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July 8, 2013
Economic Analysis: Pfizer's Tax Picture Dominated by U.S. Losses, Repatriation
by Martin A. Sullivan -

Full Text Published by Tax Analysts®



By Martin A. Sullivan -- martysullivan@comcast.net

Lipitor is the best-selling prescription drug of all time. Developed and first marketed by Warner-Lambert in 1997, the anti-cholesterol drug became the property of Pfizer in 2000 in a $115 billion acquisition. Since then Lipitor has generated more than $100 billion in revenue for what until 2012 was the largest pharmaceutical company in the United States.

But all good things must come to an end. In 2011 Pfizer's patent for Lipitor began expiring around the world, and on November 30, 2011, Pfizer lost its exclusive rights to sell Lipitor in the United States. Revenue from Lipitor sales dropped from $10.7 billion in 2010 to $3.9 billion in 2012. Overall, while the rest of the economy was growing, Pfizer's sales dropped from $65.2 billion to $59 billion over the same two-year period. By 2012 Johnson & Johnson had edged ahead of Pfizer in sales and market capitalization.

Like so many of its big pharma competitors, Pfizer is having trouble replacing its blockbuster drugs of decades past. The new-product pipeline is drying up, and competition from generic drug makers is relentless. Pfizer has been trying to cushion the blow, but there are no obvious solutions. In fits and starts, Pfizer is remaking itself. It is cutting costs. It is eliminating thousands of jobs. It wants to focus on its risky, core business of developing and marketing new drugs. But at the same time, it is dramatically cutting research spending. And in response to its reversal of fortune, it has gone shopping for new businesses: acquiring Pharmacia for $60 billion in 2003 and Wyeth for $68 billion in 2009. And it has been shedding others: selling its nutrition unit to Nestlé for $11.9 billion in 2012 and just last month completing the spinoff of its animal products unit Zoetis (valued at about $17 billion).


Figure 1. Pfizer's Reported Effective Tax Rates, 2004-2013



Source: Form 10-K reports filed with the SEC.

During this difficult transition, the pharmaceutical giant has had its share of drama. In 2009 Pfizer agreed to pay $2.3 billion to resolve criminal and civil allegations that it illegally promoted off-label uses and unapproved doses of its drugs. At the time, federal authorities called Pfizer a "repeat offender" because it had already reached settlements with the Justice Department on similar charges on three previous occasions. In 2011 Fortune magazine published an 8,500-word exposé about the four-year tenure of former CEO Jeff Kindler, calling it "a saga of ambition, intrigue, backstabbing, and betrayal." (See "Inside Pfizer's Palace Coup," Fortune, Aug. 15, 2011.) The Pfizer board forced Kindler to resign in December 2010. Despite all the turmoil, Pfizer today is still the 13th largest U.S. company by market capitalization ($199.7 billion). And since Kindler's successor, Ian Read, took over in December 2010, Pfizer's stock price has increased from $17 to $28 per share.

Pfizer's Taxes

Like its drug business, Pfizer's tax situation is a jumble of events and trends that eludes easy interpretation. Look, for example, at its effective tax rate, shown in Figure 1. It is a roller coaster ride of ups and downs that on its own provides little information about where the company's tax burden has been or where it is going. Is Pfizer a high-tax or low-tax company? There are no easy answers to that question, just as there is no easy answer to whether Pfizer's future is promising or whether it is a sinking ship. This article investigates the factors behind Pfizer's volatile effective tax rate, its booked tax liability ($11.4 billion over the previous five years), and its actual cash payment to tax authorities for income tax ($21.7 billion over the same period). A comprehensive collection of Pfizer's tax data from 2005 through 2009 is at the end of the article.


Figure 2. Pfizer's Domestic and Foreign
Before-Tax Profits, 2004-2012



Source: Form 10-K reports filed with the SEC.

Although public information is limited, it is worth the effort to try to understand Pfizer's taxes. It is just the type of company that might have been one of the Joint Committee on Taxation's case studies in its 2010 transfer pricing report ("Present Law and Background Related to Possible Income Shifting and Transfer Pricing," JCX-37-10, July 20, 2010). The company has lots of product and marketing intangibles. It has major operations in low-tax Ireland, Puerto Rico, and Singapore. At the end of 2012, it had $73 billion of accumulated unrepatriated foreign profits considered permanently reinvested outside the United States. And as CFO Frank D'Amelio said earlier this year, the company does "tax planning all the time." Preventing the shifting of intangible asset profits to low-tax jurisdictions is at the heart of President Obama's efforts to lower corporate rates and raise revenue, the efforts of House Ways and Means Committee Chair Dave Camp, R-Mich., to move the United States to a territorial system in a revenue-neutral manner, and the OECD's efforts to curb excessive base erosion and profit shifting.

Pfizer has many one-time events like acquisitions and settlements with the IRS that greatly affect its tax liability and taxes paid. Also, Pfizer's reported tax liability over the last three years has been significantly affected by its taking the unusual step of booking tax liability on current foreign earnings because those earnings are not considered permanently invested offshore. If the negative effect of settlements with the IRS and the positive impact of U.S. tax liability on foreign earnings are removed, the average effective tax rate for the last three years would have been 15 percent instead of the 22 percent reported.

Highlights

(1) Lopsided geographic mix of profits. In each of the last five years, Pfizer has generated large before-tax foreign profits and large before-tax domestic losses. In total over the 2008-2012 period, there were $69 billion of foreign profits and $15 billion of domestic losses. The year-to-year data are shown in Figure 2. This distribution of profits and losses is particularly remarkable given that it is routinely reported that the prices of pharmaceutical drugs are much higher in the United States than abroad. (See, for example, Steven Brill, "Bitter Pill: Why Medical Bills Are Killing Us," Time, Mar. 4, 2013.)

Although there are no hard data publicly available about the share of Pfizer's profits attributable to intellectual property, there can be little doubt that most of its profits are attributable to its patents and marketing intangibles. Several commentators have argued that governments should align the allocation of profits across jurisdictions with the allocation of sales. (See, for example, Tax Notes, June 10, 2013, p. 1218 .) Although Pfizer's shares of worldwide profits and sales have both been growing, the company's profits are disproportionately concentrated outside the United States relative to sales. Over the 2008-2012 period, while 124 percent of its before-tax profits were foreign, only 57 percent of its sales have been outside the United States, as shown in Figure 3.


Figure 3. Pfizer's Foreign Sales and Profits as
Percentage of Worldwide Totals, 2004-2012



Source: Form 10-K reports filed with the SEC.

Another point of view is that profits from intangible income should be allocated according to where the intangibles are developed. Marketing intangibles are likely to be developed where products are sold, in which case a substantial portion of Pfizer's marketing intangible profits would be allocated to the United States. Patents are developed where research is conducted, in which case a substantial portion of profit from Pfizer's patents would be allocated to the United States. Pfizer does not provide data on its research expenditures by geographic region, but it does state that its research facilities are heavily concentrated in North America.

Pfizer officials do not believe the geographical mix of revenues is a good indicator of the split between domestic and international pretax earnings. On May 9, 2012, the SEC questioned why profits were disproportionately allocated outside the United States. The agency wrote:


    Please provide us a proposed disclosure to be included in future periodic filings that explains why your domestic operations produced pre-tax losses of $2.2 billion and your international operations produced pre-tax earnings of $15.0 billion in 2011. These operating results appear to be inconsistent with your domestic and international revenues, which in 2011 were $26.9 billion and $40.5 billion, respectively.

On May 22, 2012, Pfizer replied in part:

    A U.S. multinational company may incur certain expenses having a disproportionate impact in the U.S. as compared to international locations. Such expenses could include expenses for corporate functions, charges for litigation and interest expense, among others. In addition, any multinational company would likely engage in intercompany transactions in the normal course of business which could impact the geographic split of pre-tax earnings. However, it's important to note that these intercompany transactions are eliminated for the preparation of consolidated financial statements, and as such do not impact the geographic split of third party revenue reflected in the same financial statements.

It also stated:

    We do not believe that disclosure regarding the reasons for the geographical split of pre-tax earnings would be meaningful or useful to investors.

(2) Large domestic cash injection from the repatriation holiday. In 2005 Pfizer repatriated about $37 billion of foreign earnings in accordance with the American Jobs Creation Act of 2004, and as a result it booked an additional income tax charge of $1.7 billion. Without this extra tax liability, Pfizer's effective tax rate for that year would have been 15.3 percent instead of the 29.7 percent reported. As shown in Figure 4, Pfizer's foreign profits considered permanently invested outside the United States dropped from $51.6 billion in 2004 to $27 billion in 2005.

Figure 4. Pfizer's Accumulated Foreign Profits Indefinitely
(or Permanently) Invested Abroad, 1996-2012



Source: Form 10-K reports filed with the SEC. Before 2012, Pfizer refers to these earnings as "permanently" reinvested. In its 2012 Form 10-K, it refers to them as "indefinitely" reinvested.

(3) Hidden tax payments on $34 billion repatriated for the Wyeth acquisition. As explained by Patrick Driessen, formerly an economist with the JCT and now with Bloomberg Government, the JCT analyzed Pfizer's acquisition of Wyeth as part of its background research for a revenue estimate of a second tax holiday. (For prior coverage of the JCT estimate, see Tax Notes, Apr. 30, 2012, p. 550.) According to the JCT, in connection with its acquisition of Wyeth, Pfizer reversed its assertion that $34 billion of its foreign earnings was permanently invested outside the United States. The JCT estimated that this increased U.S. taxes by about $6.8 billion. Pfizer's 2009 Form 10-K reports an unusually high current income tax expense of $10.2 billion for 2009 and states, "Virtually all of the Federal current income tax expense in 2009 was due to increased tax costs associated with certain business decisions executed to finance the Wyeth acquisition . . . including the decision to repatriate certain funds."

But this enormous tax payment was not easy to spot, because in that year $10.2 billion of current tax liability was almost entirely offset by a $10.1 billion reduction in deferred tax liability. Through what Edmund Outslay of the Michigan State University business school called "the wonders of purchase accounting," the additional tax expense did not affect the effective tax rate and profits reported to shareholders in Pfizer's annual financial statements. (See Jesse Drucker, "Dodging Repatriation Tax Lets U.S. Companies Bring Home Cash," Bloomberg, Dec. 29, 2010.)


Figure 5. Pfizer's Cash Payments of Income Tax, 2004-2012



Source: Form 10-K reports filed with the SEC.

Assuming conservatively that the JCT estimate of $6.8 billion is correct, if Pfizer recorded that tax liability in its effective tax rate calculation, its reported effective tax rate in 2009 would have been 84 percent instead of the 11 percent reported. Investors and analysts who focus on the reported effective tax rate would not have liked that at all. In 2010, presumably the year Pfizer remitted payment to the U.S. treasury for the $34 billion of repatriated earnings, its cash payments of income tax spiked from $2.3 billion in 2009 to $11.8 billion in 2010, as shown in Figure 5, and then dropped down again to $2.9 billion in 2011.

(4) Multibillion-dollar benefits from settlements with tax authorities. Over the last three years, Pfizer has obtained favorable settlements from tax authorities worth $4.3 billion. That allowed the company to reduce its reported effective tax rate by an average of 14 percentage points each year. The largest of these was in 2012, resulting from a $1.1 billion settlement with the IRS for audits of tax returns for 2006 through 2008 and $310 million for settlements with various foreign authorities. Removing this tax benefit from Pfizer's effective tax rate calculation increases its reported effective tax rate for 2012 from 22.2 percent to 33.2 percent.

   Tax and Tax-Related Information From Pfizer's Form 10-K Reports, 2004-2012

                          (dollar amounts in millions)
 ______________________________________________________________________________

 Year                       2012       2011       2010       2009        2008
 ______________________________________________________________________________

 Income from continuing operations before income tax

 United States           -$4,732    -$2,210    -$2,256    -$3,694     -$1,760

 International           $16,812    $14,514    $11,727    $14,368     $11,454

 Total                   $12,080    $12,304     $9,471    $10,674      $9,694

 Permanently             $73,000    $63,000    $48,200    $42,500     $63,100
 reinvested foreign
 earnings

 Tax provisions (based on location of taxing authority)

 United States

 Current income taxes:

      Federal              -$752     $1,349    -$2,790    $10,151        $707
      State                 -$44       $207      -$323        $68        $154

 Deferred income taxes:

      Federal*              $851       $364     $2,103   -$10,005        $106
      State and local      -$328      -$240         $8       -$93       -$136

 Total U.S. tax            -$273     $1,680    -$1,002       $121        $831
 provisions

 International

      Current income      $2,619     $2,046     $2,157     $1,516      $2,115
      taxes

      Deferred income       $216       $183        -$2       $508     -$1,301
      taxes

 Total international      $2,835     $2,229     $2,155     $2,024        $814
 provisions

 Total provisions for     $2,562     $3,909     $1,153     $2,145      $1,645
 income tax

 Tax rate reconciliation (percentage of before-tax income)

 U.S. statutory rate       35.0%      35.0%      35.0%      35.0%       35.0%

 Taxation of non-U.S.      -3.0%      -3.1%       2.5%      -9.4%      -20.2%
 operations

 Tax settlements and      -12.0%      -2.8%     -26.3%                  -3.1%
 resolution of certain
 tax positions

 U.S. healthcare            1.0%       0.7%       2.8%
 legislation

 U.S. research credit      -0.3%      -0.9%      -2.3%      -1.3%       -1.2%
 and manufacturing
 deduction

 Certain legal              1.4%                  0.4%      -1.6%        9.0%
 settlements and
 charges

 Acquired IP research                             0.5%       0.2%        2.1%
 and development

 Wyeth acquisition-                               0.5%       2.4%
 related costs

 Sales of                              0.2%                 -5.1%       -4.3%
 biopharmaceutical
 companies

 Tax legislation impact

 Repatriation of foreign
 earnings

 All other -- net          -0.9%       2.7%      -0.9%      -0.1%       -0.3%

 Effective tax rate for    21.2%      31.8%      12.2%      20.1%       17.0%
 continuing operations

 Tax rate reconciliation (in dollars)

 Provision at U.S.        $4,228     $4,306     $3,315     $3,736      $3,393
 statutory rate

 Taxation of non-U.S.      -$362      -$381       $237    -$1,003     -$1,958
 operations

 Tax settlements and     -$1,450      -$345    -$2,491         $0       -$301
 resolution of certain
 tax positions

 U.S. healthcare            $121        $86       $265         $0          $0
 legislation

 U.S. research credit       -$36      -$111      -$218      -$139       -$116
 and manufacturing
 deduction

 Certain legal              $169         $0        $38      -$171        $872
 settlements and
 charges

 Acquired IP research         $0         $0        $47        $21        $204
 and development

 Wyeth acquisition-           $0         $0        $47       $256          $0
 related costs

 Sales of                     $0        $25         $0      -$544       -$417
 biopharmaceutical
 companies

 Tax legislation impact       $0         $0         $0         $0          $0

 Repatriation of foreign      $0         $0         $0         $0          $0
 earnings

 All other -- net          -$109       $332       -$85       -$11        -$29

 Total provision for      $2,562     $3,909     $1,153     $2,145      $1,645
 income tax

 Deferred tax liability -$16,042   -$11,699    -$9,524    -$7,057      $4,471
 -- unremitted
 earnings

 Cash paid during the     $2,430     $2,938    $11,775     $2,300      $2,252
 period for income
 taxes

 Geographic segment data

 Revenues

 United States           $23,086    $26,933    $28,855    $21,450     $20,401

 Other                   $35,900    $38,326    $36,301    $27,819     $27,895

 Total                   $58,986    $65,259    $65,156    $49,269     $48,296
 ______________________________________________________________________________

                               [table continued]
 ______________________________________________________________________________

 Year                       2007       2006       2005       2004
 ______________________________________________________________________________

 Income from continuing operations before income tax

 United States              $242     $3,266       $985     $4,078

 International            $9,036     $9,762     $9,815     $9,325

 Total                    $9,278    $13,028    $10,800    $13,403

 Permanently             $60,000    $41,000    $27,000    $51,600
 reinvested foreign
 earnings

 Tax provisions (based on location of taxing authority)

 United States

 Current income taxes:

      Federal             $1,393     $1,399     $2,572     $2,273
      State                 $243       $205       $108       $340

 Deferred income taxes:

      Federal*           -$1,774    -$1,371    -$1,295    -$1,521
      State and local      -$212

 Total U.S. tax            -$350       $233     $1,385     $1,092
 provisions

 International

      Current income      $2,175     $1,913     $1,963     $1,599
      taxes

      Deferred income      -$802      -$154      -$170      -$231
      taxes

 Total international      $1,373     $1,759     $1,793     $1,368
 provisions

 Total provisions for     $1,023     $1,992     $3,178     $2,460
 income tax

 Tax rate reconciliation (percentage of before-tax income)

 U.S. statutory rate       35.0%      35.0%      35.0%      35.0%

 Taxation of non-U.S.     -21.6%     -15.7%     -20.6%     -19.0%
 operations

 Tax settlements and                  -3.4%      -5.4%
 resolution of certain
 tax positions

 U.S. healthcare
 legislation

 U.S. research credit      -1.5%      -0.5%      -0.8%      -0.6%
 and manufacturing
 deduction

 Certain legal
 settlements and
 charges

 Acquired IP research       1.1%       2.2%       5.4%       2.8%
 and development

 Wyeth acquisition-
 related costs

 Sales of
 biopharmaceutical
 companies

 Tax legislation impact               -1.7%

 Repatriation of foreign              -1.0%      15.4%
 earnings

 All other -- net          -2.0%       0.4%       0.4%       0.2%

 Effective tax rate for    11.0%      15.3%      29.4%      18.4%
 continuing operations

 Tax rate reconciliation (in dollars)

 Provision at U.S.        $3,247     $4,560     $3,780     $4,691
 statutory rate

 Taxation of non-U.S.    -$2,004    -$2,045    -$2,225    -$2,547
 operations

 Tax settlements and          $0      -$443      -$583         $0
 resolution of certain
 tax positions

 U.S. healthcare              $0         $0         $0         $0
 legislation

 U.S. research credit      -$139       -$65       -$86       -$80
 and manufacturing
 deduction

 Certain legal                $0         $0         $0         $0
 settlements and
 charges

 Acquired IP research       $102       $287       $583       $375
 and development

 Wyeth acquisition-           $0         $0         $0         $0
 related costs

 Sales of                     $0         $0         $0         $0
 biopharmaceutical
 companies

 Tax legislation impact       $0      -$221         $0         $0

 Repatriation of foreign      $0      -$130     $1,663         $0
 earnings

 All other -- net          -$186        $52        $43        $27

 Total provision for      $1,023     $1,992     $3,178     $2,460
 income tax

 Deferred tax liability  -$3,550    -$3,567    -$2,652    -$3,063
 -- unremitted
 earnings

 Cash paid during the     $5,617     $3,443     $4,713     $3,388
 period for income
 taxes

 Geographic segment data

 Revenues

 United States           $23,153    $25,822    $24,571    $27,784

 Other                   $25,265    $22,549    $22,834    $21,204

 Total                   $48,418    $48,371    $47,405    $48,988
 ______________________________________________________________________________

 Source: Pfizer annual Form 10-K reports filed with the SEC. When data
 from different reports differed, data from most recent reports were used.

                               FOOTNOTE TO TABLE

      * For 2004 through 2006, federal, state, and local deferred tax expense
 were combined into one entry.

                            END OF FOOTNOTE TO TABLE

(5) Booking U.S. tax on foreign profits. In 2012 Pfizer booked about $2.2 billion of U.S. tax expenses "as a result of providing U.S. deferred income taxes on certain current-year funds earned outside the U.S. that will not be indefinitely reinvested overseas." If the residual U.S. tax rate on these earnings was 25 percent, this would correspond to $8.8 billion, or 52 percent of the total before-tax foreign profits of $16.8 billion in 2012.

The booking of deferred tax liability on unremitted foreign profits is unusual. It is now routine for companies to treat all of their foreign profits as permanently or indefinitely reinvested so there is no need to record U.S. tax liability on their unrepatriated foreign profits. (Apple Inc. is one notable exception. See Tax Notes, Feb. 13, 2012, p. 777.) If the $2.2 billion of deferred U.S. tax liability was not recorded for foreign profits in 2012, the reported effective tax rate would have been 3 percent instead of the 21.2 percent actually reported.

Also in its 2012 Form 10-K report, Pfizer stated that tax-deferred liabilities of similar amounts were booked for 2010 and 2011 ($2.5 billion and $2.1 billion, respectively) for current-year profits earned outside the United States. In 2011, if this expense were not recorded, Pfizer's effective tax rate would have been 14.7 percent instead of the 31.8 percent reported. In 2010, if this expense were not recorded, its effective tax rate would have been -14.2 percent instead of the 12.2 percent reported.


Figure 6. Pfizer's Reported ETR and ETR Adjusted to Remove
Effects of Tax Settlements and U.S. Liability on
Foreign Earnings, 2010-2012



Source: Form 10-K reports filed with the SEC.

Why did Pfizer book this expense? It is possible it wanted to avoid the public scrutiny a low reported tax rate might attract and reduce what is now called reputation risk. Another explanation is that it had no choice. "The shifting of substantial income out of the United States has hoisted some U.S. multinationals on their own petard," said professor J. Richard Harvey of Villanova University School of Law. "It may be that some like Pfizer have shifted so much income offshore that they may be having difficulty justifying to their auditors that 100 percent of their foreign income is permanently reinvested."

The Bottom Line

Over the last half decade, Pfizer has put all of its profits outside the United States despite high prices in the United States, more than 40 percent of its sales in the United States, and a heavy concentration of research in the United States. It appears U.S. transfer pricing rules and the arm's-length standard are working well for the company. If it weren't for U.S. taxes on repatriated profits, Pfizer's tax picture would be far rosier. But cash needs and accounting requirements have upset the apple cart.

To help fund its acquisition of Wyeth in 2009, Pfizer repatriated $36 billion, paid U.S. tax on those billions of dollars, and avoided any impact on its reported profit. Beginning in 2010, Pfizer has been booking more than $2 billion annually in U.S. tax liability on its foreign profits, but it is not actually making payments corresponding to that liability. If we remove the effects of these deferred U.S. tax liabilities from the effective tax rate calculations, as well as the effects of one-time settlements with the IRS and other tax authorities, the company's effective tax rates for 2010, 2011, and 2012 would have been 12, 18, and 15 percent, respectively, instead of the 12, 32, and 21 percent reported, as shown in Figure 6.

Pfizer needs cash to pay dividends, pay down debt incurred for the Wyeth acquisition, buy back shares, and perhaps acquire more U.S. companies. At the same time, it is under pressure to shore up its after-tax earnings as patents on profitable drugs expire faster than they can be replaced. If there was ever a company that could use another tax holiday -- or generous transition rules to a territorial system -- Pfizer is it.


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