GST is expected to transform the Indian economy in the medium to long term. The new GST framework would result in the development of a common Indian marketplace, reduce the cascading effect of multiple layers of taxes and increase revenue buoyancy for the Central Government (Government) and most of the state governments. By leveraging an advanced technology infrastructure and systems, the GST framework is expected to bring greater transparency and simplicity in tax administration and compliance.
It is also anticipated that supply chain and other operational planning opportunities and efficiencies may be available, depending on a company’s facts. However, in the short term/transitional phase, all companies, including those in the pharmaceutical industry, are likely to face a number of challenges, some quite significant, including possibly negative financial impacts, the need to reassess existing supply chain structures, the need for reconfiguration of IT systems and more. It is therefore critical that companies become familiar with the proposed GST legislation, begin assessing the impacts that GST is likely to have on their business operations, and begin to develop/implement a plan to manage this mega-change by the expected implementation date.
Considerations for the pharmaceutical industry:
Opportunities to create supply chain efficiencies
Under the current regime, interstate sale of goods (i.e., sale of goods from state A to state B) attracts tax (Central Sales Tax) which is not creditable to the buyer, whereas interstate movement of goods across warehouses of the same company is not subject to tax. Hence, pharmaceutical companies have adopted a decentralized supply chain model whereby multiple warehouses located in different states in India have been operated to avoid tax leakage from the direct interstate sale of goods.
Since GST on interstate sale of goods would be creditable under the Model GST Law, there exists an opportunity for companies to revisit current supply chain structures, the number of warehouses being operated, etc. Similarly, there may exist opportunities to optimize sourcing strategies to achieve significant supply chain cost savings. For example, companies have historically designed their sourcing strategies with the primary goal of minimizing indirect taxes incurred under the current regime (i.e., whether to procure from within the state or from outside the state). Post-implementation, these tax limitations/restrictions would cease to exist, thereby affording more flexibility and enabling companies to shift their focus to non-tax sourcing considerations, including purchase price, logistics cost, etc. As a result, through proactive planning, the transition to GST could provide pharmaceutical companies with a competitive advantage in terms of pricing of the goods and margins.
Inverted duty structure
Currently, Central excise duty (tax on manufacture) is levied at 12.5% for API, whereas the formulations manufactured therefrom are subject to Central excise duty at 6% on the Maximum Retail Price (MRP) of said goods minus a special abatement. This results in substantial accumulation of input tax credit for the manufacturer with no legal provision to obtain a refund of this credit pool.
The Model GST law provides for refund of credits accumulated under the current indirect tax regime resulting from the higher tax rate on inputs vis-à-vis the lower tax rate on outputs. The transitional provision provides for transfer of such accumulated credits into the proposed GST regime. This obviously represents a welcome proposal and potentially significant benefit for the pharmaceutical industry, which so far has been unable to monetize the amounts of blocked credits.
Job work model
Companies in the pharmaceutical industry in India often rely upon third-party entities to manufacture finished formulations for and on their behalf. This arrangement is commonly referred to as a “job work” model or “loan licensee” model. Under the current regime, tax obligations of parties under a job work model are relatively clear and simple, namely:
The principal supplies input material to the job worker’s premises with no tax implication and limited documentation.
The job worker makes the payment of excise duty on the manufactured formulations based on the MRP of said goods as declared by the principal.
Similar special provisions for GST free movement of input goods/material for job work have been provided in the Model GST law. However, the process that companies will need to follow to allow for such free movement of input goods/material could become relatively cumbersome under the GST regime. It is proposed that the job work process require approval of the Jurisdictional Commissioner by way of special order. In cases in which the permission is not granted or delayed, supply of input materials for job work would attract GST. This requirement of obtaining permission could be time consuming, especially during the transition phase, and may create operational and financial challenges for companies.
The pharmaceutical industry would greatly benefit to the extent the Government were to convert the proposed job-work-related approvals requirement to a self-declaration model. This would result in greater efficiency and allow companies to avoid the possibility of a GST outlay (i.e., negative cash outflow).
Many companies engaged in the manufacture of pharmaceutical products have set up their plants in locations where the Government has offered indirect tax exemptions/ incentive schemes (such as Baddi and the state of Jammu and Kashmir, among others). These schemes provide for either upfront exemption or refund of indirect taxes paid.
Continuity of these location-based indirect tax benefits under the GST regime is critical, as companies have made significant capital investments in such areas due in part to the availability of these tax incentives. If the incentives are discontinued prematurely, such companies are likely to face financial challenges. This may also indirectly impact the cost of medicines and the ultimate price to be paid by the patients. The GST Council to be formed by the Government will be tasked with determining the fate of such exemptions under the GST regime.
Pharmaceutical companies routinely supply medicines free of charge as samples for physicians and as supplies to the World Health Organization and Government as part of health awareness programs, patient assistance programs, etc. Currently, while free supplies are subject to Central excise levy (tax on manufacturing), they are typically not subject to state VAT/CST. In addition, there are often cases where stock is transferred for destruction purposes or transferred for relabelling to meet regulatory requirements, and these transfers are also not subject to state VAT/CST.
Under the proposed GST regime, supplies made free of charge and other intra-company movements, as illustrated above, would be subject to tax. This represents a major change and could potentially have significant negative impacts on companies’ budgets, levels of available spending in connection with such programs and the overall cost of supporting patient assist programs.
In addition, it appears valuation of free supplies/transfers for levy of GST (since there would be no invoice value) could be based on GST Valuation Rules, which rely on concepts of comparable sales price, cost plus method, etc. Such practice could be operationally cumbersome and may be prone to litigation.
GST is expected to have a far-reaching impact on companies’ business operations. Pricing of products and services, supply chain and procurement, IT systems, accounting, tax compliance and other areas will be affected. Employees will also need retraining. With respect to accounting, the chart of accounts and standard operating procedures will need updating and working capital requirements, cash flow and tax cost planning will likely need to be reassessed. With respect to IT systems, enterprise resource planning systems will likely need to be reconfigured — including creating new tax masters, which can be quite time consuming and expensive. Creating awareness and educating key internal and external stakeholders, including suppliers and distributors, will need to represent a key component of every company’s GST change management process and implementation plan.
The next couple of months will be critical in determining whether GST will be implemented in April 2017 or, instead, some later date. It is currently very unclear whether the Government will be ready by April 2017 with the necessary administrative construct and support. It is also uncertain whether the GSTN, which is vital to implementation, will be completely functional by then.
We recommend that pharmaceutical companies begin now the process of assessing the potential impacts to their business and developing a transition plan to achieve four key objectives by 1 April 2017: a) engage the Government on issues and requirements that are important to the business in an effort to influence the GST rule-making process; b) avoid any business disruption on the cut-over date; c) achieve 100% compliance with all legal and procedural requirements under the GST; d) identify and implement any available tax and business/operational planning or cost management opportunities, recognizing that implementation of such opportunities may require long lead times.
(This article first featured in the EY Life Sciences Report: Asia – http://bit.ly/2cHuzKt)