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Clinical Trial - From Frying Pan to ....

CA Pradip Shah 
on 04 July 2008

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[This article appeared in Taxmann’s “Service Tax Today” Vol. 7 Part 4 dt. 23-3-2007]
 
Budget 2007-08: Clinical Trial - From Frying Pan to ……
CA. Pradip R Shah
[Executive Summary: Is proposed exemption to clinical trial of new drugs from service tax, a boon or bane? The question may sound absurd, as an exemption has to be a welcome step. However, after examining the existing provisions in this respect, industry scenario, proposed amendments and their impact on Clinical Research Organisations (CRO), the author points out that there is no doubt that India possesses huge potential in this field and its rich diversity can help both in the field of research, growing employment and more revenue to the government. One would have expected the Government to provide relief in such a way that it really helped in terms of lower tax liability and handling of less paper work. However, it appears that the proposed amendment will work exactly in the other way.]
 
Budget Speech:
1   While presenting the Budget in the Parliament the Finance Minister stated “To make India a preferred destination for drug testing, I propose to exemptclinical trial of new drugs from service tax.” [Para 157]. (emphasis supplied). For a moment, Clinical Research (CR) industry heaved a sigh of relief, for being out of clutch of service tax net. However, it was a short-lived relief for the reason that, though it appears to be a boon may, perhaps, turn out to be a bane. Let us try to understand the existing provisions in this respect, industry scenario, proposed amendments and its impact on Clinical Research Organisations (CRO).
 
EXPLANATORY NOTES - SERVICE TAX
2   Explanatory notes to Budget 2007-08 reads as follow:
(4) Exemption from service tax is being provided to technical testing and analysis services provided in relation to testing of newly developed drugs including vaccines and herbal remedies on human participants by a clinical research organisation approved to conduct clinical trials by the Drugs Controller General of India. [refer notification No. 11/2007-Service Tax dated 01.03.2007](emphasis supplied)
 
Notification No. 11/2007-Service Tax 10 dt. 1st March, 2007
3   Notification issued in this respect reads as follow:
G.S.R. (E). - In exercise of the powers conferred by sub-section (1) of section 93 of the Finance Act, 1994 (32 of 1994), the Central Government, on being satisfied that it is necessary in the public interest so to do, hereby exempts the taxable service, specified in sub-clause (zzh) of clause (105) of section 65 of the said Finance Act, provided or to be provided by a Clinical Research Organization approved to conduct clinical trials by the Drugs Controller General of India, in relation to testing and analysis of newly developed drugs, including vaccines and herbal remedies, on human participants so as to ascertain the safety and efficacy of such drugs on human participants, from the whole of the service tax leviable thereon under section 66 of the said Finance Act. [F. No. 334/1/2007-TRU] (emphasis supplied).
 
Circular D. O. F. No. 334/1/2007-TRU dt. 28-2-2007
4   Circular issued by the Service Tax Department explaining the proposed amendment reads as follow:
8.4 Clinical trial of new drugs undertaken by Clinical Research Organisation (CRO) is presently leviable to service tax under technical testing and analysis service [section 65(105)(zzh)]. Clinical trial of new drugs and the organisations undertaking clinical research are approved by the Drugs Controller General of India. Exemption from service tax is being provided to technical testing and analysis service provided in relation to testing and analysis of newly developed drugs on human participants by a CRO. New drugs include vaccines and herbal remedies. [Notification No. 11/2007-Service Tax dated 01.03.2007] (emphasis supplied).
 
Existing Provisions:
5   S. 65(105)(zzh) of the Finance Act defines “technical testing and analysis” service as taxable service provided or to be provided to any person, by a technical testing and analysis agency, in relation to technical testing and analysis. S. 65(106) defines as follow:
 
(106)   “technical testing and analysis” means any service in relation to physical, chemical, biological or any other scientific testing or analysis of goods or material or any immovable property, but does not include any testing or analysis service provided in relation to human beings or animals.
 
Explanation.—For the removal of doubts, it is hereby declared that for the purposes of this clause, “technical testing and analysis” includes testing and analysis undertaken for the purpose of clinical testing of drugs and formulations; but does not include testing or analysis for the purpose of determination of the nature of diseased condition, identification of a disease, prevention of any disease or disorder in human beings or animals;(emphasis supplied).
 
Analysis of the existing provisions:
6   An analysis of clause 106 will show that it covers analysis of all the goods and material. There is no reference to “new drugs”, no distinction is being made between testing and analysis of “new” and “old”. Thus, ST is levied on the entire range of services i.e. both in respect of new drug and old one (also known as generic drug).
 
Proposed provisions:
7   Looking to Budget Speech, Explanatory Notes, Notification issued there is no doubt that the exemption is granted with specific idea in mind i.e. services provided with reference to “new drugs”.
 
Secondly, it should be noted that there is no proposal to delete the provisions viz. 65(105)(zzh) and 106 from the statute book. Thus, there is complete clarity in this regard that, out of various activities carried on by the CROs, only the services with reference to “new drugs” are being made exempt. It means that the exemption granted is partial i.e. applicable to a certain portion of the activities carried on and not to all the services rendered by CROs. Therefore, services related to “generic drugs” will continue to be taxable.
 
Whether services to new drugs are taxable?
8   As made out in the speech, the objective is to make India a preferred destination for drug testing, implying thereby that the Government proposes to make export of services in this respect competitive and promote Indian CROs. Looking at the existing scenario and the provisions under the service tax, it appears that instead of promoting the CROs, the proposed provisions will create more problems and, perhaps in many cases, turn out to be loosing proposition as claim for Input Tax Credit (ITC) will get restricted.. This can be well appreciated if we have a look at large number of laboratories rendering services, profiles of services rendered and their contribution in total value addition.
 
At present, majority of the laboratories carrying out clinical trial and testing are rendering services for new as well as generic drugs. In fact, substantial volume of work is derived from local pharmaceuticals companies for generic drugs, known as Bioavailability (BA) and Bioequivalence (BE) studies. Looking from geographical perspective, services are also being rendered for clinical trial popularly known as Phase-I, II and III trials, both to Indian and foreign pharmaceuticals companies. Tax implications in respect of each of them can be appreciated from the following table.
 
Existing Scenario under Service Tax Regulations

 
 
Types of Services
New Drugs
Generic Drugs
A
B
C
D
Services rendered to
Phase-I, II and III
Bioavailability
Bioequivalence
1
Local Pharmaceutical Companies
Taxable subject to full ITC
Taxable subject to full ITC
Taxable subject to full ITC
2
Export of Services to foreign companies
No tax to be paid. Full ITC available.
No tax to be paid. Full ITC availa­b­le.
No tax to be paid. Full ITC availa­ble.

 
As can be seen from above SP is entitled for full ITC in respect of all the activities i.e. new drugs and generic and also services made available locally and export as well.
 
9   Under the Rule 4 of existing provisions of Export of Services Rules, any service, which is taxable under clause (105) of section 65 of the Act, may be exported without payment of service tax. It means that the service tax provider is permitted to have deduction of ITC to the full extent i.e. without any restriction. However, with the proposed amendment the whole scenario will change. In view of exemption of the services related to new drugs the service provider will face problems from various fronts. The SP either will have to maintain separate records for input services for taxable and exempt output services or to keep restricted claim for ITC at 20.00% of the out put tax payable. Even in the second alternative i.e. where separate records are not maintained and ITC is utilized to the extent of 20.00% only, ITC on input services used exclusively for exempt service cannot be claimed.
 
10 Let us have a look at Rule 6(2) of CENVAT Credit Rules. It reads as follow:
 
“(2) Where a ….. provider of output service avails of CENVAT credit in respect of any inputs or input services and …..provides such output service which are chargeable to duty or tax as well as exempted …. or services, then, ….. the provider of output service shall maintain separate accounts for receipt, consumption and inventory of input and input service meant for use …… in providing output service and the quantity of input meant for use in the …exempted …. services and take CENVAT credit only on that quantity of input or input service which is intended for use in the … in providing output service on which service tax is payable.” (emphasis supplied)
 
11 As can be seen from the above, the SP can avail ITC in respect of those services only which are utilized for providing service on which tax is payable. It means that the SP will have to classify various input services into two categories viz. services meant for new drugs and others.
 
12 In day-to-day life, it is not possible to classify all the services on the line as prescribed above. Not only that, large number of input services will be common, making it impossible to segregate between services related to new drugs and generic. Therefore, the service provider will have no option but to follow the provisions of rule 3 which reads as follow:
 
“(3) Notwithstanding anything contained in sub-rules (1) and (2), …. the provider of output service, opting not to maintain separate accounts, shall follow either of the following conditions, as applicable to him, namely:—
   (a) if the exempted goods are—
………….
   (c) the provider of output service shall utilize credit only to extent of an amount not exceeding twenty per cent of the amount of service tax payable on taxable output service.
Explanation I.—………..
Explanation II.— ………
Explanation III.—For the removal of doubts, it is hereby clarified that the credit shall not be allowed on inputs and input services used exclusively for …… exempted services.” (emphasis supplied)
 
13 It should be noted that the SP has not been given any choice. The moment he renders services in respect of new drugs, provisions regarding exemption and all other related regulations as referred to above will follow automatically. Thus, with the services in respect of new drug being made exempt, SP providing services for both the new and generic will be left with no choice but to follow the provisions of Rule 3 i.e. to keep claim for ITC restricted to twenty per cent of the amount of service tax payable on taxable output service. For the balance amount of credit, the claim will have to be carried forward and to be claimed in the next period.
 
Boost to Export of services?
14 The FM has proposed the amendment with the noble intention of making India a preferred destination for drug testing. Can it really help so? We have already seen impact on SP with respect to limited claim for ITC. Let us see its impact on services exported in respect of generic drugs.
 
In the field of export of services in the area of generic drugs i.e. services known as BA and BE, no tax is payable today as provided in Rule 4 of Export of Services Rules. However, ITC in respect of such services get absorbed against local tax liability. With the proposed amendment, there may not be any change in the nature of claim for ITC for export of BA and BE services. However, it may so happen that ITC may get accumulated due to restriction on claim being limited to 20.00% of tax liability. Thus, the proposed amendment will indirectly hit the SP.
 
15 Tax liability after the proposed amendment can be summarized as follow:
 
Scenario after the exemption for services related to New Drugs

 
 
Types of Services
New Drugs
Generic Drugs
A
B
C
D
Services rendered to
Phase-I, II and III
Bioavailability
Bioequivalence
1
Local Pharmaceutical Companies
Tax Exempt- No ITC
Taxable subject to ITC restricted to 20.00% of ST payable
Taxable subject to ITC restricted to 20.00% of ST payable
2
Export of Services to foreign companies
Tax Exempt- No ITC
No tax payable. ITC restricted to 20.00% of ST payable.
No tax payable. ITC restricted to 20.00% of ST payable.

 
Conclusion:
16 There is no doubt that India possesses huge potentiality in this field and its rich diversity can help both in the field of research, growing employment and more revenue to the Government. One would have expected the Government to provide relief in such a way that it really helps in terms of lower tax liability and handling of less paper work. However, it appears that the proposed amendment will work exactly in the other way.



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