New ruling on character of medicaid rebates; Timing issue not addressed

Pharma and Life Sciences Tax News - Vol 7, No. 8

Overview

Rev. Rul. 2008-26 holds that Medicaid rebates paid by a pharmaceutical manufacturer to state Medicaid agencies are adjustments to the sales price in calculating gross receipts earned from applicable pharmaceuticals. Rev. Rul. 2005-28 previously had addressed this issue and the new ruling affirms the favorable result intended by the earlier ruling with respect to the calculation of the research credit. Like Rev. Rul. 2005-28, the new ruling does not address when a taxpayer should take the rebates into account for federal income tax purposes.

Analysis

In Rev. Rul. 2005-28, the IRS concluded that Medicaid rebates are "purchase price adjustments that are subtracted from gross receipts in determining gross income." This ruling arguably had the effect of increasing a pharmaceutical manufacturer's research credit by reducing its four-year average gross receipts. However, the wording of the ruling had led some to question whether Medicaid rebates are an adjustment directly to gross receipts or rather should be subtracted from gross receipts in determining gross income (e.g., similar to cost of goods sold). The answer to this question is relevant for purposes of computing the research credit. Rev. Rul. 2008-26 now clarifies that Medicaid rebates are an adjustment directed to the sales price in calculating gross receipts.

Both Rev. Ruls. 2008-26 and 2005-28 rely on the decision in Pittsburgh Milk Co. v. Commissioner, 26 T.C. 707 (1956), to support the proposition that Medicaid rebates should reduce the sales price because the sales price and rebate are negotiated before the sale takes place.

Observation: Although neither ruling addresses the treatment of pharmaceutical chargebacks (i.e., amounts paid by a pharmaceutical manufacturer to a wholesaler for the wholesaler's sale of manufacturer's products to a preferred vendor ), the IRS apparently believes that the rationale employed in both rulings should be extended to chargebacks (i.e., chargebacks are purchase price adjustments that are directed to the sales price in calculating gross receipts). See TAM 200624066.

Observation: Rev. Rul. 2008-26 continues to partially suspend Rev. Rul. 76-96, which held that rebates paid by an automobile manufacturer to qualifying retail customers are purchase price adjustments that are not includible in the retail customer's gross income. The 1976 ruling further held that the manufacturer may deduct the rebates as ordinary and necessary business expenses. The IRS has indicated that it will reconsider its prior position with respect to whether the rebates should be treated as an ordinary and necessary business expenses. If the IRS were to change its position and now hold that an automobile manufacturer cannot deduct rebates that are paid to retail customers as ordinary and necessary business expenses, but instead must adjust the sales prices by these rebates in calculating gross receipts, it could have an impact on companies that previously relied on Rev. Rul. 76-96.

Timing

The new ruling does not specify when a pharmaceutical company may take Medicaid rebates into account. At a recent American Bar Association Tax Section meeting, IRS officials informally stated that Rev. Rul. 2008-26, like Rev. Rul. 2005-28, is intended to address only the character of the rebates (i.e., the impact of treating Medicaid rebates as an adjustment to gross receipts on a taxpayer's research credit), and not the timing issue. However, the IRS officials stated that they are aware of the timing question and hope to address it during the 2008-2009 business plan year. Until the IRS addresses the timing issue in further guidance, it remains unclear whether the IRS' view with respect to timing of Medicaid rebates has evolved from analyzing the timing of the rebates under the section 461 rules to evaluating the timing of the rebates under section 451.

Observation: For any taxpayer contemplating a change in method of accounting to exclude Medicaid rebates as an adjustment to purchase price at the time of the sale of applicable pharmaceuticals, it appears questionable whether the IRS would grant such a request.