IRS clarifies ruling allowing drug manufacturers to subtract Medicaid rebates from gross receipts
Rev Rul 2008-26, 2008-21 IRB
In a revenue ruling that clarifies an earlier one issued in 2005 on the same subject, IRS concludes that Medicaid Rebates that a pharmaceutical manufacturer pays to State Medicaid Agencies are adjustments to the sales price in calculating gross receipts rather than ordinary and necessary business expenses that are deductible from gross income under Code Sec. 162.
Observation: In lieu of the foregoing conclusion, the earlier ruling (Rev Rul 2005-28, 2005-19 IRB 997) stated that Medicaid Rebates incurred by a pharmaceutical manufacturer are purchase price adjustments that are subtracted from gross receipts in determining gross income. Also, unlike Rev Rul 2005-28, the current ruling specifically states that its holding is limited to Medicaid Rebates that a pharmaceutical manufacturer pays pursuant to the Medicaid Rebate Program established by the Omnibus Budget Reconciliation Act of 1990.
Observation: IRS had reached the opposite conclusion in Field Service Advice 200101004 where it concluded that rebates paid by pharmaceutical manufacturers to state Medicaid agencies under the Medicaid Rebate Program couldn’t be excluded from the manufacturer’s gross sales as a discount or price adjustment. Had IRS not changed its view in Rev Rul 2005-28 and Rev Rul 2008-26, an issue could have arisen as to whether Code Sec. 162(c)(3) would bar any business expense deduction for the rebates. It provides that no business expense deduction is allowed for any rebate made by a provider of services, supplier, physician or other person who furnishes items or services for which payment is or may be made under the Social Security Act, or in whole or in part out of federal funds under a state plan approved under such act, if the rebate is made in connection with the furnishing of such items or services or the making or receiving of such payments.
Background on Medicaid rebates. The Omnibus Budget Reconciliation Act of 1990 (the Act) established the Medicaid Rebate Program to increase Medicaid beneficiaries’ access to prescription drugs. Under the Act, pharmaceutical manufacturers must sign a Rebate Agreement with the Department of Health and Human Service (HHS) to gain access to the Medicaid-funded segment of the pharmaceutical market.
The Rebate Agreements require pharmaceutical manufacturers to pay Medicaid Rebates directly to each State Medicaid Agency. A Medicaid Rebate is a portion of the price paid by State Medicaid Agencies to retailers for covered outpatient drugs dispensed to Medicaid beneficiaries. The amount of the Medicaid Rebate is designed to ensure that the Medicaid Program is charged no more for covered outpatient drugs than any other purchaser.
Facts of ruling. M, which uses an accrual method of accounting and files returns on a calendar year basis, manufactures and sells prescription drugs. In ’92, it entered into a “Rebate Agreement” with HHS. In 2005, the following events occur:
- M sells Product D, a prescription drug, to W, a wholesaler;
- W sells Product D to R, a retail pharmacy;
- R dispenses Product D to individual A, a Medicaid beneficiary, and then files a reimbursement claim with S, a State Medicaid Agency;
- S approves the claim and then reimburses R for the cost of Product D plus a dispensing fee; and
- M pays a Medicaid Rebate to S under the Rebate Agreement.
Background on tax treatment. In a manufacturing business, gross income means the total sales, less the cost of goods sold, plus any income from investments and from incidental or outside operations or sources. (Reg. § 1.61-3(a)) Ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business are deductible. (Code Sec. 162)
In Pittsburgh Milk Co, (1956) 26 TC 707, the Tax Court addressed whether allowances, discounts, or rebates paid by a milk producer to certain purchasers of its milk, in willful violation of state law, are adjustments to the purchase price of the milk resulting in a reduced sales price, or ordinary and necessary business expenses under Code Sec. 162 (in which case no deduction would be allowed under Code Sec. 162(c)). The court found that the allowances were part of the sales transaction and concluded that gross income must be computed with respect to the agreed net prices for which the milk was actually sold. Thus, under Pittsburgh Milk, where a payment is made from a seller to a purchaser, and the purpose and intent of the parties is to reach an agreed upon net selling price, the payment is properly viewed as an adjustment to the purchase price that reduces gross sales.
Rev Rul 76-96, 1976-1 CB 23, concluded that an automobile manufacturer that offered rebates to retail customers who independently negotiated a purchase price with the dealer could deduct the rebates as ordinary and necessary business expenses under Code Sec. 162 .
Analysis. Rev Rul 2008-26 notes that the Medicaid Rebate is paid by M to S pursuant to the terms of the rebate agreement. Under the purpose and intent test of Pittsburgh Milk , the Medicaid Rebate is a factor used in setting the actual selling price, negotiated and agreed to before the sale to W takes place.
Observation: In Rev Rul 2005-28 the foregoing sentence read as follows: “Under the purpose and intent test of Pittsburgh Milk , the Medicaid Rebate is made with the purpose and intent of reaching an agreed upon net selling price, and is negotiated and agreed to before the sale to W takes place.”
Accordingly, as noted above, in language that varies somewhat from that in Rev Rul 2005-28, Rev Rul 2008-26 concludes that Medicaid Rebates that a pharmaceutical manufacturer pays to State Medicaid Agencies are adjustments to the sales price in calculating gross receipts rather than ordinary and necessary business expenses that are deductible from gross income under Code Sec. 162.
Effect on other rulings. Rev Rul 2008-26 clarifies and supersedes Rev Rul 2005-28. Rev Rul 2008-26 notes that Rev Rul 2005-28 suspended, in part, Rev Rul 76-96. Rev Rul 2008-26 then states that IRS is reconsidering whether a rebate of the type described in Rev Rul 76-96 is an ordinary and necessary business expense or, alternatively, is an adjustment to the sales price in calculating gross receipts. Therefore, pending IRS’s reconsideration of the issue and publication of subsequent guidance, IRS will not apply, and taxpayers may not rely on, the conclusion of Rev Rul 76-96 that rebates made by the manufacturer are ordinary and necessary business expenses deductible under Code Sec. 162.
Observation: Using somewhat different language, Rev Rul 2005-28 also said that Rev Rul 76-96 could not be relied on pending its reconsideration by IRS.
Observation: Thus, while Rev Rul 2008-26 nominally involved a drug manufacturer, its scope is far broader as a result of the reconsideration of the stated conclusion in the earlier ruling.
Observation: Should IRS conclude that rebates are allowed only as an adjustment to the sales price and are not deductible as ordinary and necessary business expenses, this could actually be good for taxpayers because (1) they would not be faced with the bar on deductions under Code Sec. 162(c), and (2) they could qualify for a potentially larger research credit if the credit is reinstated and its amount is again determined with reference to a taxpayer’s research expenditures as measured under a formula taking into account its gross receipts.