The Health Care and Education Reconciliation Act of 2010 (Health Care Act), P.L. 111-152, added new Sec. 4191, Medical Devices, to the federal excise tax subtitle of the Code, effective for sales of taxable medical devices after Dec. 31, 2012. Under this new provision, a tax equal to 2.3% of the sale price is imposed on the sale of any taxable medical device by the manufacturer, producer, or importer of the device. Taxpayers may face a number of unresolved issues in preparing to comply with the tax.
Taxable Medical Device
Under Sec. 4191(b)(1), a taxable medical device is a device, as defined in Section 201(h) of the Federal Food, Drug, and Cosmetic Act (FFDCA) (21 U.S.C. §321(h)), that is intended for humans. The latter provision defines “device” as an “instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent, or other similar or related article”—including “any component, part, or accessory”—that meets certain requirements. The device must be:
(1) Recognized in the official National Formulary, or the United States Pharmacopeia, or any supplement to them;
(2) Intended for use in the diagnosis of disease or other conditions, or in the cure, mitigation, treatment, or prevention of disease in man or other animals; or
(3) Intended to affect the structure or any function of the body of man or other animals.
The device must also “not achieve its primary intended purposes through chemical action within or on the body of man or other animals” and not depend “upon being metabolized for the achievement of its primary intended purposes.” Sec. 4191(b)(1) limits the definition for purposes of the tax to devices intended for humans.
Under what is commonly called the “retail exemption,” the tax provision does not apply to eyeglasses, contact lenses, hearing aids, and any other medical device determined by Treasury to be of a type that is commonly purchased by the general public at retail for individual use. As stated in the Joint Committee on Taxation’s Technical Explanation of the Revenue Provisions of the “Reconciliation Act of 2010 ,” as Amended, in Combination With the “Patient Protection and Affordable Care Act” (JCX-18-10), p. 138 (March 21, 2010), Treasury may determine that a specific medical device is exempt if the device generally is sold at retail establishments (including over the internet) to individuals for their personal use.
The exemption is not limited by device class as defined in Section 513 of the FFDCA (21 U.S.C. §360c). For example, items purchased by the general public at retail for individual use could include Class I items, such as certain bandages and tipped applicators; Class II items, such as certain pregnancy test kits and diabetes testing supplies; and Class III items, such as certain denture adhesives and snakebite kits. Such items would be exempt only if they generally are designed and sold for individual use. In this regard, Congress anticipated that Treasury will publish a list of medical device classifications that are of a type commonly purchased by the general public at retail for individual use.
Current excise tax exemptions for further manufacture and for export also apply to the tax imposed under Sec. 4191. However, traditional federal excise tax exemptions for use as supplies for vessels or aircraft, and for sales to state or local governments, nonprofit educational organizations, and qualified blood collector organizations do not apply. That is, the tax ordinarily will apply to sales of taxable medical devices to such organizations and for such uses.
In February 2012, the IRS issued proposed regulations (REG-113770-10) defining “taxable medical device” and implementing the retail exemption. The proposed regulations would affect significantly the manner in which industry members design and refine their electronic compliance systems to capture the information needed to meet the Jan. 1, 2013, effective date of Sec. 4191.
The proposed rules address a number of issues raised by comments made in response to Notice 2010-89 concerning the definition of taxable medical devices, the scope of the retail exemption, and related matters concerning the treatment of veterinary devices, devices that have both medical and nonmedical uses, research and investigational devices, kits and products combining more than one device or combining drugs or biological products with devices, and secondary devices and components sold with primary devices. The proposed regulations generally defer to the Food and Drug Administration’s registration rules for the definition of taxable medical devices and certain exemptions. In addition, the regulations set forth a set of nonexclusive factors to be examined in determining whether any medical device meets a two-prong, facts-and-circumstances test, as well as a safe harbor, both for purposes of the retail exemption.
The proposed regulations state that existing rules applicable to Code chapter 32 (manufacturers excise taxes) will apply to Sec. 4191. Accordingly, existing Sec. 4216(b) rules apply to constructive pricing for intercompany sales made other than at a fair market price. The proposed rules did not adopt comments made in response to Notice 2010-89 concerning transitional relief for sales contracts for medical software and information technology systems entered into before Jan. 1, 2013. Also, while the preamble mentions leases, it is not clear whether the tax will apply to Sec. 4217 lease payments received on or after Jan. 1, 2013, for taxable medical devices leased prior to Jan. 1, 2013, as only the Sec. 4216 installment payment rules are discussed.
Final regulations are expected to continue to follow a facts-and-circumstances approach to the definition of a taxable medical device. In addition, it is anticipated that the IRS also will address (1) factors and examples or safe harbors that could be added to provide greater certainty on the exclusion from the term “taxable medical device”; (2) whether the packaging and labeling of a taxable medical device, the terms and conditions of the manufacturer’s warranty with respect to a device, and substantial sales of a device over the internet would be meaningful factors in establishing whether the device qualifies for the retail exception and, if so, how such factors should be described and applied; (3) how devices that fall within the definition of “inexpensive equipment” in 42 C.F.R. Section 414.220(a)(1) would be identified in applying a specific factor within the taxable medical device facts-and-circumstances test; and (4) the extent to which combination products may be subject to the annual fee on branded prescription pharmaceuticals enacted along with the Health Care Act by the Patient Protection and Affordable Care Act, P.L. 111-148, and the mechanisms by which the combined effect of both the excise tax and the fee could be avoided.
In clarifying that the existing chapter 32 rules apply to taxable medical devices, the IRS has provided numerous pieces of guidance to industry members to answer questions ranging from constructive pricing to the allocation of price between associated services and the medical device itself. While the existing guidance should be useful to industry members in determining answers to chapter 32–related questions, it has not been updated in decades and may not apply directly to the diverse array of devices and the complicated supply chains currently found in the medical device industry. Consequently, industry members may want to consider requesting letter rulings on specific issues or applying for industry issue resolution program guidance. These processes may be particularly important in selecting a methodology to determine a fair market price or to elect a constructive price under existing revenue rulings when the first sale in the United States of a taxable medical device is an intercompany sale. Further, the constructive pricing rules may help to lower the tax base when sales are made at retail or to retailers.
The IRS Office of Chief Counsel may decline to issue Sec. 4216(b) letter rulings pending review of any comment letters on Sec. 4216(b) constructive pricing issues. The office has not yet announced whether it will issue letter rulings on taxable medical device exemptions after the rules are final. This ruling posture underscores the need to submit detailed comments on this issue, particularly concerning the use of transfer-pricing concepts as a surrogate for fair market price in the application of Sec. 4216(b).
Annette Smith is a partner with PwC, Washington National Tax Services, in Washington, D.C.
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