The medical device tax codes just finalized by the IRS were met with much consternation and hand-wringing, but some device makers were breathing sighs of relief – after all, it could have been worse.
The IRS mostly "stayed the course" on provisions that it had set out in the tax proposal released earlier this year, while also reversing key measures that would have resulted in double-taxation for device kits, a set of 2 or more medical devices bundled together and sold to an end user.
The new tax guidelines also excludes certain devices from the 2.3% sales tax, providing a "retail exemption" for devices purchased by the general public for individual use.
"There’s general relief that the exemptions are in place like they’d proposed them in the 1st draft," Kristian Werling, partner at McDermott Will & Emery with a focus on medical device and lifesciences companies, told MassDevice.com. "Though reality is setting in that this tax is 30 days away, and so they are involved in strategic discussions of: Do we have to raise a price? How do we account for this in a lease structure? What are we going to do with this?"
In an in-depth discussion of the impacts of the tax and the new regulations, Werling told us how his practice’s clients are responding, which device makers will be the hardest hit by the tax and the industry can expect over the next year.
MassDevice: Tell us a little about what you do.
Kristian Werling: I’m a partner at McDermott Will & Emery, member of our lifesciences practice group and I lead the medical device section of the group. Most of my clients are medical device companies or investors, like private equity funds and venture capital funds that own medical device companies.
Most of my clients are either U.S. or European-based and distribute their products all over the world. The core of my legal practice is doing mergers and acquisitions, but I provide a lot of ongoing commercial, tax and regulatory advice to the companies based on my familiarity with the industry.
MassDevice: In regard to the newly release medical device tax guidelines, what’s the general reaction from your clients?
KW: Well there’s 2 levels of things – 1 is a number of my clients do sell products into the retail class of devices and so the retail exemption was a very big focus for them. The clarifications set forth in the rule, overall, people that fell into the retail class trade are feeling very positively, particularly for prosthetics and orthotics manufacturers and for manufacturers of things like catheters, diabetes supplies, home use products and things like that. So that’s been good and those clients have been pleased.
But now we’re at the 2nd area everyone’s been asking about and where I have a little bit less answers, just some of the details of what devices are taxable and how we’re going to calculate this thing.
Now the hard work begins, really for the accountants, to figure out and apply the IRS’s rules here. The call I was just on, they were talking about, ‘Alright well we’ve got this agreement and we function as a distributor for some of the products, as a manufacturer for others, some products are going to Canada, others to Puerto Rico and some to the U.S. and others to Europe – what’s going to be taxable, how do we price it, all that stuff.
Now the hard work begins and if we only have 30 days or so to do it, so the I think, big picture, the IRS stayed the course with a lot of the rules based on what was in the proposed rule, but I do think that, based on the diversity of the medical device industry, we’re gonna see lots of IRS guidances over the coming months and years.
No 2 medical device companies are alike. They sell all sorts of stuff – software, catheters, pacemakers, they’re very diverse – and they all have different ways of selling them. The client I was just on the phone with leases a lot of products and so they’ve got to figure out, ‘Alright, how do we recognize that revenue and when does it get taxed when we’re giving a lease, or what if we’re selling a bundle of products, where its a product and a disposable?’
That’s unlike with the pharmaceutical and insurance taxes, which are relatively straightforward. The medical device one, because of the diversity in the industry, is going to have a whole ton of guidances and changes as this evolves.
At the end of the day though it’s going to get the government $30 billion plus in revenue, so that is going to be worth it for them to keep trying to capture as much revenue as possible through this thing.
MassDevice: Are device makers more relieved by the small wins in the rules or more panicked by the finality of the guidelines?
KW: There’s general relief that the exemptions are in place like they’d proposed them in the 1st draft. Those clients that assemble kits were pleased because that issue got resolved – there was some double-taxation of kit-makers, which is a big business. Overall they were relieved with the outcome, I’ll say.
I think though, to your point, reality is setting in that this tax is 30 days away, and so they are involved in strategic discussions of: Do we have to raise a price? How do we account for this in a lease structure? What are we going to do with this?
There’s no easy answers to those questions, they need to start to get their head around it.
One thing that’s interesting is, if you look at some of the literature that is out there, the popular press or the hospital industry would have you say, well the medical device companies are just going to raise their prices 2.3%, right? It’s not that easy.
First of all, it’s not like all contracts expire at the end of this year. Many of our clients have long-term contracts with purchasers, with GPOs that bind them to a price and limit the price increase. Not everyone’s contracts expire on the 31st so they can just add 2.3%, so that’s going to be a complex thing. Second, hospital systems and GPOs are very large and they have some significant bargaining power over many of the device manufacturers out there. So it’s not like you just call up the big purchasing group at a Catholic health system or at Tenet or at HCA and say ‘hey, we’re raising your price 2.3%.’ They’re going to have an issue with that. So yeah, device makers are looking at how this will affect their pricing, but it’s not an immediate ability to do that.
MassDevice: Are any of your clients talking about layoffs as a means of cutting costs ahead of the tax?
KW: Too early to say. I’ve seen some of that in the press, but none that I’ve talked with very recently are directly linking them, no.
MassDevice: The IRS offered some minor conciliations in the tax, in waving certain late fees and relaxing the tax requirements for companies with a smaller liability. How are your clients responding to that?
I haven’t gotten a ton of direct reaction to that yet because people are just more focused on understanding it so far, but I think what that does – the IRS was smart in doing that, because it takes away the argument that, ‘well, you published this rule 23 days before, or 27 days before or something, because they have this grace period of 3 quarters where, yes they have to start paying the estimated amount but it doesn’t have to be a perfect amount. I haven’t gotten much reaction to it yet, but I do think it strategically takes away this argument that these regulations are too late so you should delay this tax by a year.
MassDevice: Are your clients active in the device tax repeal efforts?
KW: Yes, definitely. They’re all supportive. Many of my clients are AdvaMed members, or MDMA members. They’re definitely supportive of repeal. Particularly the smaller ones, the clients that have revenue of less than $20 million are the ones that get hit hardest with this.
MassDevice: Does the finality of the new IRS regulations dampen some of the optimism about repeal?
KW: It’s a good requisition. I haven’t sensed that yet, though. I think you see a very big lobbying effort, the CEO of Cook Medical came out and said that this is going to require them to make some layoffs. I think the lobbying effort will continue strong.
MassDevice: What types of reactions are you seeing from venture capital firms?
KW: At this point they see some uncertainty in it, just based on the possibility of repeal, and they’re still not totally clear on where it will apply and when and how it has to be paid.
If you know any venture capitalists, they create very detailed models projecting how a company will grow and right now the line that’s got "tax payments" is just a little bit muddled, a little bit unclear until companies that they have currently in their portfolio really start to pay this thing. For most companies you can’t just simply apply 2.3% and call it a day, it’s not that easy. You’ve got to look at whether it’s calculated based on their transfer pricing, based on their pricing to wholesalers, based on their retail pricing – there are some real technicalities here that I think the VCs are still trying to get their head around.
MassDevice: Has venture capital funding gotten more conservative over this last year?
KW: Yes. That’s driven a little bit by the tax, but more by some uncertainty on the FDA approval process that’s going on right now. I think people believe there will be medical device FDA reform in the not too distant future and so that makes it unclear to them whether they need to invest money to enable a company to spend 2 years working on getting approval or 3.5 years – that’s a big change. That could be $4 million dollars or $8 million dollars, and so it’s just hard to figure that out. They’d rather just sit on the sidelines than invest the wrong amount. The tax I don’t think is the number 1 reason for that, I think it’s more the FDA.