Practice Areas Review: Pharmaceuticals

Dealing in Drugs 2016: A Bumpy Road Ahead

Mykola ORLOV

Mykola ORLOV

Managing Partner, Law Offices of OMP

PROfile

OMP

Address:
9 Tarasivska Street,
4th Floor, Kiev, 01033
Tel:
+380 44 391 3001
Fax:
+380 44 391 3002

Law Offices of OMP is well known on the CIS legal market and as the most dynamic full service Law Firm on the Ukrainian legal market with particular industry focus in a pharm business, agriculture, construction and development. The firm’s practices also include the following fields: M&A, corporate law, taxation tax audit securities, dispute resolution — litigation and arbitration, etc. 

 

With the past two years witnessing a slump in pharmacy sales, there is no promise of a U-turn in 2016. The increasing devaluation of the national currency has led to a steep rise in the prices of almost all medicines. This is bad news for the government. Unfortunately, it is even worse so for the industry, which is held to blame by public officials. All of that spells rough ride for all stakeholders in the current year. One does not need a crystal ball to predict fierce competition and continued misunderstandings with the state. Below are just a few of the legal hot spots to keep a wary eye on.

Misplaced Competition Concerns

Following several hikes of prices at pharmacies, the Antimonopoly Committee of Ukraine set about correcting the situation. The usual suspect was the retail sector. (Surprisingly, the AMCU seemed to take little notice of the effect the rapid devaluation of the Hryvnia had on these prices.) It did not take the regulator long to start blaming the marketing services provided by the pharmacies to the pharmaceutical companies.  Marketing bonuses were accused of distorting the competition and driving up the cost of medicines to the public.

In its non-binding recommendations of March 2015, the AMCU voiced concern that marketing services agreements might be in breach of competition laws. It went even further and effectively advised retailers to refrain from charging marketing fees in excess of the actual cost of such services. At the same time, the regulator had to admit that marketing services agreements were both common (with over 50% of the industry using  them) and arm’s length (with the individual contractual terms being agreed upon on a case by case basis). The AMCU position was further weakened by the fact that none of the pharmacies dominates the market nationally and only a few do so locally.

Predictably, no investigations and prosecutions followed. The absence of solid legal grounds meant that the AMCU limited its push to circulating enquiries into group structure of the pharmacies and their overall sales on the regional level. Nonetheless, the fresh wave of accusations and recommendations brought a considerable degree of uncertainty to the market. Wary of fresh repressions, pharmacies panicked. Many of them sought to terminate marketing services agreements or camouflage them. As a result, quite a few of the previously transparent over-the-counter arrangements were gradually substituted for convoluted arrangements involving private entrepreneurs or intermediaries. The main victim of the witch-hunt became marketing bonuses linked to the volume of sales of medicines. (In the case of pharmacies and pharmaceutical producers, these bonuses are paid to the retail on the basis of the volume of medicines supplied to it by the distributors.)

The midyear change in the top brass at the AMCU brought with it a fresh round of negotiations with the industry. From July through November 2015, the agency held several meetings trying to make up their mind what to do with the marketing services agreements. From the legal stand point, the opponents of these agreements cannot pinpoint any rule or law which is violated by these arrangements. There is no evidence of any misuse or market abuse where the marketing services were involved. To the contrary, marketing services appear to provide the much needed incentive for pharmacies to keep stock of the expensive medicines of non-Ukrainian origin. These pharmaceuticals take longer to sell and, but for the additional bonuses, might have well been omitted from the orders of many local drugstores.

AMCU Corrects Itself

The year long dispute culminated with the AMCU clarifying their recommendations on the marketing services agreements. Rather than revoking its controversial recommendations, the regulator decided to effectively restate some of them in the press release of 14 December 2015. First and foremost, the AMCU admitted that the pharmacies could make a profit on their marketing services, although it warned that its price should be economically justified. This was in stark contrast to the previous position that the price of these services could not exceed the cost of their provision.

Second, the regulator finally offered clear guidelines on the use of marketing bonuses linked to the volume of sales. These effectively ended speculation regarding the use of such marketing instrument. The AMCU effectively indicated its intention to prosecute volume-based bonuses only when these are employed by market players enjoying dominant position and only in three types of cases:

— if such bonuses impede access to the market of other producers or remove them from the market;

— if such bonuses are offered on different terms under similar contracts which discriminate against some market players; and

— if such bonuses lead to higher consumer prices which would otherwise be lower had there been more competition on the market.

On the face of it, the AMCU recognized lawfulness of the above bonuses and their admissibility from the point of view of antimonopoly regulation. Furthermore, the new guidelines demonstrate that marketing services agreements in general and volume-based bonuses in particular are subject to the same antitrust rules as any other contractual arrangements in the market. Thus, they can and may be investigated and prosecuted only when and if there is proven market abuse. Otherwise, market players should be left free to agree on any contractual terms they choose.

Unfortunately, the year-long battle left the market unnerved and disillusioned. The AMCU has once again demonstrated that it can deviate from its own regulations if it is justified by political considerations. As a result, the industry is no longer comfortable with the marketing services agreements, although there is no other instrument which can effectively substitute them.

Marketing Services: Do’s and Dont’s

Contrary to what may be the popular perception of the latest AMCU actions, marketing services agreements are permitted under Ukrainian law. Their legality has never been disputed. They are also widely used in every type of retail active in Ukraine. The disputed bit of the marketing services is their price which under certain (rather unique) conditions might fall foul of antimonopoly regulations. The usual accusations would be market abuse (for pharmacies) and pricing competitors from the market (for pharmaceutical producers). It is yet to be proven (if at all possible) that marketing services lead to an actual increase in price for the consumers.

Marketing services and, in particular, volume-based bonuses might be frowned upon if targeting rare and expensive medicines, as well as medicines that are in short supply. Recent examples of such instances proved to be oncology, hepatitis and diabetes medicines which are often in short supply and are quite expensive. Special care should be taken in instances when there are only one or two competitors whose market share is decreasing dramatically. These could always try to improve their stakes by claiming unfair market practices and intentional squeezing from the market.

One more concern is pharmacies enjoying dominant position on local markets. In some regions, local chains do control over 35% of the market which makes them the usual suspects for any market abuse enquiries and investigations. Expectedly, their promotional services would be closely scrutinized by the AMCU. Arguably, the main reason for such scrutiny would be the better legal position for any actions on the part of the regulator which has broader powers vis-à-vis market monopolists.

In response to what was widely perceived as the growing unpredictability of AMCU policies, the market has been developing its risk minimization strategies. The two most popular structures for camouflaging marketing services agreements are (a) contracting with private entrepreneurs instead of pharmacy chains and (b) hiding volume-based bonuses behind payments for other marketing services. In the case of private entrepreneurs, tax risks might outweigh antimonopoly ones. In order to minimize any challenges regarding the the validity of such agreements (as sham transactions), private entrepreneurs should have proven links to the respective pharmacy chains. Ideally, they should have their own marketing services agreements with pharmacy chains.

Substituting accrued payments for marketing services for volume-based bonuses is far from transparent and straightforward. Differences in performance of various contracted pharmacy chains usually lead to unexplainable gaps in payments for the marketing services which, on the face of it, should have been provided by all of the pharmacy chains equally. A good example of such discrepancies would be a different number of monthly visits to pharmacies or unequal payment for placement of medicines on the shelves of individual pharmacies.

Finally, it appears self-evident that the terms of marketing services agreements offered by each of the producers or pharmacies should be the same for all of their business partners. Any digression, from such terms which is hardly advisable, should be justified and reasonable.    

Tax Curse of Credit Notes

Credit notes have long become an instrument of choice for transfer of various financial incentives from pharmaceutical producers to the distributing companies and on to the pharmacy chains. The tool is commonly used to finance promotion and marketing campaigns. Of late, credit notes have come under increasing scrutiny by the Ukrainian tax authorities due to the different VAT tax rates applicable to the sale of medicines and the marketing of pharmaceuticals.

At the end of 2012, the Ukrainian tax authorities issued a letter warning the pharm market of the tax consequences of using various motivation payments under supply agreements to pay for marketing services. They claimed that such payments attracted Ukrainian VAT at the rate applicable to marketing services. The fiscal authorities did not provide any guidance on which payments were at risk. However, the warning prompted the market to reconsider the benefits offered under supply agreements, including discounts. In effect, all the discounts fell under two groups — those related to the actual shipments of goods and those used to pay for any extras. The latter included, inter alia, payments for provision of information, marketing services and promotion activities. The first group was covered by the then existing VAT exemption for sales of pharmaceuticals, while the second was at risk of being taxed at 20% as payment for (marketing) services. (Since then, the sales of medicines became subject to the 7% VAT tax rate, which is still lower than the full 20% rate applicable to marketing services, hence the unflagging attention of the tax authorities.)

On 29 October 2015, the Ukrainian tax authorities re-confirmed their position on the taxation of motivation payments under supply agreements. This time, however, they went even further. Tax collectors professed their intention to treat as payment for marketing services any bonuses paid to buyers for reaching targeted volumes of sales. This position, of course, is more than questionable under Ukrainian tax law. It is highly doubtful that such an interpretation would be upheld by Ukrainian courts, which are becoming increasingly critical of the Ukrainian tax authorities and their policies of tax extortion.

The provision of incentives, in particular, discounts, for buying more goods is at the core of any trade. It is almost universal for supply agreements. Although it might be used in the marketing of supplied goods, of itself it is not linked to any marketing services, in any of their common definitions. In the absence of any extra services covered by such bonuses it is difficult to see how such incentives may be treated as compensation for marketing services.

In order to minimize the risk of any subsequent tax-reassessment of discounts (credit notes), both parties to the supply agreements should be explicit in their description of the purpose of such discounts. Care should be taken to link them expressly to the sale of goods if this is the intention of the parties. As a practical matter, discounts provided for advance payments or achievement of targeted volumes of sales have not to date been formally challenged by the Ukrainian tax authorities.

Care should also be taken with the discounts provided on separate batches of supplied pharmaceuticals. These can give rise to the tax authorities questioning the price of such medicines used as the basis for the payment VAT for their importation into Ukraine. As a practical matter, it is less risky to spread such discounts evenly across all supplies and sales in a year.