This new digitally driven reality comes with a host of complexities for the Health Sciences & Wellness (HSW) industry. In particular, the medical device sector is already experiencing practical changes to business models as companies are making significant investments in digital technologies and are successfully commercializing digital solutions in many markets around the world.
Digital solutions provide new connection points to hospitals and patients, and are delivered in fundamentally different ways than traditional medical device products, offering new types of revenue streams. This is a transformational change for medical device companies which impacts supply chain models, operating models, and commercial models. In turn, this is creating new intercompany arrangements and complex cross-border transactions.
With these changes, there are critical tax implications that should be addressed proactively. The tax function needs to work closely with the business when executing changes to manage adverse changes in the company’s tax profile. A proactive approach may present opportunities for tax departments to deliver value across the organization. Developing a strategic tax roadmap should position medical device companies to assess, analyze and integrate digital technologies from a tax perspective.
How digitalization is changing medical device companies
The medical device sector has traditionally been a hardware-centric industry where business models were structured around the manufacture and sale of physical goods. The sector is undergoing fundamental changes as companies make significant investments in digital technologies. Over the past two years, more than half of MedTech companies’ digital investments have been focused on creating new products, services, and business models adjacent to or outside of core business, according to EY-Parthenon 2022 Digital Investment Index1, which has led to the sector being colloquially known as “MedTech”.
The prevailing trend is that a significant portion of hard engineering is transitioning to data-focused engineering, as the relevance of digital solutions becomes increasingly important for MedTech companies to maintain competitive advantages. This change has resulted in data engineers and IT departments being an integral part of the technology development process, which is a new construct for the industry. Accordingly, significant value can be placed on the underlying data and the algorithms that perform data collection and analysis.
To date, many MedTech companies have not had a centralized and coordinated strategy for how they manage and account for digital investments. This has made it difficult for tax departments to understand and plan around digital business strategies. Moreover, tax teams may not be aware of the breadth of digital investments being made across their organization and the status of digital innovations.
There are several ways in which MedTech companies are delivering digital solutions. Many digital advancements involve the integration of different technologies – i.e., products that combine traditional hardware (i.e., legacy medical devices) with device connectivity and artificial intelligence/machine learning. There is also a growing subset of medical products that are pure software solutions and are delivered under a software-as-a-service (SaaS) model. Other new digital offerings may require a basic hardware component, with the core value of the offering being a digital solution. Further, highly complex medical devices may incorporate digital solutions, such as surgical robots employing data analytics solutions to provide interoperative feedback.
With respect to supply chain and operating models, MedTech companies have built processes and systems around the production of components and finished goods. The manufacturing and quality functions have been key value drivers under this model. However, digital solutions introduce profound changes to the supply chain and value drivers for these businesses.
From a commercial perspective, MedTech companies are exploring novel pricing structures, such as subscription-based pricing, per-use fees and access fees. In certain instances, digital solutions may be offered as a loss leader or free of charge to incentivize sales of other products as part of a broader package deal. These pricing structures introduce new transaction types (i.e., services, royalties), which have historically not been a part of the MedTech operating model.
The digitization of the MedTech sector brings up a number of complex tax considerations as businesses change their models.
How MedTech changes are affecting income taxes
Digital solutions introduce income tax issues that are novel to the MedTech sector and have an impact in every country around the world. The collection, use, and exploitation of data may have a significant impact on the value chain and how transactions are analyzed from a tax perspective.
With the delivery of a digital offering to an end customer, there are several layers of transactional flows for which tax consequences must be considered. In general, payments flow from the customer through several affiliated entities and ultimately to the intellectual property (IP) owners, with some of these payments crossing a border.
The characterization of each payment as a physical good, service or royalty will have different tax consequences. Tax characterization is determined based on a number of factors and can vary across jurisdictions. Factors may include:
- The nature of the digital solution as a stand-alone solution, a solution embedded in a piece of hardware, or a solution delivered in conjunction with the use of hardware
- The relative value of the digital solution and the connected hardware (if applicable)
- The manner in which a service is provided to the customer
- The delivery terms and use of the solution by the customer
- The rights granted to the customer
For US multinationals with controlled foreign corporations (CFCs), sales, services and royalty transactions have different rules under the Subpart F provisions of the US tax code, which may impact whether the transaction is taxed as Subpart F income or Global Intangible Low-Taxed Income (GILTI) income (at 21% and 10.5% rates currently). Similarly, the Foreign Derived Intangible Income (FDII) provisions (which currently offer an effective tax rate of 13.1%) also have different rules and documentation requirements depending on the US tax characterization of a transaction. US corporations must also assess outbound intercompany payments, as these flows may be considered as Base Erosion and Anti-Abuse Tax (“BEAT”) payments. Accordingly, digital solutions may have significant US tax implications. Furthermore, the interplay between Subpart F and GILTI presents tax planning opportunities.
Depending on characterization, the payments for digital solutions may attract withholding taxes. This applies to both third party revenues and intercompany payments. Withholding taxes must be assessed for each cross-border flow, taking into account the applicability of relevant tax treaties. Whether withholding tax applies in a “source” jurisdiction may depend on the tax characterization of the transaction, where the income is sourced, and whether the income can be attributed to a taxable presence in that source jurisdiction. Where withholding taxes apply, the character of the income could also determine the availability of foreign tax credits in the counterparty jurisdiction.
Tax credits and incentives can be considered for all digital development efforts and will depend on the jurisdiction where the development is performed and funded. Certain credits and incentives may be in relation to R&D expenditures, while other incentives may take the form of a reduced tax rate on commercial profits (e.g., patent or innovation boxes). Additionally, the US Foreign Derived Intangible Income (FDII) rules present opportunities to increase deductions on US tax returns.
Indirect tax considerations
Indirect tax considerations will be key for MedTech companies as the sector moves away from the traditional “supply of goods” model, requiring companies to determine the nature of what is being supplied. Advancements in technologies, dynamic access to data and the shift to value-based care are several factors that will create additional indirect tax complexities and compliance obligations, which businesses in the sector may previously not have encountered. These factors may lead to the supply no longer being considered as a simple domestic supply of goods, but potentially a cross-border supply of services, or a combination of the two. Additionally, certain digital solutions may be considered a license, which adds further complexities.
If a supply is deemed to be a service or license, this brings with it additional indirect tax nuances. MedTech businesses should carefully consider whether the supply is a digital service and if the beneficiary of the supply is a patient or business. Companies will also have to consider the location of both the supplier and the recipient of the service.
Digital services are likely to result in new Value-Added Tax (VAT)/Goods and Services Tax (GST) reporting obligations in the country where the patient is located. MedTech companies will need to consider that new digital offerings and cross-border supply chains may result in broader and more complex indirect tax footprint.
Further, Digital Service Taxation (DST) may apply if supplies are deemed as digital services due to the transmission, monitoring, and use of health data. This is a rapidly evolving area that must be monitored as new rules with compliance obligations are being introduced in several jurisdictions.
In summary, the introduction of digital technologies and new business models in the sector have complex indirect tax implications, such as determining the nature of what is being supplied, the appropriate VAT/GST treatment of transactions, and the associated reporting and compliance obligations.
Transfer pricing considerations
The transfer pricing frameworks employed by MedTech companies have been developed around the manufacture and sale of tangible goods. Under this approach, MedTech companies have relied on the intercompany pricing of physical goods to allocate group profits across jurisdictions. While certain MedTech companies utilize licensing strategies, these arrangements generally relate to manufacturing licenses where a manufacturer is granted a license to make and sell a product.
Digital solutions remove the physical flows from traditional MedTech operating models and introduce new forms of IP that provide unique contributions to the value chain. The underlying data and analytical capabilities can be considered as IP and may be key value drivers from a tax perspective. For example, the data analytics that drive instructions for a surgeon to perform robotic surgeries may be more valuable than the hardware devices being used in the procedure.
As value drivers are considered, there is a fundamental question around the value of data and where such value should be attributed (i.e., to source countries where patients are located, to the legal owner of the patient data, or to the location of data engineers where algorithms are developed). These value drivers must be assessed as transfer pricing policies are established for digital offerings.
From a development perspective, digitalization trends have resulted in new types of innovation efforts and new forms of IP. Tax departments should understand the current status of development efforts and take purposeful steps to ensure the alignment of a long-term operating model and IP ownership structure. A proactive approach to digital strategy will help to drive a future operating model that simplifies cross-border transactions and aligns with tax considerations.
Additionally, the OECD/G20 Inclusive Framework has been pushing forward with the Pillar 1 initiative to address the challenges associated with the value of consumers/users and the associated data, with the elimination or halting of enactment of DSTs as a core component of the Pillar 1 reforms. While Pillar 1 has recently lost some momentum, there remains ongoing uncertainty regarding the taxation of digital technologies. It will be important for MedTech companies to monitor legislative developments and consider how intercompany transactions are structured as digital offerings expand in the MedTech sector.
What businesses should do
Business model changes resulting from digitalization create significant tax complexities that are novel to the sector. Tax departments should evaluate all digital innovations and assess the tax characterization of payment flows. Working closely with the business to understand shifts in business strategy will allow tax professionals to proactively navigate potential changes to different tax characterizations, allowing companies to stay compliant while managing overall tax positions.
