Cash flow opportunities in life science companies through

better VAT management

Industry leading practice

However, a number of factors are causing multinational businesses to focus on managing VAT more globally, these being better awareness and understanding of both the complexities and amount of VAT to be managed annually and the benefits to be achieved in having higher standards in the management of VAT, resulting in better recoveries of VAT and reduced exposures. This is of benefit in two ways as it minimizes the risks of large VAT assessments, of which there have been many in the industry, while increasing the ability to secure refunds, improve cash flow and reduce cost. In addition, businesses have a far better understanding of the mechanics of VAT, realizing that good risk management of VAT lies in managing the tax across the whole end-to-end process.

As a result, not only is VAT throughput, use of shared service centers and VAT cash flow of ever increasing importance in the complex supply chains of the life sciences industry, an ability to manage significant irrecoverable VAT costs in key areas such as clinical trials and emerging markets only add to the increasing importance of VAT in the industry sector.

On the operational side, apart from the ongoing challenge of building the complex supply chains in ERP systems or tax engines, another critical development is the use of shared service centers. Invariably these centers offer great savings due to the unified processes and lower labor costs. However, from a VAT point of view often the local knowledge is lost and errors with processing invoices are in fact increasing. This requires a stringent process and control environment whereby the momentum of using specific VAT automation and technology such as data analytics, workflow management etc should form a critical part to ensure compliance.

These tools are often available within the existing ERP environment or IT department or may require additional third party software. The key here is to find the technology solution that fits the business and means that a strategy should be developed to make the right choices.

Greater patient connectivity – the VAT impact

As supply chains move towards more business-to-consumer type flows, there will be a significant impact on a life science company’s VAT footprint especially if these changes are combined with a centralised cross-border selling model. Within the EU, sales to private individuals are subject to VAT in the country of dispatch unless registration limits are exceeded in the member state of the customer (or where a voluntary registration is sought). In the latter case, VAT is charged in the country where the customer resides resulting in the possibility of multiple VAT registrations in many EU member states and adherence to local administrative rules. This will impact a company’s ERP system and set-up increasing the overall compliance burden. It is therefore important that the tax or finance function is made aware of such critical business model changes in a timely fashion to ensure compliance with the rules of each state thereby safeguarding the company from irrecoverable VAT or exposures for late registration and/or payment of VAT.

Cost reduction and cash flow management have become topics of increasing importance on the finance agenda of major life science companies over the last number of years. However, a relatively underutilized area for generating savings is value added tax “VAT”, which is a turnover based tax that applies at all stages of production in almost every country in the world outside the US. With average rates of up to 20% and the increasing complex legal and financial flows in big pharma, the numbers under management can quickly become very large and into the billions for very large companies, often equivalent to 30 – 35 % of non US revenues.

In recent years, some of the major life science companies have begun to focus on this area in order to reduce net VAT cost and optimize cashflow – a 1% shift in a VAT throughput of US$10billion obviously adds up and can result in a very significant cash benefit.

The introduction or planned introduction of VAT type taxes by countries in the last 10 years has been enormous leaving the US as the only major economy without a VAT system (but for how long?). It reflects the global trend towards taxing consumption rather than income. For example, China is considering VAT reform and the transitioning of a majority of its services from business tax to VAT with the authorities running pilot programs to better understand the impact of such a shift.

Cash flow opportunities in life science companies through better VAT management

VAT exemptions on personalized medicines

With the shift to more personalized medicines some recent developments in this area include possible VAT exemptions for the provision of this aspect of evolving medical care. While this is a positive development for the ultimate customer of such care, the downside for companies is that all associated VAT on costs, including R&D etc will be non-recoverable. This may have a severe impact on the company’s cost-model where no account has been taken of the fact the personalized medicines could be VAT exempt with appropriate adjustments to the cost base. The gross margin of the new product will come under pressure and could be negative in some cases. We would expect this trend will continue especially in the EU with some Member States already applying such an exemption on personalized medicine.

VAT on clinical trials (valuations) and CRO management

As more and more clinical trials are moving to emerging markets there is a resultant increase in irrecoverable VAT due to the high import VAT rates on pharmaceutical products. These amounts are irrecoverable due to the fact that the importer does not take title to the clinical materials and/or resell it in the market, which is a usual condition for VAT recovery in emerging markets. This applies whether it is a CRO or local affiliate as importer.

It is therefore important to verify local rules on recovery and try to utilize specific applicable regimes to minimize VAT, if such exists or attempt to restructure the transaction to recover VAT via an affiliate, which is possible in some, but not all markets. Another method for managing indirect tax is to develop a global policy around valuations for “non-commercialized” shipments, such as clinical trial materials, charitable product, and so on. Determining an acceptable valuation for clinical trial materials and other materials is a key challenge facing R&D groups as in the absence of same, the customs authorities will try and impose the higher commercial value for customs/VAT purposes resulting in higher import tax costs.

VAT issues on major acquisitions and disposals

With the sector experiencing increased M&A activity careful consideration should be given to the increasing technical complexity surrounding VAT recovery on acquisition costs, share deals etc. For example the European Court of Justice case law is becoming more and more stringent on this point especially in relation to where costs are incurred for non-economic purposes (that is non-economic from a VAT stand point). Proper structuring of the deal in advance is critical to prevent unexpected VAT costs later on.

Optimizing the VAT throughput in the complex pharmaceutical supply chains and the changing business models including (co – partnering)

The supply chains within the industry remain very complex with the legislation struggling to keep up to date with developments. This often results in complex VAT outcomes and difficulties in setting up such transactions in ERP systems. If this is coupled with centralized selling and manufacturing models, it often means that a single entity requires a multitude of VAT registrations with an increase in the administrative burden. Luckily, it is still possible to plan and utilize certain reliefs that mitigate cash flow but obviously proper consideration is key prior to implementation.

Cash flow opportunities in life science companies through better VAT management

Contacts

Neil Byrne Global Life Sciences Tax Leader +353 (0)1 221 2370 neil.byrne@ie.ey.com

Paul Fitzgerald Global Life Sciences Tax Sector Resident +353 (0)1 221 2517 paul.fitzgerald@ie.ey.com

Daniel Kroesen Indirect Tax Partner +31 (0)88 407 8361 daniel.kroesen@nl.ey.com

In conclusion, therefore, whilst it is in essence a simple tax, individual country rules and interpretations result in a complexity that will test the tax management resources of any organization out of proportion to a tax that is meant to be tax neutral for business. Historically, while the response by business has been varied but generally it has been to leave the accounting and compliance responsibility for VAT to the finance department and for tax to deal with issues as they arise but usually only when it is brought to their attention and in a lot of cases too late for appropriate action to secure refunds or mitigate penalties.

However, given the quantum of VAT that has to be managed each year by companies in this industry, and the industry specific additional VAT issues that must be dealt with, there is a clear and direct benefit from taking a proactive approach to managing VAT for the benefit of the organization. Such an approach has been shown to result not only in cost savings but also in reduction in exposure to assessments, penalties and interest through implementing robust VAT processes, procedures and controls right across the end to end process with some of the leading life science companies already making significant strides in this area.

Ernst & Young

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