Inside Schering's $437M Tax Fraud: "It Doesn't Count If It's in Dutch!"

Last Updated Sep 1, 2009 2:58 PM EDT

Schering-Plough lost a $437 million tax case in New Jersey federal court after arguing that it was innocent because documentation from its attempt to hide $839 million in cash from the IRS was written in Dutch. (Schering was using a Dutch investment bank to construct the transaction.) The company also tried to convince the court that taxable loans it took out were not loans, even though the company's own tax executives referred to them as loans.

Schering now forfeits a proposed $473 million refund on taxes the company believes it was overcharged for a set of complicated interest rate swaps.

The ruling itself is worth reading. It's complicated, but Judge Katharine Hayden has done a fine job of cutting through the investment-banking obfuscation in favor of the hard facts: That Schering was caught red-handed in a $473 million fraud as it attempted to hide cash abroad and not pay tax on it. It also gives insight on the breathtaking cynicism that companies and banks have when it comes to tax avoidance.

Here's a digest of the juicy bits: In 1991 and 1992, Schering's tax department found itself with the kind of problem that only drug companies regard as a "problem": Its Swiss operations were generating too much cash, and that cash -- about $839 million -- was accumulating in Ireland. The "problem" was that if Schering wanted to use the cash in the U.S., it would have to pay tax on it. Here's how it stood:

By the end of 1990, Limited [a Schering unit] had accumulated $391.5 million of this Irish cash, of which only $41 million was previously taxed income [PTI] ...
By 1991, the earnings figure had grown to $498 million, of which only $16 million was PTI; and by 1992 it had ballooned to $829.7 million, of which only $29.6 million was PTI.
So Schering retained Netherlands investment bank ABN, Banco di Roma and Merrill Lynch to come up with a solution. They proposed an "interest rate swap." Simply, Schering promised to give the unit holding its Irish cash a set of future cash payments, and in exchange the Irish unit would give a lump sum of $690 million to Schering. (This lump sum was put toward a $1 billion stock buyback.)

Rather than telling the IRS, however, Schering pretended that the $690 million was arriving in dribs and drabs over two decades, the ruling states:

Schering-Plough did not report the lump sums as present income. Instead, it deferred reporting income until later years, ... Schering-Plough reported income for the lump sums by amortizing them over the period in which the future income streams had been assigned ...
Schering reasoned that this was a "sale" of future cash flows, and under IRS law such a sale is not taxed. The problem is, the "sale" looks almost exactly like a loan: The Irish unit gives Schering a big bunch of money, and in return Schering promises to pay back a stream of smaller sums.

Under IRS law, foreign loans from subsidiaries are taxed for the obvious reason that if they weren't, then all companies would park their money offshore and "loan" it back to themselves, and nobody would pay any tax.

Hayden makes tax law seem simple:

... when a taxpayer's method of accounting does not clearly reflect the income the taxpayer actually generates, the method of computing taxable income - as prescribed by the Commissioner of the Internal Revenue Service (IRS) - should nonetheless be reflective of such income.
The juiciest bits of the judge's analysis concern Schering and its banks' internal memos, and the testimony of their executives at the trial. Of Jay Ludwig, who served in Schering-Plough's treasury department at the time, Hayden wrote:
... he never saw accompanying formalities such as loan documentation, promissory notes, or other documents containing any covenants, warranties, or default events. Nor did he ever see a transferee post security or collateral for an advance.
It is on page 37 that Hayden catches Shering's execs and bankers telling lies. Despite insisting that the transfers were sales and not loans, the IRS found:
An internal ABN credit proposal, dated December 21, 1990, [stating] "The reason for this structure is the fact that the parent through this mechanism receives a 20-year amortizing loan from it's [sic] subsidiary without incurring any negative tax implications in the U.S."
Daniel Filiberto, Schering-Plough's director of financial reporting and compliance [wrote notes that said]: "We are really accounting for the net deferred income as a loan, but tax could not have us record it as a loan."
Ludwig, Schering-Plough's Assistant Treasurer, admitted at trial that there were only two possible conclusions: "[E]ither Schering-Plough violated its own brand-new policy or Schering-Plough didn't think these were really investments."
Schering tried to persuade the judge that some of these documents should be dismissed because they were written in Dutch:
Schering-Plough urges the Court not to give much or any weight to these documents. First, it claims that because the internal credit proposal generated by ABN was largely written in Dutch and the author was not identified, the Court should discount its probative value.
... it is rather unsurprising that portions of an internal ABN document proposing massive and complex transactions to the upper echelon of the investment bank are written in Dutch--after all, ABN is a Dutch bank!
Besides, the judge said, the relevant part of the document was nonetheless written in English:
"a 20-year amortizing loan . . . without incurring any negative tax implications in the U.S." is written in English and is thus readily comprehensible.
Image by Flickr user AMagill, CC.