A new medical device manufacturers’ excise tax, effective for sales made after December 31, 2012, employs the same procedures that for many years have governed other manufacturers’ excise taxes, so many expected it to be a relatively “routine” way to increase the federal government’s revenue and to offset certain tax expenditures. But that simple plan was foiled with the addition of a very complex inclusion—a so-called “retail exemption.” Although lobbying is still underway to encourage a repeal of the new tax, observers generally believe it will become effective as enacted. What can manufacturers of medical devices do in the meantime?
Open PDF: Will your products be subject to the new 2.3% Federal Excise Tax on “taxable medical devices” next year?
You have six months to determine what’s taxable and gear up for payment
In March 2010 Congress passed Internal Revenue Code Sec. 4191, effective for sales made after December 31, 2012. The new medical device manufacturers’ excise tax employs the same procedures that for many years have governed other manufacturers’ excise taxes, so it was expected to be a relatively “routine” way to increase the federal government’s revenue and to offset certain tax expenditures.
Congress had a relatively simple plan, but unfortunately made the new tax very complex by including a so-called “retail exemption.” Under the new tax law, all medical devices are subject to the tax except for:
- Contact lenses,
- Hearing aids, and
- “. . . any other medical device determined by the Secretary (of Treasury) to be of the type which is generally purchased by the general public at retail for individual use.”
On February 7, 2012, the Treasury Department issued proposed regulations to implement the new tax regime. At a hearing last week, numerous industry representatives criticized the proposed regulations and identified numerous uncertainties regarding exactly what is subject to the tax. Most of the uncertainties involved the retail exemption.
Although lobbying is still underway to encourage a repeal of the new tax, observers generally believe it will become effective as enacted.
What is a medical device?
The definition of medical device is identical to that used in Sec. 201(h) of the Federal Food, Drug, and Cosmetic Act (21 U.S.C. 301 et seq.). FFDCA defines a “device” as any instrument, apparatus, implement, machine, contrivance, implant, as well as in vitro, or any other similar or related article, including any component, part, or accessory that is intended for human or animal use in the diagnosis, cure, mitigation, treatment, or prevention of disease or other conditions, or intended to affect the structure or function of the body, and which requires no chemical action or metabolization in order to be effective. Because of the astounding breadth of this definition, the medical device tax may be levied on manufacturers of the components or parts of a medical device as well as manufacturers of a finished medical device.
The FDA regulations at 21 C.F.R. Part 862-892 classify over 1700 types of medical devices into Class I, II, and III, based on the degree of risk they pose. The three classes are irrelevant for tax purposes, but the list of devices is incorporated by reference directly into the tax law. Treasury believes that anyone manufacturing a covered medical device will have already been subjected to the FDA device regulation process before being allowed to market his or her product. Therefore, the drafters of the tax regulations do not expect any significant degree of uncertainty regarding the definition of a medical device.
The retail exemption
The proposed regulations employ a “facts and circumstances” test to determine what qualifies for the exemption, based on a nonexclusive list of factors. The regulations also contain safe harbor exemption categories for specific devices, such as home use lab tests, certain durable medical equipment, and enteral nutrients.
The comments made to Treasury regarding the proposed regulations highlight several areas of concern.
- Bonus goods and rebates are common in the medical device industry. How do these figure into the taxable sales price?
- “Convenience kits” present several tax issues.
- These kits often contain both exempt and taxable items, and since the entire kit will be taxable, the exempt items effectively lose the benefit of their exemption.
- Some kit packagers will pay the excise tax on component items. When the items are assembled into a kit, which itself is a taxable item, some of the contents will be subject to double taxation.
- There are numerous non-economic uses of medical devices, such as samples, demonstration products, charitable contributions, and surgical instruments loaned by manufacturers to health care providers for implanting their devices. Will these be subject to the tax?
- Sales of devices to purchasers for further manufacture and for export are exempt. How will this category be defined?
- Treasury has reserved the authority to impose the tax on a “constructive sale price” if it determines that the actual sale was not made at arm’s length. How will this be determined?
General rules and procedures applicable to all excise taxes
Most manufacturers of medical devices are unfamiliar with the existing rules for payment of the excise tax. The general rules are published in Chapter 5 of IRS Publication 510. These include:
- The taxable sales price of a device will include charges for packaging but not for delivery.
- Both leases and installment sales of taxable medical devices are subject to the tax.
- A manufacturer whose sales are exempt because the customers will conduct further manufacturing, or because they are export sales, must register in advance using IRS Form 637, to be entitled to claim exempt sales.
- Sales to state and local governments are exempt, but they require the manufacturer to obtain a copy of the customer’s exemption certificate at or before the time of sale.
What should manufacturers do now?
Six months is not enough time to expect Treasury to clarify all these areas of uncertainty. Manufacturers of medical devices must design a plan of action so that they are prepared to pay the tax on sales beginning January 1, 2013.
It may be wise to resolve all doubts in favor of presuming that a device is taxable. This will enable manufacturers to determine a new pricing strategy and evaluate the competitive market. If the manufacturer initially pays tax on some sales that are later determined to be exempt, there is a procedure for claiming refunds or credits against future tax payments.
Nixon Peabody will continue to publish clarifications of these rules as they become available. We will also advise clients when it becomes possible to obtain IRS private letter rulings regarding the taxability of specific products.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.