Is There a Panacea for Tax Issues of Foreign Pharmaceutical Companies?

Boris Bruk

The Russian government’s increasingly vigorous regulation of pharmaceutical pricing has put a squeeze on foreign pharmaceutical companies’ profits from their Russian operations, with adverse tax consequences.

Foreign drug manufacturers now face a new requirement when they begin working on the Russian market: They must register the maximum prices they may charge when selling many pharmaceutical products to Russia. Onward distribution is also under tight state control, with regional governments allowed to establish and enforce the maximum wholesale and retail margins that wholesale distributors and retail chains may charge on top of the prices set by the manufacturers. The vast majority of foreign pharmaceutical companies have no logistical capability to directly supply retail chains in the regions and are therefore essentially dependent on Russian regional distribution channels. It is no surprise then that relatively little margin is left in the hands of the Russian branches and/or subsidiaries that foreign pharmaceutical companies use to channel wholesale distribution in Russia as well as promote their products, especially after accounting for all the additional sales and marketing costs incurred locally.

As a result, these branches/subsidiaries increasingly find themselves reporting losses on their Russian tax returns but meet with little sympathy from the Russian tax authorities, with their ingrained skepticism toward loss-making businesses. Thus, foreign pharmaceutical companies ultimately often find themselves between a rock and a hard place, with no avenues for profit expansion and apparently no means fully to bear costs and suffer losses.

Some Possible Solutions

While no universal cure-all exists to remedy the above tax-driven problem, and each case should be addressed on its own merits, it is nevertheless possible to suggest a general approach to improving the position of foreign pharmaceutical companies in Russia.

As a starting point, costs incurred by the Russian branch/subsidiary of a foreign pharmaceutical manufacturer, in particular sales and marketing costs, need to be analyzed to ensure that they are favorably allocated. In nearly all cases, the sales branch or subsidiary will bear rent both of office space and storage facilities, advertising and promotion costs, including the sales staff payroll and necessary expenses such as cars, and currency exchange fluctuations. If the above costs are not fully absorbed by the margin available to the branch or subsidiary, it would be logical to consider moving some of these costs outside the sales division by redistributing certain functions between the foreign pharmaceutical company and its branch or subsidiary. It is abundantly clear though that certain costs such as storage facility rental and sales management payroll costs are intrinsic to the business of the sales branch or subsidiary and cannot be moved without impacting the activities of the business.

On the other hand, marketing and advertising costs, primarily advertising fees charged by third-party advertising service providers, are relatively easy to redirect from the sales division back to the foreign manufacturer or to a dedicated marketing division, which would generally be expected to be a noncommercial representative office of a foreign legal entity.

Redistribution of costs is just one of many possible solutions. Apart from decreasing the costs of a Russian sales branch/subsidiary, attributing additional income to this sales division should be considered an extra tool to better cover the costs incurred.

In particular, the sales branch or subsidiary could be viewed as an agent of a separate marketing division of the group (in the case of a Russian sales branch) or the parent manufacturing company (in the case of a Russian sales subsidiary) that is involved in purchasing third-party advertising and marketing services for the benefit of the marketing division (parent manufacturing company). This should allow the sales unit to earn extra income as agency fees and thus accommodate its incurred costs more comfortably. In practice, the scope of agency activities may be extended to include obtaining marketing authorization for product distribution in Russia.

Although now probably of reduced importance given the increased stability of the Russian ruble, the negative effects of foreign currency fluctuations could be mitigated by fixing the purchase price between the sales branch/subsidiary and suppliers in Russian rubles. Some companies already employ this practice.

Of course, the above steps rest on one very important assumption that the foreign manufacturer as a group is willing to accept and bear economically the excessive costs of business in Russia, as both redistributing functions and attributing additional income to Russian sales divisions are merely tools for shifting the economic burden within the group. If no such cost-sharing policy is acceptable for the foreign pharmaceutical manufacturer, then recovery of the situation would most likely be a long and arduous one and may still ultimately end in disappointment.