overseas. When in fact, those are booked profits. In other words, the U.S. sales are booked to the advantage of the subsidiary, or overseas offices of the American multinational.

“Pharma shifts profits outside of the U.S. even though its sales are mostly here. This data tells you there is a problem, because these companies are not paying taxes on the money they earn from this market,” said David Morse, head of tax policy for Coalition for a Prosperous America. “Big Pharma is one of the reasons why we advocate for Sales Factor Apportionment. When a company earns income from American sales, Sales Factor apportionment would keep that revenue in the US.”

Pharmaceutical companies are always looking for the new blockbuster drug. Unless they are 100% in the generics space, big pharma is spending big money on research and development. But they can offshore those costs by associating their cost of R&D with an offshore facility in what is known as cost-sharing agreements. This is generally between two pharmaceutical companies – at least one here and one in Europe. They make an agreemeent as to which company will get what type of profits and who will own the intellectual property and collect the fees on that. These costs can also target insurance and even shipping and logistics.

“Companies look at the tax code and make decisions based on which company – the one in the U.S., or their subsidiary or partner abroad – will own what share to increase profits. This mechanism allows them to avoid a lot of taxes and it is completely permissible by U.S. tax law,” said Morse.

In other words, existing tax laws allow pharmaceutical companies to offshore the results of their R&D dollars, some of which they may have received from the government. And then say that the profits from making the drugs and selling the drugs, are all owed by the lower tax jurisdiction, such as Ireland.

“We invested in the R&D, but another country benefits by manufacturing it and selling it back to us. The country then collects the tax revenue because they create a beneficial tax mechanism to have the manufacturing,” said Morse. “The problems that we are facing regarding profit shifting would be resolved with a sales factor mechanism because these companies would have to pay taxes based on how much of their sales were in the U.S.,” said Morse. “It would get rid of the current advantage that they have by reporting profits overseas; profits that have largely come from U.S. sales.”

Companies have been allowed by the U.S., and by European countries who have been at this for generations – namely Switzerland, The Netherlands, and more recently Ireland –  to create this fiction regarding where the value of the product was really created.

From David Morse: “There is this academic idea out there about who has a right to tax and they debate and argue over this. The status quo multinational allies argue ‘value creation’ is dependent on a complex set of factors. By overly complicating the issue of value creation, they figure they can say that the value was created in low-tax havens. Switzerland, Netherlands, Ireland…they are not using these drugs, they are shipping them to the United States. They’re sometimes not even making the drugs. They can just be where the IP is housed. There are a lot of ways to game it and it leads to lower tax revenue for the U.S., which makes it harder for the U.S. to cut corporate taxes overall, and it can lead to offshoring production.”

Some other ways to change all this, which could lead to more domestic production, include:

• Expanding the international tax rules to give market economies a broader and clearer share from income taxes, known as expanding OECD Pillar 1;
• Improve the Tax Cuts and Jobs Act by increasing the tax on offshoring profits effective tax rates known as GILTI and BEAT rates to negate the benefit;
• Limit or allow clawback of profits from the creation of R&D cost-sharing agreement or sale of IP at an early stage of discovery to a subsidiary in low tax countries;
• Impose larger exit taxes when a company leaves the U.S. for low-tax jurisdictions;
• Decline acceptance of easy-to-create tax avoidance subsidiaries from low-tax jurisdictions

Other than sales factor apportionment, ending foreign company cost-sharing agreements would be a good start, Morse said.

“Cost sharing for a subsidiary usually means moving production of your R&D overseas, where you can make it cheaper, or to Ireland, to say your IP is there and that is where the value from the drugs come from,” said Morse.

“All of this affects the American pharmaceuticals market the most because we are the biggest market for medicines in the world. We pay the most for it, and because of that, if you can keep the profit shifting to a different country – a country that is not at all imperative to your bottom line because that’s not your prime sales target – then, you are reducing your taxes here and bringing in more profit. That makes sense for the company,” said Morse. “But it means that any U.S. pharmaceutical company that wants to be a domestic drug manufacturer will always be at a tax disadvantage. And that makes it even more enticing to manufacture medicines abroad or contract manufacture abroad. Then you have shortages and quality control issues. What you don’t have is a growing pharmaceutical industry at home. You, instead, have one that increasingly cedes market share to global pharma companies that will produce wherever it is cheaper, and wherever the taxes are most beneficial. The U.S. can do something about the tax issue, at least. That will help American-made drugs.”

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