WSJ: Turlington Helps Merck Save $1.5 Billion in Taxes

Interesting front-page article in the Wall Street Journal:  Bermuda Triangle: How Merck Saved $1.5 Billion Paying Itself for Drug Patents; Partnership With British Bank Moved Liabilities Offshore; Alarmed U.S. Cracks Down; "The Art of Tax Avoidance," by Jesse Drucker:

Merck & Co.'s medications Zocor and Mevacor have been used by millions of people to help lower their cholesterol. But Merck also used the drugs to lower something else: its U.S. tax bill.

Thirteen years ago, Merck set up a subsidiary with an address in tax-friendly Bermuda, in partnership with a British bank. Merck quietly transferred patents underlying the blockbuster drugs to the new subsidiary, according to documents and people familiar with the transaction. Merck then paid the subsidiary for use of the patents. The arrangement in effect allowed some of the profits to disappear into a kind of Bermuda triangle between different tax jurisdictions. The setup helped Merck slash $1.5 billion off its federal tax bills over roughly the next 10 years.

Now, the complicated transaction -- never publicly disclosed -- has sparked one of the largest tax disputes ever involving a U.S. corporation. The IRS is challenging the tax benefits from the arrangement, which the company code-named "Project Ryland," after a fancy restaurant near the company's New Jersey headquarters. Merck anticipates it will be ordered to hand over a total of $2.3 billion in back taxes, interest and penalties, according to its filings with the SEC, which give the amounts in dispute but virtually no other details....

The cases are part of an attempt by U.S. authorities to crack down on what is often called "tax arbitrage." The usual strategy: lower a company's tax bills by structuring transactions so certain types of income or expenses are classified as one thing by the IRS, but something very different by another country's tax regulators....

Many of the strategies like the ones used by Merck, Dow and GE were inspired by one man. In 1988, longtime tax attorney and New York University law school professor R. Donald Turlington published an influential article in the proceedings of a tax conference. Subtitled "The Art of Tax Avoidance," the article began with a 1931 quote from the late Chicago Mafia boss Al Capone: "A good lawyer with a briefcase can steal more than ten men with machine guns." In the article, Mr. Turlington laid out ways companies could lower their taxes by exploiting a loophole in the way income was allocated within partnerships for tax purposes.

He focused on the concept of depreciation, a key tool to lowering taxes. For example, in the U.S. a factory is considered to have a finite life of 39 1/2 years and loses its value gradually during that life. An owner is allowed to deduct a portion of its cost each year, so if the factory cost $39.5 million, the company can deduct $1 million a year from the plant's taxable income. But after that, a company can end up with considerable income from the asset and no offsetting deductions. In the case of pharmaceutical patents, tax write-offs generally are used up during research and development.

Mr. Turlington pointed to a way around such problems by putting the already-depreciated asset into a partnership, and allocating some of its taxable income to a member of the partnership that for one reason or another wouldn't mind shouldering it. That could reduce the tax bill for the company contributing the assets.

Mr. Turlington called on the government to close this loophole, and in December 1992, the U.S. Treasury Department decided to do just that, proposing an "anti-abuse" regulation. But before the government finalized the new regulations a year later, several companies moved to shift assets and establish partnerships to exploit the loophole. Mr. Turlington himself helped structure the Merck deal, counseling Goldman Sachs on the transaction, despite his call for the law to be changed.Merck, GE and Dow Chemical also were aided by some of the country's most prominent partnership tax lawyers, who also once served in high government tax posts. William Nelson, a former IRS chief counsel, advised Merck and GE on their deals, according to people with knowledge of his involvement. The firm he founded with William McKee, a former University of Virginia law professor and U.S. Treasury Department tax legislative counsel, litigated the GE dispute with the government at trial. The firm also is representing Dow in the litigation over its disputed partnership. Mr. Nelson and Mr. McKee declined to comment on the Merck deal....

Mr. Turlington, now retired, says the Merck deal with Abbey was a tax-advantaged way to raise significant capital, and not simply a tax-saving measure. "In my mind the question with a deal like Merck was, and still should be, 'Can a taxpayer who decides to do something for a legitimate business reason, like raising [money], do it in a way that's tax efficient by taking advantage of a rule that the government wrote?'" He added: "Merck's obligation is to do the best it can for its shareholders. If you were going to write that Merck is under some higher social obligation to maximize its taxes, that would probably catch Merck by surprise."