5 Tax Reform Takeaways for Orthopedic Companies

Republican lawmakers in the U.S. congress have passed legislation which would significantly overhaul the U.S. tax code this year.

While the final details are still being worked out in conference committee, there are five key aspects of the bill which are likely to become law—and two overriding conclusions.

• Orthopedic suppliers will be more profitable in 2018 and 2019 because their tax rates will drop from 35% to 20%. Big change.
• Companies that have global operations will have new incentives to bring overseas cash, intellectual property and manufacturing back to the U.S. Another big change.

What does it all mean for orthopedic physicians, hospitals, sales reps and investors?

Here are 5 takeaways that explain it all.

1. Supplier Profit Margins Will Increase

The corporate tax rates will drop from 35% to 20%. While most orthopedic companies have an effective tax rate of less than 35%, this drop will still lower the amount of taxes being paid by U.S.-based orthopedic suppliers. We’re confident that the ultimate rate will fall to 20% because both House and Senate bills propose that. The main difference is when that rate takes effect. Senate is 2019. House is 2018. One potential compromise is to lower the rate to 22% in 2018, then 20% in 2019. However it’s worked out in conference, the bottom line is that taxes are dropping for orthopedic suppliers.

Who will likely be the biggest winners? Easy. The companies who pay the most taxes—like JNJ, Medtronic, Stryker, Zimmer Biomet, Integra LifeSciences, Globus Medical, NuVasive, Conmed and Orthofix.

2. Overseas Cash, Intellectual Property and Manufacturing May Come Back

This tax reform bill is also an expression of an “America First” approach and has built in several financial incentives to bring overseas cash, intellectual property (IP) and manufacturing back to the U.S. The Senate bill proposes to drop the tax on repatriating overseas cash from 35% to 14.5% and to also drop the tax on non-cash overseas assets to 7.5%. The House bill has slightly different tax rates (14% and 7%), but the direction is the same. Also, both bills give the companies have eight years to pay the tax.

One company for whom this could be a big deal is Medtronic—which holds most of its cash and short-term investments outside the U.S.

But, the real question is whether this could have any practical impact on corporate orthopedic R&D spending or product pricing decisions. So far, it’s hard to see a connection.

One area that may have a small practical affect is overseas intellectual property. The Senate’s tax bill allows companies to bring IP into the U.S. at the cost basis at the time of acquisition, not today’s market value.

That could bring some IP into the U.S.

3. The Medical Device Tax Still Lives?!

Somehow, this fell between the cracks.

The Affordable Care Act (ACA) levied a 2.3% excise tax on medical device sales but, in December 2015, President Obama suspended the tax for two years. It is, therefore, scheduled to take effect in about three weeks—January 1, 2018.

One report from Larry Biegelson’s team at Wells Fargo said that the medical device tax could be addressed as part of the pending budget and spending package.

Because this excise tax has had such bipartisan support in the past, we would expect that it will be repealed.

However, the broader tax cuts have raised concerns over a potential trillion-dollar deficit. This excise tax could be the give back. We’ll see.

4. Companies With Losses Penalized by New Net Operating Loss Provisions

Roughly 30% of public orthopedic companies and at least that percentage of the approximately 350 private orthopedic companies report losses each year.

Both tax reform bills are proposing to LIMIT the use of Net Operating Loss (NOL) carry forwards to 90% of taxable income each year. Use of NOLs today is 100% and largely unlimited.

Every company with unexpired NOLs or existing losses will be affected. Especially vulnerable are those firms that have just crossed the breakeven line and are enjoying positive cash flow for a change. They are able to shield their cash from tax by using accumulated NOLs. These bills would limit that ability.

In addition, the bills are proposing to repeal rules with allow for NOL carryback although they would still allow carry forwards.

5. 100% Capital Expenditure Expensing

Back when inflation rates were mid-double-digits, depreciation rates for capital equipment were woefully inadequate for capital-intensive industries like automobile manufacturing, steel or paper mills.

Both the Senate and House bills are proposing to allow companies to expense 100% of their equipment and machinery purchases over five years. Since the life of these assets of typically much longer than five years, it puts the depreciation write-offs off-sync from the assets useful life.

Since we are in a low-inflation economy, this would have a cash generating effect for companies.

Importantly, the bills are offering this goodie retroactively to the end of the third calendar quarter of 2017.

In the Senate bill, this accelerated depreciation allowance would expire after five years.

Orthopedics is both a classic manufacturing and a high technology business. There’s a lot of metal and plastic fabrication and large, expensive machines working at places like Zimmer Biomet, Stryker, Medtronic and so forth.

One would hope that the excess cash flow generated by this provision would migrate over to the R&D line of the income statement.

Overall, this could be good for orthopedics—if the boost in cash flows at the supplier level finds its way to the surgeon, clinic, sales rep and investor in the form of higher R&D spending, greater pricing flexibility and more investment in fighting the reimbursement fight.