Defining Issues. U.S. Health Care Reform Creates Potential Accounting and Disclosure Changes

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1 Defining Issues April 2010, No KPMG LLP U.S. Health Care Reform Creates Potential Accounting and Disclosure Changes The recently approved health care reform law could have significant accounting consequences for companies in diverse industries. 1 For example, companies may be impacted when accounting for other postemployment benefit (OPEB) obligations and companies in the health insurance, pharmaceutical, and medical device industries may be impacted when accounting for certain industry-specific provisions of the new law. Under U.S. GAAP, the effect of legislation usually is reflected in the financial statements in the period of enactment. Therefore, even though many of the law s provisions are not effective immediately, it will require many companies to reflect accounting consequences of some provisions in first quarter financial statements. Additionally, companies will need to disclose known and potential future effects beginning in first quarter financial statements. OPEB Plan Measurements 1 Pharmaceutical Industry 4 Health Insurers (Excluding Self-insurers and Government Agencies) 6 Medical Device Manufacturers 8 Economic Substance Doctrine 8 Disclosures KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved NSS Photo: GettyImages_ OPEB Plan Measurements Retirement Drug Subsidy Change. Federal subsidies are given to companies with qualified retiree prescription drug plans that are actuarially equivalent to Medicare Part D plans. Previously, the subsidy was tax free and companies were permitted to deduct the gross amount of their drug costs. Under the new law, companies may deduct only the net amount of their drug costs. Companies reduce the postretirement benefit obligation on the balance sheet by the amount of the estimated subsidy to be received. However, the related deferred tax asset is based on the gross benefit obligation before the reduction for estimated future subsidies because the subsidy is tax free. 2 Because the new law makes future subsidies taxable starting in 2013, the related deferred tax assets will now be based on the benefit obligation net of subsidy payments expected after The reduction in the deferred tax asset will be recorded in earnings from continuing operations in the period including the March 2010 enactment date. Defining Issues No described this provision and its accounting consequences in detail. 1 Both the Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act overhaul and reform the U.S. health care system. 2 FASB ASC paragraph , available at

2 Defining Issues April 2010, No Other Provisions Affecting OPEB Obligations. There are several other provisions in the new law that might affect a company s measurement of its OPEB obligations. The following provisions, if applicable, would generally be expected to increase employers obligations: Excise Tax on High Cost Coverage. A 40% excise tax will be imposed on high-cost health plans ( Cadillac plans ) beginning in The tax will apply to plan costs that exceed $10,200 for individuals or $27,500 for families and will be indexed to inflation. There will be higher limits for individuals employed to repair or install electrical and telecommunications lines and other high-risk professions such as law enforcement, fire protection, paramedics, longshoremen, construction, mining, agriculture (excluding food processing), forestry, and fishing. Retirees with 20 years of service in these professions also qualify for the higher limits. There will be exclusions for long-term care, certain accident or disability insurance, dental, and vision care. However, reimbursements from and contributions to tax-advantaged health spending accounts will be included in the cost-of-coverage calculations. 3 For companies that purchase insurance policies, the excise tax is assessed to the insurance company. For self-insured plans, the tax will be assessed to the benefits plan administrator. Even when the tax is not assessed directly to an employer, the cost is expected to be passed through to plan sponsors as higher premiums or higher claims administration fees, increasing the plan sponsor s obligations. Health Care Reforms. Consumer protections, such as eliminating lifetime or annual coverage limits and providing coverage for preventative health services may increase estimates of per capita costs for plan participants. These provisions are effective in late September 2010 and also will apply to plans that include retirees. However, some experts believe health insurance plans that only cover retirees may be exempt from the prohibition on lifetime limits. Medicare Advantage Changes. Beginning in 2012, the government will significantly and permanently reduce subsidies to Medicare Advantage programs, which are run by private insurers to deliver benefits that are actuarially equivalent to Medicare. Some companies offer part of their postemployment benefits package, particularly prescription drug coverage, through Medicare Advantage plans. Those companies may experience increases in the costs per Medicare Advantage participant as well as changes in the participation rates that will affect measurements of benefit obligations. Fees for Health Plans. Inflation-adjusted fees equal to $2 for each person covered by a health insurance policy will be imposed whether it is on an insured or self-insured basis. The fees will be imposed on each policy plan year ending after September 30, 2012 through policy plan years ending September 30, However, for fiscal year 2013, the fee will be reduced to $1 per person per policy. Black Lung Benefits. The law rolls back the eligibility criteria for black lung benefits to less stringent criteria that were in effect in This is expected to expand the pool of recipients eligible to make claims to mining companies for black lung disease treatments and other benefits and to increase benefit obligations. 3 Examples include reimbursements from Health Flexible Spending Accounts, Health Reimbursement Accounts, and contributions to Health Savings Accounts, or Archer Medical Savings Accounts.

3 Defining Issues April 2010, No Other provisions that are expected to generally reduce employers obligations include: Current Gaps in Coverage (Doughnut Hole). Because pharmaceutical companies will be required to provide a 50% rebate for branded prescription drugs sold to Medicare beneficiaries while they are in the doughnut hole (between $2,831 and $6,439), some retirees may conclude that opting into Medicare Part D coverage would be more advantageous than continuing to receive employer-based coverage. This decision will reduce employers costs and related obligations. (See further description of the doughnut hole under Pharmaceutical Industry Medicare Part D Discounts for Current Gaps in Coverage. ) Temporary Reinsurance Program. A $5 billion fund has been created to subsidize coverage for early retirees. Employers that incur qualified health care costs between $15,000 and $90,000 relating to retirees aged 55 to 64 may apply to the government for a rebate of 80% of those costs. Any payments received must be used to lower costs under the plan and are tax free. This fund expires on the earliest occurrence of January 1, 2014 or when the entire $5 billion has been spent. Some actuarial and tax professionals believe it will be very difficult at this stage for employers to measure the impact of some of these provisions on a company s benefit obligations. Examples of this uncertainty include the excise tax on high-cost coverage, the reinsurance fund for early retirees, and the changes in the doughnut hole. When determining whether a plan s benefits constitute high-cost coverage, experts are unsure whether employers should measure costs of insurance on an individual retiree basis or on a pooled basis. If a pooled basis is acceptable, there are questions about whether the pools may comingle retirees with active employees, with other retirees in different employer-sponsored plans, or on some other basis. Differences in the methodology could impact whether the tax applies and its amount. For the temporary reinsurance fund, uncertainty exists about whether there are plan characteristics that must be met before an employer is eligible to participate, the aggregate amount of claims that all employers will submit, and how quickly the fund will be exhausted. Some also believe that it will be difficult to predict at this stage how the changes in the doughnut-hole coverage will affect retirees participation in employer-sponsored plans. U.S. GAAP requires annual measurements of postretirement benefit plan obligations and assets as of the employer s fiscal year-end. 4 Those measurements are then used in interim periods of the subsequent year unless a significant event, such as a plan amendment, settlement, or curtailment, occurs. If so, an interim remeasurement is required. There are no current standard-setting activities to give companies a grace period to evaluate the impact of the law. Therefore, companies should evaluate the new law and make a best estimate of how it will impact their benefit obligations based on available information. Companies should continue to monitor developments in interpretations and guidance relating to the law and incorporate the latest thinking in future interim and annual measurements if a significant difference is identified compared with a previous estimate. Based on a company s facts and circumstances, disclosures about the key interpretations and their possible impact on future measurements of the benefit obligation may be appropriate. 4 FASB ASC paragraph , available at

4 Defining Issues April 2010, No In some cases, employers will reach a conclusion with relative ease about the effects of the law and their significance to a plan. However, when there are multiple possible interpretations of a provision or multiple possible impacts resulting from an interpretation, significant judgment will be needed to evaluate the law. Currently there is limited guidance available to assist in that process. Nevertheless, companies should attempt to determine the best estimate of the likely impact of all applicable provisions. It generally would not be appropriate to assume that there is no impact of a provision of the law unless there is an interpretation that would produce that result and that interpretation is the company s best estimate of the likely outcome. If the combined effects of the law are not significant, a remeasurement would not be necessary until the next required measurement date (i.e., year-end or on occurrence of a significant event before year-end such as a curtailment, settlement, or a plan amendment). If the combined effects of the law are significant to a company s benefit obligation, a full remeasurement as of the enactment date (i.e., first quarter 2010 for calendar-year companies) would be required. Significance primarily is based on comparing the benefit obligation before and after the effects of the new law. It also is important to consider the impact of other changes since the last measurement date (i.e., changes in discount rates or other actuarial assumptions) and the net impact that all of these changes would have on net periodic benefit cost for the remainder of the year. There are no bright lines for making these judgments. However, changes in the benefit obligation of five to ten percent are possibly significant. Pharmaceutical Industry Pharmaceutical Industry Fee. Beginning in calendar-year 2011, an annual fee will be imposed on pharmaceutical manufacturers and importers that sell branded prescription drugs to specified government programs (e.g., Medicare Part D, Medicare Part B, Medicaid, Department of Veterans Affairs programs, Department of Defense programs, and TRICARE). Total fees to be allocated among pharmaceutical manufacturers will be $2.5 billion in 2011, $2.8 billion in both 2012 and 2013, $3.0 billion in each year from 2014 to 2016, $4 billion in 2017, $4.1 billion in 2018, and $2.8 billion for 2019 and thereafter. The annual fee will be allocated to companies based on their previous calendar-year market share using sales data that the government agencies that purchase the pharmaceuticals will provide to the Treasury Department. The fee will be nondeductible and therefore will increase pharmaceutical companies effective tax rates. The Treasury Department will calculate the annual fee for each company based on the ratio of their covered sales for the previous calendar-year to the total covered sales for all companies. The formula for calculating market share uses the following percentages of covered sales: Covered Branded Drug Sales per Year Percent of Sales Used in Market Share Calculation Up to $5 million 0% Over $5 million and up to $125 million 10% Over $125 million and up to $225 million 40% Over $225 million and up to $400 million 75% Over $400 million 100%

5 Defining Issues April 2010, No Covered branded drug sales include any prescription drug or biological product. Sales of branded orphan drugs will be excluded for any period in which a tax credit was allowed but not for periods after the FDA approves marketing of the drug for any indication. 5 Representatives from the pharmaceutical industry met with the SEC staff to discuss whether this fee should be accrued in the year that sales that are used to allocate the fee are recorded (i.e., during 2010 for the 2011 fee) or recorded during the calendar year in which a company is assessed its share of the fee (i.e., during 2011 for the 2011 fee). The SEC staff agreed that it would be acceptable to record the fee through the income statement ratably over the year of assessment. Even though the fee is allocated based on prior year sales, it is viewed as a cost of doing business during the calendar year of assessment because the law indicates that a company will not be assessed a share of the fee for a calendar year unless it has sales in that period. Pharmaceutical companies will begin to recognize the fee on a straight-line basis in 2011, which is the first year the payment is due. Companies with a non-calendar year-end will accrue the fee ratably over the calendar year. It will be acceptable for companies to make an accounting policy election to either classify the fee as an expense or a reduction of revenue, unless standard setters issue additional guidance. Companies will present these fees consistently with other similar fees and disclose their policies on presentation and the amount, if significant. Medicaid Rebate Rate Increases. Rebates are currently provided for prescription drugs sold to Medicaid beneficiaries and those rebates will increase in The rebate percentage for branded (non-generic) drugs will increase to 23.1 percent from 15.1 percent of the average manufacturer price (AMP). The generic drug rebate will increase to 13 percent from 11 percent. The new rebate rates became effective January 1, Companies will need to reflect the higher rebate rates in the period of enactment (the first quarter ended March 31, 2010 for companies with calendar year-ends). Companies accrue an estimate for rebates to Medicaid when sales into the distribution channel are recorded. Therefore, the adjustment to the rebate accrual to be recorded in the period of enactment will include the impact of the higher rebate on sales into the distribution channel that have or will be purchased by Medicaid beneficiaries on or after January 1, 2010, including drugs sold into the distribution channel prior to January 1, 2010 but purchased by Medicaid beneficiaries on or after January 1, 2010, and drugs that remain in the distribution channel at the end of the period that are expected to be purchased by Medicaid beneficiaries. In addition to increasing existing rebate rates, the law also requires companies to start paying rebates for drugs dispensed to Medicaid beneficiaries who are enrolled in a Medicaid managed care organization (MCO).The effective date is not yet clear, but may be as early as March 23, 2010 for purchases made by a Medicaid MCO. There also are changes that will require pharmaceutical companies to calculate AMP excluding sales to non-governmental customers. This will increase AMP, which will be multiplied by the higher rebate rate. These changes take effect on October 1, In addition, there will be new rules governing how companies should calculate AMP when a new formulation of an existing drug is approved. 5 Internal Revenue Code, Section 45C.

6 Defining Issues April 2010, No Further expansion of the rebate program will occur in 2014 when the income limit for individuals to be eligible for Medicaid will be raised, which is estimated to result in an additional 16 million people being covered. Medicare Part D Discounts for Current Gaps in Coverage. Medicare currently covers the first $2,830 for recipients and then covers amounts over $6,440 each year. Costs between those two numbers (the doughnut hole) are not covered. Beginning in 2011, drug manufacturers must provide a 50 percent discount on branded prescription drugs to Medicare Part D participants who are in the doughnut hole. Sales subject to the discount will be based on both the actual usage rates of individual Medicare recipients and the time they are in the doughnut hole, which likely will occur in uneven patterns throughout the year. It may be difficult to estimate the amount of rebates because covered sales into the distribution channel will occur before a company knows which drugs will ultimately be sold to a Medicare beneficiary when they are in the doughnut hole. Nevertheless, an estimate of the discount generally should be recorded as a reduction of revenue at the time revenue is recognized. The coverage gap will be phased out by Health Insurers (Excluding Self-insurers and Government Agencies) Limit on Tax-Deductible Employee Compensation. Health insurance companies will not be permitted to deduct for income tax purposes an individual s compensation that exceeds $500,000. The limit will include compensation that is deferred, performancebased, commission-based, share-based, or earned under existing binding contracts and will apply to amounts paid to officers, employees, directors, other workers, and individual independent contractors. For most other public companies the limit is $1,000,000 and generally applies only to compensation paid to the most senior officers. There are exceptions to the limit for other employers that pay performancebased compensation, which will not be available to health insurers. 6 The detailed rules to apply these limits have not yet been written, but are expected to resemble the rules that banks that received TARP funds are required to apply. 7 If so, the deductible limit for health insurers will be based on the period when the compensation is earned and not necessarily when it is paid or becomes deductible. Because there can be timing differences between the financial reporting of compensation cost and its deduction for income tax purposes (e.g., share-based payments, cash bonus arrangements, and deferred compensation arrangements), health insurance companies may need to trace payments to the year in which the compensation was earned to determine if compensation exceeded $500,000. This limit also applies to compensation previously paid to retired or terminated employees. All compensation paid to an individual by companies under common control or affiliates must be considered when determining whether the limit applies. Companies may need to change their reporting systems and processes to comply with the new law. The health insurance compensation provisions will be effective in 2013 but the limit will be applied to amounts paid after 2012 that were earned after It is possible that certain deferred compensation and share-based compensation accrued in or attributed to 2010 may not be deductible in 2013 and later, which will need to be considered when recording deferred tax assets in See section 162(m) of the Internal Revenue Code. 7 See section 162(m)(5) of the Internal Revenue Code.

7 Defining Issues April 2010, No Normally, for income tax purposes, share-based compensation is attributed in full to the period of exercise (for share options) or to the period of vesting (for nonvested shares). Based on guidance provided by the Joint Committee on Taxation, attribution rules similar to those used by banks that received TARP funds may apply. 8 If those rules apply, health insurers will be able to attribute share-based compensation for tax purposes ratably over the period of service rather than in full to the period of exercise or vesting. We do not believe this treatment for tax purposes would be available for compensation elements not covered by the new law. Because the IRS has not publicly commented on whether affected companies will be permitted to attribute share-based compensation costs for tax purposes ratably over the period of service, companies considering this treatment should consult with their tax or legal advisors. Further guidance from the IRS could impact the amount of share-based compensation expense that is deductible. The following example compares the expected impact of these provisions on the deductibility of compensation expense paid by a health insurance company if the cost is attributed over the service period with the deductibility if it is all attributed to the year of vesting. On December 31, 2010, ABC Health Corp. grants 100,000 nonvested shares to its CEO. The award will cliff vest on December 31, The grant date fair value of the award is $6 per share. For financial reporting purposes, ABC recognizes share-based compensation cost of $200,000 in 2011, 2012, and On December 31, 2013, the award vests when the market price of the stock is $21 per share. ABC s tax rate is 40%. Assume the CEO had taxable cash compensation of $400,000 in 2011 and 2012 and $500,000 in Share-based compensation expense for U.S. tax purposes is $2,100,000 based on the fair value on the vesting date. Because 2013 is the period of payment for the share-based award for tax purposes, the entire $2,100,000 is assumed to be subject to the limits. If attribution over the service period is permitted for tax purposes, $700,000 of share-based compensation cost will be attributed for tax purposes to 2011, 2012, and Because the cash compensation paid to the CEO in 2011 and 2012 was $400,000, ABC would be able to deduct $100,000 of the cost attributed to each of those years. Because cash compensation paid to the CEO in 2013 was $500,000, which is equal to the compensation limit, none of the $700,000 attributed to 2013 would be deductible. If attribution over the service period is not permitted for tax purposes, the entire $2,100,000 will be attributed to However, because cash compensation for 2013 was $500,000, none of the $2,100,000 share-based payment compensation cost would be deductible. Health Insurance Industry Fee. An annual fee will be imposed on certain health insurance providers beginning in 2014 based on their respective share of the U.S. health insurance market for the previous year as determined by the Treasury Secretary. The annual nondeductible fees to be allocated among industry participants will be $8 billion in 2014, $11.3 billion in both 2015 and 2016, $13.9 billion in 2017, and $14.3 billion in After 2018 the nondeductible annual fees will be indexed 8 See Section 162(m)(5) of the Internal Revenue Code.

8 Defining Issues April 2010, No to the rate of insurance market premium growth using 2018 as a base. The fee will be nondeductible, which will result in an increase in health insurance companies effective tax rates. Health insurance under this provision does not include coverage only for accident, disability, specified diseases or illnesses, hospital indemnity, long-term care, or Medicare supplemental health insurance. The Treasury Secretary will calculate each insurance provider s annual fee based on the ratio of its net written U.S. health insurance premiums for the preceding calendar year plus two times the third-party administration fees to the total pool. The net premiums in this calculation include written reinsurance premiums that will be reduced by reinsurance ceded and ceding commissions. There are exclusions and adjustments for the first $50 million of premiums written, the first $10 million of third-party administration fees, and net premiums written that are attributable to certain tax-exempt activities. The accounting for this fee has not yet been resolved. The fee s structure has characteristics that are similar to the pharmaceutical industry fee and there may be a basis for similar accounting. However, there is insurance industry guidance in U.S. GAAP for insurance-related assessments that may apply. Under that guidance, insurancerelated assessments are recognized as liabilities when they are imposed or are probable of being imposed, an event obligating a company to pay has occurred, and the amount of the assessment is reasonably estimable. Medical Device Manufacturers A 2.3% excise tax will be imposed on the sale of taxable medical devices beginning in The tax will not apply to retail products sold to the general public for individual use (e.g., eyeglasses, contact lenses, and hearing aids). The Treasury Department will list all retail devices that receive the excise tax exemption. The tax applies to sales beginning on January 1, 2013 regardless of the company s fiscal year-end. Like other taxes based on revenue-producing transactions, companies may elect to classify the excise tax in the income statement as an expense or a reduction of revenue. 9 Companies should present these fees consistently with similar fees and should disclose their accounting policy and, if significant, the amounts reflected in the financial statements. Unlike the health insurance provider fees and pharmaceutical industry fees, the excise tax will be deductible. Economic Substance Doctrine The economic substance doctrine is a common-law doctrine that has been applied by courts to deny tax benefits resulting from transactions that do not meaningfully impact a taxpayer s economic position other than providing a tax reduction. This doctrine can be applied even if the transaction meets the requirements of a specific tax provision. The health care law codifies the economic substance doctrine, which may change the way courts evaluate transactions. The law does not provide guidance about when the economic substance doctrine should apply but it provides a definition of economic substance that can be used to evaluate transactions to which a court determines the doctrine should apply. Under the economic substance doctrine, a transaction is treated as having economic substance if: 9 ASC paragraph , available at

9 Defining Issues April 2010, No The transaction changes the taxpayer s economic position in a meaningful way (apart from federal income tax effects), and The taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction. The economic substance doctrine was addressed in the new legislation because courts and jurisdictions have applied the doctrine differently. Some have required that one of the two criteria be met while others have required both to be met. Companies should consider whether both criteria are met when evaluating uncertain tax positions where the economic substance doctrine may apply. If a tax position is determined not to have economic substance, there is a 40 percent penalty that would apply to the tax understatement. The reasonable cause and good faith exception to the penalty has been removed. Even if a company has an opinion from a tax advisor and reasonably believes a transaction meets the criteria, the 40 percent penalty would apply if the court determined the transaction did not have economic substance. This penalty should be considered when determining the amount of penalties that should be accrued related to an uncertain tax position. The codification of the economic substance doctrine is not intended to disallow tax benefits that are consistent with congressional intent or alter the tax treatment of certain basic business transactions that are permitted under longstanding judicial and administrative practice just because the choice between meaningful economic alternatives is largely or entirely based on comparative tax advantages. These basic transactions include choices between using: 1. Debt or equity to capitalize a business enterprise; 2. A foreign corporation or a domestic corporation to make a foreign investment (for a U.S. citizen); 3. A transaction or series of transactions that constitute a corporate organization or reorganization under subchapter C of the Internal Revenue Code; and 4. A related-party company in a transaction if the arm s-length standard of Section 482 and other applicable concepts are satisfied. 10 The codification of the economic substance doctrine is effective for transactions entered into after March 30, Disclosures Private and public companies that will be or are reasonably expected to be impacted by the new law should consider their disclosure requirements for interim and annual financial statements (public companies should also consider disclosing possible future effects of the new law outside of the financial statements). 11 Financial statement disclosures may include a statement affirming the existence of the new law, a summary of the recognized effects and the known or anticipated future accounting impacts, and a description about when those impacts will be reflected in the company s financial statements. Companies that have determined the amount and 10 Internal Revenue Code Section Regulation S-K, Item 303, Management s Discussion and Analysis of Financial Condition and Results of Operations.

10 timing of the future financial statement impacts of the new law should include this information, if significant. Companies are encouraged to describe the key judgments used in their assessments. Companies that have not yet determined the amount or timing (or both) of the future financial statement impacts of the new law should disclose that fact and state the key reasons why that is not yet determinable. Accounting Standards Update No , Accounting for Certain Tax Effects of the 2010 Health Care Reform Acts The FASB issued Accounting Standards Update No , Accounting for Certain Tax Effects of the 2010 Health Care Reform Acts, to include the SEC Staff Announcement, Accounting for the Health Care and Education Reconciliation Act of 2010 and the Patient Protection and Affordable Care Act, in the SEC content of the Accounting Standards Codification. The ASU indicates that, in this particular fact pattern, the SEC staff would not object to a registrant incorporating the effects of the Health Care and Education Reconciliation Act of 2010 (which was enacted on March 30, 2010) when accounting for the Patient Protection and Affordable Care Act (which was enacted on March 23, 2010) if a period end falls between the enactment dates of the two Acts. This view is based in part on the SEC staff s understanding that the two Acts, when taken together, represent the current health care reforms as passed by Congress and signed by the President. This is a publication of KPMG's Department of Professional Practice Contributing authors: Jeffrey N. Jones Charles P. Lynch Meredith L. Canady Earlier editions are available at: The descriptive and summary statements in this newsletter are not intended to be a substitute for the requirements of the FASB Accounting Standards Codification TM or any other applicable or potential accounting literature or SEC regulations, or for the provisions of the legislation and applicable tax laws. Companies applying GAAP or filing with the SEC and companies determining their income tax obligations should apply the texts of the relevant laws, regulations, and accounting requirements, consider their particular circumstances, and consult their accounting and legal advisors. Defining Issues is a registered trademark of KPMG LLP KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent member firms affiliated with KPMG International Cooperative ( KPMG International ), a Swiss entity. All rights reserved NSS