U.S. Life Sciences
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Imposition of Annual Fee on Branded Pharmaceutical Manufacturers Under Health Care Reform Legislation
On March 23, 2010, President Obama signed into law the Patient Protection and Affordable Care Act (HR 3590) (the “Act”), the Senate version of health reform legislation. Then, on March 30, 2010, President Obama signed into law the Health Care and Education Affordability Reconciliation Act of 2010 (HR 4872) (the “Reconciliation Act”), which amends several aspects of the Act. The Act and Reconciliation Act are collectively referred to herein as the “Legislation.”
The Legislation is projected to cost $940 billion over 10 years. The sources of funding for the Legislation include annual fees that will be imposed on manufacturers and importers of branded pharmaceuticals. Branded pharmaceutical manufacturers will be required to pay these annual fees to the Secretary of the Treasury beginning in calendar year 2011.
According to the Legislation, the amount of the annual fee payable by a branded pharmaceutical manufacturer determined to be a “covered entity,” as defined, is based on a ratio of (1) the difference between (a) certain of that entity’s branded prescription drug sales taken into account during the preceding year and (b) the aggregate branded prescription drug sales of all covered entities taken into account during the preceding year multiplied by (2) a fixed dollar amount, which is $2.5 billion in 2011. For example, the fee payable in 2011 will be determined on the basis of branded prescription drug sales for the year ended December 31, 2010. The fee would be payable during the calendar year on a date determined by the Secretary of the Treasury, but in no event later than September 30. The percentage of a covered entity’s aggregate branded prescription drug sales that are subject to inclusion in the ratio is based on a tiered table included in the Act.
Under the Legislation, a “covered entity” is any “manufacturer or importer with gross receipts from branded prescription drug sales.” The term “branded prescription drug sales” refers to “sales of branded prescription drugs to any specified government program or pursuant to coverage under any such program.” “Branded prescription drugs” are “any prescription drug the application for which was submitted under section 505(b) of the Federal Food, Drug, and Cosmetic Act [or] any biological product the license for which was submitted under section 351(a) of the Public Health Service Act.” The Legislation notes that branded prescription drug sales do not include the “sales of any drug or biological product with respect to which a credit was allowed for any taxable year under Section 45C” of the Internal Revenue Code of 1986, subject to certain exclusions, referred to as “orphan drug sales.” For tax purposes, the fee imposed will be treated as an excise tax and is not deductible.
Timing of the Recording of the Annual Fees
As mentioned above, the annual fee imposed on a branded pharmaceutical manufacturer is determined on the basis of the covered entity’s branded prescription drug sales during the preceding calendar year in proportion to the aggregate branded prescription drug sales during the preceding year of all covered entities. Because the annual fee payable in a given calendar year is determined by reference to branded prescription drug sales in the preceding calendar year, a question arises about the timing of recognizing the related liability. Should the annual fee be accrued and recognized in the period that the relevant branded prescription drug sales on which the fee is determined are recognized, or is the annual fee more akin to an assessment for the right to do business that should be recognized in the period in which it becomes due? In response to this question, two approaches to accounting for the annual fee are discussed below.
The first approach is to recognize the annual fee in the period in which the covered entity becomes obligated to pay the annual fee (i.e., payment becomes unavoidable) on the basis of the payment provisions of the Legislation. Those who support this approach believe that the intent of the Legislation is to impose the fee on a covered entity in the year that the annual fee is due only if the covered entity has sold branded prescription drugs to specified government programs or pursuant to coverage under any such program in that calendar year. Supporters feel that that Legislation’s reference to “branded prescription drug sales taken into account during the preceding calendar year” is solely to circumscribe the method of calculating the then-current calendar year’s liability for the annual fee imposed by the Legislation. Likewise, supporters believe that branded prescription drug sales in 2010 would be used merely in the calculation of the annual fee and that such branded prescription drug sales would not in themselves obligate the covered entity to pay the fee. Further, in no event would a covered entity be obligated to pay the annual fee in a calendar year in which it had no branded prescription drug sales as defined in the Legislation, regardless of whether it had such branded prescription drug sales in the preceding calendar year. Accordingly, the expense would be recorded pro rata throughout the calendar year in which it is paid as a cost of doing business for that year.
Under the second approach, because the annual fee is determined by reference to branded prescription drug sales in the preceding calendar year, the covered entity would accrue and recognize the annual fee in the period in which the relevant branded prescription drug sales occur because the annual fee is linked to those sales transactions. Those who support this approach believe that because payment of the annual fee is linked to branded prescription drug sales transactions in the preceding calendar year, the guidance in ASC 605-50-25-72 (formerly EITF Issue 01-93) can be applied analogously to the timing of the recognition of the fee. Accordingly, the covered entity would estimate the amount of the annual fee it would be obligated to pay in the following calendar year and allocate that amount to each branded prescription drug sale that is contributing to the amount of the assessed annual fee.
Based on our interpretation of the language in the Legislation, our position is that the accounting impact of the first approach results in a model that captures the intent of the Legislation. The event that obligates a covered entity to be subject to the annual fee is the branded prescription drug sale to a specified government program that causes an entity to become a “covered entity” during the year in which the annual fee is due. Our understanding is that the intent of the Legislation was not to create a cost before the period that the annual fee was due. For example, under the Legislation, it is the sale of a branded prescription drug to a specified government program in 2011 that creates a legal obligation and therefore makes the covered entity subject to the annual fee to be paid in 2011. The branded prescription drug sales in 2010 are used simply as a component of the calculation of the amount of the annual fee to be paid in 2011. Further, our interpretation of the Legislation is that there would not be a liability without relevant branded prescription drug sales in 2011. We acknowledge that the second approach could be viewed as a legitimate basis for accrual of the annual fee; however, such approach would result in a liability being established for the annual fee before a legal obligation exists.
In informal discussions with the SEC staff, which included members of the Big Four accounting firms and various representatives of the pharmaceutical industry, the SEC staff indicated that it did not object to the use of the first approach to account for the annual fee. That is, the SEC staff did not object to the recognition of the annual fee expense in the year in which the annual fee was due, with attribution of the expense on a straight-line basis over the related calendar year. The SEC staff did note that diversity in practice regarding the timing of the annual fee accrual would not be desirable, and the staff expressed a desire to be made aware of situations in which an entity believed that the second approach was appropriate under its facts and circumstances. Accordingly, entities considering adopting the second approach as their accounting policy are encouraged to consult with their independent auditor and to consider discussing their situation with the staff of the SEC on a pre-filing basis.
Balance Sheet Recognition of the Annual Fee
During the informal discussions, the SEC staff also inquired about whether a balance sheet gross up approach should be used in the first period in which the 2011 annual fee would be accrued (i.e., recognize a liability for the entire estimated annual fee at the beginning of the calendar year as well as a prepaid asset at the same time). No conclusion or preference on this topic was noted.
Income Statement Classification of the Annual Fee
Questions have also been raised about how to appropriately classify the annual fee in pharmaceutical companies’ financial statements. One method would be to record the annual fee as a reduction of revenue based on sales to specific customers in a government program under the guidance in ASC 605-50-25 (formerly EITF Issue 01-9). Another method would be to record the annual fee as an operating expense based on the substance of the transaction. Given the lack of authoritative literature and the view by some that either of these methods could be deemed acceptable, some have expressed a desire that entities be allowed to make a policy election and provide appropriate disclosure about how the annual fee is classified.
The approach that entities should make a policy election and provide appropriate disclosures was proposed in the informal discussions with the SEC staff; however, the SEC staff believed that the income statement classification, along with the balance sheet gross up questions noted above, should be raised with the FASB staff for potential consideration as an EITF agenda topic. Accordingly, further guidance on these issues could be forthcoming from the FASB.
However, any entity that chooses not to follow this approach and account for the enactment of the two laws in different financial statement periods should consult with its auditors or accounting advisors. In addition, the nearly simultaneous enactment of two laws that affect the same financial reporting item over different accounting periods is very unusual; accordingly, the accounting for the enactment of a law in a financial statement period that precedes the enactment date of that law (i.e., including the change to the effective date in the Reconciliation Act in financial statements for periods ending before March 30, 2010) is not to be analogized to in other circumstances.
Watch for additional Deloitte communications on other provisions of the Act. For insight into some of the Act’s other provisions, see Deloitte’s Prescription for Change ‘Filled’ — Tax Provisions in the Patient Protection and Affordable Care Act.
The annual fees are described in Section 9008, “Imposition of Annual Fee on Branded Prescription Pharmaceutical Manufacturers and Importers,” of the Act as amended by Section 1404, “Brand Name Pharmaceuticals,” of the Reconciliation Act.