II. Analysis

In 1993, Merck in conjunction with a British bank entered into a Bermuda partnership whose assets were substantially comprised of the soon-to-be-valuable patents behind cholesterol-lowering medications Zocor and Mevacor.[2]  In creatinig this partnership, Merck engaged in a practice called "inversion:" a method of reorganization wherein a domestic corporation reorganizes itself to become a subsidiary of a foreign parent entity, thereby rendering any profits generated by the foreign business operations outside of the reach of the federal income tax.[3]  In other words, "the arrangement . . . allowed some of the profits to disappear into a kind of Bermuda triangle between different tax jurisdictions."[4]

In order for such a reorganization to pass IRS muster, it must have independent "economic substance," meaning that there must be some economically colorable justification for the reorg other than tax avoidance.[5]  Merck offers that the partnership, whose existence was never previously publicly disclosed, was simply a way of raising financing for its 1993 acquisition of a pharmacy benefits firm: Medco.[6]  Presumably, Merck's argument would go as follows:in order to incentivize investment by the British bank (the other partner), they had to secure the investment with a sure thing, like their Zocor patents.  Similar facts were seen in a recent Second Circuit case where the court held that the foreign banks in a GE deal were not "bonafide equity partners" and on this basis found no economic substance in the transaction.[7]  While the IRS has not disclosed the basis upon which it will pursue Merck for back taxes, a similar fate may await the drug company.

III. Conclusion

In light of the constant struggle that exists between corporate efficiency and preservation of the tax base, consider for a moment tax arbitrage as a matter of theory.  Does tax avoidance differ substantially from other things that corporations do on  regular basis?  In what way is shopping around for favorable tax treatment in different jurisdictions different from, say, shopping around for favorable labor laws for the purpose of minimizing a manufacturer's overhead?  Or from shopping around for favorable management laws upon incorporation?  Doesn't tax avoidance, on a very rudimentary logic level, have very valuable economic substance all its very own?  This is not to say that there aren't valid policy reasons for obligating corporations to behave in this counter-capitalist manner.  It is all but undeniable that the corporate tax base has the potential to be a if not the most valuable source of tax revenue for the federal government.  However, it is at very least debatable as to whether the corporate tax comes even near to that potential in practice given the many creative tax arrangements engineered for corporations.[8]  Given that the value pouring out of the corporate tax base is most likely far less than it could be, is it possible that the funds recouped through investigation and prosecution are not worth the dollars that the government spends in the process?  This author does not know the answer to that question.  However, it seems possible that trying to reach funds that have been merely shopped around on the international tax market costs more than it is worth to this government, and that aiming to keep corporations from taking advantage of lower tax rates elsewhere is a losing battle not worth fighting. 

[1] See, e.g. James Poterba, Program Report: Public Economics, The National bureau of Economic research Reporter, available at www.nber.org/reporter/winter06.

[2] Merck Evading Taxes?, The Red Herring, Sept. 28, 2006, available at www.redherring.com/Article.aspx?a=18859&hed=Merck+Evading+Taxes%3F+.

[3] See id., see also Corporate Inversions, The Tax Prophet, at www.taxprophet.com/hot_topic/August03.shtml.

[4] Jesse Drucker, How Merck saved $1.5 billion paying itself for drug patents, The Wall Street Journal, Sept. 28, 2006, available at www.post-gazette.com/pg/06271/725846-28.stm.

[5] Donald R. Korb, Remarks at the 2005 University of Southern California Tax Institute: The Economic Substance Doctrine in the Current Tax Shelter Environment (Jan. 25, 2005), available at www.irs.gov/pub/irs-utl/economic_substance_(01_25_05).pdf.

[6] Supra note 4.

[7] Id.

[8] See, e.g. George K. Yin, How Much Tax Do Large Corporations Pay? Estimating the Effective Tax Rates of the S&P 500, virginia law review, forthcoming, available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=390260.