The Medical Device Excise Tax

Last night the Tea Party crowd in the House passed a couple of resolutions. Most of today’s endless political mania is over the Faustian choice between either eliminating a centrist health care reform on the eve of when it will actually start helping people or watching the government shut down. The other resolution would repeal the Medical Device Excise Tax and it actually has the support of a few Democrats who just happened to be bought and paid for by the medical device sector. I just listened to one of them say that the tax will cause these firms shift production offshore. Paul N. van de Water rebutted this ridiculous claim yesterday:

the excise tax creates no incentive whatever for medical device manufacturers to move production overseas. The tax applies to imported as well as domestically produced devices. Thus, sales of medical devices in the United States will be equally subject to the tax whether they are produced here or abroad, and the tax will not make imported devices any more attractive to domestic purchasers. In addition, devices produced in the United States for export are exempt from the tax, so it will not reduce the competitiveness of U.S.-made devices in international markets.

Paul did an admirable job of addressing some of the other claims from the medical device sector so let me turn to a more subtle point about this alleged 2.3% tax rate. Section 4191 notes the tax is applied to the wholesale price as opposed to the retail price even though companies like Medtronic and Johnson & Johnson sell into the retail market. So the law allows for a constructive price, which is effectively the arm’s length price between the manufacturing division and the distribution division. The government seems to think that this price should be around 75% of the retail price, which is likely about right. If these companies accept this government position, their effective tax rate would be only 1.73% not 2.3%. But suppose the Big Four accounting representatives of these companies draft transfer pricing reports that base the price on production costs plus a modest markup over costs, which would like argue that the constructive price should be closer to 30% of retail sales. In this case, the effective rate would likely be less than 0.7% of sales. While any reasonable person would recognize that no medical device manufacturer would ever forego their substantial intangible profits by selling their goods so cheaply to a distributor, we will have to see whether the IRS has the intelligence and fortitude to challenge such incredibly aggressive tax evasion through transfer pricing manipulation.