On August 13, 2021, the IRS released a Chief Counsel Advice (“CCA”) (CCA 202132009) addressing the tax treatment of intercompany reimbursements of the Branded Prescription Drug (“BPD”) fee, a non-deductible excise tax imposed by the Patient Protection and Affordable Care Act on entities that manufacture or import branded prescription drugs for sale to specified government programs. The CCA concludes that intercompany reimbursements of the BPD fee are not per se excludable from gross income, but rather, the inclusion or exclusion of the reimbursement depends on whether the entity paying the fee was the beneficiary of the payment under the facts and circumstances. For pharmaceutical companies subject to the BPD fee, the CCA stops short of providing certainty that reimbursements of the fee are per se excludable, but nevertheless, offers useful guidance on how the reimbursements might be structured to support exclusion in many cases. Outside of the pharmaceutical industry, companies in other industries that pay and receive intercompany reimbursements of other material non-deductible costs may also find the CCA’s guidance to be instructive by analogy.
The Challenges of Non-Deductible Expenses for Intercompany Transactions
In the transfer pricing world, it is taken for granted that related party distributors, service providers and other “tested parties” are generally subject to income tax only on the markup or other net profit they earn from related party transactions. Thus, intercompany reimbursements of costs should ordinarily have no net tax impact. To the extent such reimbursements are considered to be items of gross income, the related party’s payment of the cost would ordinarily be deductible or recovered through COGS (as the case may be), resulting in no net impact on taxable income. However, this usual offsetting effect can break down when the related party receives intercompany reimbursements of costs that are non-deductible for tax purposes. Although the taxpayer may not be able to deduct an expense for tax purposes, it may still be an operating expense for financial reporting purposes that is taken into account in its transfer pricing calculations and benchmarking analyses (which are ordinarily based on book, not tax results). The mismatch between the tax (non-deductible) and book treatment of the cost can result in the taxpayer reporting taxable income that far exceeds what would otherwise be an arm’s length level of profitability as benchmarked by reference to comparable companies with similar functions, assets and risks. However, such a mismatch can be avoided if the taxpayer can support the position that the reimbursement is properly excluded from income under general tax principles.
Additional transfer pricing concerns arise from the possibility that the companies selected as comparable to test a related party transaction adopt a different approach to such non-deductible expenses as compared to the tested party. For example, do the comparables incur the same type and magnitude of non-deductible expense? Is the non-deductible expense passed on to the end consumer – in other words, is it reflected in the comparable companies’ revenues? These issues and others can have an impact on profit level indicators (“PLIs”) calculated on the basis of the income statement items. If inconsistencies in accounting for non-deductible expenses between the comparables and the tested party are not resolved, the reliability of the PLIs may erode.
It is for these reasons that the tax treatment of intercompany reimbursements of non-deductible expenses such as the BPD fee as includable or excludable can be a material issue for multinationals.
The BPD Fee
The Patient Protection and Affordable Care Act, Public Law 111-148 (124 Stat. 119 (2010)) (ACA)) imposes the BPD fee on entities that manufacture or import branded prescription drugs for sale to Medicare Parts B and D, Medicaid and certain other specified government programs. The total amount of the fee imposed on all taxpayers selling branded prescription drugs to the specified government programs is $2.8 billion a year in 2019 and subsequent years, which amount is generally allocated among the universe of taxpayers subject to the fee based on relative market shares as measured by covered sales in the prior calendar year. The BPD regulations treat controlled groups as single entities for purposes of calculating the fee, and require each group to designate a single entity to file reports and pay the BPD fee to the US Treasury. The BPD regulations also provide that all members of a controlled group are jointly and severally liable for payment of the fee.
The CCA’s Guidance
The CCA addresses a fact pattern in which a US limited risk distributor (“LRD”) receives an intercompany reimbursement of the BPD fee from a foreign related party that is the manufacturer of the drug. Specifically, under this fact pattern, the CCA addresses the questions (1) whether the intercompany reimbursement is per se excludable from the LRD’s income on the ground that other members of the controlled group are jointly and severally liable for payment of the fee, and (2) if joint and several liability does not result in per se exclusion, what factors should be analyzed in determining whether some or all of the reimbursement is includable in gross income. In summary, the CCA concludes that intercompany reimbursements of the BPD fee are not excludable solely by reason of the joint and several liability of all group members, but rather, whether the reimbursement is excludable in any case depends on whether the entity remitting the BPD fee is the beneficiary of the fee under the facts and circumstances.
To address this question, the CCA distinguishes broadly between reimbursements that constitute the payment of expenses of another taxpayer – which courts have held to constitute gross income– and reimbursements of expenses for which the remitting taxpayer acted as an agent or conduit – which courts have generally held to be excludable. The CCA further notes that courts have acknowledged a corollary principle that reimbursements of expenses to advance the business interests of the payor are generally excludable, even if the taxpayer receiving the reimbursement benefited incidentally or indirectly. Finally, the CCA acknowledges that reimbursements of certain expenses that benefit both the taxpayer and another party can also be excludable in some cases.
In light of the foregoing, the CCA concludes that the following five factors should be considered to determine whether intercompany reimbursements of the BPD fee are includable in or excludable from gross income in any given case:
(1) whether the parties intended that [the foreign reimbursing party] will bear the economic burden of the fee; (2) whether Taxpayer has an unconditional obligation to remit the amount received by [the foreign reimbursing party] as payment of the BPD Fee; (3) whether Taxpayer profits, gains, or benefits from the amount received and remitted; (4) whether Taxpayer claims the amount received as its own; and (5) whether the amount is received by Taxpayer in exchange for services provided by it.
These five factors do not provide new guidance, but rather, effectively summarize the applicable case law and IRS guidance governing the tax treatment of intercompany reimbursements examined in the CCA.
Implications and Takeaways
While stopping short of providing certainty that intercompany reimbursements of the BPD fee are per se, or even ordinarily excludable from gross income, the CCA nevertheless provides multi-factor guidance that may support the exclusion of reimbursements of the BPD fee in many cases. In particular, the five relevant factors cited by the CCA suggest that a typical LRD or another limited risk or fixed-margin entity that neither bears the economic burden of the fee nor has potential upside benefit (e.g., in terms of additional profits) could often support excluding the fee, and that this position could be further supported by a well-drafted intercompany agreement and robust transfer pricing documentation. Interestingly, the CCA observes in a footnote that “the evaluation of which entity receives the benefits and bears the risks of the activities associated with the BPD Fee [for purposes of determining the inclusion or exclusion of the fee in gross income] is relevant to the Taxpayer’s transfer pricing for the foreign-manufactured drugs and their U.S. branding/distribution rights under section 482.” However, it would seem that the reverse is also true: a functional analysis of benefits and risks associated with the BPD fee and related activities conducted for transfer pricing purposes should also be relevant to the inclusion or exclusion of the reimbursements in gross income. The functional analysis and accounting consistency between the comparables and the tested party with regard to the BPD Fee will be paramount for reliable application of the arm’s length standard. Finally, while the CCA directly addresses only one particular industry-specific material non-deductible expense – the BPD fee – the CCA’s guidance and analysis may be relevant and helpful by analogy to taxpayers in a wide range of industries that pay and receive intercompany reimbursements of other types of non-deductible expenses. Thus, taxpayers in all industries receiving intercompany reimbursements of non-deductible expenses from foreign related parties may find the CCA’s guidance to be instructive.