Government Fires Back Its Defense To Large Tax Refund Suit Recently Filed By Perrigo Co. (USA) Alleging Elaborate Assignment Of Pharma Licenses From U.S. Subsidiary To Israeli Controlled Foreign Corporation And Related Transactions Were Shams

By: Jerald David August

Perrigo Company and Subsidiaries (“Perrigo”) on August 15, 2017, filed a tax refund suit against the United States in the United States District Court for the Western District of Michigan, Southern Division, No. 1:17-cv-00737. [1] Perrigo alleged it overpaid Federal income taxes, penalties and interest, for its 52-53 week tax years ending in the last week in June for the years 2009 through 2012 by over $163 million. 

The source of the overpayments in tax were: (i) transactions involving the purchase, distribution, and sale of store-brand, over-the-counter (“OTC”) pharmaceutical products containing omeprazole (protein pump inhibitor) [2] with respect to which Perrigo is a leading manufacturer and distributer of store-brand OTC and generic pharma products; and (ii) the deductibility of legal fees paid or incurred in defending against certain patent infringement lawsuits in 2011 and 2012.  After timely claims for refund were filed and disallowed by the Service, the refund suit was filed. See Treas. Reg. 1.1502-77.

The amount of the refund in tax, penalties and interest claimed for each year in issue were stated by the complaint as follows:

                        2009                                        $37,221,289

                        2010                                        $61,462,133

                        2011                                        $40,148,650

                        2012                                        $24,730,253

Well What About the Inversion of Perrigo into Ireland in 2014?  Any Coincidence That the Years Immediately Preceding the Inversion Resulted in Large Tax Deficiencies and Penalties?

The total amount sought to be refunded by the Irish-patented pharmaceutical company through its US subsidiary is $163.6 million, plus interest. The Plaintiff in the case, based in Allegan, Michigan, is wholly owned by Perrigo Co. PLC, which inverted to Ireland through its $8.6 billion acquisition of Elan Corp. PLC in 2013. Despite its Irish incorporation, the SEC still lists a mailing address for Perrigo Co. PLC in Allegan, Michigan, where the company was founded roughly 130 years ago. The Elan inversion was part of a series of Irish inversions involving U.S. pharmaceutical companies in 2013 and 2014. This included North Carolina based Salix Pharmaceuticals, Medtronic Inc.’s $42.9 billion acquisition of Covidien PLC which resulted in an inversion and California’s Questor Pharmaceuticals being acquired by Dublin-based Mallinckrodt for $5.6 billion just to name a few. As Perrigo’s headquarters moved from Allegan to Dublin through purchasing Elan Corp. for $6.2 billion, a press release noted that the inversion would immediately yield $150 million in tax savings in 2014 and a substantial drop in its global effective tax rate. Do you think the IRS wanted to get back some of the savings lost through the inversion to Ireland and its 12.5% statutory corporate rate?

Claims for Refund Denied

Perrigo's refund claims, which were filed on June 11, 2015 for 2009 and 2010, and June 7, 2017 for overpayments in tax for 2011 and 2012, were denied based in part on the IRS's contention that PITLP/Perrigo LLC is a sham entity and that the assignment agreement between LPC and PITLP/Perrigo LLC lacks economic substance under the common-law of taxation doctrine. The IRS maintains that under the assignment of income doctrine, income from the sale of generic OTC omeprazole should be attributed from PITLP/Perrigo LLC to LPC, according to the complaint.

The Service made an alternative argument in its earlier notice of deficiency that most of the income from sales of generic OTC omeprazole should be reallocated from PITLP/Perrigo LLC to Perrigo under section 482. Perrigo characterized the theory as "unreasonable, arbitrary, and capricious" and an abuse of the IRS’s discretion that doesn’t ultimately produce an arm's-length result.

There were mutually exclusive penalties asserted by the IRS in its prior notices of deficiencies for 2009-2012 including substantial understatement, negligence or disregard of rules, gross valuation misstatement, and substantial valuation misstatement penalties, according to the complaint.  Well, the law requires that ultimately the IRS must pick one penalty and it selected the 40% gross valuation misstatement penalty which the Plaintiff argued in its complaint cannot be sustained by application of the Service’s primary common-law theories. In other words, based on the Service’s common law sham transaction, sham entity and assignment-of-income theories, there could be no valuation misstatement. The taxpayer also denied application of the negligence or substantial understatement penalties. As set forth in the statement of facts below, the Plaintiff relied on the tax advice as well as the several intercompany pricing models prepared by its “global” tax advisor and accounting firm.

The company said it applied appropriate transfer pricing methods to the contract assignment and transactions related to the sale and distribution of generic OTC omeprazole in good faith reliance on  its global tax adviser, EY’s, professional advice.

Factual Background to Present Perrigo Refund Suit

It is helpful in understanding the case before the Federal District Court to set out the facts in some detail

  1. In 2006, Perrigo entered into a supply and distribution agreement with an Israeli pharmaceutical manufacturer, Dexcel, who was developing a potential generic OTC omeprazole product for the U.S. See FN 2.  In connection with the supply and development contract:

  2. Perrigo formed Perrigo Israel Trading Limited Partnership (“PITLP”) in Israel in 2006.  It was a reverse hybrid entity, i.e., PITLP was a corporation for U.S. income tax purposes and a partnership for Israeli tax purposes. PITLP was also a controlled foreign corporation under §957 and was not a member of Perrigo’s consolidated group.

  3. Perrigo LLC (“LLC”) is a limited liability company organized under Delaware law in 2006, and was 100% owned by PITLP. It was a defective entity for U.S. tax purposes with all assets, liabilities and activities of the LLC treated as owned and operated by PITLP. [3]

  4. On November 29, 2006, LPC, the wholly owned U.S. subsidiary of Perrigo, and PITLP/LLC entered into an assignment agreement under which LPC assigned its rights and obligations under the supply and distribution agreement to LLC. PITLP/LLC paid $877,832 for the assignment of licensing rights to OTC omeprazole based in reliance on an economic study provided by its global tax accounting firm.

  5. On the same date, a sales and distribution agreement was entered into by PITLP/LLC and LPC whereby if approved by the FDA, LPC would distribute Dexcel’s generic OTC omeprazole on behalf of PITLP/LLC. LPC was granted a guaranteed return on its distribution activities and a percentage of the residual profits from the sales of the generic OTC omeprazole. Again, the agreed consideration to be paid to LPC was based on an economic study prepared by the same accounting firm.

  6. After Dexcel filed a new generic drug approval filing with the FDA, in May 2006, AstraZeneca sued Dexcel for alleged infringement of patents related to Prilosec Rx.  Perrigo was not a party to this suit which settled in September, 2007. The settlement allowed Dexcel to market its generic OTC omeprazole product in the United States upon receipt of FDA approval. Perrigo was not involved in settlement negotiations between Dexcel and AstraZeneca. Dexcel received FDA approval for its generic OTC omeprazole product for sale in the U.S. in December, 2007.

  7. By 2008, six companies had generic versions of Prilosec Rx on the market and now there are nine.

  8. During the tax year ending on June 30, 2007 and the first eight months of the 2008 tax year, PITLP/LLC was provided with capital through its parent company Perrigo UK FINCO Limited Partnership, a U.K. entity taxable as a corporation for U.S. income tax purposes.

  9. During the final four months of the 2008 tax year and from 2009-2012 tax years, PITLP/LLC had substantial capital, income and accounts, was performing under three contracts with unrelated parties, and made substantial dividend distributions and loans. It also made payments to Plaintiff for management services, making payments to LPC for marketing and project management services, and making payments to Perrigo Research and Development Company, a member of the Plaintiff’s consolidated group, for research and development services. This means, of course, that the Plaintiff will strongly maintain that PITLP/LLC was not a sham entity.

  10. During its 2011 and 2012 tax years, Perrigo was a named defendant in several patent infringement cases. Perrigo incurred substantial legal costs to defend against the alleged patent infringement case. Generally, the taxpayer thought such patent litigation defense costs are deductible as ordinary and necessary business expenses.  §162(a).

  11. The IRS examined the plaintiff for its 2007 and 2008 tax years and did not propose adjustments to the taxpayer’s reporting position including: (i) an income adjustment related to the supply & distribution contract assignment; (ii) challenge Perrigo’s transfer pricing reporting positions under §482; or (iii) propose accuracy-related penalties under §6662.

  12. The IRS later examined the Plaintiff’s consolidated returns for 2009 thru 2012 and reopened issues previously examined (unadjusted) positions for 2007 and 2008. The IRS later asserted deficiencies in tax with respect to the intercompany transactions and arrangements allocating all or virtually all of the income from US sales of generic OTC omeprazole to Perrigo for 2009 through 2012 tax years.

  13. On June 11, 2015 Perrigo timely filed claims for refund for 2009 and 2010. On June 7, 2017, Plaintiff filed timely claims for refund for 2011 and 2012 tax years.  The claims for 2009 and 2010 were disallowed on August 18, 2015, and the claims for 2011 and 2012 tax years were disallowed on July 11, 2017.  Note, as discussed above, the years under audit predated the inversion transaction but the government’s notice of deficiencies presumably were issued after the Elan inversion transaction was made public.

  14. The IRS position as set forth in its 90 day letter and again in its answer to the complaint in the case at bar, was that the PITLP/LLC is a sham entity that must be disregarded for Federal income tax purposes.  The second argument made by the IRS is that the assignment agreement between LPC and PITLP/LLC lacked economic substance and should be treated as a sham transaction. Third, the Service contended that the assignment-of-income doctrine applies to attribute income from the sale of generic OTC omeprazole from PTILP/LLC to LPC. Alternatively, the Service argued that most of the income from sales of generic OTC omeprazole should be reallocated to PITLP/LLC to Perrigo under §482 as an alternative theory to the sham transaction theory or doctrine.  This theory results in nearly all of the adjustments to the Plaintiff’s taxable income for 2009 thru 2012.  In its answer to the complaint filed by Perrigo, the government admits that the tax assessments reflected in its notice of deficiency are based on common-law doctrines of sham entity, economic substance and assignment of income and not primarily under §482.

  15. As to accuracy related penalties, the Service asserts a 20% substantial understatement penalty under its common-law theories.  In the alternative it asserts an accuracy related penalty of 20% for negligence or disregard of rules or regulations penalty under its primary common-law theories.  An alternative 40% gross valuation misstatement penalty was assessed by the Service under §482. See §§6662(a), 662(b)(3), 6662(e)(1)(B)(ii) and 6662(h)(2)(A)(iii). The Service, in the alternative asserts a 20% substantial valuation misstatement penalty, i.e., the 20% §482 penalty.

  16. As to its litigation defense costs defending patent infringement cases, the government assessed deficiencies in income tax for 2011 and 2012 on the basis that such expenses should be capitalized instead of currently deducted. This is based on two arguments: (i) under the origin-of-the-claim doctrine capitalization was required since the origin of the patent infringement claims was Plaintiff’s filing for FDA licensure of the generic formula; and (ii) the regulations under §263 require capitalization since the patent litigation defense costs were “transaction costs” that “facilitated” FDA approval of the Plaintiff’s generic OTC omeprazole. §263; Treas. Reg. §1.263(a)-4.  Accordingly the IRS reduced the Plaintiff’s deductions for 2011 and 2012 by $2,185,376 and $7,062,889 respectively. In addition the IRS treated the adjustment to income for capitalizing the expenditures for the litigation as a change in accounting requiring a §481 adjustment for 2011 increasing income for that year by $12,651,062.

The case now follows into the discovery state and then, if there is no settlement, to trial. Will the government request a jury to hear its position that the entire offshore strategy was derived to avoid U.S. tax and defer the reporting of the U.S. profits?  This case is bound to gather attention as the government is playing hard on relying on sham transaction and sham entity to unlock and unwind elaborate §482 related party transactions that yield large earnings stripping outcomes.


[1] Plaintiff is the common parent of an affiliated group of corporations having its principal place of business at all times relevant in Allegan, Michigan.

[2] The commonly known commercial brand name for omeprazole is “Prilosec”. The drug omeprazole was developed by Astra Zeneca which had claimed patent protection with respect to omeprazole. In 2002 and continuing through 2006, Perrigo attempted to formulate a generic omeprazole product as an alternative to Prilosec OTC. Later, in 2005, a subsidiary of Perrigo, L. Perrigo Company, entered in a supply and distribution agreement with an unrelated Israeli pharmaceutical manufacturer, Dexcel, for a potential generic OTC omeprazole product for the U.S.  Under the contract, Dexcel was responsible for formulating and developing generic OTC omeprazole in tablet form and obtaining FDA approval for the product. If the FDA approved the product, Dexcel would be responsible for manufacturing the product. The Dexcel agreement provided that the parties would equally divide net profits from United States sales of the product after certain cost allowances charged to each party. 

[3] The PITLP/LLC structure was formed in accordance with tax advice provided by an international accounting firm. 


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