International Taxation General Principles, Roche as an example Presentation at New York University Peter Eisenring, Bruce Resnick New

York City, October 17, 2011

Table of contents
1. General business information 2. Organization of Group Tax 3. Basics of Tax Strategy 4. Transfer Pricing Policy for Goods and Services 5. Group Tax Rate and Tax Rate Drivers 6. US Domestic rules 7. OECD rules 8. Discussion 3 9 12 17 37 39 56 58
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1.

General business information

Basic Facts and a Glance

1. 2. 3. 4. 5.

Founded 1896 in Basel, Switzerland Pharmaceutical and diagnostic products Currently active in 150 countries on all continents Employing around 80000 people 11000 employees in Switzerland

Pharmaceuticals division Sales of our top 10 products in 2010

Product

Sales in mCHF

% Change in local currency

Avastin MabThera Herceptin Pegasys Lucentis Xeloda Tarceva CellCept NeoRecormon

6461 6356 5429 1645 1458 1426 1325 1290 1285

+9 +9 +7 +2 +27 +17 +6 -15 -15 +1

Bonviva/Boniva 1013

Pharmaceuticals Production network

Mannheim

North America
Boulder Nutley

Clarecastle Legans

Penzberg Segrate

Basel/Kaiseraugst
Karachi Shanghai

Florence Toluca

Europe & Africa

Latin America
Rio Montevideo Isando

Asia Pacific

Diagnostics Main Product list (selection)

Research Products Molecular Systems Pharmacogenomics Clinical Chemistry Immunology Coagulation Blood Glucose Testing Urinanalysis Point of Care LightCycler, MagNA Pure LC, Genome Sequencer COBAS AMPLICOR, AmpliScreen, AmpliPrep, TaqMan AmpliChip Roche/Hitachi and COBAS INTEGRA lines Elecsys and MODULAR ANALYTICS SWA CoaguChek, STAGO systems Products of the Accu-Chek family Miditron, Combur product line, Urisys CoaguChek, Cardiac Reader, Reflotron

Blood gas / electrolytes OMNI C/S

Key Figures of the Roche Group 2010 in CHF m

Total sales consolidated (Pharma 37058, Diagnostics 10415) Cost of sales Marketing and Distribution Research and Development All other (net) Financial income (net) Pretax Profit Income taxes (20.7%) Net income 47473 -13293 -9488 -10026 -1183 -2272 11211 -2320 8891
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100% 28% 20% 21% 2% 5% 24%

2.

Organization of Group Tax

FS - Finance Tax, Int. Trade Affairs and Insurance

CFO FS

Corporate Income Tax & VAT

Intl. Trade Affairs & Customs Regulations

Insurance

Technical know-how and cross-functional interaction are crucial for success

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Tax Organization Group Solid and dotted lines

Head Group Tax

US US Tax Directors

Switzerland Area Tax Directors

Germany Tax Director Germany

All other Affiliates

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3.

Basics of Tax Strategy

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Group Consolidation versus Tax View

National Borders, many Companies Management view Tax view

Country X
Company A

Country Y
Company B

Consolidation

Border for Income tax, VAT, customs

Large number of cross-border transactions require management of transfer prices

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Transfer Prices

Determine the Profits on Both Sides

Invoice for goods

Roche Company A In Country X

Invoice for services Invoice for interest on loan

Roche Company B In Country Y

All intercompany transactions have to be invoiced at an arms length price, the (intercompany) transfer price Higher prices for company A generate higher profits for A and lower profits for B an vice versa
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Different Countries, Different Tax Rates

Countries are competing for the tax money of multinationals to finance their expenses Some countries are collecting income taxes at higher rates than others. These are the nominal rates: Japan US France Germany Mexico UK Switzerland Bermuda 40% 40% 34% 29% 30% 26% 8% - 23% 0%

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Major Drivers of the Tax Strategy

are Transfer Prices and Tax Rates

Transfer prices determine profits of Group companies Profits of (Roche) companies are only acceptable to tax authorities in each country if transfer prices and the resulting profits are reasonable and in accordance with local and international rules (Taxable) profits are taxed at different tax rates in competing countries

The rules Roche is applying are summarized in the Transfer Pricing Policy
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4.

Transfer Pricing Policy for Goods and Services

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4.1 Organizational Structure

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Organizational Structure

Functions Operate across Border

Pharma & Diagnostics

R&D

Manufacturing

Services

M&D

Countries

Countries

Countries

Countries

Pharma and Diagnostics are operating on a global basis Synergies are achieved by centralized coordination of transactions between legal entities in different countries
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Centrally Managed Value Chain

Pharma and Diagnostics

Central Functions
R&D

Central Management
Central Services M&D

Manufacturing

Services

Logistics

Pharma and Diagnostics manage the global functions centrally, such as Research & Development (R&D), Intellectual Property (IP), Manufacturing and Central Services
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4.2 R&D and Intellectual Property (IP)

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Intellectual Property (IP) in Pharma

World-Wide R&D Cost Sharing (excluding Genentech and Chugai)

US IP Owned by US company Ex-US IP Owned by Switzerland

US and Switzerland share R&D cost based on a contract

US Switzerland

Genentech and Chugai are not included in this general R&D cost sharing agreement Basel/US
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Commercialization Agreement between FHLR and GNE

Joint Development
Genentech Research and Early Development (gRED) is operationally and financially separated (no sharing of cost) FHLR opts in gRED projects following the rules of the commercialization agreement GNE / FHLR, then co-develops projects and shares cost
FHLR Co-development shared development cost free exchange of information Genentech

Development in FHLR and affiliates

Late Stage Development

Co -operation projects (e.g. Avastin)

Research and Early Development

(gRED)

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4.3 OECD Transfer Pricing Methods and Application by Function

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OECD Transfer Pricing Methods

Methods for an appropriate Profit Allocation

Methods according to the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (2010 edition): Traditional Transaction Methods Comparable Uncontrolled Price Method Resale Price Method Cost Plus Method

Transactional Profit Methods Transactional Net Margin Method (TNMM) Transactional Profit Split Method

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Application of OECD Transfer Pricing Methods

General remarks: Methods and appropriate Results

The Roche Group Transfer Pricing Policy describes the general rules for the intercompany pricing following OECD Guidelines. For practical reasons or based on local law, there might be some exceptions or deviations from the uniform application of the methods described in this document. Also exceptions have to follow the arms length principle considering the functions, assets, risks, contractual arrangements or specific market conditions.
Intercompany transfers of goods and services have to be invoiced as it would have been done between unrelated parties under the same market conditions and the same contractual arrangements
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4.4 Manufacturing

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Contract & Toll Manufacturing

Cost Plus Method

Manufacturers
Cost plus mark-up

Central Entrepreneurs (IP Owner)

How to achieve the transfer price for the manufacturer? OECD transfer pricing guidelines section 2.39: The cost plus method begins with the costs incurred by the supplier... An appropriate cost plus mark up is then added to this cost, to make an appropriate profit in light of the functions performed This method probably is most useful . where associated parties have concluded long-term buy-and-supply arrangements .
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Contract & Toll Manufacturers Invoice at Cost Plus

Manufacturers

Cost plus mark-up

Central Entrepreneurs (IP Owner)

Contract and Toll Manufacturers are reimbursed for their fully loaded FGA (Financial Group Accounting) manufacturing cost plus a mark-up

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4.5 Marketing and Distribution

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Transfer Pricing for Marketing and Distribution

Affiliates are Invoiced with the Resale Price Method

Resale price minus gross margin

Central Entrepreneurs

M&D

Resale price

Customer

OECD transfer pricing guidelines section 2.21: The resale price is then reduced by an appropriate gross margin ... out of which the reseller would seek to cover its selling and other operating expenses and, in the light of functions performed (taking into account assets used and risks assumed), make an appropriate profit. section 2.69: As prices are likely to be affected by differences in products, and gross margins are likely to be affected by differences in functions, but net profit indicators are less adversely affected by such differences, the resale price method is tested with TNMM.
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Invoicing to Marketing and Distribution Affiliates

Example
Central Entrepreneurs
Invoiced at 72 Invoiced at 100

M&D
(resale minus 28)

Customer

Resale margin of affiliate ./. Operating cost Operating profit

28 25 3

The resale margin of an affiliate should result in an appropriate operating profit for the totality of the products (basket approach) The operating profit is compared with data from third party transactions, if available, thus applying the Transactional Net Margin Method (TNMM)

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Economic Studies

Example for Marketing and Distribution Activities

Possible profit ranges resulting from a specific economic study:

- 1% minimum

1,5% lower quartile

3% median

5% upper quartile

8% maximum

Economic studies show profits ranges for arms length transfer pricing

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4.6 Summary

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Summary of Transfer Pricing Policy

Transfer Prices for Goods and Services

Central Functions (non US)
Pharma, Switzerland Manufacturing Diagnostics, Switzerland Services Marketing & Distribution

R&D

The entrepreneurs bear a substantial portion of the business risks and therefore generate correspondingly high profits or losses The pooling of entrepreneurial risks leads to an offsetting of profits and losses and therefore does allow taking high investments and risks (e.g. R & D) compared to a stand alone situation
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Sustainable Tax Management

is Alignment with Management and Tax Authorities

Functional Strategies (e.g. Manufacturing, R&D, M&D) Interaction and Alignment

Tax Strategy, Transfer Pricing, Legal Structures Compliance plus tax optimization

Tax Law and Practice

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5.

Group Tax Rate and Tax Rate Drivers

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Group Tax Rate

Example only
Pretax Income Tax Rate Tax After Tax Income

US Non-US Total

300
(30%)

37% 16% 22%

110 110 220

190
(24%)

700
(70%)

590
(76%)

1000
(100%)

780
(100%)

Pretax profit contribution of US is 30%, the after tax contribution is 24%

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6.

US Domestic Rules (examples, not related to Roche business)

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What is Transfer Pricing?

Widget Distributors, Inc. and Subsidiary

Widget Distributors, Inc. U.S. Parent, U.S. federal tax rate = 35% Export sale of Widgets to subsidiary Manufacturing cost = $60

Widget Distributors, Pty. 100% owned Japanese marketing subsidiary Japanese total tax rate = 40%, marketing cost = $15 Resale of product to Korean customer for $100

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What is Transfer Pricing? - Continued

Widget Distributors, Inc. (Parent) must set an appropriate transfer price for the sale of the widgets to Widget Distributors, Pty. (the Japanese subsidiary). Group profit = $25 ($100 - $60 - $15) Impact of alternative transfer prices: Transfer price of $ 60 would allocate entire $25 profit to foreign subsidiary Transfer price of $ 85 would allocate entire profit to U.S. parent Transfer price between $ 60 and $ 85 splits the profit between the U.S. parent and the foreign subsidiary.
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Internal Revenue Code 482

Goal: Clearly reflect income of affiliated corporations engaged in inter-company transactions. Standard: Arms-length price (or market value) standard for evaluating transfer prices Practical difficulty: Market values are highly judgmental and depend on the facts and circumstances. Result: Transfer pricing is the most contentious area of audit and litigation controversy in international taxation. Many states have similar provisions to 482.
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Principal Factors for Assessing Comparability of Controlled and Uncontrolled Transactions

Functions performed by the parties involved Contractual terms governing transaction Risks assumed by each party Economic or market conditions in which parties conduct business Nature of property or services transferred in transaction

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Transfer of Intangibles (Reg. 1.482-4)

Widget Distributors, Inc. and Subsidiary

Widget Distributors, Inc. U.S. Parent, U.S. federat tax rate = 35% Grants patient right to Irish subsidiary

Widget Distributors, Ltd. 100% owned Irish subsidiary, Irish rate = 12.5% Pays royalty to parent for use of patent

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Transfer of Intangibles (Reg. 1.482-4) - Continued

Problem Congressional response Pricing methods

No comparables due to uniqueness of intangibles Commensurate with income requirement Comparable uncontrolled transaction method Comparable profits method Profit split method

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Comparable Profits Method (Reg. 1.482-5)

Determine which affiliate will be the tested party. Obtain data regarding comparable uncontrolled parties. Choose profit level indicator, such as operating profit/sales or operating profit/operating assets. Construct arms length range of comparable profits for tested party. Make adjustment if reported profit lies outside arms length range.

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6662(e) Transfer Pricing Penalties

Rationale
Promote more voluntary compliance with arms length standard Promote better documentation of transfer pricing policies

20% penalty applies if:

Transfer price 200% (or 50%) of arms length price (transactional penalty), or Net 482 adjustment > either $ 5 million or 10% of gross receipts (net adjustment penalty)

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6662(e) Transfer Pricing Penalties - Continued

40% penalty applies if:

Transfer price 400% (or 25%) of arms length price, or Net 482 adjustment > either $ 20 million or 20% of gross receipts

Reasonable cause exception

To avoid net adjustment penalty, taxpayer must have created contemporaneous documentation

DHL Corporation, TC Memo 1998-481

IRSs imposition of 6662 penalty upheld in court

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How Do Taxpayers Manage Transfer Pricing Risk?

Develop documentation that supports methodology and results Principal documents ( 1.6662-6)
Nature of business Economic and legal environment Organizational structure Controlled transactions Pricing methods selected, rationale Comparables used Economic analysis and projections

Assess risk of transfer pricing adjustment

Dollar magnitude of inter-company transactions Percentage of worldwide profits attributed to low-tax foreign subsidiaries

Obtain transfer pricing study from outside expert or negotiate an Advance Pricing Arrangement (APA) with IRS
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163(j)Earnings Stripping

Earnings stripping is the practice of reducing taxable income by paying excessive amounts of interest to related parties
163(j) was enacted to prevent earnings stripping it applies to U.S. subsidiaries that have: Debt to equity ratio in excess of 1.5 to 1 Disqualified interest payments, and Excess interest expense Definition of disqualified interest Interest paid to a related party and exempt from U.S. tax (or subject to reduced withholding tax rate) Interest paid to unrelated party (e.g. U.S. bank), but guaranteed by related party (e.g. foreign parent) and exempt from U.S. withholding tax

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Earnings Stripping Provisions - Continued

Disallowed interest expense deductions are limited to the amount of excess interest Definition of excess interest
Net interest expense minus 50% of Adjusted Taxable Income Net interest expense = interest expense interest income Adjusted taxable income = Taxable income
+ Net interest expense + NOL carryovers + Depreciation expense +/- Changes in receivables and payables

Excess interest is a cash flow concept Indefinite carry-forward of disallowed interest expense deductions
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Planning for Section 163 (j)

Remove foreign parents guarantee Reduce U.S. subsidiarys debt-to-equity ratio below 1.5 to 1 Increase U.S. subsidiarys Adjusted Taxable Income without increasing taxable income

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Foreign Tax Credit

Designed to minimize or eliminate double taxation Only allowed for creditable taxes such as income tax FTC limitation= (foreign source income/world wide income) x US tax on world wide income Actual foreign tax credit is lesser of limitation or foreign taxes paid or accrued Unused credits may be carried over (back one year. forward ten) Compare to statutory or treaty exemption could be more or less favorable depending on respective tax rates
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Foreign Tax Credit Example

J Co. earns $300,000 of income in U.S. and $150,000 in Belgium. It pays Belgian tax of $60,000. U.S. federal tax liability before credits is $157,500 $150,000 $450,000 x $157,500 = $52,500

Foreign tax credit allowed in current year is equal to limitation of $52,500 Carryover of $7,500
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7. OECD Rules

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OECD Model Tax Convention on Income and on Capital

Associated Enterprises (Article 9) Affiliate A Country A Country B Affiliate B PE of A in country B Business profits (permanent establishment) (PE) (Article 7) Affiliate A

Purpose of OECD Model and double taxation treaties: Avoid taxation of the same income by countries A and B Basic systems to avoid double taxation: Exemption system or credit system
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8.

Discussion

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We Innovate Healthcare
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