Editor: Jon Almeras, J.D., LL.M.
In early December 2012, Treasury published final regulations (T.D. 9604) and additional interim guidance under Sec. 4191 relating to the medical device excise tax that was enacted as part of the Health Care and Education Reconciliation Act of 2010, P.L. 111-152, in conjunction with the Patient Protection and Affordable Care Act, P.L. 111-148 (the health care acts).
Effective Jan. 1, 2013, Sec. 4191 imposes a 2.3% excise tax on sales of certain medical devices by the devices’ manufacturer, producer, or importer. The regulations generally adopt the guidance in the proposed regulations issued on Feb. 7, 2012 (REG-113770-10), but provide greater certainty with respect to the types of devices subject to the medical device excise tax and clarify the retail and other exemptions.
The IRS and Treasury continue to evaluate certain issues and issued Notice 2012-77 and a frequently asked questions document (available at tinyurl.com/cchfbez) with interim guidance on some of the more significant issues facing the medical device industry as it readied itself for and implemented the medical device excise tax. In particular, Notice 2012-77 provides guidance on:
- Determining the taxable sale price for certain common supply chain scenarios under the constructive pricing rules;
- Treatment of licensed software;
- Donations of taxable medical devices;
- Excise tax treatment of FDA-listed medical device kits; and
- Interim penalty relief to taxpayers for the first three calendar quarters of 2013.
Observation: Although the regulations and interim guidance provide clarity on the medical device excise tax, organizations will continue to face challenges in complying with this law.
Transition Rule Provided
The regulations provide transition relief for certain long-term contracts, including leases and installment sales. Specifically, payments made on or after Jan. 1, 2013, for contracts entered into before March 30, 2010, are not subject to the medical device excise tax unless the contract was materially modified on or after March 30, 2010, the date the health care acts were enacted.
Taxable Medical Devices
Under the statute, a “taxable medical device” is any device, as defined under Section 201(h) of the Federal Food, Drug, and Cosmetic Act, P.L. 75-717 (FFDCA), that is intended for humans. The regulations narrow the scope of this definition to products (with certain exemptions and exclusions) listed with the U.S. Food and Drug Administration (FDA) under Section 510(j) of the FFDCA and 21 C.F.R. Part 807, or that the FDA determines should have been so listed. They also clarify that certain biologic devices, such as those used for in vitro blood screening that are regulated under 21 C.F.R. Part 607 and not listed with the FDA under Section 510(j) of the FFDCA and 21 C.F.R. Part 807 do not meet the definition of a taxable medical device.
Observation: Taxpayers that manufacture, produce, or import listed medical devices that may be sold either as medical devices or for other uses (e.g., a microscope) are nevertheless taxed on all sales of such devices unless another exemption or exclusion applies. This includes FDA-listed devices sold for veterinary use. Similarly, FDA-listed medical devices that are combined with branded prescription drugs are not exempt from the medical device excise tax, even if the same article is subject to the branded prescription drug fee imposed by the health care acts.
Manufacturer, Producer, or Importer
Existing regulations broadly define the term “manufacturer” to include “any person who produces a taxable article from scrap, salvage, or junk material, or from new or raw material, by processing, manipulating, or changing the form of an article or by combining or assembling two or more articles. The term also includes a ‘producer’ and an ‘importer’” (Regs. Sec. 48.0-2(a)(4)(i)). Note that definitions of “manufacturing” or “production” used by the FDA or in the Internal Revenue Code under subpart F (Secs. 951–965) or Sec. 199 do not apply to the excise tax.
Taxable use: Taxable uses of medical devices by the manufacturer, producer, or importer (MPI) are subject to the manufacturers excise tax rules of Sec. 4218.
Donated Medical Devices
Donated medical devices are not specifically addressed in the regulations; however, under the interim guidance, a donation of a taxable medical device to an eligible charitable organization is not treated as a taxable use, provided the device is not intended to be sold by the donee. For this purpose, an eligible charitable organization is defined by Sec. 170(c) and generally includes U.S. federal, state, and local governments and U.S. charities organized and operated exclusively for religious, charitable, scientific, literary, or educational purposes, or to foster amateur athletic competition.
Products Used for Demonstration, Promotion, or Testing
The regulations’ preamble indicates that FDA-listed medical devices used for demonstration purposes (e.g., displayed at a medical device trade show) are likely taxable when first used (citing Rev. Ruls. 60-290 and 72-563). The subsequent sale of the used device is not taxable, however. FDA-listed medical devices that are provided as samples likely have a similar treatment. If an FDA-listed medical device is used by its manufacturer to test another device that it also manufacturers, the first device is not subject to tax on such use; but providing devices for testing or evaluation by others likely is considered a taxable use under Sec. 4218 and the regulations. The tax is computed based on the price for which the product would have otherwise sold.
Secs. 4221 and 4191 provide general exemptions to the tax that include (1) products exported or destined for export; (2) components sold for further manufacture; (3) products intended for nonhuman use; and (4) eyeglasses, contact lenses, hearing aids, or any other medical device the IRS determines to be “of a type which is generally purchased by the general public at retail for individual use” (the retail exemption).
Retail exemption: The regulations retain the facts-and-circumstances approach in the proposed regulations to determine whether an otherwise taxable medical device is generally purchased by the public at retail for individual use and thus qualifies for the retail exemption. The regulations emphasize that this approach requires a balancing of factors in which no one factor is determinative.
The proposed regulations included a nonexclusive list of positive and negative factors, as well as a list of safe-harbor factors, for determining whether the retail exemption applies. The final regulations adopt and expand on these factors, particularly criteria for whether consumers who are not medical professionals can purchase a device. The regulations also provide examples of how to evaluate all three sets of factors.
Positive factors (Regs. Sec. 48.4191-2(b)(2)(i)) include:
- Consumers who are not medical professionals can purchase the device directly through sales channels including in person, over the telephone, or over the internet; through retail businesses such as drugstores, supermarkets, or medical supply stores; and through retailers that primarily sell devices (e.g., specialty medical stores; sellers of durable medical equipment, prosthetics, orthotics, and supplies (DMEPOS); and similar vendors);
- Consumers who are not medical professionals can use the device safely and effectively for its intended medical purpose with minimal or no training from a medical professional; or
- The device is classified by the FDA under subpart D of 21 C.F.R. Part 890 (physical medical devices).
Negative factors (Regs. Sec. 48.4191-2(b)(2)(ii)) to be considered in applying the retail exemption include:
- The device must generally be implanted, inserted, operated, or otherwise administered by a medical professional;
- The cost to acquire, maintain, and/or use the device requires a large initial investment and/or ongoing expenditure that is not affordable for the average consumer;
- The device is a Class III device under the FDA system of classification;
- The device is classified by the FDA under any of a number of categories, including cardiovascular, general and plastic surgery, and dental; or
- The device qualifies as DMEPOS for which payment is available exclusively on a rental basis under Medicare Part B payment rules and is an “item requiring frequent and substantial servicing” as defined in 42 C.F.R. Section 414.222.
The regulations include 15 examples that illustrate the retail exemption, including safe-harbor provisions described below, and balancing factors for particular devices. Two of these examples are of products in classification categories 21 C.F.R. Parts 868 (anesthesiology devices) and 876 (gastroenterology-urology devices), as well as examples of home health care products (oxygen concentrators, wheelchairs, and therapeutic beds).
Observation: The totality of the facts and circumstances relating to a listed medical device determines whether it qualifies for the retail exemption. Single factors may be more meaningful than others, but no one factor is determinative. All relevant facts and circumstances must be considered, including those not listed in the regulations.
The regulations maintain the proposed regulations’ safe harbor for certain devices under the retail exemption, including FDA-approved in vitro diagnostic home-use lab tests, devices designated or classified by the FDA as available over the counter, and certain DMEPOS. The regulations and preamble also clarify that prosthetic and orthotic devices, as defined in 42 C.F.R. Section 414.202, meet the retail exemption if they do not require implantation or insertion by a medical professional (even if they require initial or periodic fitting or adjustment).
Devices that do not qualify for safe-harbor treatment may still qualify for the retail exemption based on all the facts and circumstances.
Medical Devices Not Intended for Humans
The regulations adopt the guidance in the proposed regulations on the “intended for humans” element of the definition of a taxable medical device. The preamble to the proposed regulations explains that veterinary devices, while included in Section 201(h) of the FFDCA, are not taxable medical devices if they are intended for use exclusively in veterinary medicine and labeled as such. Devices used exclusively for certain other nonmedical purposes, such as “research use only” devices or those subject to an “investigational device exemption” from FDA approval, are not taxable if they are listed with the FDA as such.
Determination of Taxable Price
The medical device excise tax was enacted as a manufacturer’s excise tax under Internal Revenue Code chapter 32, and the IRS and Treasury intended to rely on the existing body of statutes, regulations, and interpretations in administering the new tax. For example, manufacturers excise taxes are levied on an MPI’s sale to an unrelated “wholesale distributor,” as defined under Regs. Sec. 48.4216(b)-1(c)(3), with certain adjustments. Sec. 4216(b) and the regulations thereunder contain rules for transactions that do not fit this model; these are known as the “constructive sale price” (CSP) rules. However, the IRS and Treasury have received numerous comment letters and informal communications illustrating situations where the CSP rules, applied to manufacturers of medical devices, lead to an inequitable result. The IRS has provided interim guidance in Notice 2012-77 as it continues to study these issues.
One of the challenges in applying the existing CSP rules to the medical device industry is that key participants in medical device supply chains do not easily conform to the definitions in the existing CSP rules. For example, the definition of a wholesale distributor in Regs. Sec. 48.4216(b)-1(c)(3) is “a person engaged in the business of selling articles to persons engaged in the business of reselling such articles.” In many cases, medical device manufacturers sell their products to distributors who may sell the products to hospitals, clinics, and physicians. However, since these customers frequently consume the products in the delivery of various health care services, the distributors do not meet the definition of wholesale distributors. Indeed, the IRS states in Section 4 of Notice 2012-77 that, until it provides further guidance, sales to hospitals and doctor’s offices are treated as retail sales (i.e., sales to end users).
CSP Rules for Different Supply Chains
Notice 2012-77 addresses many of the common supply chain scenarios in the medical device industry and provides a CSP for each. In lieu of using the actual sale price of an article or determining its fair market price (for which the taxpayer bears the burden of proof), under interim rules, taxpayers may apply a CSP illustrated in Notice 2012-77.
- For direct sales by the MPI to unrelated end users at retail; no regular sales to independent wholesale distributors: The CSP is 75% of the actual selling price after certain adjustments (e.g., the medical device excise tax, freight, and insurance) and certain readjustments (e.g., rebates).
- Sales to unrelated retailers; no regular sales to independent wholesale distributors: The CSP is 90% of the lowest price sold to unrelated retailers, less the medical device excise tax. No other adjustments or readjustments are available.
- Sales to related retailers; no regular sales to independent wholesale distributors: The CSP is 71.25% of the actual selling price (to an unrelated person), less the medical device excise tax. The CSP is lowered from 75% to make up for exclusions otherwise allowed in Sec. 4216(a). No other adjustments are allowable, but price readjustments appear to be available.
- Sales to related reseller that leases and sells at retail: The CSP is 71.25% of the actual selling price (to an unrelated person). As in (3), the CSP is lowered from 75% to make up for exclusions otherwise allowed in Sec. 4216(a). No other adjustments are allowable, but price readjustments appear to be available.
- Sales to related reseller that only leases at retail; no regular sales to independent wholesale distributors: The price is the actual sale price to the related reseller, provided that the selling price reasonably approximates the fair market price of the article under Sec. 4216.
Use of Transfer Pricing
The preamble to the regulations states that the standards for manufacturers excise taxes under Sec. 4216 are different from those for determining arm’s-length prices for income tax purposes under Sec. 482. Therefore, while some facts used to support a transfer price for purposes of Sec. 482 may be relevant for determining medical device excise tax, transfer-pricing studies generally are not conclusive for the excise tax.
Observation: It appears that the IRS is skeptical that companies can successfully present economic analysis and expert testimony that will meet the burden of proof in establishing a fair market price in cases where the taxable transaction involves a related party. Although the interim guidance does provide helpful relief in certain supply chain scenarios, some companies may believe that using an appropriately determined arm’s-length price other than the unrelated price, the CSP, or the Notice 2012-77 CSP will prevent overpaying the medical device excise tax.
The regulations also reiterate the existing rules regarding rebates and other price readjustments; these items may be taken into account only when they occur and cannot be accrued.
Observation: Note that neither the regulations nor Notice 2012-77 provided any specific guidance on two issues that are significant to the industry: the medical device excise tax treatment of (1) fees paid to group purchasing organizations; and (2) instrumentation provided at no charge to hospitals, medical institutions, doctors, and others.
Replacement Parts and Refurbishing Used Devices
The regulations’ preamble clarifies that replacement parts are subject to the medical device excise tax if they are separately listed medical devices, as they meet the definition of a taxable medical device. If an article is replaced under warranty, the taxable price of the replacement article is the amount paid, if any, to the manufacturer.
The preamble also states that if the refurbishing or remanufacturing activity creates a new and different listed medical device, then the activity constitutes manufacturing, and the resulting device is taxable upon its sale or use. The regulations adopt the positions contained in prior rulings regarding what type and level of activity constitutes manufacturing a new article.
Licenses and Leases
The regulations adopt a provision of the proposed regulations that addresses leases of medical devices and refers to Sec. 4217(a), which provides that the lease of a taxable article by the manufacturer is considered a sale. The tax can be applied to leases in either of two ways. If the manufacturer is also in the business of selling devices in arm’s-length transactions, the tax is applied to each lease payment until the tax equals 2.3% of the sale price of the device. Otherwise, the tax is applied to each lease payment, effectively causing the manufacturer to pay tax on the interest amount inherent in the lease payments.
Notice 2012-77 also provided in interim guidance that a license of software that is an FDA-listed medical device is treated as a lease of that device as of the date both parties entered into the license agreement.
In some cases, taxpayers assemble, sterilize, and vacuum-seal FDA-listed medical devices and possibly other items to sell as a kit for customers’ convenience. The FDA requires many of these kits to be listed as medical devices. Under the proposed regulations, FDA-listed medical device kits were considered taxable, and the listed medical device components of a kit were considered tax-free sales of components for further manufacture. The IRS and Treasury have issued interim guidance as they continue to study this issue; however, the final regulations do provide that hospitals and other medical institutions that assemble kits for their own use are not producing taxable medical devices, because the FDA exempts such “self-kitters” from its listing requirements.
Observation: The interim guidance in Notice 2012-77 splits the medical device excise tax treatment of kits into domestically produced and imported kits. Kits produced domestically are not taxed (although listed medical device components they contain are taxable), while sales by importers of imported kits are taxed on the portion of their price that is allocable to the FDA-listed medical device components they include. Importers that, in addition to imported kits, sell all of the kits’ components separately may use the sale price of the taxable components relative to the kits’ sale price to determine the taxable portion of the kits; importers that do not also sell all the components individually may use a relative cost allocation.
The regulations’ preamble confirms that, as with other excise taxes, medical device excise tax deposits must be made semimonthly unless the expected liability for a calendar quarter is $2,500 or less (in which case payments may be made quarterly). The first medical device excise tax deposit, covering the first 15 days of January, was due on Jan. 29, 2013. The IRS is allowing transition relief from deposit penalties during the first three calendar quarters of 2013, provided that taxpayers demonstrate a good-faith effort to comply with the tax deposit rules and that the failure was not due to willful neglect. Taxpayers report their medical device excise tax on Form 720, Quarterly Federal Excise Tax Return, which is filed within 30 days following each calendar quarter.
In addition to paying the tax and filing Form 720, if a company expects to have tax-free sales, such as exports or component sales for further manufacture, then it must register with the IRS using Form 637, Application for Registration (for Certain Excise Tax Activities). The regulations’ preamble makes clear that the Form 637 and Form 720 requirements apply on a legal-entity-level basis (i.e., each entity with a separate employer identification number, including disregarded entities, is subject to these compliance requirements).
Observations: In light of these upcoming compliance deadlines, taxpayers should develop a process for computing the tax, including calculating and supporting price adjustments such as discounts, rebates, refunds, and allowances. Companies also need to determine whether they are eligible for any of the exemptions and be able to document and support the claimed exemptions. Companies may need to provide the IRS with proof of further manufacture by their customers and proof of exportation by them or their customers.
Moreover, complying with the medical device excise tax may require information technology system updates to handle frequent tax computations and to track purchases. New processes must also be established to handle registration requirements, exemptions, and credit and refund issues.
The IRS is requesting taxpayer comments on the regulations and interim rules in Notice 2012-77. The deadline for comments on the notice is March 29, 2013. In particular, the IRS is requesting comments on:
- Supply chains commonly employed by the medical device industry.
- How the CSP rules might address medical device industry segmentation, including what is a reasonable percentage of the applicable sale price for determining the CSP for a segment or product.
- Alternative methods for determining price for the supply chain scenario where a manufacturer sells to related resellers that lease but do not sell taxable medical devices at retail and neither the manufacturer nor the reseller sells regularly to independent wholesale distributors.
- Identification of listed components of devices where the devices are exempt under Sec. 4191(b) and Regs. Sec. 48.4191-2(b) and the components are not included in a safe harbor or do not otherwise fall within the retail exemption by application of the facts-and-circumstances test.
The authors thank Arianda Hicks, CMI, Houston; Christine Kraft, CPA, J.D., Parsippany, N.J.; and John Badertscher, CPA, Stamford, Conn., for their contributions to this item. A version of this item originally appeared as a Deloitte Tax Alert.
Jon Almeras is a tax manager with Deloitte Tax LLP in Washington, D.C.
For additional information about these items, contact Mr. Almeras at 202-758-1437 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.