Update on the Medical Device Excise Tax

Editor: Michael D. Koppel, CPA/PFS/CITP, MSA, MBA

Excise Taxes

Section 1405 of the Health Care and Education Reconciliation Act, P.L. 111-152 (which amended the Patient Protection and Affordable Care Act, P.L. 111-148), provides that any “manufacturer, producer, or importer” of taxable medical devices must pay a tax equal to 2.3% of the sale price of the medical device. Sec. 4191 imposes the tax on all sales of taxable medical devices after Dec. 31, 2012. The medical device industry has made numerous requests to repeal the tax, arguing that it may jeopardize jobs or force companies to scale back critical research.

The tax is assessed regardless of a company’s profitability. Further compounding the issue, companies might not be able to pass on the cost of the tax to group purchasing organizations (GPO) and integrated hospital networks if those customers can resist paying the additional cost or any proposed price increases.

The IRS issued final regulations in December 2012 (T.D. 9604) and issued interim guidance with Notice 2012-77. On Feb. 3, the IRS posted “Medical Device Excise Tax: Frequently Asked Questions.”

A “taxable medical device” is defined as any device covered under Section 201(h) of the Federal Food, Drug, and Cosmetic Act (FFDCA), P.L. 75-717, that is intended for use by humans. These devices are listed with the U.S. Food and Drug Administration (FDA) under Section 510(j) of the FFDCA. This includes all biologic devices that are listed with the FDA. Section 201(h) of the FFDCA defines “device” as an “instrument, apparatus, implement, machine, contrivance, implant, in vitro reagent, or other similar or related article.” All such devices are subject to the excise tax unless a specific exemption applies.

Statutory exemptions are provided for eyeglasses, contact lenses, and hearing aids. Exemptions are also provided for devices generally purchased by the general public at retail for personal use, such as home-use lab tests, over-the-counter devices, prosthetic and other orthotic devices not requiring insertion by a medical professional, therapeutic shoes, etc. The excise tax does not apply to devices exported or destined for export outside the United States or for devices sold for further manufacturing.

The so-called retail exemption applies to any medical devices that are “regularly available for purchase and use by individual consumers who are not medical professionals, and if the design of the device demonstrates that it is not primarily intended for use in a medical institution or office or by a medical professional” (Regs. Sec. 48.4191-2(b)(2)). The retail exemption includes devices bought over the internet or by telephone that are not otherwise FDA Class III devices (those not of a type generally purchased by the general public at retail for individual use), although the retail exemption is not limited by FDA device classification.

Fifteen examples of exempt and nonexempt devices are provided by the IRS (Regs. Sec. 48.4191-2(b)(2)(iv)). The examples and related guidance conclude that devices that fall within the retail exemption and are not subject to the excise tax include nonsterile absorbent-tipped applicators, adhesive bandages, snake bite suction kits, denture adhesives, pregnancy test kits, blood glucose monitors, prosthetic legs, mechanical and powered wheelchairs, portable oxygen concentrators, urinary ileostomy bags, and therapeutic alternating-current-powered adjustable home-use beds. Examples of devices that do not fall within the retail exemption and are therefore subject to the excise tax are mobile X-ray systems, nonabsorbable silk sutures, nuclear magnetic resonance imaging systems, and powered flotation therapy beds.

The preamble to the final regulations also makes clear that certain dental devices that are customized for individual patients, such as crowns and bridges, may be subject to the excise tax, as requests for a special rule exempting such devices were denied. However, the preamble further states that customized dental devices may qualify for the exemption if, based on all the facts and circumstances, they are of a type generally purchased by the general public at retail for individual use.

The interim guidance also addresses medical convenience kits (two or more devices enclosed in a single package for the convenience of health care professionals or end users). Pending further guidance, the excise tax does not apply to the sale of any domestically produced convenience kits. However, it will apply to any taxable medical device that goes into the medical convenience kits, meaning that producers will need to allocate costs to determine the ultimate sale price of the medical device subject to the new tax.

Letter Ruling 201351002 dealt with a company that produced convenience kits assembled abroad, sometimes containing taxable medical devices that were also manufactured abroad. The ruling held that since the U.S. company retained title to the devices, it was the “producer” of the convenience kits assembled abroad, making them “domestically produced” convenience kits. However, any medical device similarly produced by the company and included in the convenience kit was subject to the excise tax.

Under the interim rules in Notice 2012-77, until further guidance is issued, the medical device tax is imposed on the sale of a convenience kit by an importer. However, in the case of an imported convenience kit in which taxable articles and nontaxable articles are sold together in the kit, the tax applies only to that portion of the importer’s sale price allocable to the taxable articles. In cases in which the items in the convenience kit are also sold separately, the taxable portion of the kit is determined by taking the ratio that the separate sale price of the taxable articles bears to the sum of the sale prices of both the taxable and nontaxable articles and applying it to the manufacturer’s sale price of the kit. In cases in which the items in the convenience kit are not sold separately, this is calculated by comparing the actual costs of the items in the convenience kit. For example, if the cost of the taxable article is 60% of the total cost of the kit, then the excise tax will apply to 60% of the sale price charged by the manufacturer for the convenience kit.

The regulations state that the manufacturer, producer, or importer making the sale of the taxable medical device is liable for the tax imposed under Sec. 4191(a) and Regs. Sec. 48.4191-1(c). This point was confirmed in an early court case in this area. In Chemence Medical Products, Inc. v. Medline Industries, Inc.,No.1:13-CV-500-TWT (N.D. Ga. 12/4/13), a district court held that Chemence, the manufacturer, rather than the distributor, Medline Industries Inc., was responsible for paying the excise tax.

In Letter Ruling 201420004, released on May 16, 2014, the IRS held that a contract manufacturer, Company 1, which produced a medical device for Company 2 under a license agreement, and where all intellectual property rights related to the medical device remained with Company 2, was not the manufacturer for purposes of the excise tax.

A sale creating liability for the excise tax occurs when title to the device passes from the manufacturer to the purchaser. This includes any installment sales. Also, for purposes of the medical device excise tax, a lease is considered a sale. In addition, a medical device used as a demonstration product may also create a liability for the excise tax under certain circumstances.

Many medical device companies sell their products to stocking distributors or to contractors/representatives that sell directly to hospitals. This is a blended distribution model and requires the company to make some detailed calculations. The IRS interim guidance provides rules for determining the constructive purchase price upon which the tax will be based. Special rules apply to sales to related parties or affiliates (see Secs. 4216(b)(3) and (4) and Notice 2012-77).

It is important to note that the sale price for calculating the excise tax does not include the excise tax itself; the actual cost of transportation, delivery, installation, or insurance; discounts, rebates, and similar allowances granted to the purchaser; local advertising charges; or charges for a warranty paid at the purchaser’s option. Medical device companies generally include the excise tax in their cost of sales and then deduct it for tax purposes.

A company pays the excise tax by filing Form 720, Quarterly Federal Excise Tax Return. Each company must file its own Form 720; the regulations do not allow an affiliated group of corporations to file a consolidated return for purposes of paying the excise tax. Semimonthly deposits of the tax must be made—on the 15th and last day of each month—in all instances where the tax liability is expected to exceed $2,500 for the quarter. Form 720 is filed with the IRS quarterly and is due on the last day of the month following the end of the quarter. In general, a company must make deposits through the Electronic Federal Tax Payment System (EFTPS) (which requires the transaction to be initiated at least one day before the due date). Companies that expect to have sales that are exempt from the excise tax, such as export sales, are required to register with the IRS using Form 637, Application for Registration (for Certain Excise Tax Activities). Failure-to-file or failure-to-pay penalties can be abated upon a showing of reasonable cause.

The medical device excise tax with its complex regulations and reporting requirements is particularly onerous because it essentially amounts to a sales tax on members of a targeted industry group regardless of whether they have profits. And, according to the Medical Device Manufacturers Association, 80% of all medical device companies employ fewer than 50 employees. The financial impact of the tax on these small companies is still to be determined.

EditorNotes

Michael Koppel is with Gray, Gray & Gray LLP in Canton, Mass.

For additional information about these items, contact Mr. Koppel at 781-407-0300 or mkoppel@gggcpas.com.

Unless otherwise noted, contributors are members of or associated with CPAmerica International.