Setting-up a Bermuda subsidiary in the 1990s to cut its tax bill by $1.5 billion has ended up costing global pharmaceutical company Merck & Co much more after US tax authorities probed and exposed the offshore tax loop-hole.

The company has agreed to pay $2.3 billion to settle outstanding tax bills, interest and penalties with the US Internal Revenue Service.

At the centre of the tax dispute was Merck’s setting up of a subsidiary in Bermuda and moving the intellectual rights, or patents, of a number of its popular prescription drugs into the stewardship of that offshore subsidiary.

It then paid the subsidiary patent royalties to use the drugs, which its own scientists had created, and was therefore effectively paying itself. But because the subsidiary was in Bermuda rather than the US, Merck avoided paying an estimated $1.5 million in US tax between 1993 and 2001.

The New Jersey-based company, regarded as the seventh largest in the world with revenue of $22 billion in 2005, said in a statement the settlement amount will come out of previously reserved funds and is not expected to have any material impact on the company’s earnings for 2007.

The tax disputes arose in part from Merck’s use of minority equity interest financing transactions, said the Internal Revenue Service (IRS).

Merck disclosed in November it faced liabilities from tax disputes in both the US and Canada. It cited a total of $5.58 billion in potential liabilities at the time, including $3.82 billion in taxes, interest and penalties payable to the IRS, according to a company filing with the Securities and Exchange Commission.

An IRS spokesman declined to comment on the roughly $1.5 billion discrepancy between the November amount cited by the company and the settlement announced yesterday. Merck spokesman Ray Kerins also declined to comment.

Merck said in a statement that the IRS settlement was in the company’s best interests given the uncertainty and cost of potential litigation. The Canadian claim remains unresolved.

The Merck settlement relates to a partnership deal set up in 1993. The Wall Street Journal reported in September on how Merck, in partnership with British bank Abbey National, set up a subsidiary with an address in Bermuda.

Merck then transferred patents on some of its blockbuster drugs to that subsidiary, later paying it for use of those patents, the newspaper reported. The deal allowed the company to shave its tax bill.

Merck’s November SEC filings refer only to a 1993 partnership transaction in discussing its then-potential liabilities to the IRS.

The Canada Revenue Agency still seeks US$1.76 billion in taxes and interest from Merck “related to certain inter-company pricing matters,” according the company’s November SEC filings. Merck has said the Canadian agency’s claims are without merit.