Company Requests Clarification in Proposed Regs on Medical Device Excise Tax

Dear Commissioner Shulman:

On behalf of McKesson Corporation ("McKesson"), I am pleased to submit the following comments regarding the implementation of the new excise tax on medical devices ("MD Excise Tax") imposed by section 4191 of the Code.¹ In Notice 2010-89, the Treasury Department ("Treasury") and the Internal Revenue Service ("IRS") requested comments on issues that should be addressed in guidance implementing section 4191. On March 24, 2011, McKesson submitted comments in response to Notice 2010-89. On February 7, 2012, Treasury and the IRS published proposed regulations for the MD Excise Tax (REG-113770-10), which is the subject of the comments herein. Unless otherwise addressed, the comments from our March 24, 2011 comment letter are incorporated herein by reference.

Section 4191 imposes a 2.3% excise tax on the sale of any "taxable medical device" by the manufacturer, producer, or importer of the device beginning January 1, 2013. A "taxable medical device" is defined in section 4191(b)(1) as "any device (as defined in section 201(h) of the Federal Food, Drug, and Cosmetic Act) intended for humans." Section 201(h) generally defines a device as an instrument, machine or similar article which is intended to diagnose, treat or prevent a disease or condition, or is intended to affect the structure or function of the body, and does not achieve its primary purpose through a chemical reaction in the body or upon being metabolized.² However, various exemptions provide that certain medical devices will not be subject to the excise tax. For example, section 4191 provides a specific exemption for eyeglasses, contact lenses, and hearing aids, as well as a general exemption for "any other medical device determined by the Secretary to be of a type which is generally purchased by the general public at retail for individual use."

A Fortune 14 corporation, McKesson sells or delivers medicines, pharmaceutical supplies, information and care management products, and services designed to reduce costs and improve quality across the healthcare industry. For purposes of the MD Excise Tax, McKesson has entities that are manufacturers or importers. McKesson operates in two business segments that provide distribution and technology solutions. The McKesson Distribution Solutions segment distributes brand and generic pharmaceuticals, medical-surgical supplies and equipment, and health and beauty care products throughout North America. This segment also provides specialty pharmaceutical solutions for biotech and pharmaceutical manufacturers, sells financial, operational and clinical solutions for pharmacies (retail, hospital, long-term care), and provides consulting, outsourcing and other services. The McKesson Technology Solutions segment delivers clinical, patient care, financial, supply chain, and strategic management software solutions, pharmacy automation for hospitals, as well as connectivity, outsourcing and other services (including remote hosting and managed services) to healthcare organizations. This segment also includes claims payment solutions, medical management software businesses, and care management programs. The segment's customers include hospitals, physicians, homecare providers, retail pharmacies, and payers from North America and abroad.

As the MD Excise Tax will impact many of the company's businesses, our comments focus on ways to make the MD Excise Tax easier for both administration and compliance. Additionally, we are requesting clarification on its application in a number of areas. We appreciate the opportunity to provide comments on this subject and would be pleased to provide further information on any of our recommendations.

I. Consistency between U.S. Food and Drug Administration ("FDA") and the Service's Definition of Medical Device

McKesson supports the position in the proposed regulations that would define a "device" for purposes of IRC section 4191 by reference to whether it is listed as a device with the FDA under section 510(j) of the of the FFDCA and 21 CFR Part 807, pursuant to FDA requirements.

The proposed regulations also take the position that "if a device is not listed with the FDA but the FDA later determines that the device should have been listed as a device, the device will be deemed to have been listed as a device with the FDA as of the date the FDA notifies the manufacturer or importer in writing that corrective action with respect to listing is required."

We support this approach but ask that the rule clarify that the device will be deemed to have been listed as a device with the FDA as of the date the FDA "delivers final written notification" to the manufacturer or importer that corrective action with respect to the listing is required. We believe it could cause administrative burdens for both taxpayers and the IRS if the date of a deemed listing turns on an initial FDA notification that a device should be listed. In some cases, for instance, the FDA may notify the taxpayer a device should be listed, the taxpayer may challenge the notification, and the FDA may ultimately conclude the device is not a listed device. We believe it will be both easier to administer and more reasonable to wait until the FDA's administrative procedure process is complete before deeming a device to be listed. Accordingly, the date of such listing should be the date of the final FDA determination.

II. Application of Existing Manufacturers Excise Tax Rules

In the event the above rule is not adopted, McKesson requests the adoption of a safe-harbor rule similar to rules under the Chapter 31 retail excise taxes 75% safe harbor in section 4052(f) (related to certain repairs and modifications not treated as manufacture).

We also urge further clarification on a number of situations unique to the medical device industry that are not specifically covered under the current manufacturers excise tax rules. These include treatment of medical industry software.

III. Issues Unique to the Medical Software Industry

Licensed software is either provided to customers under a perpetual software license (the right to use the software indefinitely) or a term software license (the right to use the software for a fixed period of time). McKesson provides perpetual software license agreements to groups of health care facilities, such as groups of hospitals, which often includes very long IT service periods that typically last from two to eight years. In this situation, McKesson typically receives a partial payment upfront, with receipt of the remaining payments at various times during the two to eight year period that correspond with the completion of certain project milestones. As stated above, title to the software does not transfer and the license is indefinite and non-exclusive.

McKesson arrangements may also include maintenance contracts related to perpetual software licenses. The maintenance contracts are for a specific period of time and are generally renewable annually. Such maintenance contracts include providing upgrades, new releases, patches that correct software programming bugs, software information updates, new computer code enhancements, and corrections to programming errors in the software or interface, as well as transportation, delivery, insurance, IT and help desk services. The maintenance contract may be optional; McKesson may not require the customer to purchase the maintenance contract in order to license the medical software.

Regarding "term" software licenses, McKesson's medical software is sometimes licensed to the end user for a specified term which is usually subject to renewal. Again, title to the software does not transfer and the customer does not generally obtain an exclusive license under term software agreements.

We note that medical software suppliers are increasingly moving from selling traditional large-scale, multi-year software packages to offering various software products on an application service provider license model basis. This license model provides software functionality on a remote processing basis from McKesson's data centers. The data centers provide system and administrative support as well as processing services to McKesson's customers. This license model is also a non-exclusive license and title to the software does not transfer.

The licensing of software via nonexclusive license agreements and the treatment of IT services and maintenance does not fit squarely within the rules related to sales or leases. Accordingly additional guidance is requested.

For nonexclusive license agreements that are subject to the tax, we urge clarification that the tax is due as payments are received under the license agreement. This is the case for installment sales and exclusive license agreements and we believe should also be the case for nonexclusive license agreements.

Under section 48.4216(a)-1(e), "where a taxable article and a nontaxable article are sold by the manufacturer as a unit, the tax attaches to that portion of the manufacturer's sale price of the unit which is properly allocable to the taxable article. . . . Normally, the taxable portion of a unit may be determined by applying to the manufacturer's sale price of the unit the ratio which the manufacturer's separate sale price of the taxable article bears to the sum of the sale prices of both the taxable and nontaxable articles, if such articles are sold separately by the manufacturer. Where the articles (or either one of them) are not sold separately by the manufacturer and have no established sale prices, the taxable portion is to be determined from a comparison of the actual costs of the articles to the manufacturer. . . ."

McKesson believes that the provision of listed software and IT services falls squarely within this rule because they are provided as a "unit." McKesson requests confirmation of this interpretation in the final regulations.

IV. Issues Unique to the Medical Convenience Kit Industry

McKesson believes the final regulations should recognize the unique nature of the medical convenience kit industry and clarify when the excise tax applies to medical convenience kit assemblers. In our view, the existing manufacturers excise tax rules do not require that assembly of such a kit be treated as constituting further manufacture of the finished taxable medical devices that are included in the kit or of the convenience kit (when the kit itself is a listed medical device). Therefore, the statement in the proposed rule that articles used in the assembly of a listed kit "lose their identity as separate articles" once they are incorporated into a kit which is itself a taxable medical device, is not in line with long standing IRS policy.

As an example, assembling a kit, pack, or tray often may begin with a request from a hospital or other medical provider specifying that a particular array of generally small, disposable medical products, such as gauze, surgical drapes or bandages, be placed into a single package to facilitate a medical or surgical procedure. The products are often placed side-by-side for efficient use by the healthcare provider; instead of receiving products in a series of boxes, the healthcare provider receives the necessary products for a medical procedure in a single, ready-to-use Kit, Pack or Tray.

There are many types of kits, ranging from those used for the most minor in-office procedure (e.g., a suture removal kit containing a few basic medical products) to those for more complex surgeries (e.g., a hip replacement surgery kit containing a larger number of medical products and devices). Assembling kits is an important customer service that contributes to improving cost management, patient outcomes from medical procedures, and the healthcare providers' employee productivity.

The process of creating a kit consists of purchasing medical devices (that could include sterile and non-sterile devices) from manufacturers and positioning the individual finished medical devices in a combined package. Although, the individual devices have been included in a kit, the assembly process does not cause them to lose their identity, change their intended use or end their regulation by the FDA as a medical device.

Accordingly, while we agree with the proposed regulations regarding kits in general, we urge the Service to clarify the final rules to ensure that the mere assembly of a convenience kit does not constitute further manufacturing for purposes of the MD excise tax. Failure to take this position in the final regulations may result in the removal of certain items from kits which could reduce the quality of care for patients. For instance, in the case of a kit that itself is a listed device, a taxpayer may simply eliminate from the kit all items in the kit that are not listed or that would have qualified for the retail exemption, so such items would not become subject to the tax.

V. Retail Exemption

McKesson requests further clarification with regard to section 4191(b)(2)(D)'s exemption for "any other medical device determined by the Secretary to be of a type which is generally purchased by the general public at retail for individual use" ("Retail Exemption").

Specifically, we would like clarification of the rule in the proposed regulation for devices that are "of a type" that is generally purchased by the general public at retail for individual use. As an example, McKesson manufactures many different gloves that are listed devices. Many of these gloves are generally purchased by the general public at retail for individual use. In other cases, the gloves may have been modified by the addition of powder or lubricants. These modified gloves may not typically be sold at retail and may be listed under a separate FDA product code. Some gloves may be used in a medical setting, but possibly by an orderly or other person who is not a medical professional. None of these uses requires any specialized training. All of these gloves, regardless of use, are "of a type" that could be purchased by the public and are permitted to be sold at retail. They are all gloves and may be viewed as functionally indistinguishable from each other.

Therefore, we urge the final regulations to clarify that if a device is determined to meet the "Retail Exemption" under section 4191(b)(2)(D), then devices meeting the "of a type" requirement include, but are not limited to, devices that are listed under the same single product code in conjunction with the FDA's device listing rules. We believe this clarification would provide greater consistency for taxpayers and accurately reflect Congressional intent.

If such a position is not adopted, we urge that if a device is determined to meet the "Retail Exemption" under section 4191(b)(2)(D), a safe harbor be created to provide clarity that all devices in the same product code listing be deemed to be "of the same type" for purposes of this rule. The proposed regulations take the position that "all devices that are listed under a single product code listing in conjunction with the FDA's device listing requirement are "taxable medical devices," unless they fall within an exemption under section 4191(b)(2)." We would urge that a logical extension of this rule is that a device that falls within an exemption under section 4191(b)(2) includes all devices that are listed under the same FDA product code listing.

We believe that a broad exemption would provide greater consistency for taxpayers and be the easiest method for the IRS to administer.

VI. Conclusion

McKesson believes its recommendations and requests for clarification regarding the implementation and application of section 4191 are supported by the statutory language and congressional intent, and are necessary to ensure proper and consistent application of the MD Excise Tax. We further believe that our recommendations will facilitate taxpayer compliance and ease the Service's administration of the MD Excise Tax. We appreciate the opportunity to be part of this process and would welcome any requests for clarification or further discussion regarding any of our comments. Please let me know if you have any questions. I can be reached at (415) 983-9006 or at paul.a.smith@mckesson.com.

²See definition of the term "device" in section 201(h) of the FD&C Act, 21 U.S.C. 321 (2006).