Starting on Dec. 31, 2012, the Patient Protection and Affordable Care Act’s (ACA’s) Medical Device Excise Tax began to be applied to the sales of all taxable medical devices in the US. Now, almost two years later, the 2.3 percent tax has ruffled investors and stunted new inventions. Industry experts, nonetheless, continue to remain bullish about the future of the medical device innovation sector.

The ‘Hidden’ Tax

Fig. 1 – Clinical medical devices, like this scanner, are subject to the medical device tax.
Excise taxes are nothing new for US thought leaders. Considered a “hidden” tax, an excise tax is reflected in the final price of a product, impacting manufacturers, producers, and investors, rather than a tax directly on consumers. While many politicians appreciate the indirect nature of this tax, industry experts argue that it hurts business development and product innovation.

When the Affordable Care Act, otherwise known as Obamacare, began rolling out on Jan. 1, 2013, a hidden tax also went into effect—a 2.3 percent medical device excise tax. This provision quickly became a controversial issue. Legislators who support the tax say it’s a justifiable way for a very profitable industry to help finance the ACA, at an estimated $29 billion over a decade, according to the Internal Revenue Service. Industry leaders, on the other hand, say the tax on sales can, and will, harm startups by delaying profitability and forcing cuts on research and development spending, which powers future product development.

For many investors, the excise tax feels like the last straw in a recent onslaught of damaging decisions. “It’s a perfect storm,” said Guy Nohra, the managing director at Alta Partners, a venture capital firm, in EY’s medical technology report. “There are regulatory challenges with the [U.S. Food and Drug Administration], there are reimbursement challenges, there is a lack of available venture capital, corporate buyers are mostly missing in action, and the capital markets have disappeared.”

The medical excise tax is imposed on clinical medical devices, such as CAT scan machines, defibrillators, and other devices sold directly to hospitals and other healthcare providers. (See Figure 1) The tax does not apply to consumer medical devices, such as hearing aids, eyeglasses, and contact lenses, which are purchased directly by a consumer in a store. The IRS defines a clinical medical device as a product “listed as a device with the FDA under section 510(j) of the Federal Food, Drug, and Cosmetic Act.”

Once enacted, the excise tax quickly became a point of contention among medical device startups, investment firms, and fiscally conservative politicians. On April 4, 2013, the Senate Finance Committee passed a tax reform bill that many legislators and industry experts thought would address the hidden tax. When the “tax extenders package” was passed, it covered 50 provisions worth $85.3 billion—but it very publically left the excise tax unrepealed. As a result, the provision received yet another bout of negative attention.

The Changing Marketplace

Fig. 2 – Historical Trend Data (Credit: PwC/NVCA MoneyTree Report, Data: Thomson Reuters)
It’s been nearly two years since the tax went into effect, and medical device startups are finding it more challenging than ever to secure funding and successfully get their product to market. Many political experts predict that the tax is not going away anytime soon. Making an idea come to life is challenging enough on its own accord, and with the fiscal, regulatory, and nuanced marketplace tightening to adapt to the new tax, many startups feel they are at a disadvantage before they even begin.

Since the tax implementation, the investment market has noticeably dipped. Total venture capital (VC) funding of medical device startups fell about 19 percent in 2013 over the previous year to $2.1 billion in 2013, from $2.6 billion in 2012, according to a MoneyTree Report by PricewaterhouseCoopers and the National Venture Capital Association. At its 10-year peak in 2007, medical device and equipment funding reached nearly $4 trillion.

“Financing has become increasingly scarce for small companies,” said EY in its Pulse of the Industry: Medical Technology Report 2013. “Slowing growth has resulted in ‘lost’ revenues of $131 billion and ‘lost’ research and development of $12 billion between 2008 and 2012.”

The recent drop in investment funds is especially harmful to medical device startups that are still a couple of years away from getting their products on the market. Potential acquirers, for example, may be less likely to fund certain devices, as the pressure on sales and profits builds through a raised price point used to pay for the hidden tax.

In a 2013 survey by the Advanced Medical Technology Association (AdvaMed), a trade association that benefits medical technology firms, 75 percent of its survey respondents, which were composed of the association’s partner companies, said they had “deferred or cancelled capital investments,” “reduced investment in start-up companies,” and “found it more difficult to raise capital among startup companies,” as a direct result of the excise tax.

While the biggest problem startups face is acquiring a strong financial backing for their products, medical device entrepreneurs, on a basic level, are finding it difficult to understand the provision — exactly which devices are subject to the excise tax?

As referenced earlier, some products, such as devices sold directly to consumers at drug stores, aren’t subject to the tax. But for many manufacturers, this distinction is a confusing gray area. Mobile health apps and software that have been cleared through the FDA, for instance, go through the same processes as a medical device, yet the government has not determined whether or not they are subject to the excise tax, creating an air of uncertainty within the community.