The 2.3% medical device tax has been in effect for about half a year now, meaning some of the myths about the levy are being slowly stripped away.
As it turns out, the retail exemption contained in the IRS codes, protecting over-the-counter medical devices from the tax, aren’t as cut-and-dried as they seem. Neither are the oft-mentioned price increases that medical device makers have posed as a way to deal with the excise tax.
MassDevice.com caught up with McDermott Will & Emery partner Kristian Werling, for an update on "unpleasant discoveries" in the medical device tax code, why raising prices isn’t as simple as it sounds and other features of the medtech tax that companies are still wrestling with. Here’s our Q&A, edited for clarity, with Werling:
MassDevice: The last time we talked, it was the fall of 2012 and the medical device tax was just about to take effect. How are companies handling the tax now that they’ve been dealing with it for about half a year?
Kristian Werling: Well, I think a lot of companies were a little bit behind, because there was some probably false hope in the 4th quarter of last year that it might be repealed at the last minute. Once it became clear that it wasn’t going to get repealed, a lot of companies got down to the task of registering as an excise-taxed payer and figuring out how to get the data out of their systems and pay the estimated tax payments
I took a lot of calls around the first couple weeks of the year as they were trying to figure that out. It’s been a little bit quiet now, with questions about the basics. Companies that know they’re supposed to be paying it have settled into the pattern of paying the estimated amounts and figuring out how the tax is going to apply to their product line. That’s kind of the 50,000-foot view. People are getting the hang of it.
MassDevice: Are there parts of the tax that are still catching device makers off-guard?
KW: There are some elements. As people are digging into the tax and how it applies to their products, there are things that they’re discovering. I don’t know if they’re much caught off guard, but they’re discovering unpleasant things.
For example, one thing that companies are discovering is that if they are purchasing a device overseas and importing it, some device manufacturers thought that they would be exempt from the tax. But the tax applies to either importers or sellers, so if a device is being made overseas it is not exempt from the tax.
Another example is that some medical device companies planned to essentially attempt to pass the tax through to their customers in the form of either price increases, if they could, or as an add-on tax. What they are discovering, having now sent out some bills to their customers, is that many of their contracts either don’t mention or mention in the wrong way who’s responsible for any applicable excise taxes.
The medical device tax is a specific type of tax. An excise tax is a unique type of tax and most medical devices sales agreements did not at all reference who would be responsible for excise taxes that apply to the product.
They may have allocated responsibility for a sales tax or an import tax or fee, but usually our industry was not prepared to deal with who would pay for an excise tax.
If you’re reading a sales agreement, it usually has a kind of uniform language that says that the buyer shall be responsible for all applicable sales tax importation fees and other applicable fees, something like that. Usually the laundry list didn’t include or specifically reference the buyers’ responsibility for excise taxes, because it’s a unique kind of tax that medical device companies have never dealt with before.
MassDevice: So what’s the result?
KW: If they try to pass along the tax as an add-on to their customer, the customer calls back and says ‘Whoa, whoa, whoa! What’s this? This percentage you’re adding on here is a tax that our contract doesn’t say that I’ll be responsible for paying." And a number of the GPOs, as I’m sure you’ve been seeing, have come out and specifically stated that their clients, their GPO participants, are not going to be responsible for paying the tax.
Some device makers last year were saying, ‘Well it’s a tax, but at the end of the day it’s just going to be passed on to customers.’ If you’re trying to pass it on as a fee or as a tax, medical device companies are discovering that their contracts were not drafted to allow them to pass an excise tax.
MassDevice: How about companies that plan to raise their prices to make up for the tax?
KW: If you have the ability to do that, that is an easier way that it can be passed on to customers, because then you can just incorporate it within the price increase you would normally do. If you’re normally going to do a price increase of 5% you can either make it 5% plus 2.3, so you can make it 7.3% or you could use some of that 5% to cover the tax internally.
MassDevice: I’m sure that strategy isn’t as easy as it sounds.
KW: Oh yeah, you know all customers love price increases, right? [laughs] It does present a host of issues. For many customers … it didn’t catch them by surprise or blind-side them, but I think many medical device companies and customers have been engaged in this dialogue of who’s going to be responsible for this additional cost.
“Those that are having a harder time with dealing with the tax are those that don’t necessarily view themselves as a medical device maker.” – Kristian Werling
MassDevice: Are some companies struggling with this more than others?
KW: In terms of struggling, those that are having a harder time with dealing with the tax are those that don’t necessarily view themselves as a medical device maker. Unfortunately the statute and the regulations really define a medical device as anything that’s registered with the FDA, and so you’ve got things like, for example, personal protective devices. They are products that are usually worn by a medical professional; either glasses or a lead vest by an x-ray tech, things like that. Their manufacturers don’t really view them as medical devices. They’ve registered with the FDA but it’s not like a pacemaker, like you and I think of a medical device, or an MRI machine. Those things are straightforward medical devices, but there’s a lot of in-betweens. Those companies are still trying to wrestle with, "All right, I’m going to be a medical device and I’m stuck with it."
The other parties that are kind of struggling with this is investors. Let’s say you’re an investor that’s a venture capital funder or private equity fund that’s going to invest in a medical device company. There’s not a lot of track record of what the tax’s impact has been on the company that you’re investing in, so it’s not as straightforward as it sounds.
We know the tax is 2.3%, so if I’m an investor and I’m looking at buying in a company that had $10 million dollars of revenue, it comes to sales of their devices. You kind of think, "Okay, then they made $10 million dollars of revenue, I’m just going to multiply that by 2.3% and it looks like the tax is $230,000." But that’s not the right answer.
The tax actually applies on what’s called the gross sales price to an independent wholesale distributor. Many manufacturers might not typically sell to an independent wholesale distributor, so then you need to calculate it based on the excise tax rules for calculating what your gross sales price is. Many customers might sell directly to a hospital, but then there’s all sorts of rebates and charge-backs and things – so the long story short is, you need to closely look at the excise tax rules to determine how a tax would apply to a company’s revenue. And you shouldn’t just assume that the tax is going to be $230,000 of a $10-million-dollar-revenue company. It might be less, it might be more – there’s kind of a complex body of IRS rules around this.
MassDevice: So how are investors handling the new challenge?
KW: Very carefully. [laughs] For the smart investors, I don’t think it’s scaring them away from the industry yet. It certainly is a drag on profits, it cuts 2.3% that wasn’t going to be paid last year, but the smart investors understand the nature of what an excise tax is. They hire smart accountants to look at it and calculate it so they can build it into their model, and they hire smart lawyers to make sure the company’s applying it correctly.
“You have to add the IRS and the medical device tax as one more thing you’ve got to do due diligence on.”
MassDevice: So what’s the net effect? Is it slowing down the whole investment cycle?
KW: Yeah, that’s a good observation. It does just take a little bit more due diligence and a little longer to get a deal done in this space. Investors in medical device companies have always been really concerned with, "Does a company have any FDA issues, does the company have issues with importing and exporting of their devices to other counties, does a company have regulatory issues with other countries’ FDAs?" Now you have to add the IRS and the medical device tax as one more thing you’ve got to do due diligence on.
MassDevice: Is the effect going to fade away? Will the tax always be a drag on investment time-frames?
KW: No, it think it’s going to be a new thing that is always on investors’ due diligence checklists. Eventually people will get good at it, I guess, but for the next couple of years it’s definitely going to continue to drag on timing, for the foreseeable future.
MassDevice: The IRS rules included an exemption for medical devices that are sold directly to patients. Does the retail exemption help medical device companies?
KW: It was a relief for investors generally and for medical device companies generally. People were a little bit concerned that they would put out a specific list of products and say, "Here, these products are retail, everything else is not." They didn’t do that.
Instead they adopted a relatively flexible facts-and-circumstances type of test that a medical device manufacturer can apply. But in order to meet the retail exception you’ve got to look at whether this device is regularly available for use by individuals and you’ve got to look at whether the design of the device demonstrates that it’s not primarily intended for use by a medical professional.
And so what that creates is a little bit of gray area. The nice part about having a list is that if the IRS would have taken that approach and put out a list it’s pretty easy to follow, right? Instead they’ve put out this test which generally is better because it’s broader, you can fit more things, but also it’s bound to create some gray areas.
MassDevice: It sounds like fitting into that exemption may come down to how you form your argument.
KW: Yep. Exactly. And the way it works is, as the device company, you don’t have to apply to get the retail exemption. It’s kind of like when you and I do our taxes.
I’ve got 3 kids and so I say, "Alright, I can take the child credit for all 3 of them. I see my 3 kids there, they live in my household, I can take the child credit." That’s a pretty easy one, right?
But a harder one for us might be if we’ve got a home office. It needs all these qualifications in the IRS rules and you can deduct a portion of your mortgage expenses and your house expenses. So it’s just up to you and I as taxpayers to make that determination and to take that position on our 1040 forms. Same thing for the device companies.
You don’t send in a retail exemption application to the IRS and they send it back they say, "Congratulations, your device is sold as retail and you don’t have to pay the tax on it." Instead, as a device company, you have to go through the analysis, make that decision and then you need to not pay the tax based on that decision – or pay it.
That makes it a little bit of a harrowing area for device companies. Some devices are obviously retail, it’s easy – but there’s a lot of in-betweens that might not be.
MassDevice: Are companies taking a gamble of sorts in making that decision?
KW: It is a little bit of a gamble. If you’re in between, the conservative thing to do might be to just reserve for the tax and pay it.
“Companies need to take a close look at their service providers and determine whether the tax should be paid by the service provider or should be paid by the medical device company.”
MassDevice: Are there other areas of the tax that have been tough to deconstruct?
KW: A lot of medical device companies have a lot of out-sourced service providers – you’ve got contract manufacturers, kit packers, private label manufacturers. Those service providers might all be here in the U.S. or some of them are off-shore in Costa Rica or Mexico or China.
Companies need to take a close look at their service providers and determine whether the tax should be paid by the service provider or should be paid by the medical device company. In some cases the service provider’s the importer of record and then the medical device company is just reselling. It may be that the excise tax on the device is only payable by the service provider.
When there’s multiple people importing an item, you need to really look closely at all the facts and circumstances and see who is inducing and causing the goods to be brought into the U.S. for purposes of sale to an end user. There’s a large body of excise tax law built up around those determinations. Other examples of excise taxes are alcohol and cigarettes. There’s all there excise taxes on rubber, if you buy it overseas, other types of raw materials, etc., so the IRS has like this long-standing body of law about who’s an importer and who should be paying these taxes.
MassDevice: At least there are some precedents for companies to rely on, right?
KW: Yeah, I mean we’re not reinventing the wheel. You can go and look at all these old decisions and figure out, "All right, who do you think is causing the importation, who should be paying the tax on this product?" But I think a lot of companies were, at first, worried about, "Let me let me run around figure out which of my products are taxable." Then they should be thinking about whether their outsourced service provider should be paying instead.