Healthcare winners and losers in tax reform

One can only hope the spate of tax-motivated mergers in the pharmaceutical and medical-device industries finally will motivate Congress to reform the corporate tax code—a long-sought goal of the business community.

Some healthcare-related firms have a lot to lose from tax reform, and their maneuverings to avoid the tax man have drawn justifiable anger from the Obama administration.

For the mainstream business community, the issue driving reform is the U.S.' nominal 35% tax rate on corporate profits—the highest among advanced industrial countries. Switzerland, Ireland and Germany, for instance, have tax rates of 15% or less.

But there is less to those nominal rates than meets the eye, especially in the healthcare sector. Health insurers, for-profit hospital chains and other providers, drug and devicemakers, distributors and suppliers pay very different effective tax rates depending on the nature of their business.

For most healthcare providers, corporate taxes are not a major issue. About 80% of hospital capacity is housed in not-for-profit organizations and most non-salaried physicians are not incorporated.

But for the rest of the for-profit healthcare sector whose operations are almost entirely domestic—think hospital chains, post-acute-care provider chains, pharmacy retailers and supply distributors, for instance—high nominal tax rates matter a lot. They have small research and development budgets and are labor-intensive, not capital-intensive.

Drug, device and medical-equipment firms, on the other hand, tend to have global operations and sales. They spend up to 20% of their total budgets on researching new products. Their manufacturing processes usually require lots of capital equipment.

The current tax code provides numerous advantages for these globally oriented firms. It gives special tax breaks for R&D and capital investment. The code also doesn't tax overseas profits until they are repatriated to the U.S.

Tax reform threatens to upend the tax calculations of these globalized firms. As Modern Healthcare reporter Beth Kutscher's story in this week's issue notes, the specter of tax reform drove a slew of big-ticket mergers and acquisitions in the second quarter. The biggest transactions involved U.S. drug and device firms buying overseas rivals so they could relocate their headquarters to their acquisitions' home countries, thus permanently avoiding paying taxes to the Internal Revenue Service on their overseas earnings.

That wouldn't be necessary if tax reform lowered rates close to their effective rates now, which are often under 20% because of the other tax breaks in the code. Most pharmaceutical, biotechnology and medical-device companies are international in scope, have tons of taxable income, and get numerous tax incentives in the current code for research and development and equipment depreciation.

When the tax debate began a few years ago, reform advocates focused on lowering the corporate tax rate to make it internationally competitive. The only way to do that is by eliminating some tax breaks. Research- and capital-intensive healthcare firms had the most to lose under reform. A company paying taxes at a 10% or 15% overall rate because of R&D and other tax credits might wind up losing under a scenario that eliminated those tax breaks in exchange for a lower rate of, say, 25% or 28%, the numbers most frequently bandied about in Washington.

For-profit health insurers and hospital chains, on the other hand, pay taxes at or near the statutory maximum of 35% because they have little R&D and no overseas operations. They would benefit substantially from a reform bill that lowered rates while eliminating tax breaks they rarely use.

Clearly, tax reform will have winners and losers. That's why the rush by so many pharmaceutical, biotechnology and medical-device firms to merge or acquire their way into a foreign domicile—dubbed “inversion” in the mainstream press—is probably best understood as a hedge against the outcome of the tax-reform debate that will unfold over the next few years.

With hundreds of billions in corporate earnings already parked abroad and tens of billions of tax revenue at stake, Treasury Secretary Jacob Lew asked Congress last week to pass a retrospective law preventing U.S. firms from shifting their incorporation abroad to avoid paying taxes on already-earned income. While that's not likely to happen, here's hoping the tax-motivated merger wave will finally spur Congress to tackle tax reform and create a corporate tax code that isn't riddled with unnecessary loopholes.

Follow Merrill Goozner on Twitter: @MHgoozner