Bermuda?s reputation has come under fire again for tax avoidance following a front page story in yesterday?s Wall Street Journal that alleges pharmaceutical giant Merck & Co. used a Bermuda subsidiary to cut its US tax bills by $1.5 billion over the course of a decade.

The front page story, headlined ?Bermuda Triangle: How Merck saved $1.5 billion paying itself for drug patents?, reported that Merck set up a a subsidiary ?with an address in tax-friendly Bermuda, in partnership with a British bank? 13 years ago.

The story said Merck ?quietly transferred? patents underlying the blockbuster cholesterol-reducing drugs Zocor and Mevacor to the new subsidiary and then paid the subsidiary for use of the patents.

?The arrangement in effect allowed some of the profits to disappear into a kind of Bermuda triangle between different tax jurisdictions,? the story said. ?The setup helped Merck slash $1.5 billion off its federal tax bills over roughly the next ten years.?

The story added that the transaction, which has never been publicly disclosed, has sparked ?one of the largest tax disputes ever involving a US corporation?.

Merck has reported in regulatory filings that it may be ordered to hand over a total of $2.3 billion in back taxes, interest and penalties, but denies any wrongdoing, saying the deal ? known internally as ?Project Ryland? after a restaurant near Merck?s New Jersey headquarters ? was simply a way of raising financing for its 1993 acquisition of a pharmacy-benefits management firm, Medco Containment Services Inc., the newspaper said.

?We believe the partnership transaction is in full compliance with IRS rules and regulations and we vigorously disagree with the proposed IRS adjustments,? says Merck spokesman Raymond Kerins, who declined to discuss details of the dispute.

The Merck deal is one of several that the IRS is pursuing. Others involve Dow Chemical and General Electric. GE also used a Bermuda-based partnership in its case, Bloomberg News reported.

The newspaper said the cases are part of an attempt by US authorities to crack down on so-called ?tax arbitrage? in which companies lower their tax bills by structuring transactions so certain types of income or expenses are classified as one thing by the IRS, but something very different by another country?s tax regulators.

?Often the strategies are aided by overseas banks or non-profit organisations that use complex legal structures to effectively share their tax advantages with US companies,? the story said. ?US and UK banks also have teamed up to devise structures that lower each other?s taxes.

?IRS Commissioner Mark Everson warned a US Senate panel in June that strategies like those are ?on the rise?.?

Calling tax arbitrage among the most significant enforcement problems the agency faces, Mr. Everson said the IRS has formed a team to consider crafting new international treaties, as well as performing tax audits that would simultaneously look at a company?s tax obligations in multiple countries.

Proponents of the deals say it?s only smart business to take advantage of US loopholes and the differences among tax rules around the world. Technology and pharmaceutical companies, for instance, are aggressively shifting intellectual-property assets to countries with far lower tax rates, such as Singapore and Ireland.

Merck?s potentially costly dispute with the IRS comes as the company battles more than 14,000 lawsuits related to its now-withdrawn Vioxx pain reliever, with its projected liability topping $4 billion. Like other big drug makers, Merck?s biggest sellers are losing patent protection while its newer drugs are not expected to make up the lost revenue.

The story said many of the deals like the ones used by Merck, Dow and GE were inspired by tax attorney and law school professor R. Donald Turlington, who helped to structure the Merck deal, in spite of calling for the loophole that allowed it to be changed. The Merck deal was put together six months before the loophole was closed.

The Merck deal came about in July 1993 when Merck bought Medco for $6 billion.

?It had cash on hand to fund only part of the giant purchase, and said at the time it would need additional financing,? the story said. ?Sometime before the Medco deal was announced, a Goldman banker named David Ackert, along with Mr. Turlington, presented Merck officials with the partnership idea as a way to raise financing and enjoy significant tax savings. Mr. Ackert, who no longer works for Goldman Sachs, referred questions to the investment bank.

?At the time, Merck?s Mevacor and Zocor were two of the company?s biggest-selling drugs. Merck no longer had deductions to write off against the patents, according to a person familiar with the matter.

?A few weeks before the Medco deal was announced, Merck transferred ownership of the patents to a new Delaware subsidiary, MSD Technology LP, and then registered other Merck subsidiaries that were partners in MSD to do business in Bermuda.?

Because Merck need a partner ?willing to absorb taxable income? Merck made a deal with a unit of UK bank Abbey National Plc.

?According to a document filed in an unrelated lawsuit, Abbey took a limited partnership interest in MSD. The arrangement, according to people familiar with the situation, involved Abbey contributing several hundred million dollars in cash to the partnership in exchange for a minority stake. Merck then began paying royalties to the MSD partnership to use the patents covering the anti-cholesterol drugs, these people said.

?In effect, Merck was paying itself ? its subsidiaries still owned a majority of MSD ? for the right to use drugs its own scientists had developed. The royalties it paid then largely went straight back into its own coffers, as much of the money was lent to Merck through another subsidiary, according to the people familiar with the transaction. A subsidiary of MSD collected the interest, most of which effectively was returned to Merck when the partnership was liquidated.

The convoluted arrangement gave Merck a sizable tax reduction for roughly a decade. On MSD?s internal books ? and only there ? a portion of the incoming royalty payments were allocated as taxable income to Abbey. That reduced Merck?s tax liability.?

However, the story said Abbey wasn?t liable for the taxes either, because UK authorities didn?t recognize tax allocations within the books of US partnerships.

In April 2004, the IRS gave Merck a preliminary notice that it was disputing the company?s taxes for four years beginning in 1993, the year the Bermuda partnership was established. Late last year, the tax agency finalised that decision for 1993, and proposed disallowing tax benefits from the following three years, according to Merck?s SEC filings. Merck says in the filings that it expects similar final notices for subsequent years.