International TaxationGeneral Principles, Roche as an examplePresentation at New York University

Peter Eisenring, Bruce ResnickNew York City, October 17, 2011

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Table of contents

1. General business information 3

2. Organization of Group Tax 9

3. Basics of Tax Strategy 12

4. Transfer Pricing Policy for Goods and Services 17

5. Group Tax Rate and Tax Rate Drivers 37

6. US Domestic rules 39

7. OECD rules 56

8. Discussion 58

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1. General business information

Basic Facts and a Glance

1. Founded 1896 in Basel, Switzerland

2. Pharmaceutical and diagnostic products

3. Currently active in 150 countries on all continents

4. Employing around 80’000 people

5. 11’000 employees in Switzerland

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Pharmaceuticals divisionSales of our top 10 products in 2010

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Product Sales in mCHF % Change in local currency

Avastin 6’461 +9

MabThera 6’356 +9

Herceptin 5’429 +7

Pegasys 1’645 +2

Lucentis 1’458 +27

Xeloda 1’426 +17

Tarceva 1’325 +6

CellCept 1’290 -15

NeoRecormon 1’285 -15

Bonviva/Boniva 1’013 +1

PharmaceuticalsProduction network

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Nutley

Toluca

Rio

MontevideoIsando

ShanghaiKarachi

Leganés

Mannheim

Basel/KaiseraugstSegrate

Latin America

North America

Europe & Africa

Asia Pacific

Boulder

Clarecastle Penzberg

Florence

DiagnosticsMain Product list (selection)

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Research Products LightCycler, MagNA Pure LC, Genome Sequencer

Molecular Systems COBAS AMPLICOR, AmpliScreen, AmpliPrep, TaqMan

Pharmacogenomics AmpliChip

Clinical Chemistry Roche/Hitachi and COBAS INTEGRA lines

Immunology Elecsys and MODULAR ANALYTICS SWA

Coagulation CoaguChek, STAGO systems

Blood Glucose Testing Products of the Accu-Chek family

Urinanalysis Miditron, Combur product line, Urisys

Point of Care CoaguChek, Cardiac Reader, Reflotron

Blood gas / electrolytes OMNI C/S

Key Figures of the Roche Group 2010in CHF m

Total sales consolidated 47’473 100%(Pharma 37’058, Diagnostics 10’415)

Cost of sales -13’293 28%

Marketing and Distribution -9’488 20%

Research and Development -10’026 21%

All other (net) -1’183 2%

Financial income (net) -2’272 5%

Pretax Profit 11’211 24%

Income taxes (20.7%) -2’320

Net income 8’891

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2. Organization of Group Tax

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FS - Finance Tax, Int. Trade Affairs and Insurance

FS

InsuranceCorporate

Income Tax & VAT

Intl. Trade Affairs&

Customs Regulations

CFO

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

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Tax Organization GroupSolid 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 ViewNational Borders, many Companies

Consolidation

Management view

Country X

Country Y

Company A

Border for Income tax, VAT, customs …

Company B

Tax view

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

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Transfer Prices… Determine the Profits on Both Sides

Roche Company AIn Country X

RocheCompany BIn Country Y

Invoice for goods

Invoice for services

Invoice for interest on loan

All intercompany transactions have to be invoiced at an arm’s lengthprice, 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 theirexpenses

• Some countries are collecting income taxes at higher rates than others. Theseare the nominal rates:

– Japan 40%– US 40%– France 34%– Germany 29%– Mexico 30%– UK 26%– Switzerland 8% - 23%– Bermuda 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 StructureFunctions Operate across Border

Synergies are achieved by centralized coordination of transactions between legal entities in different countries

Pharma and Diagnostics are operating on a global basis

Pharma & Diagnostics

R & D

CountriesCountries Countries

M & D

Countries

Manufacturing Services

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Centrally Managed Value ChainPharma and Diagnostics

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

R & D

M & D

Services

Manufacturing

CentralManagement

Central Services

Logistics

Central Functions

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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 and Switzerland share R&D cost based on a contract

Ex-US IPOwned by

Switzerland

US IPOwned by US

company

Genentech and Chugai are not included in this general R&D cost sharing agreement Basel/US

US Switzerland

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Commercialization Agreement between FHLR and GNEJoint Development

• Genentech Research and Early Development (gRED) isoperationally 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 Genentech

Late StageDevelopment

Research and Early

Development(gRED)

Co -operation projects (e.g. Avastin)

Co-development

shared developmentcost

free exchange ofinformation

Development in FHLR and affiliates

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4.3 OECD Transfer Pricing Methodsand Application by Function

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OECD Transfer Pricing MethodsMethods 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 MethodsGeneral 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 arm’s 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

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 ….“

ManufacturersCost plus mark-up Central Entrepreneurs

(IP Owner)

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Contract & Toll Manufacturers Invoice at Cost Plus

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

ManufacturersCost plus mark-up Central Entrepreneurs

(IP Owner)

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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

OECD transfer pricing guidelinessection 2.21:The resale price “is then reduced by an appropriate gross margin ... out of whichthe 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.

Central Entrepreneurs

Resale price minusgross margin

M & D CustomerResale price

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Invoicing to Marketing and Distribution Affiliates Example

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)

Resale margin of affiliate 28./. Operating cost 25

Operating profit 3

Central Entrepreneurs

Invoiced at 72

M & D CustomerInvoiced at 100

(resale minus 28)

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Economic Studies Example for Marketing and Distribution Activities

Possible profit ranges resulting from a specific economic study:

- 1% 5%3%1,5% 8%

minimum lower quartile

median upperquartile

maximum

Economic studies show profits ranges for arm’s length transfer pricing

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4.6 Summary

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Summary of Transfer Pricing PolicyTransfer Prices for Goods and Services

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

Central Functions(non US)R & D

Marketing & Distribution

Services

ManufacturingPharma, Switzerland

Diagnostics, Switzerland

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Sustainable Tax Management …is Alignment with Management and Tax Authorities

Interaction and Alignment

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

Tax Strategy, Transfer Pricing, Legal Structures

Tax Law and Practice

Compliance plus tax optimization

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5. Group Tax Rate and Tax Rate Drivers

Group Tax RateExample only

Pretax Income

Tax Rate Tax After Tax Income

US 300(30%)

37% 110 190(24%)

Non-US 700(70%)

16% 110 590(76%)

Total 1000(100%)

22% 220 780(100%)

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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)

Widget Distributors, Pty.100% owned Japanese marketing subsidiary

Japanese total tax rate = 40%, marketing cost = $15Resale of product to Korean customer for $100

What is Transfer Pricing?Widget Distributors, Inc. and Subsidiary

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Widget Distributors, Inc.U.S. Parent, U.S. federal tax rate = 35%

Export sale of Widgets to subsidiary

Manufacturing cost = $60

What is Transfer Pricing? - Continued

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• 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.

Internal Revenue Code § 482

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• Goal: Clearly reflect income of affiliated corporations engaged in inter-company transactions.

• Standard: Arm’s-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.

Principal Factors for Assessing Comparability ofControlled 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

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Widget Distributors, Ltd.100% owned Irish subsidiary, Irish rate = 12.5%

Pays royalty to parent for use of patent

Widget Distributors, Inc.U.S. Parent, U.S. federat tax rate = 35%

Grants patient right to Irish subsidiary

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

• Problem No comparables due to uniqueness of intangibles

• Congressional response Commensurate with income requirement

• Pricing methods Comparable uncontrolled transaction method

Comparable profits method

Profit split method

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Comparable Profits Method (Reg. 1.482-5)

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• 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 arm’s length range of comparable profits for tested party.

• Make adjustment if reported profit lies outside arm’s length range.

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§6662(e) Transfer Pricing Penalties

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• Rationale– Promote more voluntary compliance with arm’s length standard– Promote better documentation of transfer pricing policies

• 20% penalty applies if:– Transfer price ≥ 200% (or ≤ 50%) of arm’s length price (“transactional

penalty”), or– Net §482 adjustment > either $ 5 million or 10% of gross receipts (“net

adjustment penalty”)

§6662(e) Transfer Pricing Penalties - Continued

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• 40% penalty applies if:– Transfer price ≥ 400% (or ≤ 25%) of arm’s 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– IRS’s imposition of §6662 penalty upheld in court

How Do Taxpayers Manage Transfer Pricing Risk?

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• 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

§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

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• 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

Planning for Section 163 (j)

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• Remove foreign parent’s guarantee

• Reduce U.S. subsidiary’s debt-to-equity ratio below 1.5 to 1

• Increase U.S. subsidiary’s “Adjusted Taxable Income” without increasing taxable income

Foreign Tax Credit

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• 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

Foreign Tax Credit Example

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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

x $157,500 = $52,500

–Foreign tax credit allowed in current year is equal to limitation of $52,500

–Carryover of $7,500

$450,000$150,000

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7. OECD Rules

OECD Model Tax Convention on Income and on Capital

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

Affiliate A Affiliate A

Affiliate B PE of A incountry B

Country A

Country B

Associated Enterprises(Article 9)

Business profits(permanent establishment) (PE)

(Article 7)

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8. Discussion

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