Medical device industry takes another shot at tax repeal

Medical device industry takes another shot at tax repeal

Is the second time the charm? The medical device industry hopes so.

While the Affordable Care Act earned the ire of many for the major overhauls to insurance, health care and employment law, one relatively minor clause in the legislation has had the medical device sector in an uproar since the law was implemented in 2013.

With a failed attempt under their belt, hundreds of firms have again signed a petition to repeal what they see as a job-killing, innovation-stifling 2.3 percent tax on medical device sales.

“It’s like a ball and chain around your ankle,” said Peter Farrell, founder of San Diego-based ResMed (NYSE: RMD). “If you want to stop innovation in the medical device and life science industry, that’s a great way to do it — put a tax on revenues.”

While 2.3 percent might not sound like much, industry leaders say it’s having profound perverse effects, and San Diego firms like CareFusion (NYSE: CFN), NuVasive (Nasdaq: NUVA), Volcano Corp. (Nasdaq: VOLC) and ResMed haven’t been untouched. Each company has signed the repeal petition, and as dozens of CareFusion and NuVasive employees have voiced personal concern as well.

The problem is that the tax isn’t on profits, but on sales. For every medical device manufactured in or imported into the United States — including catheters, surgical gloves, joint replacements, surgical equipment and anything not commercially bought by the individual patient — companies must pay a 2.3 percent tax on that revenue, which translates into a much bigger loss for the company.

Steve Ferguson, chairman of the board of the Indiana-based Cook Medical Group — which has 12,000 employees and dozens of subsidiaries, including K-Tube in Poway, said the tax effectively reduces companies’ profits by a third.

“Assume you’ve got $100 million in sales,” Ferguson said. “Bottom-line profit industrywide — we’re a bit above 8 percent before tax, so that would be $8 million. The industry’s average is typically around 6 percent, so $6 million. So you have $6 million, and this tax just took away $2.3 million of it. Now you’re down to $3.7 million. That’s the simple way of looking at its impacts — it takes about a third of profits.”

That figure aligns with what Nim Shah, a partner at venture capital firm Domain Associates who specializes in investing in medical device companies, calls the average effect of the top-line tax on the bottom line: from 29 to 30 percent.

Paul Van de Water — a senior fellow at the Center on Budget and Policy Priorities who specializes in Medicare, Social Security and health issues, and who wrote the center’s article opposing repeal — said framing the tax’s impact this way is misleading: it’s simply $2.3 million out of that $100 million.

“It’s literally true, yes, that it is a tax on sales not on profits, but that’s true of excise taxes in general,” Van de Water said.

“No one would ever think to say the fact my local grocery store collects — in Virginia at least — sales tax on all the groceries I buy, no one would say that’s coming out of the profits of the grocery store. Sales taxes are being largely passed on to the consumer.

“And the best we can tell, this tax is likely to be passed on to purchasers as well. Saying it's coming out of profits is just not correct. … As far as I can tell, that argument is slightly disingenuous at best.”

But Cook Medicals' Ferguson and others disagree. They say that passing the tax on to consumers isn’t an option in the medical field because much of the hospital-grade buying is done through large purchasing groups that will simply end contracts with U.S. firms trying to raise the price of devices.

Domain Associates' Shah also added that this situation is different from other taxes because there are no exemptions or exclusions based on company size or stage, as there are with the pharmaceutical industry’s tax on branded prescription drugs.

So how then would a company cope with this? Ferguson sees three options: cut research and development funding, reduce the number or cost of employees, or end capital expenditure projects in the United States.

The Advanced Medical Technology Association trade group surveyed its members in January, and found that the tax amounted to workforce reductions of 14,000 employees in 2013 and 4,500 in 2014, with the industry not hiring 20,500 employees over the next five years.

“We’ve never laid anyone off and it feels foolish to cut employees or R&D, so what we did was make the decision to hold all capital projects in this country,” Ferguson said.

“Our president said there were five projects he was counting on doing, but we put all of those on hold. Each one of those would have added 300 jobs or something like that.”

Spinal device maker NuVasive tells a similar story.

“Since the inception of the tax, we have had to reduce the number of planned hires because of the tax’s impact on our bottom line,” said Carol Cox, NuVasive’s executive vice president of corporate affairs and human resources.

“Additionally, we have had to reduce our investments in R&D and, as a result, are unable to fund R&D at the historical levels of the past.”

Companies say the tax makes the option of manufacturing abroad increasingly enticing. While corporate taxes in the United States are typically between 40 to 50 percent for companies in this space, a company can go to Costa Rica — as Volcano did — and pay no corporate taxes for the first eight years, or pay 12 percent in Ireland as Cook Medical did. Canada has a corporate tax rate of roughly 15 percent.

Cox said this shows how “incredibly ironic and counterproductive it is to have a tax that incentivizes companies to pursue revenues outside of the United States, which has the unfavorable consequence of creating job growth internationally instead of inside U.S. borders.”

CareFusion, now a Becton Dickinson (NYSE: BDX) company, said the tax cost them $23 million in fiscal year 2014, and amounted to $50 million for Becton Dickenson.

The tax is “assessed against the majority of BD products, ranging from needles and syringes to infusion pumps to cervical cancer screening tests to tools used to guide treatment decisions for HIV patients,” a CareFusion representative said.

That’s another problem some see with the tax — it disproportionately affects small companies that have a larger portion of their revenue coming from medical devices, often aren’t profitable yet and don’t have sizeable operations overseas.

“Smaller companies are often not cash-flow positive and not profitable, so this tax likely has a disproportionately negative effect on small, growth-oriented companies that would be better served investing those lost dollars into development efforts,” Cox said.

“Further, the medical device tax applies to U.S. revenues. As a result, large multinational companies are generally less affected, as many generate anywhere from 30 to 50 percent of revenue from overseas. Currently, NuVasive’s overseas revenues are just over 10 percent, so we feel the impact of the tax more acutely.”

In addition to the problems for the medical device firm, Shah said the tax is an issue for VCs as well, which now have to take into account that a large portion of their investment will go to pay this tax for early-stage companies. These companies aren’t yet profitable but are still expected to pay the 2.3 percent, and won’t be using the funds to hire new talent or further develop products.

Shah said that in theory it also affects company valuations. If a third of the profit is removed from the bottom line, the company is worth less, though the larger issue VCs are seeing is the inability to hire people and invest in R&D.

So the industry is back at it with the Protect Medical Innovation Act of 2015 to eliminate the tax from the Affordable Care Act legislation after failing to do so in September 2013.

Van de Water — of the Center on Budget and Policy Priorities — said he sees two problems. One, repealing the tax would be a costly process, and two, the tax is expected to generate about $26 billion from 2015 to 2024.

Though it’s not earmarked to fund the Affordable Care Act as is often said, that amount would be missing from the federal budget nonetheless.

“Certainly, I think the biggest stumbling block is figuring out how to offset the cost of repealing it,” he said. “And that’s going to continue to be a difficulty. It’s easy to figure out how to reduce taxes, but harder to figure out how to raise them.”

To date, however, the tax has produced less revenue than expected. Annual collections from 2014 — the first full fiscal year it was in effect — totaled $2 billion, compared to the $2.7 billion the Joint Committee on Taxation had expected. Ferguson says this is just a rounding error in the multitrillion dollar budget.

“I think everybody realizes that a mistake has been made,” he said. “Now it’s a procedural question of when and how there’s a vehicle to remove it.”

Rep. Scott Peters, who voted to repeal the tax in 2013, said the current version of the bill, the Protect Medical Innovation Act of 2015, has a number of cosponsors in both the House and Senate, and just needs to be brought to the floor for a vote.

"My belief is it would probably pass, but I don’t have any control over whether it's brought to us or not," Peters said. "And I don't know what the president would do in terms of vetoing it."

This article was originally published on San Diego Source.