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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.