Basic Deferral Platform
U.S. companies with profiles similar to that outlined in the Base Case should consider, at a minimum, the deployment of a basic deferral planning structure to reduce U.S. tax exposure with respect to foreign sales.
Working with the facts outlined in the Base Case, assume for purposes of illustrating the application of a deferral planning strategy, Basic Deferral Platform, that Product X has a fairly substantial foreign market. To better serve the non-U.S. markets, Biotech Co decides to form a wholly owned subsidiary in Switzerland, Swiss Sub. Swiss Sub is incorporated under the laws of Switzerland, and pursuant to an advanced ruling with the Swiss federal and cantonal officials, Swiss Sub secures a tax holiday that provides it with a 10% effective tax rate for a 10-year period.
Swiss Sub enters into a nonexclusive license with Biotech Co to manufacture and sell Product X in all markets outside the U.S. Due to the U.S. transfer pricing rules, the license allowing Swiss Sub to manufacture and sell Product X must be made at a market rate—or at arm’s length.
Under the U.S. transfer pricing rules, the arm’s length standard, which is the test typically applied in transfer pricing, provides that the terms of a transaction between related parties will satisfy the arm’s length standard if the results arising from the transaction are consistent with the results that would have been realized if unrelated taxpayers had engaged in the same transaction under the same circumstances.
Assume, for purposes of illustration, that under the Basic Deferral Platform it is determined that the arm’s length pricing on a nonexclusive license with respect to Product X should be $300 per dose. Employees of Swiss Sub, based in Switzerland, perform all manufacturing, testing, packaging, labeling, and storage of Product X for the non-U.S. markets. Further Swiss Sub supervises and incurs all marketing and distribution of Product X to non-U.S. patients.
Assuming Swiss Sub also realizes a pretax and preroyalty profit of $1,000 per dose under the Basic Deferral Platform, its net profit after the royalty and Swiss taxes are considered would be $630 per dose ($1,000 profit per dose, less the royalty of $300, less Swiss tax of $70 on the after-royalty profit). Provided the activities and investments of Swiss Sub are properly structured to avoid triggering the U.S.’s antideferral provisions, the profit of $630 may enjoy deferral from U.S. federal income tax until a later date when such profits are distributed by Swiss Sub as a dividend to Biotech Co.
The $300 royalty per dose paid to Biotech Co under the Deferral Platform would give rise to a U.S. federal income tax of $105. Thus, the net profit after taxes to Biotech Co with respect to the royalty income would be approximately $195 per dose.
Under the Base Case, Biotech Co realized an after tax profit of $650 per dose on all foreign sales. In contrast, the after tax profit realized on the foreign sales under the Deferral Platform would be $825 per dose (Swiss Sub’s after tax profit of $630, plus Biotech Co’s after tax profit of $195). As illustrated by this simple example, basic deferral planning can give rise to substantial tax savings for a U.S. biotech with respect to its foreign sales. Those savings can then be utilized by the foreign sub in a myriad of ways such as funding further R&D, the expansion of the foreign business, or a foreign acquisition.