TAX PRACTICE                                ®                                                                             ...
COMMENTARY / TAX PRACTICEthe ultimate consumer or user’’5 should consider                        diagnostic ultrasound pro...
COMMENTARY / TAX PRACTICEmay be impractical. There are more than 5,630 FDA                        imposes the tax on uses ...
COMMENTARY / TAX PRACTICE   from retail prices or by building up from cost                         use of property before ...
COMMENTARY / TAX PRACTICEmore complex. Therefore, manufacturers, produc-ers, and importers of medical devices would be wel...
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E and Y Tax Notes: Medical Device Tax 11 21 2011


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Estimated at $20B, the Medical Device Tax was included in the Affordable Care Act that was signed into law in 2010. The amount is based on a 2.3% excise tax that will be levied on the total revenues of a company, regardless of whether a company generates a profit, starting in 2013.

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E and Y Tax Notes: Medical Device Tax 11 21 2011

  1. 1. TAX PRACTICE ® tax notesMaking Sense of the New Excise likely will not increase reimbursements to cover it, and the federal government pays for more than halfTax on Medical Devices of all medical devices through Medicare, Medicaid, By Christopher J. Ohmes and the Veterans Administration, and the Department of Michael Udell Defense. Given the magnitude of technological advances, the rapid pace of innovation, and the complex Christopher J. Ohmes is a partner and Michael Udell is a supply chains within the medical device industry, it senior manager in Ernst & should be no surprise that the industry’s manufac- Young’s National Tax Office in turing and marketing processes do not fit neatly Washington. The views ex- within the existing rules applicable to manufactur- pressed in this article are the ing excise taxes. There are several issues that need authors’ own and do not repre- to be addressed. sent the views of Ernst & Young LLP. Who Pays the Tax? Christopher J. Ohmes Manufacturers and import- The MDET is imposed ‘‘on the sale of any taxable ers of medical devices will medical device by the manufacturer, producer, or need to be prepared by January importer.’’ Many elements of the Food and Drug 1, 2013 to implement a new 2.3 percent excise tax on sales and Administration’s definition of manufacturing align taxable uses of medical devices. with the tax definition of manufacturing.2 Given This article describes how the that the FDA rules treat as a manufacturer anyone tax will operate and highlights ‘‘who manufactures, prepares, propagates, com- many issues that medical de- pounds, assembles, or processes a device by chemi- Michael Udell vice companies will need to cal, physical, biological or other procedures,’’3 resolve to comply with it. taxpayers undertaking those activities may be sub- Copyright 2011 Ernst & Young LLP. ject to the MDET on their sales of medical devices.4 All rights reserved. As a result, FDA-regulated manufacturers are likely to be manufacturers for purposes of the MDET.Introduction Owners and operators of FDA ‘‘establishments’’ The healthcare reform law included, within the or ‘‘facilities’’ involved in the production and dis-revenue raisers, a new 2.3 percent manufacturers tribution of medical devices intended for use in theexcise tax on medical device sales. This new excise United States must also consider the MDET. Indeed,tax applies to sales (and uses that are treated as any manufacturer or importer of medical devicessales) occurring after December 31, 2012. Once fully subject to the FDA establishment registration proc-implemented, this tax is projected to raise $2.7 ess should consider the extent to which this new taxbillion or more annually. For manufacturers, pro- may apply to it.ducers, and importers of medical devices,1 the Also, a party that ‘‘furthers the marketing of aliability for this new tax likely will be a material device from a foreign manufacturer to the personitem. who makes the final delivery or sale of the device to Also, the medical device excise tax (MDET) mayresult in substantial economic disruptions withinthe medical device manufacturing industry. By way 2of example, determining the incidence of this tax For purposes of this article, we are relying on the definition of manufacturing in the relatively recent and extremely com-will be complicated because government programs prehensive regulations defining manufacturing for purposes of the foreign base company sales rules of subpart F set forth in T.D. 9438, Doc 2008-27115, 2008 TNT 249-5. 3 21 C.F.R. section 806.2(g). 1 4 These taxpayers will be referred to collectively as ‘‘manu- Some assembly activities, however, may not rise to the levelfacturers’’ throughout this article. of manufacturing for tax purposes.TAX NOTES, November 21, 2011 12
  2. 2. COMMENTARY / TAX PRACTICEthe ultimate consumer or user’’5 should consider diagnostic ultrasound products, X-ray ma-the manner in which the MDET applies to im- chines and medical lasers.8porters. Given the broad language in section 4191, manu- However, it is unclear whether taxpayers that facturers would be wise to begin from the assump-bundle their medical devices with devices manufac- tion that all their medical device sales will generatetured by others will be treated as engaged in a liability for the MDET. Manufacturers will then need to consider the application of a handful ofmanufacturing by the FDA and therefore subject to exclusions. Determining how to implement the ex-the MDET.6 The FDA includes in its definition of clusions for specific medical devices sold primarilymanufacturing the preparation of kits consisting of at retail, for export, and for further manufacturingboth medical devices and other articles, whether will entail substantial complexity.combined by the medical device manufacturer oranother party. But that type of activity may not be The retail sales exclusion. Section 4191(b)(2)manufacturing for tax purposes. Further guidance specifies that eyeglasses, contact lenses, and hearingon this issue will be necessary. aids are exempt from the definition of taxable medical devices. Also, section 4191(b)(2)(D) del- More guidance will be required for contract egates to Treasury the authority to exempt frommanufacturing arrangements. The FDA definition taxable medical devices any medical device ‘‘deter-treats a taxpayer that ‘‘initiates specifications for mined by the Secretary to be of a type which isdevices’’ as a manufacturer, even when the activi- generally purchased by the general public at retailties of physically transforming raw materials into a for individual use.’’medical device are performed by someone else. For Arising out of a desire to hide the cost of thistax purposes, merely designing an article, does not newly enacted tax from individual consumers ofmake a taxpayer a manufacturer. medical devices, the exclusion for devices soldWhat Devices Will Be Subject to the Tax? primarily at retail will be the most complex of the MDET exclusions to implement. Several important The MDET is imposed on the sale of ‘‘any taxable questions arise from the limits set forth in thismedical device.’’ Taxable medical devices are de- exclusion:fined with reference to section 201(h) of the Federal • How is the general public defined?Food, Drug, and Cosmetic Act. Unlike some of the • Is the fact that a device is available only byproposed but not enacted versions of the tax, all prescription relevant?medical devices may be subject to the enacted • Is the fact that a device is designed to beMDET, without regard to whether they are classi- administered only by a healthcare professionalfied into one of the three major medical device taken into account? What if it is not adminis-classifications (classes 1, 2, and 3).7 tered by a professional? Many healthcare products we use regularly are • Should devices labeled ‘‘over the counter’’ ormedical devices, including toothbrushes, bandages, ‘‘for home use’’ be deemed to be sold at retail?feminine hygiene products, and wheelchairs. Medi- • Does it matter who pays for the use of thecal devices are an essential component of the deliv- device?ery of healthcare services. According to the FDA: • What volume of sales determines when a de- vice is ‘‘generally purchased’’? Medical devices range from simple tongue • What if a particular taxpayer sells a device type depressors and bedpans to complex program- solely through retail channels, but competitors mable pacemakers with micro-chip technol- sell both through retail and to hospitals? ogy and laser surgical devices. In addition, While forthcoming guidance likely will address medical devices include in vitro diagnostic those definitional elements, a more complicated products, such as general purpose lab equip- policy question may arise in choosing the mecha- ment, reagents, and test kits, which may in- nism used to implement the exclusion. Although clude monoclonal antibody technology. Congress envisioned that this retail sale exclusion Certain electronic radiation emitting products would be implemented through an item list,9 that with medical application and claims meet the definition of medical device. Examples include 8 See dicalProcedures/default.htm (last updated Oct. 12, 2011). 5 9 21 C.F.R. section 807.3(g). Joint Committee on Taxation, ‘‘Description of Revenue 6 Id. Provisions Contained in the President’s Fiscal Year 2011 Budget 7 Medical device classifications are set forth in title 21 of the Proposal,’’ JCS-2-10 (Aug. 16, 2010), Doc 2010-18224, 2010 TNTCode of Federal Regulations, pts. 862-892. 158-13, contains the following statement: ‘‘It is anticipated that (Footnote continued on next page.)13 TAX NOTES, November 21, 2011
  3. 3. COMMENTARY / TAX PRACTICEmay be impractical. There are more than 5,630 FDA imposes the tax on uses of taxable articles. Thus, asproduct codes for medical devices. Eyeglasses, con- currently structured, the MDET applies to use in thetact lenses, and hearing aids, which are tax-exempt performance of research, to charitable contribu-by statute, constitute 25 of them. Thus, Treasury tions, and to the common practice of lending ofand the IRS would need to address more than 5,600 tools. Valuation in those situations will, of course,device types to promulgate a list. We estimate that be problematic.of those, roughly 266 may be eligible for the retailsales exclusion depending on how the limits of the Rental and leasing transactions also trigger aexclusion are defined. No matter how the defini- liability for the tax, although the tax is generallytional questions are resolved, to derive a list, Trea- spread out and collected along with the rentalsury and the IRS will need a great deal of payments. Under section 4216, each transactioninformation that is not publicly available for all whereby a taxable article is rented to a customer isthese device types. Moreover, even if the data were treated as a use, and the tax is imposed on theavailable, it would take a significant amount of element of the rental payment that relates to the useeffort to characterize the data by the ‘‘general of the taxable article. That particular rule will createpublic,’’ ‘‘individual use,’’ and ‘‘retail’’ filters and valuation difficulties in arrangements under whichthen apply whatever definition of the phrase ‘‘gen- medical device manufacturers provide for the useerally sold’’ is to be used. of a medical device in conjunction with services Other exclusions. The MDET is structured to such as training.apply only once to a medical device sale. Sales of Some lease transactions are afforded specialmedical devices for further manufacturing are ex- treatment, whereby the entry into the lease isempt in accordance with the section 4221 manufac- treated as a sale and the tax on the device is appliedturing excise tax rules. It is anticipated that the IRS’s to each lease payment until a ceiling amount of tax,exemption certificate system under those rules will computed as if the tax had arisen at the outset, isbe used for purposes of the MDET. Obviously, reached.11 That treatment is available only to manu-buyers and sellers will need to agree on when this facturers that both lease medical devices and sellexemption applies, which means medical device the same (or substantially similar) medical devicesmanufacturers will have to consider the implication to unrelated customers.12of this exclusion within their supply chains. Also, export sales are exempt, as are sales to a How Is the Tax Measured?reseller that acquires a medical device for export.Taxpayers will need to be able to identify medical Because the MDET is a manufacturers excise tax,devices that are intended for export at the end of it is designed to be levied not on the retail price ofmanufacturing to avoid paying the MDET and later a taxable device, but on its wholesale price.13 Con-seeking a refund. gress offers a good explanation of the pricing para- Additional considerations. Another important digm in its discussion of the operation of the truckconsideration is that some exclusions that often excise tax pricing rules:apply to excise taxes do not apply for purposes of Consequently, the bill requires that every ef-the MDET. Accordingly: fort be made to ascertain the manufacturers’ or • the MDET applies to sales to nonprofit and producers’ price at the place of manufacture or tax-exempt purchasers; production. In the case of those commodities • the MDET applies to sales to federal, state, and which are ordinarily sold at wholesale, this local governmental entities; and price will be the price at which the manufac- • the MDET applies to sales for resale. turer sells to the wholesaler, even though theHow Is the Tax Triggered? particular sale is at retail. This price may be As with other manufacturers excise taxes, the established with respect to any particular saleMDET attaches to the first sale of a taxable medical or class of sales, for example, by existingdevice by a manufacturer or importer in the United wholesale prices, or by a system of discountsStates.10 Thus, the tax is structured to apply once toa finished medical device. In situations in which thefinished article is used rather than sold, section 4218 11 It appears that a lease-by-lease accounting mechanism would be necessary to compute this ceiling and apply MDET payments collected during the lease term. 12 The application of the lease rule to the medical devicethe Secretary will publish a list of medical device classifications industry is likely to be very limited because it is unusual withinthat are of a type generally purchased by the general public at the industry to both lease directly and sell the same articles. 13retail for individual use.’’ See Hoffman Motors Corp. v. United States, 473 F.2d 254, 256 10 See Indian Motorcycle Co. v. United States, 283 U.S. 570 (1931). (2d Cir. 1973).TAX NOTES, November 21, 2011 14
  4. 4. COMMENTARY / TAX PRACTICE from retail prices or by building up from cost use of property before December 31, 2012, will of production, whichever method may be the permit ongoing revenue streams to be exempt; most practical.14 • how a lease is defined and which rental ar- Given the technological complexity and sophis- rangements are treated as leases; andtication of today’s medical devices, manufacturerscommonly distribute their products through related- • whether to respect transactions between re-party distribution arrangements. In related-party lated parties.situations like those, measuring and substantiating Implications and Unintended Consequencesthe price on the sale from the manufacturing entityto the distribution entity may complicate compliance Congress adopted this new 2.3 percent excise taxwith the MDET. Also, the IRS can be expected to on domestic medical device sales (and uses) to payscrutinize related-party distribution arrangements, for healthcare reform. However, this new tax couldand it has at its disposal a series of antiabuse pricing have several unintended consequences. It has beenrules it can apply.15 suggested that this tax might merely be added to the invoice price of taxable medical devices andHow Will the Tax Be Paid? passed along to customers in a manner similar to, The new tax will be paid semimonthly based on for example, the manufacturers excise tax on tires.sales occurring during the preceding two weeks. However, because Medicare and Medicaid, the Vet-The first payment of tax will be due January 28, erans Administration, and the Department of De-2013, for sales through January 14, 2013. We antici- fense pay for the majority of the medical devicepate that the IRS will modify Form 720, ‘‘Quarterly sales and uses in the United States, a simpleFederal Excise Tax Return,’’ to accommodate the passthrough seems unlikely. Manufacturers may tryneed for quarterly reporting of the MDET. to push the tax back onto their suppliers or try to Because this tax is completely new, taxpayers will reduce their operating costs in response to this newneed to design, develop, and test entirely new tax.compliance procedures for it. In developing theprocedures, taxpayers will have to identify and Also, there may be pressure to limit taxabledevelop processes, fulfill manpower needs, train medical device sales as companies seek to unbundlepeople, document procedures, and establish and arrangements consisting of both the use of propertytest controls. Moreover, mechanisms will need to be and services and to modify the item defined as acreated to identify, extract, and manipulate the data medical device to determine whether componentto ensure compliance. Because that data are often parts can be excluded from the medical deviceunavailable, most manufacturers subject to the definition. For example, is it possible to exclude aMDET will need to evaluate changes to their data keyboard used to initiate the operation of a pro-processing systems as they seek to implement the cedure from the definition of a medical device? ThisMDET. response could be complicated, because the act of unbundling some components to avoid federal ex-Questions, Questions, Questions cise tax may expose a previously exempt medical Section 4191 leaves many unanswered questions, device to additional state and local sales taxes.which Treasury may address in regulations or otherguidance. In addition to the question of exemptions, In some cases, medical devices that are profitablyguidance will be necessary on: manufactured in the United States may no longer be • the definition of manufacturing (as it applies to sold profitably. The profitability of some rental assembly, bundling, warranty work, and re- arrangements likely will be substantially reduced. It manufacturing) that applies to determine who is also possible that captive U.S. manufacturing is liable for the tax; arrangements may become uncompetitive in com- • how to determine sales prices in an industry in parison with the importation of a similar good. As which complex contractual arrangements pro- the January 1, 2013, effective date of the tax ap- vide for a variety of allowances and rebates; proaches, medical device manufacturers may need • what value should be applied to uses treated as to consider that the MDET may simultaneously sales of medical devices; create tension within distribution channels and • whether existing rental streams and leases give supply chains. rise to uses treated as new sales, or whether the Although bills have been introduced to repeal the MDET, it is highly unlikely that it will be repealed before it goes into effect. Creating new 14 H.R. Rep. No. 72-708 (1939), reprinted in 1939-1 C.B. (Part 2) systems and procedures to ensure proper compli-457, 480. ance with this new tax will be demanding, but 15 See section 4216(b). determining how to respond to this tax will be even15 TAX NOTES, November 21, 2011
  5. 5. COMMENTARY / TAX PRACTICEmore complex. Therefore, manufacturers, produc-ers, and importers of medical devices would be welladvised to begin now to plan for the implementa-tion of the MDET.TAX NOTES, November 21, 2011 16