Pharma News

‘Tax’ing Indian pharma

The Indian pharma industry is at an inflexion point.

Changes in patent laws have propelled Indian pharma to the centre stage of global attention with respect to outsourcing of contract research, manufacturing, pre-clinical and clinical trials. Simultaneously, large Indian generic companies are acquiring a global footprint and aspire to be innovator companies.

However, in the domestic market, challenges exist with respect to pricing pressures, IPR, enforcement and data exclusivity regulation. In order to keep the momentum going, taxation and fiscal policies will be key in attracting investment and development of the pharma industry. The taxation structure as relevant to the pharma industry and the issues and solutions are discussed below.

Direct taxes

Taxability of income in India is governed by the provisions of Income-tax Act, 1961 ("Act"). There are some benefits provided under the Act that are more specific to the pharmaceutical industry as explained below.

Scientific research and development: Under the provisions of section 35(1) of the Act, a deduction of 100 percent expenditure, not being expenditure in the nature of cost of any land and building is available in respect to scientific research related to the business.

Further, subject to fulfilment of certain conditions, scientific research and development expenditure for companies engaged in the business of biotechnology or in the business of manufacture or production of any drugs, pharmaceuticals, electronic equipment, computers, telecommunication equipment, chemicals or any other article or thing notified by the Board (not being expenditure in the nature of cost of any land and building) is eligible to claim a weighted deduction of 150 percent of expenditure incurred up to March 31, 2007.

Special Economic Zones: SEZ is the latest buzzword for investments in India. They are duty free enclaves outside the customs territory of India. SEZ developers/units are entitled to 100 percent tax holiday for 10 continuous years out of 15 years with the exemption from payment of minimum alternate tax, as well as dividend distribution tax. Expenditure on developing the SEZ shall also be exempt from all duties of customs, excise, CST and service tax.

Even though there are various incentives that are available specific to the pharmaceutical industry, there are some challenges that are faced by the industry relating to the incentives available under the Act.

Indirect taxes

Indirect taxes consist of customs duty on import of goods, excise duty on manufacture of goods, Value Added Tax (VAT) and Central Sales Tax (CST) on sale of goods; and service tax on specified services provided in India. The multiplicity of indirect taxes have been the result of successive government policies, which viewed indirect taxes as a means to garner additional revenue rather than focusing on a robust indirect tax regime based on sound fiscal revenue principles. Nevertheless, liberalisation of the Indian economy and the WTO regime has forced governments to embark on gradual reform of indirect taxes. The highlights of the indirect tax reforms to date have been the gradual reduction of customs duty levels to match rates prevailing in ASEAN countries, rationalisation of excise duty structure, widening of service tax net in view of increasing significance of the service economy and finally, the introduction of Value Added Tax system with respect to goods at the state level.

The final destination of the reform process would be the introduction of Goods & Services Tax (GST) in lieu of excise duty, VAT, CST and service tax. The Finance Minister has announced that GST would be introduced by 2010. In all likelihood, India with its federal government structure, where powers of taxation are shared between the centre and the states, would have a dual VAT/GST system at the central and the state level. In the intervening transition period, it is a challenge for the businesses to optimise indirect tax cost in the day-to-day business operations. In this context, it is worthwhile to understand the tax regime as relevant to the pharma industry and analyse the lacunae, as well as possible solutions.

Customs duty: Customs duty consists of Basic Customs Duty (BCD)-12.5 percent, additional duty of customs under section 3(1) ('CVD')-16.32 percent and additional duty of customs under section 3(5) (ADC)-four percent. Further, education cess at two percentage is also levied on aggregate of customs duty. The above aggregates to an effective rate of customs duty of 36.74 percent.

Central excise duty: Excise duty is levied at 16 percent on the transaction value of goods manufactured in India. Together with the education cess at two percent of excise duty, the effective excise duty rate is 16.32 percent. Drugs and medicines classified under chapter heading 3003.10 and 3003.20 are subject to excise duty on the basis of the Maximum Retail Price (MRP) printed on the package with an abatement of 40 percent of MRP.

A manufacturer can avail credit of excise duty, CVD, ADC paid on inputs and capital goods, as well as service tax paid on input services and utilise the same to pay excise duty on final products (CENVAT credit).

Value Added Tax and CST: VAT/CST is levied on sale of movable goods in India. Barring Uttar Pradesh, Tamil Nadu and Pondicherry, all the other states in India have implemented VAT regime. Under VAT, tax is levied on each successive sale of goods with credit of tax paid on the purchase (Input Tax Credit or ITC). CST paid on inter-state purchases is not available as a credit.

Drugs and medicines are taxed at four percent except Assam where the rate is six percent. Although, it was expected that VAT would bring in uniformity in classification of products, descriptions in the tariff schedule varies from state to state. For example, medical devices are taxed at 12.5 percent in three states, whereas in all other states, the tax rate is four percent.

To date, 11 states have introduced a system of levying tax on MRP at a single point ie first sale in the state is subject to VAT on the basis of MRP and subsequent sales, in general, are exempt. MRP system is optional in six states. It should also be noted that states such as Madhya Pradesh, Chattisgarh and Orissa levy entry tax on entry of medicines and devices in to these states.

CST rate is four percent against furnishing of prescribed declarations. Otherwise, the rate of tax is 10 percent or the VAT rate prevailing in the originating state, whichever is higher. CST is widely acknowledged as creating barriers to trade and hampering free movement of goods within the country, and is proposed to be gradually phased out by 2010.

Service tax: Service tax is levied by the Central government on specified services. Service tax is not payable on export of services subject to fulfilment of prescribed conditions. Conversely, services received in India are taxed in the hands of the recipient. The rate of service tax is 12 percent, together with education cess at two percent ie 12.24 percent. Further, credit of service tax paid on input services and excise duty, CVD and ADC paid on inputs and capital goods is available as a credit to pay service tax on output services.

Issues and solutions

Pharma industry has to operate under multiple indirect taxes and a fractured VAT chain resulting in a cascading effect. The effective tax rate considering excise duty and VAT on MRP is substantial. The pharma industry has been lobbying for excise duty at eight percent, especially when the duty is levied on MRP.

The availability of excise duty holiday for a period of 10 years in select states as discussed above has resulted in many pharma companies shifting the manufacturing base to these states. Further, CST continues to support the stocking point model in each state as against a regional stocking hub, which could be more supply chain efficient. The supply chain continues to be driven by tax benefits as against logistics costs. If the Central government is able to adhere to its roadmap for phasing out CST, pharma industry can plan their supply chain to optimise distribution costs.

VAT on MRP: The rationale for the State governments to levy VAT on MRP was that since under the Drugs Price Control Order (DPCO), MRP has to be printed exclusive of local taxes, it would be difficult for stockists and chemists to compute the VAT liability. The Central government has amended the DPCO to make it mandatory with effect from October 2, 2006 to print MRP inclusive of local taxes on goods manufactured post October 2, 2006.

Recently, the Supreme Court, in the context of erstwhile sales tax regime in Rajasthan has held that in a single point sales tax regime, tax cannot be levied on MRP basis as the measure of tax has to be commensurate with the point of taxation. This judgment, though in the context of erstwhile sales tax regime, does raise doubts on the validity of levy of VAT on MRP basis. MRP basis as a measure to levy VAT assumes a linear trade model up to the final consumer and as such is against the basic principles of VAT. The State governments should tax drugs and medicines on the basis of the sale price.

Inconsistent classification: The description of entry drugs and medicines varies from state to state. Most states levy VAT on life saving drugs, though some states like Kerala have provided exemption to specified life saving drugs. Similarly, medical devices are taxed in most states at four percent. However, in states like Maharashtra, Gujarat and Kerala, medical devices are taxed at 12.5 percent except for a few specified ones. Consistent classification and rate across states is necessary for trade harmony.

Service tax on clinical research: Outsourcing of clinical research to India is the next big opportunity after the BPO boom. However, pharma majors need to factor in the service tax impact on clinical research. Depending on the scope of activities, services of a clinical research unit can be classified either under technical testing or scientific consultancy or business auxiliary services. The classification assumes importance because to qualify as exports apart from other stipulated conditions, the service should be delivered and used outside India. It would be difficult to comply with this condition in case of classification under technical testing. Service tax at 12.24 percent would affect the viability of outsourcing clinical research to India. The Central Government should exempt clinical research from service tax so as to provide a major boost to outsourcing of clinical research to India.

Trademarks and patents: In case a right to use trademarks or patents is granted by an entity outside India to an entity in India, the same would be subject to service tax under Intellectual Property services. The contracts in such a case would be considered as executed outside India as the transferor signs the contract outside India. However, state VAT authorities have contended that such a right to use would also attract VAT as use of the same is in India. This contention is against the Supreme Court decision in 20th century case, wherein, for intangibles, it has been held that transfer of right to use takes place where the agreement is executed. The dual applicability of VAT, as well as service tax would increase the cost of operations of pharma companies. The above lacunae in indirect taxes regime lead to only one conclusion that GST is the ultimate solutions for businesses in India. The Central and State governments need to be sensitive to the concerns of the pharma industry and ensure that taxes do not affect the competitiveness and the larger social concern of providing medical care at least cost to the masses.