Winners and Losers

Hospital chains, health insurers and retail pharmacy groups are likely to wind up big winners in any shakeup of the corporate tax code, while pharmaceutical companies and medical-device makers may find themselves fighting tooth and nail to keep the status quo.

In his 2014 budget plan unveiled last week, President Barack Obama laid out his desire to pursue revenue-neutral corporate tax reform in the coming year. The idea, which is being pushed by business groups in Washington upset that the U.S. now has the world's nominally highest corporate tax rate, is gathering bipartisan support on Capitol Hill. Given the divided Congress and the president's urge to rack up some second-term achievements, Washington insiders say the pieces may be falling into place for the first major overhaul of the nation's complex and convoluted tax code since 1986.

However, any overhaul means there will be winners and losers in corporate America, and nowhere is that more true than in healthcare. Corporate tax reform, at its core, would lower the federal statutory tax rate while closing loopholes and eliminating certain deductions. But whether that benefits or hurts a company's bottom line depends on how well it is faring under the current system.

If the idea of corporate tax reform takes hold, interests are likely to align in two camps. Opposition may come from companies that are most deftly exploiting the current loopholes and credits in the code. Proponents are likely to be those firms that benefit most from a lower overall tax rate, largely because they use fewer write-offs.

While corporate tax reform is still a big “if,” the discussion came back into focus with the president's budget plan, which revisited previous tax-overhaul proposals.

But the idea also found bipartisan support two days earlier when Sen. Max Baucus (D-Mont.), chairman of the Senate Finance Committee, and Rep. Dave Camp, (R-Mich.), chairman of the House Ways and Means Committee, penned a joint op-ed in the Wall Street Journal headlined, “Tax reform is very much alive and doable.”

Support in the healthcare industry for a revamping of the tax code is likely to fall along a fault line that pits companies that perform substantial research and development and have sizable overseas operations against those that are strictly domestic services and retail businesses.

A Modern Healthcare analysis of the current effective tax rates in the healthcare industry for 2012 found investor-owned hospital chains, health insurers and retail and wholesale pharmacy companies paid the highest effective tax rates, often hovering close to the 35% federal statutory tax rate for large corporations.

Pharmaceutical, biotechnology and medical device companies, on the other hand, paid significantly lower rates—often below 25%—as they took advantage of tax breaks related to the depreciation of plants and equipment, research and development and domestic manufacturing. The key distinction between the two groups is that many drug and device makers are multinational conglomerates with a number of subsidiaries in other countries, many of which have lower tax rates than the U.S. “They're able to shift a lot of their profits overseas and into tax havens,” said Martin Sullivan, chief economist at Tax Analysts.

In his budget, the president called for six specific changes in the corporate tax code that suggest the direction he would like to see corporate tax reform go. Two would be most relevant to research-intensive healthcare companies.

The first would help them. A change to the research and experimentation tax credit would raise the base credit rate to 17% from 14% and provide an estimated $99 billion in research incentives over the next 10 years.

But the second targets international tax havens and cracks down on opportunities for companies to shift profits on intellectual property to countries with lower tax rates. This tactic is frequently deployed by the pharmaceutical industry.

The proposal also would eliminate deductions for moving production overseas and implement a new tax credit when production is brought back to the U.S. It estimates that the latter reforms would raise $157 billion over 10 years.

As it stands now, pharma companies can enter into cost-sharing agreements with their own overseas entities and then move assets—including valuable patents—into these subsidiaries. If the government limits the ability to shift profits out of the U.S., Sullivan said, “that would seriously hurt the pharmaceuticals, the biotechs and the medical device manufacturers.”

A spokeswoman from trade group Pharmaceutical Research and Manufacturers of America said the group does not have any comment on the specific proposals under Obama's corporate tax reform plan. A representative from the Advanced Medical Technology Association, which represents medical device manufacturers, was not available to comment at deadline. The group represents major leading medical device players such as Medtronic (17.6% effective tax rate for its fiscal year that ended last April), which have been on the front lines seeking repeal of the 2.3% medical device tax used to support healthcare reform.

When drug and device companies are excluded from the mix, healthcare companies are paying some of the highest effective tax rates among Fortune 500 companies—even higher than retailers, an industry that has been one of the most vocal proponents of tax reform.

“Healthcare companies as a whole don't seem to be benefiting as much” from current deductions and loopholes, said Matthew Gardner, executive director of the Institute of Taxation and Economic Policy, which conducted an analysis of tax rates among Fortune 500 companies.

Obama has proposed lowering the statutory income tax rate to 28% while House Republicans would prefer a deeper cut to 25%.

But in setting a lower rate, the real question is what companies will have to give up in order for tax reform to be done in a revenue-neutral manner, said Annette Nellen, a professor of tax and accounting at San Jose State University.

Nellen pointed, for instance, to the code section 199 deduction, which relates to domestic production activities, as well as credits for conducting research. Both are used by the pharmaceutical industry and would have a significant impact if they were on the chopping block.

Under “plain-vanilla tax reform,” healthcare providers would likely be the clear winners, Tax Analysts' Sullivan said. “They don't get a lot of deductions.”

The dynamic in the healthcare industry parallels the broader divide among businesses, with service providers and retailers on one side and manufacturers and high-tech companies on the other. “It's very much in the interest of the service providers to push for classic tax reform,” he said.

Yet even among healthcare providers, there are exceptions. Gardner noted that three healthcare companies—Tenet Healthcare Corp., Health Management Associates and Omnicare—stood out as paying no federal income tax at least once over the past three years, instead choosing to defer their tax liabilities.

Effective tax rates also can vary widely year to year. Pfizer, for instance, which paid an effective tax rate of 21.2% last year, had a tax rate as high as 31.8% in 2011 and as low 12.2% in 2010, according to its annual report.

The latest budget proposal isn't the first time Obama has come out in favor of eliminating special-interest loopholes, including the ability to shift profits outside of the U.S.. While the president was roundly criticized for that plan a few years ago, a number of factors have coincided to make such reforms more attainable.

Camp has singled out overseas tax shelters, and the Organization for Economic Cooperation and Development similarly has been under pressure to address base erosion and profit-sharing—or what happens when profits are allocated to locations different from where business is conducted. “They're all in a flurry about this,” Sullivan said. “It's now mainstream. There's a lot of progress in attitude—but not necessarily on Capitol Hill.”

The greater challenge will be reaching consensus on lowering the individual tax rates, Nellen said, and she didn't think one type of tax reform could be accomplished without the other.

And the healthcare industry is likely to be the subject of the tax debate in another way, once the costs and penalties of complying with the Patient Protection and Affordable Care Act become clearer next year.

The medical device industry already is lobbying hard to eliminate the tax on their products, which was included in the Affordable Care Act as the sector's contribution to the overhaul. More fights over the many reform-related taxes, Nellen said, could divert attention from discussions on meaningful tax reform.

TAKEAWAY: Corporate tax reform would be a boon to many healthcare companies, but drug and device makers may prefer the code they have now.

Follow Beth Kutscher on Twitter: @MHbkutscher