The OECD’s pillar one blueprint – is pharma in or . . . in?

By Philippe Paumier, VECTOR TP, Paris

“The intersection of law, politics, and technology is going to force a lot of good thinking” – Bill Gates.

The OECD’s draft pillar one blueprint has not yet been publicly released but is now widely shared on the internet.

The latest draft (dated Sept. 16) illustrates the dissent over the definition of the scope pillar one, and the difficulty to align a principled approach on scoping with tax policy objectives.

The convolutions around the definition of customer-facing industries in pillar one do not come as a surprise to the pharmaceutical industry, where the definition of “customer” is complex.

The role of intermediation in the pharmaceutical industry

The OECD contemplates two options: either the entire pharma industry is within the scope of the measure or just the over-the-counter segment. The draft discusses these two options in detail.

In its discussion of the second option, the draft rightfully identifies the limitations of the consumer-facing concept in the highly intermediated prescription drug market.

In the prescription drug business, the patient is typically prescribed a drug by a doctor, the drug is paid for through indirect funding streams (insurance, government, etc.), and the product is supplied through wholesalers and pharmacies.

The pharmaceutical industry is one of the most regulated industries (both geographically and across its different functions, from research to marketing). The high level of intermediation that stems from that set of regulations has a tremendous impact on the marketing mix of a pharmaceutical product.

For instance, the relationship between elasticity of demand and price or promotion is much more complex in this industry than for fast-moving consumer goods.

The main customer-related issue of pharmaceutical products is the ex-ante and ex-post perception of value, leading to prescription and adherence, respectively, the pillars of marketing.  

This feature tends to be common in products embedding a high proportion of intangibles, such as luxury brands.

These products are usually classified by economists as either experience goods or credence goods. The fundamental difference between luxury brands and pharmaceuticals regarding this aspect is that the value proposition of drugs comes to the user with two levels of pre-validation.

Agencies such as the US’s Federal Drug Administration or European Medicines operate on a “better than the Beatles paradigm”: drugs are approved if their cost/benefit profile meets or beats the latest standard.

Physicians then ensure correspondence between the symptoms and drug and ultimately monitor the treatment.

This, in addition to the role of reimbursement policies (public or private) in some jurisdictions, are a critical component of prescription drug patterns.

Such pre-validation exists because the needs of patients are established and measured (diagnosis) and then demand to be met. There lies the fundamental difference between prescription drugs and actual consumer goods. The inherent characteristics of the product are objectivized.

From a value creation standpoint, this line of argumentation directly questions the legitimacy of the marketing intangible concept for prescription drugs, which was the cornerstone of the entire pillar one approach.

Does it really matter? If all pharma segments are included within the scope of the measure – probably not much.  

The economic analysis seems to count as much as the supply chain, even if the latest draft does remind that market participation is “attributable to the nature of what is being supplied, how it is being supplied and the active interaction or engagement with market jurisdictions”.

In this author’s view, there is a high probability that after a fierce debate, pharma is fully included in the scope: the OECD cannot realistically carve out one of the most profitable industries in the world, regardless of whether the value stems from the product or from the market and its users. The draft illustrates that, beyond the OECD, many countries would not accept such a carve-out, starting with the most significant pharma market, the US.

Blueprint considerations

It is difficult to argue with the pillar one blueprint’s assertion that pharmaceutical companies design their products to meet the needs of patients and deploy significant efforts to ensure that the product is supplied to the patient.

The draft states that “drugs are accessible to consumers for personal consumption” and that the goods or services are developed to “be regularly, repeatedly, or ordinarily supplied to consumers, including by undertaking research as to consumer needs and being available for providing consumer support.”

But stating the obvious and asserting that the effects of the multiple regulations and intermediation do not materially affect the consumer-facing profile of pharma, is not enough. The draft errs in using “patient” and “customer” in an interchangeable manner, reflecting the shortcut that is being proposed: users (patients) delegate their consumer role to intermediaries, therefore the consuming facing character of the industry is preserved.   

Without developing an unproductive obsession about the superiority of the arm’s length principle, one regrets the absence of value creation analysis, one of the many learnings of BEPS. Within a value creation framework, it would have been necessary to analyze how the choices are made by the intermediation bodies on behalf of the patient, and the effects of regulation would have been identified.

The draft now reverts to the old excess spending theory, and it could have elaborated on the well-known pharma paradox: pharma spends every year an average of 15% of its revenues on research (R&D) and development and significantly more on selling, general and administrative expenses (SG&A).

The paradox can be partially debunked: R&D expenditure is for a small portfolio of drugs and one year on R&D cycles of 10 to 12 years, while SG&A is for global infrastructure (heavy in pharma) and for promoting and distributing hundreds of products in more than one hundred countries.

But one fact remains, pharma does spend a significant amount of dollars in promotional activities, for the lack a better word. The draft correctly points out that those “marketing efforts and activities are directed at regulatory compliance”, but unfortunately does not elaborate further on the consequences of that particular type of marketing activities.

Generics

The OECD has missed an important segment, representing three times the value of over-the-counter: GX-generics (one-third of pharma sales, roughly, while over-the-counter represents 10–12% of pharma sales).  

Indeed, inspired by arguments developed for the carve-out of other industries in the paper, one could be tempted to conclude that generics should be carved out because “such products are generally generic goods which are sold, and whose price is determined, on the basis of their inherent characteristics” (§.111).

Of course, the reasons are deeper: the generics market is predominantly driven, not only by price and costs, but also by regulations and health policy that severely affects the sales of a given product.

In some countries, substitution policies can require a switch from the branded product to the generic where the latter is available. Other interesting policies require physicians to label prescriptions based on the international nonproprietary name (the molecule behind the brand) to ease the switch to generics. A last set of policies monitor the costs at the level of physicians to ensure a proper balance between generics and branded drugs.

Some may argue that countries have different profiles when it comes to generics, rendering the pillar one blueprint’s criteria quite selective and penalizing countries that have implemented such cost containment policies. The fact remains that generics are as close as pharma gets to a commodity market, even though it is a high-end commodity market (quality requirements).

Patient-centric industries

A key to the analysis of prescription drugs could be found in the following question: can patient-centric industries be non-consumer facing?

Pharma companies have evolved in the last decade towards a patient-centric approach, fostered by their capacity to use massive amounts of data due to the digitalization of societies and daily life.

The goal of this shift of mindset is to better appraise the customer experience through multiple and longitudinal datasets, facilitated by apps that act as treatment companions to patients.

While these tools have an incredible social impact (adherence to treatment remains a significant health problem), they might also have some relevance to the discussions on the customer-facing aspects of pharma.

Similar arguments could be made about the recent evolution of pharmaco-vigilance, also known as drug safety.  These arguments can be debated and countered, but at least they are grounded on economic analysis and value creation.

The draft could have elaborated on the potential rise of e-detailing for over-the-counter products, and the e-platforms directed towards users in a context where the latter are willing to exercise an increased level of control over their prescriptions. Exerting more control can be achieved by partially correcting information asymmetries, and that is where the digital tools – for pharma and for users – could play a significant role.

Pharma and pillar one

The successive drafts have evidenced that it is risky to reach conclusions on the extent to which pharma will be within the scope of pillar one, days away from the next round of OECD and the Inclusive Framework discussions.

It is difficult to analyze each industry. The fact that the OECD made an effort to address the issue of the pharma industry in the consumer-facing analysis should be appreciated. The debate will go on.

Tax and transfer pricing practitioners operating in the pharma industry should curb their enthusiasm, though. One way or the other, pharma will be within the scope.

As pointed out by the proponents of the full inclusion of the industry, pharma is too significant in terms of sales and profits. It has also been the origin of major transfer pricing controversy in many countries, not to mention that pharma was the cradle of the marketing intangible concept.

Pharma is clearly one of the primary non-digital targets of pillar one. And for that reason, the inclusion of the industry in the digital tax agenda deserves a more principled argumentation.

Moreover, the inclusion of the entire industry should not be based on practicalities related to segmentation issues. Complexity cannot be eliminated, it usually gets centralized and its management supported by strong processes, based on factors that are unequivoval and agreed, to avoid the scourge of interpretation, and of controversy. Devil is in the practical details.

We should press the OECD to raise the bar, even if, in the end, it all might amount to simply including all industries that yield profit before tax above 10% or 15%. This route, though even less principled, is at least a more honest one. The US proposal on safe harbors might contribute to blow off some steam in the scoping discussion, by partially pushing the decision to taxpayers, but such approach can only cast a doubt on the reach of pillar one on tax certainty on cross border transfer pricing matters for distribution.