Making Sense of the New ExciseTax on Medical Devices

By Christopher J. Ohmes andMichael Udell

Introduction

The healthcare reform law included, within therevenue raisers, a new 2.3 percent manufacturersexcise tax on medical device sales. This new excisetax applies to sales (and uses that are treated assales) occurring after December 31, 2012. Once fullyimplemented, this tax is projected to raise $2.7billion or more annually. For manufacturers, pro-ducers, and importers of medical devices,1 theliability for this new tax likely will be a materialitem.

Also, the medical device excise tax (MDET) mayresult in substantial economic disruptions withinthe medical device manufacturing industry. By wayof example, determining the incidence of this taxwill be complicated because government programs

likely will not increase reimbursements to cover it,and the federal government pays for more than halfof all medical devices through Medicare, Medicaid,the Veterans Administration, and the Department ofDefense.

Given the magnitude of technological advances,the rapid pace of innovation, and the complexsupply chains within the medical device industry, itshould be no surprise that the industry’s manufac-turing and marketing processes do not fit neatlywithin the existing rules applicable to manufactur-ing excise taxes. There are several issues that needto be addressed.

Who Pays the Tax?

The MDET is imposed ‘‘on the sale of any taxablemedical device by the manufacturer, producer, orimporter.’’ Many elements of the Food and DrugAdministration’s definition of manufacturing alignwith the tax definition of manufacturing.2 Giventhat the FDA rules treat as a manufacturer anyone‘‘who manufactures, prepares, propagates, com-pounds, assembles, or processes a device by chemi-cal, physical, biological or other procedures,’’3taxpayers undertaking those activities may be sub-ject to the MDET on their sales of medical devices.4As a result, FDA-regulated manufacturers are likelyto be manufacturers for purposes of the MDET.

Owners and operators of FDA ‘‘establishments’’or ‘‘facilities’’ involved in the production and dis-tribution of medical devices intended for use in theUnited States must also consider the MDET. Indeed,any manufacturer or importer of medical devicessubject to the FDA establishment registration proc-ess should consider the extent to which this new taxmay apply to it.

Also, a party that ‘‘furthers the marketing of adevice from a foreign manufacturer to the personwho makes the final delivery or sale of the device to

1These taxpayers will be referred to collectively as ‘‘manu-facturers’’ throughout this article.

2For purposes of this article, we are relying on the definitionof manufacturing in the relatively recent and extremely com-prehensive regulations defining manufacturing for purposes ofthe foreign base company sales rules of subpart F set forth inT.D. 9438, Doc 2008-27115, 2008 TNT 249-5.

321 C.F.R. section 806.2(g).4Some assembly activities, however, may not rise to the level

of manufacturing for tax purposes.

Michael Udell

Christopher J. Ohmes

Christopher J. Ohmes is apartner and Michael Udell is asenior manager in Ernst &Young’s National Tax Office inWashington. The views ex-pressed in this article are theauthors’ own and do not repre-sent the views of Ernst &Young LLP.

Manufacturers and import-ers of medical devices willneed to be prepared by January1, 2013 to implement a new 2.3percent excise tax on sales andtaxable uses of medical devices.This article describes how thetax will operate and highlightsmany issues that medical de-vice companies will need to

resolve to comply with it.

Copyright 2011 Ernst & Young LLP.All rights reserved.

tax notes®

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the ultimate consumer or user’’5 should considerthe manner in which the MDET applies to im-porters.

However, it is unclear whether taxpayers thatbundle their medical devices with devices manufac-tured by others will be treated as engaged inmanufacturing by the FDA and therefore subject tothe MDET.6 The FDA includes in its definition ofmanufacturing the preparation of kits consisting ofboth medical devices and other articles, whethercombined by the medical device manufacturer oranother party. But that type of activity may not bemanufacturing for tax purposes. Further guidanceon this issue will be necessary.

More guidance will be required for contractmanufacturing arrangements. The FDA definitiontreats a taxpayer that ‘‘initiates specifications fordevices’’ as a manufacturer, even when the activi-ties of physically transforming raw materials into amedical device are performed by someone else. Fortax purposes, merely designing an article, does notmake a taxpayer a manufacturer.

What Devices Will Be Subject to the Tax?

The MDET is imposed on the sale of ‘‘any taxablemedical device.’’ Taxable medical devices are de-fined with reference to section 201(h) of the FederalFood, Drug, and Cosmetic Act. Unlike some of theproposed but not enacted versions of the tax, allmedical devices may be subject to the enactedMDET, without regard to whether they are classi-fied into one of the three major medical deviceclassifications (classes 1, 2, and 3).7

Many healthcare products we use regularly aremedical devices, including toothbrushes, bandages,feminine hygiene products, and wheelchairs. Medi-cal devices are an essential component of the deliv-ery of healthcare services. According to the FDA:

Medical devices range from simple tonguedepressors and bedpans to complex program-mable pacemakers with micro-chip technol-ogy and laser surgical devices. In addition,medical devices include in vitro diagnosticproducts, such as general purpose lab equip-ment, reagents, and test kits, which may in-clude monoclonal antibody technology.Certain electronic radiation emitting productswith medical application and claims meet thedefinition of medical device. Examples include

diagnostic ultrasound products, X-ray ma-chines and medical lasers.8

Given the broad language in section 4191, manu-facturers would be wise to begin from the assump-tion that all their medical device sales will generatea liability for the MDET. Manufacturers will thenneed to consider the application of a handful ofexclusions. Determining how to implement the ex-clusions for specific medical devices sold primarilyat retail, for export, and for further manufacturingwill entail substantial complexity.

The retail sales exclusion. Section 4191(b)(2)specifies that eyeglasses, contact lenses, and hearingaids are exempt from the definition of taxablemedical devices. Also, section 4191(b)(2)(D) del-egates to Treasury the authority to exempt fromtaxable medical devices any medical device ‘‘deter-mined by the Secretary to be of a type which isgenerally purchased by the general public at retailfor individual use.’’

Arising out of a desire to hide the cost of thisnewly enacted tax from individual consumers ofmedical devices, the exclusion for devices soldprimarily at retail will be the most complex of theMDET exclusions to implement. Several importantquestions arise from the limits set forth in thisexclusion:

• How is the general public defined?• Is the fact that a device is available only by

prescription relevant?• Is the fact that a device is designed to be

administered only by a healthcare professionaltaken into account? What if it is not adminis-tered by a professional?

• Should devices labeled ‘‘over the counter’’ or‘‘for home use’’ be deemed to be sold at retail?

• Does it matter who pays for the use of thedevice?

• What volume of sales determines when a de-vice is ‘‘generally purchased’’?

• What if a particular taxpayer sells a device typesolely through retail channels, but competitorssell both through retail and to hospitals?

While forthcoming guidance likely will addressthose definitional elements, a more complicatedpolicy question may arise in choosing the mecha-nism used to implement the exclusion. AlthoughCongress envisioned that this retail sale exclusionwould be implemented through an item list,9 that

521 C.F.R. section 807.3(g).6Id.7Medical device classifications are set forth in title 21 of the

Code of Federal Regulations, pts. 862-892.

8See http://www.fda.gov/MedicalDevices/ProductsandMedicalProcedures/default.htm (last updated Oct. 12, 2011).

9Joint Committee on Taxation, ‘‘Description of RevenueProvisions Contained in the President’s Fiscal Year 2011 BudgetProposal,’’ JCS-2-10 (Aug. 16, 2010), Doc 2010-18224, 2010 TNT158-13, contains the following statement: ‘‘It is anticipated that

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(Footnote continued on next page.)

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may be impractical. There are more than 5,630 FDAproduct codes for medical devices. Eyeglasses, con-tact lenses, and hearing aids, which are tax-exemptby statute, constitute 25 of them. Thus, Treasuryand the IRS would need to address more than 5,600device types to promulgate a list. We estimate thatof those, roughly 266 may be eligible for the retailsales exclusion depending on how the limits of theexclusion are defined. No matter how the defini-tional questions are resolved, to derive a list, Trea-sury and the IRS will need a great deal ofinformation that is not publicly available for allthese device types. Moreover, even if the data wereavailable, it would take a significant amount ofeffort to characterize the data by the ‘‘generalpublic,’’ ‘‘individual use,’’ and ‘‘retail’’ filters andthen apply whatever definition of the phrase ‘‘gen-erally sold’’ is to be used.

Other exclusions. The MDET is structured toapply only once to a medical device sale. Sales ofmedical devices for further manufacturing are ex-empt in accordance with the section 4221 manufac-turing excise tax rules. It is anticipated that the IRS’sexemption certificate system under those rules willbe used for purposes of the MDET. Obviously,buyers and sellers will need to agree on when thisexemption applies, which means medical devicemanufacturers will have to consider the implicationof this exclusion within their supply chains.

Also, export sales are exempt, as are sales to areseller that acquires a medical device for export.Taxpayers will need to be able to identify medicaldevices that are intended for export at the end ofmanufacturing to avoid paying the MDET and laterseeking a refund.

Additional considerations. Another importantconsideration is that some exclusions that oftenapply to excise taxes do not apply for purposes ofthe MDET. Accordingly:

• the MDET applies to sales to nonprofit andtax-exempt purchasers;

• the MDET applies to sales to federal, state, andlocal governmental entities; and

• the MDET applies to sales for resale.

How Is the Tax Triggered?As with other manufacturers excise taxes, the

MDET attaches to the first sale of a taxable medicaldevice by a manufacturer or importer in the UnitedStates.10 Thus, the tax is structured to apply once toa finished medical device. In situations in which thefinished article is used rather than sold, section 4218

imposes the tax on uses of taxable articles. Thus, ascurrently structured, the MDET applies to use in theperformance of research, to charitable contribu-tions, and to the common practice of lending oftools. Valuation in those situations will, of course,be problematic.

Rental and leasing transactions also trigger aliability for the tax, although the tax is generallyspread out and collected along with the rentalpayments. Under section 4216, each transactionwhereby a taxable article is rented to a customer istreated as a use, and the tax is imposed on theelement of the rental payment that relates to the useof the taxable article. That particular rule will createvaluation difficulties in arrangements under whichmedical device manufacturers provide for the useof a medical device in conjunction with servicessuch as training.

Some lease transactions are afforded specialtreatment, whereby the entry into the lease istreated as a sale and the tax on the device is appliedto each lease payment until a ceiling amount of tax,computed as if the tax had arisen at the outset, isreached.11 That treatment is available only to manu-facturers that both lease medical devices and sellthe same (or substantially similar) medical devicesto unrelated customers.12

How Is the Tax Measured?

Because the MDET is a manufacturers excise tax,it is designed to be levied not on the retail price ofa taxable device, but on its wholesale price.13 Con-gress offers a good explanation of the pricing para-digm in its discussion of the operation of the truckexcise tax pricing rules:

Consequently, the bill requires that every ef-fort be made to ascertain the manufacturers’ orproducers’ price at the place of manufacture orproduction. In the case of those commoditieswhich are ordinarily sold at wholesale, thisprice will be the price at which the manufac-turer sells to the wholesaler, even though theparticular sale is at retail. This price may beestablished with respect to any particular saleor class of sales, for example, by existingwholesale prices, or by a system of discounts

the Secretary will publish a list of medical device classificationsthat are of a type generally purchased by the general public atretail for individual use.’’

10See Indian Motorcycle Co. v. United States, 283 U.S. 570 (1931).

11It appears that a lease-by-lease accounting mechanismwould be necessary to compute this ceiling and apply MDETpayments collected during the lease term.

12The application of the lease rule to the medical deviceindustry is likely to be very limited because it is unusual withinthe industry to both lease directly and sell the same articles.

13See Hoffman Motors Corp. v. United States, 473 F.2d 254, 256(2d Cir. 1973).

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from retail prices or by building up from costof production, whichever method may be themost practical.14

Given the technological complexity and sophis-tication of today’s medical devices, manufacturerscommonly distribute their products through related-party distribution arrangements. In related-partysituations like those, measuring and substantiatingthe price on the sale from the manufacturing entityto the distribution entity may complicate compliancewith the MDET. Also, the IRS can be expected toscrutinize related-party distribution arrangements,and it has at its disposal a series of antiabuse pricingrules it can apply.15

How Will the Tax Be Paid?The new tax will be paid semimonthly based on

sales occurring during the preceding two weeks.The first payment of tax will be due January 28,2013, for sales through January 14, 2013. We antici-pate that the IRS will modify Form 720, ‘‘QuarterlyFederal Excise Tax Return,’’ to accommodate theneed for quarterly reporting of the MDET.

Because this tax is completely new, taxpayers willneed to design, develop, and test entirely newcompliance procedures for it. In developing theprocedures, taxpayers will have to identify anddevelop processes, fulfill manpower needs, trainpeople, document procedures, and establish andtest controls. Moreover, mechanisms will need to becreated to identify, extract, and manipulate the datato ensure compliance. Because that data are oftenunavailable, most manufacturers subject to theMDET will need to evaluate changes to their dataprocessing systems as they seek to implement theMDET.

Questions, Questions, QuestionsSection 4191 leaves many unanswered questions,

which Treasury may address in regulations or otherguidance. In addition to the question of exemptions,guidance will be necessary on:

• the definition of manufacturing (as it applies toassembly, bundling, warranty work, and re-manufacturing) that applies to determine whois liable for the tax;

• how to determine sales prices in an industry inwhich complex contractual arrangements pro-vide for a variety of allowances and rebates;

• what value should be applied to uses treated assales of medical devices;

• whether existing rental streams and leases giverise to uses treated as new sales, or whether the

use of property before December 31, 2012, willpermit ongoing revenue streams to be exempt;

• how a lease is defined and which rental ar-rangements are treated as leases; and

• whether to respect transactions between re-lated parties.

Implications and Unintended Consequences

Congress adopted this new 2.3 percent excise taxon domestic medical device sales (and uses) to payfor healthcare reform. However, this new tax couldhave several unintended consequences. It has beensuggested that this tax might merely be added tothe invoice price of taxable medical devices andpassed along to customers in a manner similar to,for example, the manufacturers excise tax on tires.However, because Medicare and Medicaid, the Vet-erans Administration, and the Department of De-fense pay for the majority of the medical devicesales and uses in the United States, a simplepassthrough seems unlikely. Manufacturers may tryto push the tax back onto their suppliers or try toreduce their operating costs in response to this newtax.

Also, there may be pressure to limit taxablemedical device sales as companies seek to unbundlearrangements consisting of both the use of propertyand services and to modify the item defined as amedical device to determine whether componentparts can be excluded from the medical devicedefinition. For example, is it possible to exclude akeyboard used to initiate the operation of a pro-cedure from the definition of a medical device? Thisresponse could be complicated, because the act ofunbundling some components to avoid federal ex-cise tax may expose a previously exempt medicaldevice to additional state and local sales taxes.

In some cases, medical devices that are profitablymanufactured in the United States may no longer besold profitably. The profitability of some rentalarrangements likely will be substantially reduced. Itis also possible that captive U.S. manufacturingarrangements may become uncompetitive in com-parison with the importation of a similar good. Asthe January 1, 2013, effective date of the tax ap-proaches, medical device manufacturers may needto consider that the MDET may simultaneouslycreate tension within distribution channels andsupply chains.

Although bills have been introduced to repealthe MDET, it is highly unlikely that it will berepealed before it goes into effect. Creating newsystems and procedures to ensure proper compli-ance with this new tax will be demanding, butdetermining how to respond to this tax will be even

14H.R. Rep. No. 72-708 (1939), reprinted in 1939-1 C.B. (Part 2)457, 480.

15See section 4216(b).

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more complex. Therefore, manufacturers, produc-ers, and importers of medical devices would be welladvised to begin now to plan for the implementa-tion of the MDET.

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