How to Find Savings in the Excise Tax Era

The Health Care and Education Reconciliation Act of 2010, in conjunction with the Patient Protection and Affordable Care Act, created a new excise tax on manufacturers and importers of certain medical devices. Just before the tax took effect on January 1, 2013, the IRS issued final regulations and interim guidance that helped eliminate some of the substantial uncertainties surrounding the tax.

Accordingly, much has been learned about the nuts and bolts of the tax, and in light of the guidance provided, manufacturers may have opportunities for savings or can take concrete steps to mitigate risk. Manufacturers that have not carefully considered all sales in light of the new rules should act now, given that the IRS’s transition relief from deposit penalties for good faith compliance errors is soon coming to an end.

Which Devices Are Taxable?
Section 4191 of the Internal Revenue Code (IRC) imposes a 2.3 percent medical device excise tax (MDET) that manufacturers and importers must pay on sales of certain medical devices. The U.S. Department of the Treasury avoided independently defining medical devices for tax purposes and linked taxability to Food and Drug Administration (FDA) status. Accordingly, the tax applies to devices that are listed as a medical device with FDA; if a device isn’t listed with FDA, it should not be subject to the tax.

An exemption to the listing rule applies to devices purchased by the general public at retail for individual use (the retail exemption). The regulations provide eight separate factors that must be considered to determine whether a device may qualify for the retail exemption.

Manufacturers that claim this exemption should carefully document (with supporting evidence) why their device qualifies under these eight factors. Prototypes manufactured for a purchaser and not currently listed with FDA also are exempt from the MDET. However, once a prototype has been accepted and must be listed, any sale would be subject to the tax.

The final regulations also clarify that medical devices intended for use in animals and that are listed with FDA are taxable if they also may be used for humans.

Determining the Taxable Price
The interim rules address how to determine the taxable price of medical devices for purposes of the MDET and resolve much of the uncertainty that existed on the issue. It is important to note that the MDET is not calculated based on a taxpayer’s actual sales of taxable devices.

The rules generally treat the price for which a manufacturer sells a taxable device to an independent wholesale distributor as the applicable price, subject to certain adjustments.

IRC Section 4216 also provides rules for determining the “constructive sale price” when a manufacturer sells a taxable device to a purchaser other than an independent wholesale distributor. The constructive sale price approximates the price an independent wholesale distributor would pay the manufacturer for an identical device.

The applicable price generally depends on the type of distribution chain. Under the interim guidance, issued by the IRS in Notice 2012-77, if a manufacturer sells directly to unrelated end users, the constructive sale price is 75 percent of the actual selling price. If the manufacturer sells to unrelated retailers, the constructive sale price is 90 percent of the lowest price for which the devices are sold.

The interim guidance also includes rules applicable to sales to various types of related retailers and resellers (that is, intercompany sales to subsidiaries, for example).

The interim guidance also states that a taxpayer can use its own independent methodology to determine a constructive sales price as long the taxpayer is able to demonstrate, using expert testimony and industry data, that the constructive price represents the fair market price of the article. Accordingly, restructuring should be considered when a manufacturer can document a fair market sales price that is substantially lower than the percentages permitted under the interim guidance.

For example, a manufacturer that sells to end users and can document a fair market price to a related distributor that is 50 percent of the sales price to end users could realize significant tax savings.


Who Is Liable for the Tax?
When the law first went into effect, contract manufacturers were not certain whether they or their customers would be liable for the tax. Generally, the manufacturer or importer of a taxable medical device is liable for the MDET.                                                      

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According to the IRS, for purposes of the MDET, the manufacturer is the person who produces a taxable medical device from scrap, salvage, or junk material – or from new or raw material – by processing, manipulating, or changing the form of a device or by combining or assembling two or more devices.

It is not uncommon for a manufacturer to contract with another manufacturer to perform some aspect of making the device. In some instances patent owners outsource their entire manufacturing process. In such cases, the IRS has explicitly directed taxpayers to Revenue Ruling 58-134, Revenue Ruling 60-42, and Polaroid v. U.S. for rules regarding the determination of which party is the manufacturer for purposes of the tax.

These examples dictate that the substance rather than the form of the transaction is determinative. These bodies of tax authority indicate three factors that must be weighed in order to determine who the manufacturer is for purposes of the MDET:

  1. Ownership of raw materials
  2. Control over production and sale
  3. Ownership of patent rights

The most important of these factors appears to be the ownership of patent rights, as parties who hold patent rights can be ultimately liable for the tax even if they take no part in the manufacturing process. The factor weighted least is ownership of the raw materials. Critics have argued that this position is inherently counterintuitive, questioning how the party who manufactures the device isn’t the manufacturer liable for the MDET.

Surgical Kits and Procedure Trays
Surgical kits and procedure trays are a common method of delivery to end users, and, as such, determining the taxable manufacturer of the items assembled into a kit is an important issue. Under the proposed regulations, assembling and packaging devices into a kit was considered manufacturing, so companies selling individual kit components would not be liable for the tax. In the final regulations, however, the opposite rule was adopted, and assembling devices in a kit is not considered manufacturing. As a result, companies selling individual devices that will be assembled into a kit must pay the MDET. However, if a manufacturer assembles a kit that includes a nontaxable device, then only the proportional value of the taxable devices should be taxed.

Further Manufacture, Export, and Resale Exemptions
Unlike a sales tax, there is no resale exemption with respect to the MDET. Section 4191 of the IRC does, however, provide several other exemptions for the MDET, including the further manufacture and export exemptions. Devices subject to the MDET are exempt from the tax when purchased for further manufacture or for resale to a second purchaser for further manufacture. A device is considered sold for further manufacture if it is sold as a material in the manufacture or production or as a component part of another taxable device to be manufactured by the purchaser.

To document a tax-free sale of a medical device that will be used for further manufacture, the customer’s purchase order must state:

  • The exempt purpose for which the devices are being purchased
  • The purchaser’s registration number

It is important to note that purchasers and manufacturers who intend to remanufacture need to register using Form 637, “Application for Registration (For Certain Excise Tax Activities).”


The manufacturer also should disclose certain information to customers who purchase a device for further manufacture in order to document the sale’s MDET tax-free treatment. The manufacturer’s invoice for sales to purchasers who further manufacture should state that:

  • Certain devices normally subject to the MDET tax are being sold tax-free.
  • The customer is obtaining those devices tax-free for an MDET-exempt purpose under an exemption certificate or its equivalent.

The invoice also should indicate that:

  • The purchaser can compute and remit the tax due if a device sold tax-free for further manufacture is diverted to a taxable use.
  • The manufacturer can remit the tax due with respect to a device purchased tax-free for resale for use in further manufacture if, within a six-month period, the manufacturer does not receive proof that the device was used for further manufacture.
  • The purchaser should notify the manufacturer if a device otherwise purchased tax-free is diverted to a taxable use.

Sales to a purchaser for resale to a second purchaser for use in further manufacture also can be exempt in certain circumstances. For example, manufacturer X sells a device to manufacturer Y, who further manufactures for sale to manufacturer Z who further manufactures and resells to the end user. The sales from X to Y and Y to Z would be exempt, and Z’s sale to an end user would be taxable. To guarantee exempt treatment, a manufacturer should obtain a statement from the purchaser similar to sample provided by the IRS in Treasury Regulation 48.4221-2.

Section 4191 also grants an exemption for sales of taxable devices for export (or for resale for export). Manufacturers should confirm that their document retention policy requires retention of documentation of export, such as proof of shipping outside of the United States. As with the remanufacturing exemption, the purchaser must provide its registration number to the manufacturer and certify on the purchase order or other document furnished by the purchaser to the manufacturer the exempt purpose for which the device will be used.

Seeking Further IRS Guidance
The IRS informally has indicated that it expects, and is open to, a number of requests for clarification because the MDET is a new tax. Medical device companies shouldn’t hesitate to reach out to the IRS Office of Chief Counsel (OCC) for guidance on uncertain issues. In some cases, companies may even consider requesting a private letter ruling (PLR) on a specific issue. The OCC might be willing to informally discuss a ruling request with a manufacturer before submitting a formal PLR request. Revenue Procedure 2013-1 provides further details on the procedures for requesting a PLR.

Reporting and Tax Deposit Rules
The IRS has developed a new six-page form for reporting the MDET – Form 720, “Quarterly Federal Excise Tax Return.” Payment is due with the return by the following filing dates:

  • January-March quarter: April 30
  • April-June quarter: July 31
  • July-September quarter: Oct. 31
  • October-December quarter: Dec. 31

Manufacturers and importers of taxable medical devices also generally are required to make semimonthly deposits of tax. The deposit for a semimonthly period is due by the 14th day following that period. Generally, this is the 29th day of a month for the first semimonthly period (14 days after the 15th day of the month) and the 14th day of the following month (14 days after the last day of the month) for the second semimonthly period.

IRS Notice 2012-77 provides transition relief from deposit penalties during the first three calendar quarters of 2013 if the taxpayer demonstrates a good faith attempt to comply with the applicable requirements and if the failure was not due to willful neglect.

Still Feel Like You Are Navigating Murky Waters?
Much of the uncertainty that surrounded the MDET at its adoption has been resolved by the regulations and interim guidance; however, it is clear that there is much more to the tax than simply reporting and remitting. Some manufacturers might benefit from re-evaluating their obligations in light of the guidance released to date to potentially reduce their tax liability.

Will Ault is a director with Crowe Horwath LLP in the New York office. He can be reached at 203-554-2486 or This email address is being protected from spambots. You need JavaScript enabled to view it..

Jonathan Soleimanzadeh is with Crowe in the New York office. He can be reached at 212-572-5579 or This email address is being protected from spambots. You need JavaScript enabled to view it..

Crowe Horwath LLP
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