Increasing the Access to Orphan Drugs and Specialty Medicines

Kabir Bogra
Khaitan & Co

Tushaar Talwar
Khaitan & Co

The Goods and Services Tax (GST) undoubtedly is the most important indirect tax reform measure taken by the Government since the Independence. This is going to be a game-changer for many industries, including Indian Pharmaceutical industry. This article highlights some of the issues which are likely to arise and would require a concerted effort by the companies to plan for as GST matures.

The Indian pharmaceutical industry has been a jewel in the crown of Indian exports and despite stiff international competition has been a consistent high performer. The government being cognizant of the importance of the industry has over the years provided sizeable incentives to the industry through export promotion schemes and exemptions. These exemptions provided pharmaceutical companies with significant savings and helped in establishing the commercial arrangements in which the industry has operated and thrived.

The advent of Goods and Service Tax (GST), though welcomed by the pharmaceutical industry is likely to create a few short and medium pain points considering that it's the unfamiliarity with the new law and its impact on certain basic business practices. This is relevant especially in the context of the fact that the pharmaceutical industry is regulated heavily both in terms of operational aspects as well as pricing aspects.

In the following paragraphs, we have highlighted some of the issues which are likely to arise and would require a concerted effort by the companies to plan for as GST matures.

1. Revised Pricing under Anti-Profiteering Mechanism:The industry for several months prior to introduction of GST filed representations requesting for rectifying the inverted duty structure likely to be created within the industry on account of an 18% rate of GST on Active Pharmaceutical Ingredients (API) and other inputs such as glass products and packaging material. Though Section 54 of the Central Goods and Services Tax Act, 2017 (CGST Act) provides for refund of accumulated tax credits on account of inverted duty structures, the jurisprudence with respect to refunds necessitates the claimant to meet the test of unjust enrichment. Simply put, this would require a company to not include the unutilized tax credits into its product pricing. This is likely to put the industry in a bind. Firstly, working capital requirements are bound to increase due to the increased input costs and secondly, as a significant number of drugs are price controlled, the manufacturers would not have the regulatory independence to increase the prices, resulting in more pressure on the margins.

Assuming a manufacturer does have the ability to adjust margins and pass on the unabsorbed credits without the end price being changed, it would not be able to claim the refund and further carry the risk of exposing itself to the anti-profiteering provisions. The anti-profiteering provisions merit some discussion to appreciate the point. The GST laws have introduced the concept of anti-profiteering for the first time in Indian fiscal laws. The essential principle for introduction of the concept is to ensure that any savings made by a business on account of tax savings would translate into reduced prices down the distribution chain and benefitting the eventual customer. The government is cognizant of the wide abuse the provisions can be subjected to and is looking to establish the National Anti-Profiteering Authority (NAPA) and issuing detailed rules to ensure the investigations are objectively undertaken. However, pending the notification of the rules and the authority, it will be a difficult few quarters for the industry while it waits and watches.

In substance, even if a manufacturer increases the prices of unregulated medicines by foregoing refund of the unabsorbed tax credits, it still may not be excluded from the ambit of the anti-profiteering provisions. Therefore, this is likely to create a Catch 22 situation for at least a few manufacturers, where their working capital requirements increase and though theoretically refunds may be available but, if not timely disbursed would create further financial burden on the companies.

The Indian pharmaceutical industry has had a troubling few quarters on account of loss of export earnings, increasing debts and consequent decline in value. It is imperative for the government to look at the industry with the correct perspective and ensure that GST as a regime does not create any further burden but instead works as facilitation tool to help the industry .

2. Overhaul of Export Promotion Schemes: Another aspect related to increased blockage of working capital is the overhaul of export promotion schemes under the Foreign Trade Policy. Previously, incentives under export promotion schemes provided for exemption from payment of all applicable duties and cesses under Customs laws, provided certain export-related compliances and realizations were maintained. An important component of these exemptions pertained to countervailing duty, which was a custom duty levied in lieu of Excise duty to ensure a level playing field vis-à-vis the domestic industry.

With the implementation of GST, the Ministry of Commerce has revised the export promotion schemes to provide for exemption from basic customs duty, however, the levy of Integrated Goods and Services Tax has not been covered under the exemption. Accordingly, exporters are required to pay Integrated Goods and Services Tax on exports and seek refund of the same under the mechanism provided under GST laws. As discussed above, the refund mechanism entails a delay of up to sixty (60) days for sanction of the refund amount and would lead to consequent blockage of working capital for the industry.

3. Elimination of Area Based Exemptions: The industry has invested heavily in setting up manufacturing operations in states such as Uttarakhand and Himachal Pradesh offering exemptions from Excise duty and sales tax. The central government has unequivocally maintained the position that such area based exemptions would be eliminated under the GST framework and individual ministries and states may take the prerogative to grant refunds to the industry as per the prior scheme.

There are several unanswered questions with respect to the refund mechanism. The principal issue arises out of the fact that the existing exemptions were origin based, whereas GST is a destination based tax. Therefore, it is uncertain how originating states will compel destination states to grant refunds in the case of inter-state supplies. Further, it is relevant to note that while the central government and the state government levy equal and concurrent taxes on the same transaction, the revenue split between the centre and the state is fixed at 58 rupees vs 42 rupees out of every 100 rupees. The unequal revenue share implies that any smooth refund mechanism will require the centre and the states to agree on a similar sharing of refund burden. Such a solution is not yet forthcoming.

Despite several weeks have elapsed since the GST regime was made effective and with almost INR 19,000 crore in taxes foregone under such area based exemptions in the fiscal year 2017, the stakes are large for the industry and the delay in providing a solution is damaging business interests and sentiments towards the GST regime.

4. Accumulation of Credits on Healthcare Services: Continuing from the erstwhile Service tax regime, the GST framework provides for an unconditional exemption on healthcare services. While this exemption has been notified with a view to keeping healthcare affordable for the public, it also gives rise to inefficiencies in the tax chain. A holistic understanding of the tax inefficiency requires a discussion on the concept of 'composite supply' under GST laws. The term 'composite supply' is understood as follows:

"a supply made by a taxable person to a recipient consisting of two or more taxable supplies of goods or services or both, or any combination thereof, which are naturally bundled and supplied in conjunction with each other in the ordinary course of business, one of which is a principal supply."

A plain reading of the definition above clearly shows that the concept of 'composite supply' envisages a natural bunding of two or more goods or services that are supplied together. In this regard, it is pertinent to note that Section 8 of the CGST Act further provides that the levy of tax on a composite supply shall be at the rates applicable to the principal supply. The term 'principal supply' is defined as the predominant supply in a transaction constituting composite supply.

In the healthcare industry, services are typically provided in conjunction with pharmaceutical products. For example, a patient admitted in a hospital for dengue may receive several services qualifying under the exemption for healthcare services. However, the treatment of dengue would also entail the administration of drugs and medication that may be taxable at 5% or 12% rate of GST. The industry may face difficulty in identifying the 'principal supply' in the composite supply of healthcare services along with taxable drugs and medications.

In a situation where the authorities take a view that healthcare services are the 'principal supply' and thus the predominant aspect of the supply, the entire composite supply of such healthcare services would be exempt from levy of GST. Accordingly, there will be excessive accumulation of credits with respect to the taxable but ancillary supply of drugs and medication. Such accumulated credits are not refundable as per the express provisions contained under Section 55 of the CGST Act.

5. Taxability of Supplies between Business Verticals: Larger companies in the pharma industry house several business divisions within the larger corporate entity, such as units dedicated solely for manufacture, research and development, contract research and manufacturing, etc. For the purposes of keeping these segments identifiable, it is common practice to maintain separate books of accounts for such business divisions. Under GST laws, the industry may be evaluating the viability of registering each such business division as a separate 'business vertical'. For reference, the term 'business vertical' under the CGST Act is defined as:

"a distinguishable component of an enterprise that is engaged in the supply of individual goods or services or a group of related goods or services which is subject to risks and returns that are different from those of the other business verticals."

Registration of a business vertical is voluntary and may be undertaken provided the business division fulfils the criteria specified in the definition above. However, a direct implication of registering a business vertical is that such a unit now becomes a distinct entity under GST laws and is treated as a separate taxable person for levy of GST taxes. It is relevant to note that taxable person under GST laws may differ from that under other laws that levy tax only on legal entities. Under the GST, a taxable person includes separately registered business verticals within a single legal entity.

Accordingly, companies considering registration of separate business verticals should be cognizant of the fact that any supply of goods or services between business verticals would constitute taxable supply and would be subject to levy of GST taxes.

Despite the above challenges, GST promises to usher in a more certain tax regime and if implemented with the same spirit that it has been championed with, it is highly likely that the concerns of trade and industry would be addressed. There already is evidence that the government is working to ensure that inconveniences are reduced to the extent possible and has issued a few instructions extending the timelines for filing of initial returns. The authors hope that the initial concessions are also followed up with a more nuanced appreciation of the peculiar issues within the pharmaceutical industry to help the sector achieve its potential for the economy.