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The Third Circuit Court of Appeals ruled against Merck & Co earlier this week on a transfer pricing tax case involving a refund of $473 million.
The three-judge panel ruled against the drug giant and upheld the lower court ruling from 2010, where the district court found that the drugmaker was not entitled to the refund.
The case is complex, even for tax lawyers as transfer pricing and Subpart F are some of the most complicated parts of tax law. It involves complicated corporate tax schemes, tax havens and a suit for refund. Let’s try to put this into plain English:
The plaintiff is Schering-Plough Corporation, which merged with Merck in 2009.
Schering basically conducted a transaction that involved a lot of money changing hands -- and borders. But the company classified these transactions as "sales". Then, the IRS came back and eventually classified these as "loans", which would have very different tax implications for Schering.
The important point here is that loans aren't usually taxable as income. Things are a bit different in the world of "transfer pricing" law, where money that crosses between foreign branches of a corporation is scrutinized a little more heavily. After all, there's always the fear that a multinational corporation will use "tax haven" countries such as Ireland to reap the tax benefits, right?
Well, that's what the IRS said that Schering did. They alleged that Schering took a transaction that was essentially a loan and characterized it as a sale, not reporting the lump sum payments as present income in 1991 and 1992, the years in which the payments had been received. After paying the $473 million tax deficiency, Schering sued for a refund.
The tax law principle that the district court used to look at the transaction was the "economic reality" test, whether or not there was sufficient economic substance in the transaction to trump the tax avoidance motives. So in reality, the court was trying to see whether the primary motive for the transaction was tax avoidance, or whether there really existed a tangible economic benefit aside from tax avoidance.
The district court sided with the IRS in finding that there was a tax avoidance scheme and essentially, a sham transaction, better known to many as a tax shelter.
On appeal, the Third Circuit was presented with the argument that Schering was treated disparately, since another taxpayer had allegedly conducted the same form of transaction but had not been taxed the same way.
The Third Circuit Court of Appeals ruled against Schering (now appearing as Merck, in the appellate proceedings) and upheld the lower court ruling.