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September 29, 2006

Offshore Patents

Financial firms advise fiduciary fun, playing house for companies to transfer patent ownership to offshore shells as a tax dodge. According to the Wall Street Journal, Merck saved itself $1.5 billion doing that. And other companies have had their fling with "tax arbitrage." The IRS, never known as the life of the party, is not amused.


Thirteen years ago, Merck set up a subsidiary with an address in tax-friendly Bermuda, in partnership with a British bank. Merck quietly transferred patents underlying the blockbuster drugs to the new subsidiary, according to documents and people familiar with the transaction. Merck then paid the subsidiary for use of the patents.

The arrangement in effect allowed some of the profits to disappear into a kind of Bermuda triangle between different tax jurisdictions. The setup helped Merck slash $1.5 billion off its federal tax bills over roughly the next 10 years.

The IRS is now challenging "Project Ryland," Merck's code name for the wheeze; the name coming from a fancy restaurant near Merck's New Jersey headquarters, where the scheme was baked and glazed.

The government supposedly closed the loophole for such shenanigans back in 1993, and it was just before the new regulations were finalized that Merck established its Bermuda partnership.

WSJ writes that, in essence, Merck was paying itself, though majority-owned subsidiaries, for the right to license patents for the drugs its own researchers had developed. Merck's reduced tax bill came from accounting maneuvers existing only in the subsidiaries' bookkeeping, allocating patent royalty payments.

Neither Merck nor the IRS are discussing the matter, other than Merck saying it was all copasetic, and "we vigorously disagree with the proposed IRS adjustments." We can all agree that any disagreement the size of $1.5 billion should be vigorous.

Dow Chemical and General Electric are also withering IRS scrutiny for the same setups. The feds argue that the supposed business partnerships with foreign banks were just designed to dodge taxes, a well-disguised loan agreement, with no legitimate business purpose.

Along those lines, the "Second U.S. Circuit Court of Appeals last month reversed a trial court and declared that foreign banks in the GE deal were not "bona fide equity partners."" There's a $62 million price tag associated with "bona fide." GE is asking the court for another chance to beg for the money.

Last year, the IRS slapped Dow Chemical with a $130 million bill for similar messing around. Dow says it was too legit to quit, and is suing to keep the money.

Geniuses at Goldman Sachs were behind both the disputed Dow and Merck arrangements. The Justice Department declared in a court filing that Goldman Sachs would be invited to dance in an "extensive discovery." Goldman Sachs expects a dressing down for that party ball.

IRS Commissioner Mark Everson told the Senate that tax arbitrage was the most significant enforcement problem it faced.

WSJ traces the strategies to the inspiration of one man.

In 1988, longtime tax attorney and New York University law school professor R. Donald Turlington published an influential article in the proceedings of a tax conference. Subtitled "The Art of Tax Avoidance," the article began with a 1931 quote from the late Chicago Mafia boss Al Capone: "A good lawyer with a briefcase can steal more than ten men with machine guns."

Mr. Turnlington himself advised in structuring the Merck deal.

Merck, GE and Dow Chemical also were aided by some of the country's most prominent partnership tax lawyers, who also once served in high government tax posts.

Posted by Patent Hawk at September 29, 2006 12:27 AM | Patents In Business