Levies in the United States

Transcription

1 Levies in the United States Issues In-Depth December 2017 kpmg.com/us/frv

2 Contents Foreword... 1 About this publication Understanding the concepts Property tax (real estate) US branded prescription drug fee US deposit guarantee scheme Acknowledgments... 34

3 Levies in the United States 1 Foreword Accounting for levies is not straightforward IFRIC 21, Levies, became effective in 2014 for most preparers. Three years later, its implementation in the United States continues to be challenging. IFRIC 21 provides guidance on when to recognize a liability for levies. It focuses on the existence of an obligating event under the relevant legislation. It thereby breaks with decades of using matching as the guiding principle for recognizing levies, both under and US GAAP. Applying IFRIC 21 also requires a thorough understanding of the related rules and regulations, which may be different across US states and local authorities. And with new or revised taxes and fees coming up regularly, this may require a high level of effort for dollar amounts that are often individually not very significant. To understand the pervasiveness and complexities of dealing with IFRIC 21, we offer in this publication our insights on three common US levies: property tax (real estate), the branded prescription drug fee, and the deposit guarantee scheme. Valerie Boissou and Prabhakar Kalavacherla Department of Professional Practice, KPMG LLP

4 Levies in the United States 2 About this publication About this publication IFRIC 21, Levies, is not a new interpretation. It became effective for annual periods beginning on or after January 1, 2014 for companies applying as issued by the IASB. However, it remains a difficult interpretation in terms of understanding when and how it applies to specific transactions. Purpose This publication looks in-depth at the application of IFRIC 21 through a sample of transactions in the United States: property tax (real estate); the branded prescription drug fee imposed on certain pharmaceutical companies; and assessments on banks related to the US deposit guarantee scheme. By analyzing the application of IFRIC 21 to these transactions, our purpose is to provide a better understanding of: the steps to go through in applying the interpretation; and the related accounting questions that arise from applying the interpretation e.g. how to account for the debit side of the journal entry. Organization of the text The publication provides a general introduction to IFRIC 21, including generic examples. It then looks at the three US transactions in detail, providing detailed fact patterns and answering a series of questions, such as: What triggers the obligation to pay the levy? When is a liability to pay the levy recognized? What is the debit side of the journal entry? What are the implications for interim financial statements? The commentary is referenced to the underlying literature. For example, IFRIC 21.4 is paragraph 4 of IFRIC 21, and IU is the newsletter, IFRIC Update, dated March In a number of cases we reference further discussion of related accounting issues in KPMG s publication, Insights into (Insights). For more information about obtaining additional KPMG resources, go to KPMG s Institute.

5 Levies in the United States 3 1. Understanding the concepts 1. Understanding the concepts IFRIC 21 provides guidance on determining the obligating event under IAS 37, Provisions, Contingent Liabilities and Contingent Assets, in connection with a levy imposed by a government. The interpretation also applies to a liability to pay a levy whose timing and amount is certain. However, the guidance in IFRIC 21 is restricted to clarifying when to recognize a liability arising from a levy, and other standards are applied to determine whether an asset or expense is recognized as a result. [IFRIC , IU 01-15] Scope A levy in the scope of IFRIC 21 is defined as an outflow of resources embodying economic benefits from an entity imposed by a government in accordance with legislation. The following are not included in the scope of IFRIC 21: fines or penalties imposed for breaches of legislation; outflows in the scope of other standards e.g. income taxes in the scope of IAS 12, Income Taxes; payments to a government for purchases of assets or services; and amounts collected on behalf of a government and remitted to it e.g. value added tax. [IFRIC , BC6 BC8] In addition, an entity is not required to apply IFRIC 21 to liabilities arising from emission trading schemes. [IFRIC 21.6] The definition of government in IFRIC 21 is consistent with the definition in IAS 20, Accounting for Government Grants and Disclosure of Government Assistance, and IAS 24, Related Party Disclosures. It refers to government, government agencies and similar bodies whether local, national or international. [IFRIC 21.4, BC6] Recognition Under IFRIC 21, the obligating event that gives rise to a liability is the activity that triggers the payment of the levy in accordance with the legislation. An entity does not recognize a liability at an earlier date even if it has no realistic opportunity to avoid performing the activity that triggers the levy. The fact that an entity will continue operating in the future, and prepares its financial statements on a going concern basis, does not imply that the entity has a present or a constructive obligation to pay a levy that will be triggered by operating in a future period. [IFRIC ] The timing of liability recognition depends on the specific wording of the relevant legislation. A levy is recognized progressively over a period of time if the activity that triggers the payment of the levy occurs over a period of time. For example, if a levy is triggered by generating revenue over a period of time, then an entity recognizes a liability for the levy at the same time as it generates that revenue. Conversely, if a levy is only payable if an entity operates in a

6 Levies in the United States 4 1. Understanding the concepts specific market on a specified date (e.g. January 1, 2018) or if the entity reaches a specified minimum threshold (e.g. a specified level of revenue) then no liability is recognized until January 1, 2018 or until the minimum threshold is reached. [IFRIC , IE1.Ex1, Ex3- Ex4] Example 1A Levy Revenue above minimum threshold Company G operates in Country Z. The following facts are relevant for this example. Under the regulation in Country Z, G is required to pay a levy if it generates revenue above 60 in a calendar year. The levy is calculated as 1% of the total amount of G s revenue for the calendar year i.e. including the first 60 of revenue. On July 17, 2017, G reaches the revenue threshold of 60. G s total revenue for calendar year 2017 is 120. Jan Jun Dec No liability recognized Progressive recognition of additional amount July 17, 2017 Obligating event G reaches the revenue threshold of 60 that triggers the levy on July 17, 2017, and therefore recognizes a liability of 0.6 (60 1%) for the levy on that date. Subsequently, G progressively recognizes a liability for the levy related to revenue generated above the threshold between July 17 and December 31, The total liability for the calendar year is 1.2 (120 1%). [IFRIC 21.IE1.Ex4] The Interpretations Committee discussed a scenario in which a levy was payable on reaching an annual threshold, which could be reduced pro rata to the respective number of days if the entity started or stopped the relevant activity during the year. [IU 03-14] The Committee noted that in this scenario an entity would be subject to a threshold that is lower than the threshold that applies at the end of the annual assessment period if, and only if, the entity stops the relevant activity before the end of the annual assessment period. In this case, the obligating event is reaching the threshold that applies at the end of the annual assessment period because until then the entity could avoid the payment of the levy by its future actions. [IU 03-14]

7 Levies in the United States 5 1. Understanding the concepts The Committee also noted that there is a distinction between a levy with an annual threshold that is reduced pro rata on meeting a specified condition and a levy that is triggered progressively over time. Until the specified condition is met, the pro rata possibility of reduction in the annual threshold does not apply. [IU 03-14] Example 1B Levy Annual threshold that may be reduced Company G operates in Country Z. Under the regulation in Country Z, G is required to pay a levy if its revenue from activity B exceeds a threshold of 60 in a calendar year. If G stops activity B at any point in time, the threshold is reduced pro rata to the actual number of days that G performed activity B during that calendar year. The levy is calculated as 1% of the total amount of G s revenue from activity B for the calendar year. In the first quarter of 2017, G generates revenue of 20 from activity B. On March 31, 2017, G stops performing activity B in a manner that triggers the pro rata threshold assessment under the regulation. The pro rata threshold for the levy in 2017 is 15 (60 90/365). Because G s revenue from activity B exceeds the pro rata threshold of 15, G recognizes a liability for the levy of 0.2 (20 1%) on March 31, However, if G had not ceased performing activity B, no provision would be recorded until the annual revenue exceeded 60. The same recognition principles apply in the annual and in the interim financial statements. An entity recognizes a liability in the interim financial statements if a present obligation exists at the interim reporting date and does not recognize a liability if the obligating event has not yet occurred. This may result in uneven charges over the course of the year. [IFRIC 21.13, BC29]

8 Levies in the United States 6 2. Property tax (real estate) 2. Property tax (real estate) Detailed contents Background Examples 2A and 2B: Fact patterns for Questions 2.1 to 2.11 Question 2.1: Is the property tax in the scope of IFRIC 21? Question 2.2: What triggers the obligation to pay the levy? Question 2.3: When is a liability to pay the levy recognized? Question 2.4: What is the debit side of the journal entry? Question 2.5: Are there deferred tax effects? Question 2.6: What are the implications for interim financial statements? Question 2.7: What happens if a property is bought or sold? Question 2.8: What happens if a property is bought or sold in a business combination? Question 2.9: How is fair value measured? Question 2.10: Does the liability for property tax ever arise pro rata over time instead of at a point in time? Question 2.11: What other complications can arise in the attribution and composition of the property tax?

9 Levies in the United States 7 2. Property tax (real estate) Background Real estate tax (commonly referred to as property tax ) is administered by local government taxing districts in the United States. It is not a Federal or State tax, although many states impose overall guidelines and exercise general supervision over local property tax administration. In general, property tax is the product of the assessment value of the property at a certain date and the tax rate for the period, as enacted by the local authority. Because the tax is administered locally, there are many variations in fact patterns, such as property assessment dates and procedures, tax rates, payment in advance or in arrears of the tax year, calendar or off-calendar tax year. This section simplifies these variations to explain the principles of accounting for the property tax, and we explore the accounting through two common scenarios. Example 2A property tax paid in arrears. Example 2B property tax paid in advance. These examples are used to answer some of the common accounting questions that arise in the United States about the specific application of IFRIC 21 and related issues. The examples are run in parallel so that the accounting outcomes can be compared. Examples 2A and 2B Fact patterns for Questions 2.1 to 2.11 The following fact patterns are used to illustrate the accounting for property tax under. Example 2A: Company A Example 2B: Company B Nature of building Office building in City A Office building in City B Property tax year January 1 December 31 July 1 June 30 Date property value assessed Date property tax invoiced Party responsible for paying January 1 of the tax year September 1 following the end of the tax year Owner of record at date of invoice January 1 before the start of the tax year June 1 before the start of the tax year Owner of record at date of invoice Payment due 30 days from invoice date 30 days from invoice date

10 Levies in the United States 8 2. Property tax (real estate) The following timeline compares the key dates in Examples 2A and 2B. Jan. 1 20X1 Dec X1 Sep. 1 20X2 Sep X2 Example 2A: A B C Tax year Tax year Example 2B: A B C Jan. 1 20X1 Jun. 1 20X1 Jul. 1 20X1 Jun X2 A Property value assessed B Invoice sent to owner of record at that date C Payment made The same amounts are used in the two examples to help compare the accounting outcomes. Example 2A: Company A Example 2B: Company B Property value $5,000,000 $5,000,000 Tax rate 2% 2% Amount payable $100,000 $100,000 Question 2.1 Is the property tax in the scope of IFRIC 21? Interpretive response: Yes. The property tax is an outflow of resources embodying economic benefits imposed by the local taxing district in the United States. It arises in a non-exchange transaction with the local taxing district, and there are no future economic benefits derived from the fee. The property tax is not scoped in by another standard, and therefore IFRIC 21 applies. [IFRIC 21.4]

11 Levies in the United States 9 2. Property tax (real estate) Question 2.2 What triggers the obligation to pay the levy? Interpretive response: In Examples 2A and 2B, the obligating event that gives rise to a liability to pay property tax is being the owner of record on the date the invoices are prepared by the respective local authorities. The activity that triggers the payment of the property tax is not owning the building during the tax period, but rather owning the building on the date the invoice is prepared. This is evidenced by the fact that no liability arises under legislation before that point, and the owner of record is legally responsible for paying the full amount of tax by the due date. For example, the local authority will not prorate payments based on the different owners during the tax period if the building is sold. [IFRIC 21.8] Question 2.3 When is a liability to pay the levy recognized? Interpretive response: In Examples 2A and 2B, the obligation is triggered by being the owner of the property at a point in time. Therefore, Companies A and B recognize a liability as follows. Example 2A: Company A On September 1, 20X2, Company A recognizes the full liability of $100,000 because it is the owner of record on that date. The tax corresponds to the previous tax year: January 1, 20X1 December 31, 20X1. Example 2B: Company B On June 1, 20X1, Company B recognizes the full liability of $100,000 because it is the owner of record on that date. The tax corresponds to the forthcoming tax year: July 1, 20X1 June 30, 20X2. The above conclusions would be unchanged if Companies A and B had the possibility or requirement to pay the property tax in installments (see Question 2.11). Comparison to US GAAP Subtopic addresses the accounting for real and personal property taxes. While this guidance acknowledges that the liability often accrues legally upon the occurrence of a certain event, it concludes that monthly accrual, during the fiscal period for which the taxes are levied, is generally appropriate. The monthly accrual basis is practical and satisfactory so long as it is consistently followed. [ ]

12 Levies in the United States Property tax (real estate) Question 2.4 What is the debit side of the journal entry? Interpretive response: IFRIC 21 does not address the accounting for the costs that arise from recognizing the liability to pay property tax. Therefore, other guidance is applied to determine if the liability gives rise to an asset or an expense. An asset is recognized if property tax is prepaid, but there is not yet a present obligation to pay that tax. Therefore, in Examples 2A and 2B, the property tax does not qualify for recognition as a prepaid asset. This is true even in Example 2B, where the property tax is paid in advance of the tax year, because the triggering event has already happened. [IFRIC 21.14] Often this will result in the property tax being expensed in full on the date that the liability is recognized. However, in some cases, further consideration may be necessary to determine whether some or all of the cost should be capitalized. The following are examples in which further judgment may be required. The property tax relates to an asset in the scope of IAS 16, Property, Plant and Equipment, that is under construction. The property tax might constitute an expenditure directly attributable to bringing the asset to the location and condition necessary for its intended use. See Insights for a related discussion about operating lease costs, including examples of a building under brand-related refurbishment before occupation (capitalization not appropriate), and a building acquired in shell form with fit-out underway (capitalization may be appropriate). The property tax relates to a manufacturing facility. The property tax might constitute a fixed production overhead that should be included in the cost of manufactured goods, in accordance with IAS 2, Inventories. However, caution should be exercised when allocating property tax to inventory. For example, the property tax would be expensed if all the inventory has been sold before the liability is recognized, or if the property tax gives rise to a manufacturing cost variance. See Insights for a related discussion about the allocation of seasonal fixed production overheads to inventory; and Insights for a related discussion about manufacturing cost variances. Question 2.5 Are there deferred tax effects? Interpretive response: Property tax itself is not in the scope of IAS 12, Income Taxes. However, for the purposes of measuring future income tax consequences, deferred taxes need to be considered. Property tax is deductible for income tax purposes in the United States. Therefore, a deferred tax asset or liability may need to be recognized as a result of the accounting under

13 Levies in the United States Property tax (real estate) compared to the tax treatment. For example, in some US tax jurisdictions, the property tax is deductible when due and paid; this may not match the timing of recognition of the IFRIC 21 liability, giving rise to a temporary difference. For simplicity, Examples 2A and 2B ignore the application of IAS 12. [IAS 12.2, 5, 15, 24] Question 2.6 What are the implications for interim financial statements? Interpretive response: In accordance with IAS 34, Interim Financial Reporting, items are required to be recognized and measured as if the interim period were a discrete stand-alone period. Therefore, the property tax cannot be recognized on a pro rata basis for the purpose of interim reporting. [IAS 34.29] Assuming the companies in Examples 2A and 2B do quarterly reporting, the property tax will be recognized in a single quarter. Quarter ended: Example 2A: Company A Example 2B: Company B March 31, 20X1 June 30, 20X1 2 September 30, 20X1 1 December 31, 20X1 Notes: 1. Company A recognizes the full amount of the property tax in Q3 20X1 because the liability is recognized in full on September 1. However, because the tax arises in arrears, the amount recognized in Q3 20X1 actually relates to the period January 1 December 31, 20X0. Similarly, the amount relating to the period January 1 December 31, 20X1 will be recognized in Q3 20X2. 2. Company B recognizes the full amount of the property tax in Q2 20X1 because the liability is recognized in full on June 1. Question 2.7 What happens if a property is bought or sold? Interpretive response: When real property is sold in the United States, it is common real estate practice for the property tax (estimated or actual) to be adjusted pro rata between the buyer and seller on the settlement statement at closing. Who pays whom depends on whether the property tax is paid in advance or in arrears in comparison to the timing of the transaction. However, this adjustment is not required by law. Instead, the parties could, and sometimes do, negotiate a different arrangement e.g. no adjustment is made.

14 Levies in the United States Property tax (real estate) Therefore, this real estate practice does not change the conclusion that the liability should be recognized entirely at a point in time. The following continues Examples 2A and 2B to show the accounting from the seller s point of view if the property is sold. Example 2A: Company A Example 2B: Company B Date property sold March 31, 20X2 March 31, 20X2 Carrying amount $4,300,000 $4,300,000 Transaction price preadjustment $5,500,000 $5,500,000 Property tax adjustment: -$127,500 1 $25,000 2 Related to 20X1 $100,000 $100,000 3 months / 12 months = $25,000 Related to 20X2 $110,000 3 months / 12 months = $27, Final transaction price $5,372,500 $5,525,000 Gain on sale $1,072,500 $1,225,000 Notes: 1. When the property is sold, Company A has not yet paid the property tax for 20X1 (it will only be invoiced September 1, 20X2) or for the three months in 20X2 (it will be invoiced September 1, 20X3). In this example, it is assumed that the assessment for 20X2 will take into account the sale price; in practice, this will depend on local requirements. 2. When the property is sold, Company B has already paid the property tax through to June 30, 20X2 i.e. for an additional three months after the sale. The table shows the perspective of the seller in both cases. In these examples, the buyer records the property at the final transaction price, and subsequently accounts for the property tax in the usual way (see Question 2.3). Question 2.8 What happens if a property is bought or sold in a business combination? Interpretive response: From the seller s perspective, there is no difference in the accounting for the property tax between selling the property as a standalone asset and selling the property in a business combination. In both cases, the seller records a gain or loss on the disposal of the asset(s) (see Question 2.7). However, the buyer will follow the requirements of 3, Business Combinations. In particular: The buyer recognizes a liability at fair value for the property tax, if the obligating event has occurred at the acquisition date but payment is pending. When the obligating event has not yet occurred, the buyer does not recognize a contingent liability for the prorated portion of the tax assumed in the business combination. This is because only present obligations can be recognized through acquisition accounting. [ 3.18, 22]

15 Levies in the United States Property tax (real estate) The buyer measures the property at fair value on initial recognition (see Question 2.9). [ 3.18] To the extent that any property tax reimbursement by the seller is an indemnification asset to the buyer, it is recognized on the same basis as the indemnified item, subject to an allowance for collectibility. [ 3.27, 57] Question 2.9 How is fair value measured? Interpretive response: There are a number of scenarios in which property will be measured at fair value under. For example: the property is measured at fair value as part of the acquisition accounting in a business combination; or [ 3.18] the entity elects to measure investment property at fair value. Even if investment property is measured on a cost basis, fair value is disclosed. [IAS 40.30, 79(e)] Irrespective of the price paid and how it was derived, determining how property tax adjustments may affect fair value is key to subsequent measurement. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In the context of US real estate practice, the property tax adjustment is taken into account in measuring fair value. The parties are free to negotiate any price and the property tax adjustment is not mandatory. However, in the United States, the parties most often adjust the property price for property tax on a pro rata basis, and therefore doing so is representative of a market participant perspective. Property tax is therefore different from a transaction cost, which is essential to the transaction, and is instead an adjustment to the value of the property. [ 13.A] This approach to estimating fair value means that, in theory, fair value will change each day simply because the attribution of property tax between a market participant buyer and a market participant seller will change. However, property tax adjustments are typically minor rounding adjustments in relation to the fair value of a property as a whole, and therefore this issue is usually insignificant compared to real changes in the property market (both positive and negative). In the United States, fair value is usually estimated as follows. Market approach. Transaction prices for comparable properties are based on final transaction prices (i.e. after any property tax adjustments), which become the official record of what the properties sold for. Referring to the examples in Question 2.7, fair value would be $5,372,500 in Example 2A, and $5,525,000 in Example 2B. Income approach. Future cash flows include payments for property tax; no adjustment is typically made to prorate property tax during the year. Again, while these approaches are not perfectly aligned, in practice the difference is typically a minor rounding difference in relation to the fair value

16 Levies in the United States Property tax (real estate) of a property as a whole. Especially when a range of values is being assessed to estimate fair value, the difference is often little more than rounding in the estimation. Question 2.10 Does the liability for property tax ever arise pro rata over time instead of at a point in time? Interpretive response: Examples 2A and 2B both illustrate the property tax arising at a point in time. While this is the typical scenario in the United States, other situations may exist where the obligation to pay the property tax arises pro rata over time (instead of at a point in time). The liability would then be recognized over time. However, in our experience this scenario is unusual in the United States and care would be required to confirm the fact pattern. Question 2.11 What other complications can arise in the attribution and composition of the property tax? Interpretive response: Examples 2A and 2B illustrate the property tax as being attributable to the owner of record at a single date in the year, and as a single tax payable in a single installment. In reality, in the United States the tax may be structured in a variety of ways. For example, the tax might be attributed to the owner of record quarterly instead of annually, with quarterly invoices and a quarterly payment schedule. Although this does not change the principles discussed in this section, it means that a liability arises at four distinct points in the year (instead of one) and the accounting for any transactions will be based on the position relative to the quarter and not the year. In addition, the tax may have two or more components (e.g. schools and other taxes), and a property might be split between two or more taxing districts. Each component may have different assessment dates, payment schedules, etc. Again, this does not change the principles discussed in this section; however, it means that the unit of account will be the component tax rather than the full amount. As a result, different component taxes may have different triggering liability recognition.

17 Levies in the United States US branded prescription drug fee 3. US branded prescription drug fee Detailed contents Background Example 3A: Fact pattern for Questions 3A.1 to 3A.8 Question 3A.1: Is the drug fee in the scope of IFRIC 21? Question 3A.2: What triggers the obligation to pay the levy? Question 3A.3: When is a liability to pay the levy recognized? Question 3A.4: On what basis is the drug fee accrued? Question 3A.5: Should the time value of money be considered? Question 3A.6: What is the debit side of the journal entry? Question 3A.7: Are there deferred tax effects? Question 3A.8: What other complications can arise if the drug fee is assessed at a group level? Example 3B: Fact pattern for Questions 3B.1 to 3B.3 Question 3B.1: What is the accounting in 20X5 if the change in labeler code occurs on or before December 31, 20X5? Question 3B.2: What is the accounting in 20X5, if the change in labeler code occurs after December 31, 20X5? Question 3B.3: What if seller and buyer agree on a reimbursement mechanism?

18 Levies in the United States US branded prescription drug fee Background Effective 2011, Section 9008 of the Patient Protection and Affordable Care Act (PPACA), as modified by Section 1404 of the Health Care and Education Reconciliation Act of 2010 (Section 9008 of the PPACA), imposes an annual fee on manufacturers and importers (covered entities) of branded prescription drugs (BPD) with qualifying sales to specified US government-funded programs. 1 Such programs include Medicaid and Medicare Parts B and D. The fee is referred to as the US branded prescription drug fee (drug fee). The total drug fee to be collected nationwide each calendar year (fee year) was set by the US Congress in Section 9008 of the PPACA. For example, the drug fee to be collected for the fee years 2016 and 2017 is $3 and $4 billion, respectively. The Internal Revenue Service (IRS) apportions the total drug fee for a given fee year between affected covered entities. The apportionment is based on their relative share of total qualifying sales to the specified governmentfunded programs. This calculation is first determined using sales with a two-year look-back. For example, the fee to be paid in fee year 2016 is first determined based on the covered entity s 2014 sales. The covered entity s drug fee for the fee year is then adjusted in the following year by taking into account the difference between the original fee for the fee year and what the fee would have been using sales data from the immediately preceding calendar year. For example, a covered entity s 2016 fee year drug fee will be adjusted in 2017 to take into account its 2015 sales. The adjustment can be positive or negative. The annual qualifying sales of each covered entity are compiled by the IRS. Sales of BPD are attributed to the covered entities that are identified by the labeler code of each BPD on December 31 of the sales year. The labeler code is assigned to manufacturers by the US Food and Drug Administration (FDA). The allocation of the drug fee between covered entities is progressive. For example, a covered entity is not liable for the drug fee on its first $5 million of qualifying sales. Section 9008 of the PPACA established the following percentage adjustment table. Qualifying BPD sales for the calendar year that are: Percentage of BPD sales taken into account: Not more than $5 million 0% More than $5 million but not more than $125 million 10% More than $125 million but not more than $225 million 40% More than $225 million but not more than $400 million 75% More than $400 million 100% 1 Read more on the IRS website, Annual Fee on Branded Prescription Drug Manufacturers and Importers, and in the Code of Federal Regulations, Title 26, Chapter I, Subchapter D, Part 51.

19 Levies in the United States US branded prescription drug fee The IRS mails a: preliminary fee calculation, including all adjustments, by March 1 of the fee year, providing the covered entity an opportunity to dispute certain matters; and final fee calculation by August 1 of the fee year, for payment by September 30. The drug fee is assessed at the entity level unless the covered entity belongs to a controlled group. In that case, all covered entities within the controlled group are jointly and severally liable for the drug fee. Example 3A Fact pattern for Questions 3A.1 to 3A.8 Pharma A is a drug manufacturer that sells BPD to the Medicare Part D program. As such, Pharma A is liable for the drug fee. The following table presents Pharma A s qualifying sales of BPD over the past three years, as well as the proportion of those sales considered in the drug fee calculation and the resulting fee calculation for those years. $ million Sales year 20X4 Sales year 20X5 Sales year 20X6 A = Pharma A s total qualifying BPD sales Nil 1,500 1,600 B = Pharma A s adjusted qualifying BPD sales Nil 1, ,383 2 C = Total qualifying BPD sales reported by the US government 21,383 27,660 Pharma A s share of the drug fee (B/C) 6% 5% Notes: 1. ($5 million 0%) + ($120 million 10%) + ($100 million 40%) + ($175 million 75%) + $1,100 million = $1,283 million. 2. ($5 million 0%) + ($120 million 10%) + ($100 million 40%) + ($175 million 75%) + $1,200 million = $1,383 million. The total drug fee to be collected by the IRS nationwide is $3 billion for fee year 20X6 and $4 billion for fee year 20X7. In fee year 20X6, Pharma A did not receive a fee calculation from the IRS because it did not have qualifying sales in 20X4. In fee year 20X7, Pharma A is notified on March 1, billed on August 1 and pays on September 30 a total fee of $420 million, calculated as follows. 20X7 preliminary estimate based on 20X5 sales: Amount to be collected by the IRS in 20X7 ($4 billion) Pharma A market share in 20X5 (6%) $240 million

20 Levies in the United States US branded prescription drug fee 20X6 final obligation based on 20X5 sales: Amount to be collected by the IRS in 20X6 ($3 billion) Pharma A market share in 20X5 (6%) Total invoice $180 million $420 million The adjustment of $180 million is the difference between the 20X6 fee (using 20X4 sales) and what the 20X6 fee would have been if 20X5 sales had been used. Pharma A had no sales of BPD in 20x4, and therefore no fee was due in fee year 20X6. Therefore, Pharma A has an upwards adjustment to its 20X7 bill of $180 million. Question 3A.1 Is the drug fee in the scope of IFRIC 21? Interpretive response: Yes. The drug fee is an outflow of resources embodying economic benefits imposed by the US government. IFRIC 21 applies to such outflows unless they are within the scope of other standards. If the drug fee was considered in the scope of the revenue guidance, then it would be out of the scope of IFRIC 21. [IFRIC 21.4] Such a question arises because the US government both collects the drug fee and funds the programs (e.g. Medicare, Medicaid) that subsidize the purchase of the drugs by patients. However, we believe that the drug fee is essentially a mechanism through which the government raises funding for part of the cost of the US health system. This is achieved by calculating in advance an annual total amount to be levied on the industry as a whole. The government then apportions the total annual amount among individual companies based on a variety of factors, including each company s participation in the market in the previous financial year. The drug fee then arises in a non-exchange transaction with the US government and there are no future economic benefits derived from the fee. Therefore, it is in the scope of IFRIC 21. [IFRIC 21.4] Question 3A.2 What triggers the obligation to pay the levy? Interpretive response: The obligating event that gives rise to the drug fee liability is the combination of the occurrence of BPD sales and being identified in the labeler code of the BPD on December 31 of the year in which those sales occur. The existence of the sales trigger is evidenced by the fact that BPD sales made in 20X5 trigger payment of a drug fee, even if Pharma A does not have any BPD

21 Levies in the United States US branded prescription drug fee sales after 20X5. Being in business in the year that the fee is actually assessed and collected is not determinative of the triggering event. Additionally, the drug fee is treated as a federal excise tax for purposes of Subtitle F of the Internal Revenue Code (relating to procedure and administration). There is no evidence that, in case of bankruptcy, the drug fee liability would not be claimed or would be automatically discharged. Therefore, this further confirms that the occurrence of BPD sales contribute to creating the obligating event that gives rise to the drug fee liability. However, the occurrence of sales during the sales year is necessary, but not sufficient, to create an obligation. If Pharma A ceases to be identified in the labeler code of a BPD before December 31, 20X5, Pharma A owes no drug fee based on the sales of that drug in 20X5. This could happen, for example, if Pharma A transfers ownership rights to manufacture or import a BDP to a third party, and the labeler code reflects the change of ownership at the end of 20X5 (see Example 3B). Conversely, the new owner of the right would now be identified in the drug labeler code on December 31, 20X5, and would be liable for the drug fee based on all sales of that drug in 20X5. Said differently, the IRS does not prorate payments based on the amount of sales of the different owners of a BPD during the sales year. [IFRIC 21.8, BC12 BC13] Question 3A.3 When is a liability to pay the levy recognized? Interpretive response: The liability to pay the drug fee is recognized entirely on December 31 of each sales year, based on the sales of that year. [IFRIC 21.8] No liability is recognized throughout the year as the sales occur because Pharma A would avoid payment if the FDA processes a change in labeler code before December 31. [IFRIC 21.8, BC12 BC13] Question 3A.4 On what basis is the drug fee accrued? Interpretive response: The drug fee is accrued on December 31 of the sales year using estimates i.e. the estimate of total qualifying BPD sales to be reported by the US government for a given year. Because these estimates are subject to change, the accrual may need to be revised until the amount of the liability is known. This could occur, for example, when the fee amount is notified by the IRS or as total aggregated BPD sales amounts are further confirmed over the two-year period until notification. [IAS 8.32, 34]

22 Levies in the United States US branded prescription drug fee Question 3A.5 Should the time value of money be considered? Interpretive response: Payment of the drug fee based on 20X5 BPD sales will only occur in September 20X7, although the liability is recognized on December 31, 20X5. If the effect of the time value of money is material, the amount of the liability needs to be the present value of the expenditure expected to be required to settle the obligation. Pharma A should use a pre-tax discount rate that reflects current market assessment of the time value of money and the risks specific to the liability. The discount rate does not reflect risks for which future cash flow estimates have been adjusted. See Insights for a discussion about how to reflect risks in a discount rate. [IAS 37.45, 47] Question 3A.6 What is the debit side of the journal entry? Interpretive response: IFRIC 21 does not address the accounting for the costs that arise from recognizing the liability to pay the drug fee. Other guidance, such as IAS 2, Inventories, should be applied to determine if the liability gives rise to an asset or an expense. The cost of inventories comprises only costs of purchase, costs of conversion and costs incurred in bringing the inventories to their present location and condition. Selling costs are excluded. The drug fee is not incurred unless the products are sold by Pharma A, and therefore the fee is akin to a selling cost and is not capitalizable in the cost of inventory. [IAS 2.10, 16(d)] Because the drug fee arises in a non-exchange transaction with the US government, there are no future economic benefits derived from the fee. The drug fee could be seen as a cost incurred for the right to sell through government programs. However, the fee is retrospective in nature and the fee arising from the BPD sales in a given year does not give the right to sell through those programs the next year. The drug fee is therefore expensed as accrued. On December 31, 20X5, Pharma A records the following journal entry. $ million Debit Credit Income statement (operating expense) Liability 180 To recognize estimated 20X6 drug fee triggered by 20X5 BPD sales. Note: 1. $3 billion (known) 6% = $180 million. This entry assumes that the market share attributable to Pharma A (6%) is known at the end of 20X5. In practice, it would be estimated and then trued up once known (see Question 3A.4).

23 Levies in the United States US branded prescription drug fee On December 31, 20X6, Pharma A records the following journal entry. $ million Debit Credit Income statement (operating expense) Liability 200 To recognize estimated 20X7 drug fee triggered by 20X6 BPD sales. Note: 1. $4 billion (known) 5% = $200 million. This entry assumes that the market share attributable to Pharma A (5%) is known at the end of 20X6. In practice, it would be estimated and then trued up once known (see Question 3A.4). For simplicity, the effect of the time value of money is assumed not material and is ignored in this example. Question 3A.7 Are there deferred tax effects? Interpretive response: The drug fee itself is not in the scope of IAS 12, Income Taxes. However, for the purposes of measuring future income tax consequences, deferred taxes need to be considered. The drug fee is not a deductible expense for federal and state income tax purposes. Therefore, no deferred tax is recognized as the drug fee is accrued. However, the tax impact of the drug fee is shown as a reconciling item in the tax reconciliation disclosure. [IAS 12.2, 81(c)] Question 3A.8 What other complications can arise if the drug fee is assessed at a group level? Interpretive response: Entities deemed covered for purposes of the drug fee can be single entities or controlled groups. Entities in a controlled group are jointly and severally liable for the fee. Also, because of the progressive tax brackets, a consolidated group is liable for a drug fee greater than the sum of the individual fees if each entity within the group is assessed separately. This may create further complexities if one entity within the consolidated group prepares stand-alone financial statements, to determine the amount of the liability to be accrued. Recharge agreements within the group may also need to be considered. [26 Code of Federal Reg 51.2(e)(3)]

24 Levies in the United States US branded prescription drug fee Example 3B Fact pattern for Questions 3B.1 to 3B.3 Pharma B s qualifying BPD sales comprise only Product P. On March 31, 20X5, Pharma B sold the right to manufacture Product P to Company C. Company C applies to the FDA to update the labeler code. This registration process is expected to take between six and twelve months. Company C has no other BPD sales. The total drug fee to be collected is $3 billion for fee year 20X6. The sales of Product P are as follows. $ million Sales year 20X4 Sales year 20X5 Sales year 20X6 Pharma B s sales of Product P (i.e. before March 31, 20X5) Nil 100 n/a Company C s sales of Product P (i.e. from March 31, 20X5) n/a Total sales of Product P Nil The regulation states that, if a covered entity transfers ownership rights to manufacture or import a BPD but does not change the labeler code, the IRS will assess all post-transfer sales to the former owner until the labeler code reflects the new ownership. [Treasury Inspector General for Tax Administration/ , May 16, 2014] Question 3B.1 What is the accounting in 20X5 if the change in labeler code occurs on or before December 31, 20X5? Interpretive response: Assume the change in labeler code is obtained on September 30, 20X5. Because on December 31, 20X5 Company C is named on the labeler code: Pharma B is not liable for any drug fee on its 20X5 sales and does not record any entry relative to the drug fee in 20X5. All 20X5 sales of Product P are attributed to Company C. Company C records a liability for the drug fee on December 31, 20X5. Company C s drug fee calculation is as follows. $ million Sales year 20X4 Sales year 20X5 A = Company C s total qualifying BPD sales Nil 400 B = Company C s adjusted qualifying BPD sales Nil 183 1

25 Levies in the United States US branded prescription drug fee $ million Sales year 20X4 Sales year 20X5 C = Total qualifying BPD sales reported by the US government 21,383 Company C s share of the drug fee (B/C) 0.86% Note: 1. ($5 million 0%) + ($120 million 10%) + ($100 million 40%) + ($175 million 75%) = $183 million. On December 31, 20X5, Company C records the following journal entry. For simplicity, the effect of the time value of money is assumed not material and is ignored. $ million Debit Credit Income statement (operating expense) 1 26 Liability 26 To recognize estimated 20X6 drug fee triggered by 20X5 BPD sales. Note: 1. $3 billion (known) x 0.86% = $26 million (rounded). This entry assumes that the percentage fee attributable to Pharma C (0.86%) is known at the end of 20X5. In practice, it would be estimated and then trued up once known (see Question 3A.4). In fee year 20X6, Company C will not receive a fee calculation from the IRS because it did not have qualifying sales in 20X4. In fee year 20X7, Company C will be charged the 20X6 final obligation based on the 20X5 sales: ($3 billion 0.86%) - $0 paid in 20X6 = $26 million. Question 3B.2 What is the accounting in 20X5, if the change in labeler code occurs after December 31, 20X5? Interpretive response: Assume the change in labeler code is obtained on October 30, 20X6. Because on December 31, 20X5 Pharma B is named on the labeler code: Company C is not liable for any drug fee on its 20X5 sales and does not record any entry relative to the drug fee in 20X5. All 20X5 sales of Product P are attributed to Pharma B. Pharma B records a liability for the drug fee on December 31, 20X5.

26 Levies in the United States US branded prescription drug fee Consistent with calculations shown in Question 3B.1, on December 31, 20X5 Pharma B records the following journal entry. $ million Debit Credit Income statement (operating expense) 26 Liability 26 To recognize estimated 20X6 drug fee triggered by 20X5 BPD sales. Question 3B.3 What if seller and buyer agree on a reimbursement mechanism? Interpretive response: Often, the purchase agreement contemplates the possibility that the labeler code will not be updated in the calendar year of the acquisition. However, this is not required by law. For example, the purchase agreement may provide the following relative to December 31, 20X5. The change of labeler code has occurred. Pharma B will pay Company C 1% of its 20X5 sales of Product P i.e. sales before March 31, 20X5. The change of labeler code has not occurred. Company C will pay Pharma B 1% of its 20X5 sales of Product P i.e. sales from March 31, 20X5. Such a refund mechanism, which depends entirely on the negotiation of the parties, does not change the conclusion that the triggering event for the drug fee has not occurred before the labeler name is confirmed on December 31 of each year post-acquisition. The accounting for any agreement between the parties depends on whether the transaction meets the definition of a business combination under 3, Business Combinations, or is a sale of assets. The logic described in Question 2.7, regarding property tax adjustments between the seller and buyer when a property is sold, applies similarly to the drug fee. The drug fee refund payment is considered part of the sales price. Even in the case of a business combination, the buyer should not recognize a contingent liability for the drug fee potentially assumed in the transaction relating to the sales before March 31, 20X5 (the acquisition date). This is because only present obligations can be recognized through acquisition accounting. Again, this discussion is the same as for property tax (see Question 2.8).

27 Levies in the United States US branded prescription drug fee Comparison to US GAAP US GAAP addresses the timing of liability recognition, the income statement classification, the balance sheet presentation and the expense recognition during the year related to the US branded prescription drug fee. [720-50] Unlike, the drug fee is accrued as the sales occur, rather than on December 31 when the labeler code is checked. The timing of recognition of the liability under US GAAP follows from an example added to the final regulations in [26 Code of Federal Reg 51.2(e)(5)] Like, the drug fee is recognized as an expense rather than as a reduction of revenue. Unlike, the liability is not discounted under US GAAP. [ ] KPMG observation The analysis of the drug fee in this section demonstrates the importance of understanding fully the applicable legislation in order to identify the obligating event. This can be particularly complex when a levy is payable only when multiple conditions are satisfied. When one of the conditions is making sales, or the amount of the levy depends on the amount of sales, it may seem intuitive to identify the occurrence of sales as the obligating event and recognize the levy progressively as those sales are made. We are aware that some believe it is appropriate in the case of the drug fee to identify the occurrence of BPD sales as the obligating event and therefore to recognize a liability under as sales are made during the year, similar to practice under US GAAP.