The global pharma sector presents specific issues and challenges from a transfer pricing perspective. The sector has traditionally exhibited above-average profitability levels. Over the period 2000 to 2018, large pharma companies had a median profitability of 13.8%, which was nearly double the S&P 500’s of 7.7%. [1] Given the high levels of profitability within pharma MNEs, tax authorities around the globe, including the Thai Revenue Department, will be alert to ensuring that they collect a fair share of taxes on pharma profits from the supply chains in their respective countries. 

Transfer pricing laws are used by the tax authorities, including the Thai Revenue Department, to ensure that arm’s length prices are charged within a pharma MNE group for tangible or intangible transactions. Arm’s length prices are prices that would be expected in transactions between independent parties in the same or similar conditions and should ensure that the MNE profits are allocated according to where value is created.

Key Pharma Value Drivers

Above-average profitability in pharma stems from high R&D investment and patent protection, which, combined with medical necessity, ensures strong market bargaining power.

The R&D process, however, is high-risk and subject to a strict regulatory environment. Only 10%–20% drugs entering clinical testing will obtain marketing approval,[2] and it takes from 10 to 15 years on average to bring new drugs to market.[3] The cost and time required to develop new drugs effectively acts as a barrier to entry for new market entrants.

Another key driver is marketing intangibles such as trademarks/tradenames and brands. Pharma MNEs use marketing activities to establish brand awareness and loyalty. Detailing is a key marketing activity involving the provision of scientific and medical information to healthcare providers by sales representatives at the local distribution level. Over the period 2000 to 2018, large pharma companies had a median selling, general, and administrative spend of 28.2% of revenues compared with the S&P 500’s16.6%.[4]

Pharma Product Segments 

Pharma products may be categorized into the following segments:

• Patent (innovator) drugs – These are the original drugs that are covered by patent and sold under a brand. As noted above, the development of these drugs would involve significant amount of R&D and marketing spend. These drugs provide high profits during the patent period.
• Generic drugs – After the expiry of the patent of the innovator drugs, generic drugs that are based on the same active ingredient as the innovator drug may enter the market. Given the reduced costs in bringing these drugs into the market through reduced R&D and brand marketing, they can be offered at lower prices. The introduction of the generic drugs may signify a “patent cliff” for the innovator drugs resulting in reduced demand and revenues/profits.

Patent and generic drugs may be prescription only or available over the counter (OTC). Some patent drugs will start as prescription before converting to OTC once their safety and efficacy has been proven. Different marketing plans will apply to prescription drugs and OTC drugs. As discussed above, detailing with healthcare professionals would be the primary marketing activity for prescription drugs while marketing direct to consumers through media may be the main marketing activity for OTC products. The different pricing and cost structure for prescription and OTC products will impact the profitability in these segments.

Centralized Organization Structures 

Over the last 30 years, there has been a trend toward centralization of business structures within the pharma MNEs. This may involve headquarters or other entrepreneurial entities being responsible for business strategy and owning the product and marketing intangibles. R&D may be conducted at the headquarter level or subcontracted to R&D centers located in countries with established infrastructure (e.g., science parks). Global or regional hubs may be responsible for centralized support services (e.g., IT, HR). 

The primary manufacturing of the active ingredients may be performed by contract or toll manufacturers in low-cost countries with ready access to the necessary raw materials and robust infrastructure. Secondary manufacturing involving the conversion of the active ingredient to the finished product may be performed by contract or toll manufacturers in local countries to meet local regulations. Given the importance of local marketing in the supply chain, local distributors may be established to perform the detailing and other marketing activities.

Under this centralized structure, the primary and secondary manufacturers, local distributors, R&D service providers, and global and regional hubs may be compensated with routine profitability while the excess profit may accrue to the headquarters/entrepreneurial entities.

Thai Pharma Presence

Many of the largest pharma MNEs have local marketing, sales, and distribution entities in Thailand. Some MNEs also have local manufacturing entities while others may use third-party contract/toll manufacturers. Thailand is also actively used by the MNEs as a location for clinical trials (mainly Phase II and III), and the local entity may assist with coordination of the trials.

The Thai sales entities of the MNEs are typically established as limited risk or routine distributors, with business risks primarily borne by the entrepreneur entity(ies). The main function of these entities is the marketing and sales of the drugs to healthcare providers in Thailand. The sales function typically targets a certain level of routine profitability for these functions.

Marketing Intangibles? 

One potential transfer pricing issue with these sales entities is whether the significant marketing efforts, especially in terms of cost, give rise the creation of a local marketing intangible, which would entitle the Thai entity to above-routine levels of profitability. However, the argument against this would be that these local marketing efforts are based around the know-how and promotional plans developed at the global level. If this position is accepted, however, there should still be a recognition of the value-added function performed by the sales entity through the marketing efforts, which should be recognized in the target profitability level.

The Thai sales entity would need to perform a benchmarking study involving a search for comparable independent distributors to determine an arm’s length level of profitability against which it can test its profitability level to support that its related party pricing is arm’s length. The Thai Revenue Department has a strong preference for local Thai companies for the purpose of this search. This analysis would need to be included in transfer pricing documentation, which would be provided to the Thai Revenue Department on request.

Such a search would typically focus on independent wholesalers that sell the same or similar products. It may, however, be difficult to find independent companies that perform the same level of marketing that the MNE distributors perform. If, for example, the wholesalers are screened based on the level of marketing costs/sales, then the potential comparable set may be very limited. A couple of solutions may be considered to address this issue:

• Relax the screening criteria to include potential compatible companies irrespective of level of marketing costs.
• Determine an appropriate arm’s length return specific to the marketing function and add this to the arm’s length return obtained for the distribution activities.

Aggregation Versus Segregation

Product profitability will typically vary by product and across product groups. As indicated above, patent drugs will earn higher profits than generics, and prescription drugs will typically earn higher profits than OTC. 

In testing the profitability of the Thai sales entity to determine if results are arm’s length, consideration should be given to whether the profitability will be tested by product, product group, or on an aggregate basis. Typically, profitability would be tested on an aggregate basis assuming a consistent functional profile across the products. Segregation by product or product group may be difficult given potential difficulties in allocating costs by product/group. Also, it may be difficult to ascertain the specific products or product mix sold by the comparable companies based on publicly available information.

In some cases, however, it may be necessary to segregate certain product groups for the purpose of testing profitability given significant differences in functional profile. For example, an MNEs OTC business may be managed separately from the prescription business given the different needs (e.g., mass consumer advertising), and a separate TP policy may be applied.

Transfer Pricing Adjustments

The TP policy applied for determining the related pricing for the sales entities in the MNE commonly involves targeting a certain profitability level on an aggregate basis wherein the target profitability level is within the arm’s length range. Adjustments to the pricing during the year or year-end may be necessary to achieve the target profitability level. The Thai corporate tax and customs/VAT implications of these pricing adjustments should also be considered carefully to avoid or mitigate any exposures.

Pillar One Amount B and Thai Pharma

Given the difficulty in benchmarking the returns for the Thai pharma distributors, one potential solution would be the adoption of Pillar One Amount B, included in the OECD’s BEPS[5] Action 1 by the Thai Revenue Department. This attempts to simplify transfer pricing compliance for certain routine distribution and marketing activities by providing acceptable levels of return on sales for these activities and thereby avoiding the need to perform the benchmarking study.

To apply the Amount B approach, the distribution business will need to demonstrate that the activities performed are routine (e.g., the distributor does not contribute any unique and valuable intangibles). In addition, quantitative criteria will be applied wherein the ratio of annual operating expenses to annual net revenues of the distributor must be within a range between 3% and an upper bound of between 20% and 30%, based on a three-year average.

The OECD has produced a global dataset of independent parties that undertake routine marketing and distribution activities. This dataset has been used to develop a global pricing matrix to approximate arm’s length returns based on return on sales. The relevant return will depend on the “factor intensity classification,” which relies on the net operating asset intensity (OAS) ratio and operating expense intensity (OES) ratio. The return on sales for pharma distribution ranges from 1.75% to 5.0 %, with the specific return to be applied depending on the OAS and OES ratios.

There is, however, a potential question on whether Amount B would apply to pharma distributors in Thailand given the need to obtain import and distribution license from the Thai FDA. The OECD guidance on Amount B[6] indicates that where a regulatory license is required to access a market, then this may be regarded a unique intangible that would make the application of the prescribed returns to the Thai distributor inappropriate. However, further analysis would be required on the nature of the license, including whether it is readily available and has the impact of restricting competitors in the market.  Also, the contribution of the Thai distributor versus other related parties in obtaining the license would need to be considered.

The adoption of Pillar One Amount B is optional. Whilst Thailand appears to be taking a wait-and-see approach, countries like Australia, Japan, and New Zealand have already publicly indicated that they will not adopt it.

Conclusion

The global pharmaceutical sector faces unique transfer pricing challenges due to its high profitability, driven by significant R&D investments, patent protections, and marketing intangibles. Tax authorities, including Thailand's Revenue Department, closely scrutinize pharma MNEs to ensure profits are allocated between group entities based on value creation. Thai pharma distributors must clearly document their role in the MNE value chain and account for local value-added marketing in transfer pricing analysis, even if classified as routine distributors.TP pricing adjustments may be required during the year or at year-end to ensure that the arm’s length profitability target for the local distributor is achieved. The Thai corporate tax and customs/VAT implications of these adjustments should be considered carefully to avoid or mitigate potential exposures. The Thai Revenue Department’s position on Pillar One Amount B should be monitored closely given the potential significant impact for pharma distributors if adopted.

[1] Fred Ledley et al., “Profitability of Large Pharmaceutical Companies Compared With Other Large Public Companies,” JAMA, March 3, 2020. 

[2] Shingo Yamaguchi et al., “Approval success rates of drug candidates based on target, action, modality, application, and their combinations,” Clin Transl Sci., May 2021.

[3] “How long does it take to develop a new drug?” MatchTrial Blog, August 25, 2020.

[4] “Profitability of Large Pharmaceutical Companies Compared With Other Large Public Companies.”

[5] Base Erosion and Profit Splitting

[6] “Pillar One – Amount B,” Section 3.3.1, Clause 21, OECD, February 19, 2024.