The Medical Device Excise Tax (MDET) – Ramifications for Device Makers

* The Medical Device Excise Tax is a 2.3 percent tax based on the sale price of certain medical devices sold in the U.S. by the manufacturer, producer or importer of the device.

* The tax goes into effect on sales made after December 31, 2012, and revenues from the tax will be used to help finance the Affordable Care Act.

* Those in the industry argue the tax will lead to the elimination of jobs, cuts to research and development budgets, and roadblocks in the development of new therapies.

* The largest impact may be on private payers – who will likely absorb much of the cost associated with the new excise tax.

*  With the excise tax introducing further price pressure on an already fragmented industry struggling to maintain innovation in the face of reimbursement cuts, the device space may see more acquisitions – especially those that introduce benefits of scale and diversity of product offering while achieving cost synergies.

Summary

Medical device makers are rallying to oppose a new “sales tax” that they argue will have broad implications for innovation and the sustainability of medical device manufacturers in the U.S.  The new tax, referred to as the Medical Device Excise Tax (MDET), imposes an excise tax on sales of any “taxable medical device” by the manufacturer, producer, or importer of the device, in an amount equal to 2.3 percent of the sales price.  The MDET, which goes into effect January 1, 2013, is forecast by the Office of Management and Budget to raise $20-30 billion over a 10-year period, and will help finance the Affordable Care Act that was signed into law in March of 2010.

Resistance from the Medical Device Industry

Faced with the new fees, the medical device industry has organized a campaign aimed at repealing the excise tax.  In a letter to Congressional leaders urging the repeal of the legislation, a coalition of over 400 medical device companies notes that it invests close to $10B in research and development annually. Outside of a few big players like Stryker, Medtronic and Boston Scientific, the medical device sector is largely a start-up and small business industry with over 80 percent of medical device companies employing fewer than 50 employees. Only two percent employ more than 500.  The letter goes on to say the device tax will have the greatest effect on many of these small to mid-sized companies, which may owe more in taxes than they generate in profits since the tax is applied to total sales revenue.  This, the coalition argues, would result in the elimination of jobs, cuts to research and development budgets, and roadblocks in the development of new therapies.

Among those voicing concern is the Medical Technology Alliance (MTA) and its regional associates such as The Massachusetts Medical Device Industry Council (MassMEDIC) and MichBio.  These groups have descended on Washington armed with data and worst-case scenarios from the industry to support their claims that the new tax while have far reaching effects on device makers.  Their arguments include a recently published survey from MassMEDIC that polled forty-two senior industry executives who are planning a variety of moves to keep the 2.3 percent excise tax from hurting their bottom lines.

Key findings of the survey include:

• As of February 2012, 10 months before the tax goes into effect, only 25 percent of responding companies have put systems into place to comply with the MDET.

• 44 percent of respondents stated that their companies would pass the cost of the new tax on to end users such as hospitals, clinics, purchasing organizations and doctors. This would result in higher costs for medical devices sold in this country.

• 39 percent of respondents stated that their companies would assume the cost of the MDET, implementing internal cost reductions to meet revenue losses, taking the following actions:

− 50 percent will cut R&D operations

− 25 percent will implement workforce reductions

− 25 percent will outsource manufacturing to lower cost areas

The survey also found that 49 percent of respondents said that the MDET would have a ‘significant impact’ on their company’s operations.

“We warned two years ago that medical device companies would be forced to deal with this tax by preparing for job cuts and reductions in R&D spending,” said Tom Sommer, President of MassMEDIC. “The U.S. leads the world in developing and manufacturing medical products, it doesn’t make sense that on one hand the government is promoting exports and manufacturing jobs, while on the other hand it is implementing policies that will cut jobs in this sector and harm its competitive advantage – the development of innovative medical technologies.”

These feeling were echoed by Stephen Rapundalo, head of the industry association MichBio, in a recent Xconomy article that also explores the impacts of the MDET. Rapundalo says the medical device tax is already forcing companies to reduce costs—which usually involves cuts to R&D—so they’ll have the money when the first tax bill comes due on January 1, 2013.  Stryker, based in Kalamazoo, Michigan, pre-emptively cut its worldwide workforce by 1,000 people last fall, which Rapundalo says was in preparation for paying the excise tax.  Another possible outcome he predicts is that companies will look at moving their operations to lower-cost areas overseas.  A much cited study financed by AdvaMed, an industry trade association, alleges that the tax would cause 10 percent of device manufacturing to move offshore, leading to the loss of 43,000 U.S. jobs.  However, this argument is debatable since the tax will only apply to medical devices sold in the U.S., including those that are imported, but does not apply to devices that are manufactured and sold abroad.  According to The Economist magazine, the effect of the excise tax on the medical device industry will be “trivial compared with other shifts,” such as “scandals, recalls, stingy customers, [and] anxious regulators,” all of which have left the industry in a “rut.”  Read the whole article here.

In a recently published white paper, the Center on Budget and Policy Priorities (CBPP) takes on other claims made by members of the medical device lobbying campaign, namely it’s effects on innovation and consumer spending.  According to the CBPP, the excise tax is not likely to have a large effect on innovation in the medical device industry, despite claims to the contrary. The CBPP cites work done by PricewaterhouseCoopers that identifies five pillars of medical technology innovation: financial incentives, human and physical resources, a favorable regulatory climate, demanding and price-insensitive patients, and a supportive investment community.  The CBPP argues the excise tax will only have a small effect on one of the pillars – financial incentives.

The CBPP also argues the effect of the excise tax on consumers’ costs for health care and health insurance will be minimal.  The CBPP goes on to explain that spending on taxable medical devices represents less than 1 percent of total personal health expenditures, so a small increase in their price would have non-material effect on health insurance premiums.

Many proponents of the health care reform law, including the CBPP, justify the MDET and other new sources of tax revenue arguing that medical device companies will experience an increase in revenue as a result of millions of newly insured citizens. However, if Massachusetts, with its universal health care law, serves as an example, opponents to the tax will point to the MassMEDIC survey that shows none of the responding device makers reported an increase in unit sales in Massachusetts since 2006.

Analysis – the real costs of the excise tax on medical device makers

On February 3, the IRS issued proposed regulations that provide guidance on the 2.3 percent excise tax that will be imposed on the sale of certain medical devices by a manufacturer, producer or importer.  The new law provides that any device defined in §201(h) of the Federal Food, Drug, & Cosmetic Act (FFDCA) that is intended for humans will be taxable. The FFDCA is written broadly to include instruments, machines, implants and in vitro reagents, among others.  However, consumer devices like hearing aids, eyeglasses, contact lenses and devices determined by the Secretary of HHS “to be of a type which is generally purchased by the general public at retail for individual use (the retail exemption)” will likely be exempt.  There is also an exemption for devices that are labeled as “Research Use Only” if they are not listed with the FDA. Less clear is whether durable medical equipment like wheelchairs, prosthetics and orthotics will be subject to the tax.  PricewaterhouseCoopers offers an in-depth look at the new IRS and Treasury rules here.

In addition to the uncertainty as to which medical devices will be taxable under the new rules, determining the incidence of this tax will be further complicated because government programs likely will not increase reimbursements to cover it, and, according to an Ernst & Young report, the federal government pays for more than half of all medical devices through Medicare, Medicaid, the Veterans Administration, and the Department of Defense.  There is also uncertainty when, or at which point in the manufacturing and sales process, the tax should be levied. Medical device companies have multiple units in the manufacturing process – meaning that determining where an actual sale occurs still isn’t clear. For example, a medical device manufacturer may have several of its products or components outsourced to engineering and design firms during the manufacturing process.

To better understand the potential costs of the MDET, including their materiality, we have provided a table with trading comps for seven leading medical device companies, as well estimates for the expected after-tax impact of the excise tax:

Medical Device Trading Comps

Estimated Excise Tax

The excise tax amounts provided in the “Estimated Excise Fee*” column were determined using the following assumptions: U.S. Sales and Net Income were determined using actual FY 2011 CapIQ data, and 80 percent of those U.S. Sales are taxable at the full 2.3 percent excise tax rate.

Two Seeking Alpha** articles provide estimated MDET liabilities for Medtronic and St. Jude Medical.  The writer estimates, for Medtronic, the after-tax impact of the excise tax to be $87 million, based on U.S. sales of some $9.1 billion, about 80 percent of which he estimates to be impacted by the tax. He goes on to explain that while the tax rate is 2.3 percent, the model assumes some offset from price increases or other mitigation factors so that the final impact is 1.5 percent before tax.  For St. Jude Medical, the after-tax impact of the excise tax is estimated to be $25 million, based on the company’s U.S. based revenue and an incidence of tax of 50 percent which contemplates that the company may be able to raise prices marginally in the wake of the excise tax.

The last column (“Company Estimates”) provides MDET estimates disclosed by Medtronic and Stryker during interviews or other disclosures.  For example, former Stryker CEO Stephen MacMillan estimated the tab on the medical device tax at $150 million when the company announced layoffs and restructuring efforts to reduce costs by more than $100 million.  Medtronic Chief Financial Officer Gary Ellis, provided his company’s estimate of $125-175 million during a recent conference call with investors.

Beyond the estimates provided above, many in the medical equipment industry are coming to realize that the tax may be even more expensive according to a recent MASS Device article.  Most of those costs will be soft, such as the opportunity cost of diverting staff from other projects. Others will be more tangible, such as having to hire accounting, IT and other specialists.  While the larger companies in the industry have the bandwidth and cash to easily absorb a few more consultants, there is concern that the many small medical device firms across the country, which make up the majority of the industry, will not be equipped to properly deal with the new tax and consolidation within the industry may result.

Ramifications for the Industry

Given the uncertainty associated with the new excise tax, there may be opportunities to restructure operations, especially related to a company’s supply chain, to better navigate the new tax laws.  In a November 2011 Ernst & Young Tax Practice presentation entitled “Making Sense of the New Excise Tax on Medical Devices”, it’s authors Christopher J. Ohmes and Michael Udell point out that while the tax might merely be added to the invoice price of taxable medical devices and passed along to customers in a manner similar to, for example, the manufacturers excise tax on tires, this scenario is unlikely because Medicare and Medicaid, the Veterans Administration, and the Department of Defense pay for the majority of the medical device sales and uses in the United States.  In this scenario, it is likely private payers that will bear the brunt of any price increases introduced to offset the MDET.  Manufacturers may try to push the tax back onto their suppliers or try to reduce their operating costs in response to this new tax.

Also, there may be pressure to limit taxable medical device sales as companies seek to unbundle arrangements consisting of both the use of property and services and to modify the item defined as a medical device to determine whether component parts can be excluded from the medical device definition. By way of example, Ohmes and Udell ask if a keyboard used to initiate the operation of a procedure could be excluded from the definition of a medical device. This response could be complicated, because the act of unbundling some components to avoid federal excise tax may expose a previously exempt medical device to additional state and local sales taxes.

In some cases, medical devices that are profitably manufactured in the United States may no longer be sold profitably. The profitability of some rental arrangements likely will be substantially reduced. It is also possible that captive U.S. manufacturing arrangements may become uncompetitive in comparison with the importation of a similar good. As the January 1, 2013, effective date of the tax approaches, medical device manufacturers may need to consider that the MDET may simultaneously create tension within distribution channels and supply chains.

A Final Note on Renewal of the Medical Device User Fee Act (MDUFA)

The second issue facing the medical device industry is the renewal of the MDUFA, which creates a new user fee agreement negotiated between the medical device industry and the Food & Drug Administration (FDA). It provides new guidelines for how companies will pay for their product-approval submissions, as well as the timeline the FDA has to conduct those product reviews. These changes are generally welcomed by the industry since they offer more stringent terms for “pay-for-performance” expectations – something that is sorely lacking at the agency.  It seems in this case, the industry is content to pay higher fees since it is puts a greater importance on the FDA acting quickly, and a more equitable way to measure approval times.

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As a healthcare-focused merchant bank, Bourne Partners provides financial advisory, direct investment, alternative assets and management consulting services to our client-partners. We play an active role in helping businesses grow by creating long-term, profitable relationships that extend beyond single transactions. It is our focus on relationships and long-term results that has yielded us an impeccable track record of client satisfaction . Our direct and indirect investments in sector-leading companies – often through our relationships with top-tier Private Equity funds – allow us to learn about the best-of-the-best from the inside and apply that knowledge to the companies we serve. At Bourne Partners, we operate within a specific set of core boundaries: integrity, accountability, teamwork, loyalty and commitment are the driving forces behind everything we do.
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One Response to The Medical Device Excise Tax (MDET) – Ramifications for Device Makers

  1. [4/4] Pharma Exec Blog “Despite Growing Momentum, Repeal of Medical Device Tax Faces Significant Hurdles” On March 21, 2013, the United States Senate approved an amendment by a vote of 79 to 20 to repeal the 2.3 percent medical device excise tax. The tax, which went into effect this past January, was included as part of the Patient Protection and Affordable Care Act. Despite the vote, it is far from clear that repeal of the tax will occur. The repeal is largely symbolic because the resolution was an amendment to the Senate Democrats’ budget, a partisan measure that is not likely to pass the Republican-controlled House of Representatives. Also, it’s not clear how the revenue created by the tax would be accounted for if it is ultimately repealed. http://blog.pharmexec.com/2013/04/04/despite-growing-momentum-repeal-of-medical-device-tax-faces-significant-hurdles/

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