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October 23, 2014
Should Corporate Inverters Worry About a Federal Contract Ban?
by Lindsey McPherson and Andrew Velarde

Full Text Published by Tax Analysts®

While lawmakers and administration officials have focused primarily on proposals to change the tax code when debating how to stop tax-motivated inversions, it is possible they could take action outside the world of taxes and institute a federal contract ban on inverted companies -- although some observers question whether such a ban would truly be effective.

Democrats have offered several proposals that would prohibit the federal government from contracting with inverted corporations, and Republicans have not yet dismissed the idea. A contract ban could have wide-ranging implications for the United States and the pharmaceutical industry, the one most closely associated with inversions, if it were enacted and fully enforced.

The government in fiscal 2014 awarded millions of dollars in contracts to Pfizer Inc., Medtronic Inc., and Mylan Inc., according to a Tax Analysts examination of federal contracting data available on the Federal Procurement Data System, which reports federal government contracts with various companies.

In recent years, Congress has passed several appropriations bills including language prohibiting government agencies from awarding contracts to inverted companies, as defined under 6 U.S.C. 395, created by the Homeland Security Act of 2002. While not tied specifically to the tax code, 6 U.S.C. 395 defines an inverted company in a similar manner to the often averted 80 percent ownership threshold set for redomestication under section 7874.

The Consolidated Appropriations Act, 2014, which authorized government funding for the latter half of fiscal 2014, implemented a government-wide prohibition on the use of funds for any federal government contract with any inverted corporation or any subsidiary of such an entity, as defined under 6 U.S.C. 395. That law expired with the end of the fiscal year on September 30.

As enunciated in section 9.108 of the Federal Acquisitions Regulation (FAR), which is a contracting officer's "bible," according to Daniel I. Gordon, former administrator for federal procurement policy under the Office of Management and Budget, the same government-wide prohibition was in place as far back as 2008. Under subpart 52.209-10 of the FAR, the government "may seek any available remedies in the event the Contractor fails to perform in accordance with the terms and conditions of the contract" as a result of the government's prohibition against contracting with an inverted company.

Given the recent increase in inversion activity, some lawmakers have proposed legislation to bar federal contracts for inverted companies when former shareholders of the domestic company own at least 50 percent of the newly expatriated entity. A lower 50 percent limit would presumably catch far more inverted companies within its net.

Recent Legislative Proposals

In July, Rep. Rosa L. DeLauro, D-Conn., introduced the No Federal Contracts for Corporate Deserters Act of 2014 (H.R. 5278), which uses the 50 percent threshold as the barrier to federal contracts for companies that invert before, on, or after May 8, 2014. The bill would provide agencies the ability to seek a waiver when the contract is in the interest of national security. It also includes a clause prohibiting some first-tier subcontracts with inverters.

The Senate version of the bill (S. 2704), introduced by Sen. Carl Levin, D-Mich., is nearly identical, but it provides agencies the ability to seek a waiver whenever necessary for "efficient or effective administration" of federal programs that provide health benefits to individuals, an exception that could conceivably apply to inverters in the healthcare industry. Levin's office did not return a request for comment.

Often, statutory authority that would change the FAR is not enacted as a freestanding law but is instead "tucked" into an appropriations act or an authorization act, said Gordon, who is now with George Washington University Law School. Even legislative proposals introduced as freestanding bills frequently find themselves folded into an appropriations or authorization act, if they are to pass, he added.

Both House and Senate Democrats have included language banning contracts with inverted companies with more than 50 percent ownership held by shareholders of the original domestic company in several proposed fiscal 2015 appropriations bills, but Congress has not passed any of those bills.

Two Democratic congressional aides told Tax Analysts that if an omnibus bill with the more restrictive contracting ban language were introduced in the lame-duck session, the likelihood of passage would be greater than in individual appropriations bills. Spokespersons for House Appropriations Committee Chair Harold Rogers, R-Ky., and Senate Appropriations Committee Chair Barbara A. Mikulski, D-Md., declined to comment on the prospects of a federal contract ban being included in an omnibus measure.

The aides noted that a narrower ban on companies that inverted to Bermuda or the Cayman Islands passed in the House as amendments to a handful of House-passed appropriations bills. Most of the amendments passed by voice vote, but one done by roll call received support from 34 Republicans, including House Ways and Means Committee Chair Dave Camp, R-Mich. The ban, though, would not affect many of the recent potential inverters that have sought to redomicile into Europe or Canada. A broader worldwide ban could be passed in the upcoming fiscal 2015 Financial Services and General Government appropriations bill, the aides said.

After the July vote on the amendment with the narrower ban for companies inverting to Bermuda or the Cayman Islands, Camp told reporters he supported it because he thought it was important to highlight his concern about inversions. Asked whether he could support a broader contract ban, Camp said, "I think that's something worth looking at."

Other Avenues for Changing Contracting Law?

Specific statutory direction is only one way the FAR could be changed to implement stricter limitations on inverted companies, Gordon said.

"Congress, decades ago, gave the president authority to take steps to promote economy and efficiency in federal procurement, so the FAR could be changed even without new congressional action with respect to inverted corporations, if that would make the procurement system more economical or more efficient," Gordon said. "But, does it in fact promote economy and efficiency in the federal procurement system to say we're not going to contract with inverted domestic corporations? I'm not sure that it does."

In August, several Democratic lawmakers sent a letter to President Obama urging the administration to take executive action, "to the maximum extent possible," to deny federal contracts to inverted corporations.

Any executive action to ban contracts from going to inverted companies would be harder to defend than actions the administration has already taken to curb inversion activity through the tax code, the Democratic aides said, noting that legislative action to ban federal contracts for inverters is preferred. The aides also said that the existing self-certification process, whereby companies assert they are not inverted in order to comply with current prohibitions against federal contracts for inverters, was also problematic.

Dollars at Stake

Tracking the amount of taxpayer dollars going to inverters or would-be inverters isn't easy. Gordon and Larry Allen of Allen Federal Business Partners agreed that while the Federal Procurement Data System was the best available resource for information about federal contracts awarded to companies, it was not without flaws. For example, only contracts over $25,000 are required to be reported within the system.

According to the Federal Procurement Data System, some corporate inverters or would-be inverters have made millions of dollars from government contracts. For example, Pfizer Inc. signed 190 contracts with the government in fiscal 2014 worth a total of $861 million. Medtronic, meanwhile, signed 10,310 government contracts in fiscal 2014, but those are worth a total of only $173 million.

Undoubtedly, a stricter federal contract ban would not be felt equally by every company that either has inverted or is still actively seeking to invert. But there are other inverters or would-be inverters that also would stand to lose some business from the government, if fiscal 2014 contracts are any indication. Over the course of fiscal 2014, Mylan signed 90 government contracts worth a total of $1.5 million; Allergan Inc. signed 99 contracts worth just under $1 million; and Questcor Pharmaceuticals Inc. signed 14 contracts worth nearly $400,000. AbbVie, which recently canceled its proposed inversion deal with Shire PLC, signed 43 contracts worth $64,000.

However, much of the sales from healthcare and pharmaceutical companies both to the federal government and in commercial markets are done through wholesale distributors, especially the "Big Three" -- McKesson Corp., Cardinal Health Inc., and AmerisourceBergen Corp. Those three giants sit at 15, 22, and 28 on the 2014 Fortune 500, respectively, ahead of household names like Boeing Co. and Microsoft Corp.

In its most recent Form 10-K, Pfizer said that 73 percent of its 2013 revenue of $20.3 billion came from sales to the three distributors. AbbVie said in its 2013 Form 10-K that "substantially all" of its $10.2 billion in U.S. sales could be accounted for through sales to these companies. Medtronic, on the other hand, disclosed in a note in its fiscal 2014 Form 10-K that it primarily markets its products through direct sales in the U.S., which totaled $9.2 billion.

The three wholesale distributers have far more contracts with the government, some of which presumably involve products from the pharmaceutical companies that have inverted or are seeking to invert. In fiscal 2014 McKesson signed 23,917 contracts with action obligations totaling $5.3 billion, Cardinal Health signed 47,979 contracts with obligations worth $893 million, and AmerisourceBergen signed 51,253 contracts with obligations worth $1.1 billion, according to the Federal Procurement Data System.

Huge Loophole?

At first glance, it would seem wholesale distributers create a huge loophole to any federal contract ban that healthcare companies could use. It could effectively allow a company to pursue an inversion and still reap the revenues from government contracts, even without considering the broader waiver available under the Senate version of the proposed ban.

But, while technically as much as 90 percent of the actual transactions will go through a third-party distributor, the reality is that these pharmaceutical companies are considered prime contractors in many cases, said Allen.

"If you are the manufacturer of a sole-source or innovator drug and you want to sell to Medicaid, you are required by statute to have those sole-source or innovator items on a [Veterans Affairs] federal supply schedule contract," Allen said, citing the Omnibus Budget Reconciliation Act of 1990. He noted that the VA federal supply program was the largest pharmaceutical program in the federal arena, with the Department of Defense making purchases from it.

The Democratic congressional aides, however, admitted that it's possible pharmaceutical companies could still get around the ban by licensing their products to a U.S. company.

The reach of this potential restriction is further narrowed by industry. A company like Medtronic, which sells medical devices rather than drugs, would likely not be caught under the contract ban if it sold its products to the government through a reseller rather than as a prime contractor, Allen said. This would require a change in business operations for Medtronic, however, given its current direct sales method.

"While some would seek to classify Medtronic as a subcontractor and therefore subject to certain contract flow-down provisions, most of the time an [original equipment manufacturer] is considered a 'supplier,' not a sub. As a supplier, you're fine," Allen said.

Skepticism Over Enactment and Enforcement

Allen said he is not overly concerned about a federal contract ban affecting the pharmaceutical industry, even if one of the proposed pieces of legislation were to pass, something he said would be a long shot.

"In the unlikely event that something like [the Corporate Deserter's Act were to become law], what would happen is that the Office of Management and Budget, which is responsible for promulgating regulations to implement that statute, would come up with a workaround," Allen said. Allen added that while he didn't think the OMB knew what its workaround would be yet, he said it was entirely possible that for any similar legislation later enacted, the third-party distributor would be deemed to be the contractor, rather than the pharmaceutical manufacturers, which would be reclassified as suppliers.

Allen was more concerned with the possibility of an executive order related to the ban after the November midterm elections, though such an order would likely be subject to legal challenges. Even if an executive order were issued, it might not be followed with the same level of compliance as a regulation or statute, Allen said.

"What's the penalty if I am at a federal agency and I don't follow an executive order?" he said. "If I'm a careerist, not a political appointee, there is no penalty."

A federal contracting ban with inverters is harmful to the government as well, Allen said. "It diminishes the government's supplier base, which reduces competition and puts government acquisition more squarely in companies that specialize in doing government business, none of which Congress has been on record as supporting," Allen said.

He said that government disbarments for small or medium-sized companies are always a possibility and in fact do happen with regularity, but meaningful action against large companies was dubious.

"They are never going to be without companies that they need to deliver basic supplies or services . . . suddenly you're going to tell a veteran they're not going to get a drug?" he said. "The government does not want to be without Pfizer's solutions. . . . It will find a way so that it can still have access to Pfizer's drugs."

Follow Lindsey McPherson (@lindsemcpherson) on Twitter for real-time updates.

Correction, October 23, 2014: The No Federal Contracts for Corporate Deserters Act of 2014 (H.R. 5278) uses the 50 percent threshold as the barrier to federal contracts for companies that invert before, on, or after May 8, 2014 and not only after May 8 as originally stated.

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