New Medical Reform in China: Pharma Companies' Tax Challenges, Opportunities and Responses

In recent years, the Chinese government has introduced a series of laws and regulations to deepen reform of its healthcare and medical system (new medical reform), including Volume-based Procurement (VBP), the dynamic adjustment mechanism of the medical insurance catalogue (Dynamic Catalogue Adjustment), the Two-Invoice System and the Marketing Authorization Holder (MAH) system.

New medical reform will further promote innovation and development in China's pharmaceutical industry, and will accelerate industry reorganization. Facing the general trends, pharmaceutical enterprises need to promptly assess and adjust their business models and future development. Tax compliance and planning are important considerations for them: Reasonable tax planning and risk management not only reduces and optimizes overall tax burden, and improves investor return, but also effectively manages tax risks.

Deloitte China Life Sciences & Health Care (LSHC) Team publishes a new report, New Medical Reform in China: Pharma Companies' Tax Challenges, Opportunities and Responses. Starting from the key policies in new medical reform, this article elaborates on the tax challenges, opportunities and response strategies for pharmaceutical enterprises. The key views are:

• Cost pressures from drug price cuts will force intra-group functional realignments, while group entity functional and risk re-positioning and appropriate transfer pricing policy approaches will create opportunities to improve tax efficiency

VBP and Dynamic Catalogue Adjustment are prompting sharp declines in drug prices, which has in turn been squeezing profit margins and putting considerable cost-cutting pressure on impacted enterprises. From a tax perspective, group functional realignment requires a group tax model that matches the new business model to manage potential tax risks. Enterprises need to balance the profit and loss status of entities within the group through reasonable TP arrangements to ensure effective loss usage. When adjusting the roles and functions of entities within the group and arranging reasonable TP policies, it is necessary to comply with the arm's length principle and respective TP rules while taking into account practices in each country or region to manage and control related tax risks.

• Sales and distribution channel restructuring under the Two-invoice System highlight the importance of tax compliance and risk management

The Two-invoice System increases the tax compliance risk of pharmaceutical companies, and their potential tax costs. In conjunction with streamlining their sales and distribution structures, pharmaceutical companies should also assess their tax compliance and management strategies, processes and systems to ensure meticulous compliance risk management with robust documentation. Meanwhile, companies should consider appropriately using technology and tax digitization tools to increase compliance and risk management efficiency.

• Innovation and R&D are becoming the core competitiveness of pharmaceutical companies, and tax and transfer pricing planning around R&D functions and IP ownership will be the "core of the core" in improving tax efficiency and risk management

The MAH system, optimization of the review and approval process for new drugs, and faster clinical trial approvals, will facilitate and encourage new drug R&D.  From a tax perspective, pharmaceutical and biotech enterprises should consider how to plan the appropriate R&D business model, and arrange R&D and IP ownership related transfer pricing policies, to improve tax efficiency and reduce the risk of unnecessary double taxation. Meanwhile, they need to maximize use of applicable national tax preferential treatments and regional financial support policies, and select and arrange appropriate incentive schemes for core R&D personnel who are often the senior management of a company and even the founders at new biotech companies.

• Specialization is becoming an industry trend, in conjunction with the widely used CMO/CRO/CDMO models, making tax model choice important in reducing overall tax burden

The MAH mechanism breaks the traditional binding of "development, manufacture and sales", and allows MAHs to designate other parties for production, R&D and sales. This is expected to proliferate CMOs/CROs/CDMOs in China. From a tax perspective, companies with group supply chains involving a CMO/CRO/CDMO should consider various tax preferential treatments and regional industry incentives. In addition, value chain allocation and corresponding transfer pricing policies should be considered to improve tax efficiency and risk management.

• Increased M&A and restructuring opportunities expand the need for prior tax assessment and subsequent establishment of enhanced tax models

New medical reform is expected to result in more M&A activity, with biotech enterprises possessing innovative drugs becoming hot targets for investment institutions and capital markets. From a tax perspective, enterprises can encounter various tax issues. Companies need to assess the potential tax implications for informed decision-making in M&A and reorganization activities. It is also important to establish an enhanced group tax model during post-M&A integration and restructuring.

• Corresponding to China market share capture and supply chain realignment strategies, multinational pharmaceutical companies should make full use of preferential local industry policies and build up tax optimized trade and supply chain models

Pharmaceutical MNCs in China should revisit their tax models and reconfigure tax optimization mechanisms to factor in direct and indirect tax or customs duty considerations arising from new product introductions and supply chain realignment. With the Chinese government having identified biomedicine as a strategic emerging industry, many local governments have elevated it to the heights of a new engine of regional economic development. Multinational pharmaceutical companies should make full use of these local policies in their China business expansions and new product introductions, as well as supply chain realignment.   

China's new medical reform is a challenge but also an opportunity for pharmaceutical companies from a business and tax perspective. Careful tax assessment and planning during business model adjustment under new medical reform is an integral part of overall business and tax efficiency improvements for pharmaceutical companies. Multinational pharmaceutical companies need to revisit their China business and supply chain plans to mitigate the short term price and cost pressure from new medical reform and introduce new products to capture market growth, supported by full use of local preferential policies and the creation of tax-optimized trade and supply chain models.