How Merck Lost $2.3B in the Bermuda Triangle

Last Updated Nov 17, 2009 12:20 PM EST

Merck (MRK) must pay $2.3 billion in tax following a dispute with the IRS over cash the company parked in the Caribbean. If you read the IRS statement, you'll be left baffled as to what this was about. The IRS said:
Among the significant issues resolved were three issues that resulted from Merck's use of minority equity interest financing transactions. The execution of these agreements should facilitate the ability of the IRS and the taxpayer to move forward and effectively address tax issues arising in subsequent examination years.
Luckily, between a report in the Wall Street Journal and one on MarketWatch, we can piece together in plain English how Merck got into trouble. One irony to emerge: Merck appears to have been doing something very similar to Schering-Plough, its merger partner, which recently lost a $437 million tax case in New Jersey (after arguing that it was innocent because its documents were in Dutch!). Both companies were using foreign units to hide cash from U.S. tax authorities.

Merck set up a unit in Bermuda and then transferred patents for Zocor and Mevacor to the Bermuda unit. Merck then paid the Bermuda unit to license the drugs back, thus funneling cash out of the U.S. and into what the WSJ called a "Bermuda triangle between different tax jurisdictions."

Schering was nabbed doing something similar in September. It parked a mountain of cash in Ireland to avoid tax, and then pretended it wasn't using it (when it was) in order to avoid paying tax.

Merck previously booked the hit and doesn't expect to have to restate its 2007 earnings, the affected year, according to MarketWatch. Also of note:

Merck still hasn't completely gotten past its tax problems. It is in a separate tax dispute with Canadian authorities who are seeking about $1.76 billion in additional taxes and interest from Merck for years dating to 1998.
The IRS was initially seeking $3.8 billion from Merck in unpaid tax:
Merck didn't immediately explain why the settlement amount of $2.3 billion was nearly 40% less than the amount it previously said the IRS was seeking. The company did say in its press release the pact "was reached as a result of the cooperation and reasonableness of the IRS and the company," indicating the amount was negotiated.
That's right: This $2.3 billion settlement isn't a hit for Merck, it's more like a $1.8 billion savings!

Next up: On page 60 of its recent 10-Q filing with the SEC, Pfizer (PFE) said its 2006, 2007 and 2008 tax years were being audited by the IRS, and that the company was appealing audits from 2002 through 2005. Audits in foreign jurisdictions are too numerous to mention here. I wonder what they'll find?