Were raw materials used to make experimental drugs for free clinical trials exempt because the finished drugs were medicines?

Plain-English summary

The biotechnology company sought a refund for July 1, 1987 through March 31, 1991. Its claim listed $111,525 for tax-paid raw materials said to qualify for out-of-state treatment and $32,828 for raw materials consumed in California clinical testing, a stated total of $144,353.

The company made two experimental drugs for controlled clinical studies under a compassionate-use program. Institutions and principal investigators conducted the studies; the company paid them based on whether a patient received a full infusion, a partial infusion or no drug. The source says the products lacked federal marketing approval and assumes that one product name and its Plus variant referred to the same drug.

The recommendation found that the finished drugs qualified as medicines and were furnished in an exempt manner by contracted licensed physicians. But the assessment concerned the company's consumption of raw materials used to manufacture those drugs. Section 6369 did not extend the medicine exemption to manufacturing inputs, and the resale rule did not apply because the finished drugs were not sold during the period at issue.

The company also failed to overcome the Department's finding that the disputed $111,525 was consumed in California. The recommendation said to allow the claim according to the October 14, 1992 reaudit and deny it in all other respects; it did not state a final allowed refund amount.

Live annotation and source posture

The current live annotation preserves the medicine-versus-input distinction and adds two important qualifications. It says No charge is made to the patients, while the supporting recommendation more specifically says the drugs were not sold during the period and describes company payments to study institutions and investigators. It also bears (Am. 2002–2) and warns that the opinion does not reflect the statutory change effective January 1, 1995 that added section 6369(a)(6).

The live page says the controlled studies investigated safety and efficiency; the source says safety and efficacy. The source itself calls the regulator the Federal Drug Administration. These wordings remain attributed to their respective official records rather than silently normalized.

The source identifies a separate commercial arrangement: in June 1987 the company transferred exclusive worldwide rights to one drug in exchange for clinical-testing and development funding, received a $2 million initial fee in 1987 and research-development fees in 1988–1990. The recommendation nevertheless says the drugs themselves were not sold during the audit period. The transfer agreement and annual-report pages are absent, so this page does not characterize those fees beyond the source's description.

The audit numbers do not form one reconciled schedule in the published document. The body reports $579,033 credited tax-paid materials, $690,558 total tax-paid purchases and $111,525 consumed in California. Footnote 4 says the reaudit instead shows $680,956 of tax-paid purchases, $109,974 consumed in California and a $570,982 difference. The recommendation adopts the reaudit generally but supplies no completed refund computation or final payment.

The source cites Annotation 425.0050, whose current page concerns an experimental drug sold to a drug company that paid doctors participating in a study. It also relies on manufacturing Annotations 440.1860 and 440.1880 for products ultimately sold. Annotation 440.1860 is absent from the current official 440 collection; its exact live URL returned HTTP 404 directly and through Sofya. This source reproduces no text for 440.1860 beyond citing it.

Legal research resolved all eight printed case reporters. The source's J. C. Penny Insurance reporter resolves to J. C. Penney Insurance Co. The Estate of Simpson reporter resolves to an inheritance-tax appeal involving Simpson's estate indexed as Kirkwood v. Simpson. Those name differences are disclosed; the official source text remains unchanged.

The September 23, 1993 conference record, research agreements, protocols, annual report, audit schedules, reaudit and supporting invoices are not reproduced. The signature block has a blank date line, and no later Board adoption, refund issuance, appeal or final disposition is supplied.

The official five-page PDF has a complete native text layer and no raster images, so no OCR was required. Two fresh direct PDF downloads and two live-page downloads were byte-identical; duplicate default text extractions also matched.

CDTFA's Annotated Legal Opinions collection says the opinion letters are summarized as annotations and statutory law controls when a statute and annotation conflict.

What this means for you

Exempt treatment of a finished experimental medicine did not automatically extend upstream to every input used to manufacture it. On these historical facts, the company consumed the raw materials and did not ultimately sell the trial drugs, defeating both the medicine-input and resale theories.

For current clinical-trial materials, separately document title and consideration for finished products and rights, who furnishes each dose, physician and patient relationships, input incorporation, in-state and out-of-state processing and use, and every later statutory change. Reconcile original-audit and reaudit schedules before stating a refund amount.

Common questions

Q: Did lack of federal marketing approval prevent the finished drugs from qualifying as medicine?

A: No. On the stated clinical-study facts, the recommendation treated the experimental drugs as medicines furnished in an exempt manner.

Q: Why were the raw materials taxable?

A: The company consumed them in manufacturing drugs that were not sold during the period, and the source found no medicine-input exemption.

Q: Did the worldwide-rights transfer make the drugs sold?

A: The source separately describes that funding arrangement but still concludes the two drugs were not sold. The agreement is absent, so the recommendation does not support a broader characterization here.

Q: Did the company receive its entire $144,353 claim?

A: No. The recommendation adopted the Department's reaudit and denied the rest, but the published source does not calculate the final allowed amount or show a final payment.

Q: Is this recommendation current law?

A: No. The live annotation expressly says the opinion does not reflect the January 1, 1995 addition of section 6369(a)(6).

Missing evidence and references

• Clinical Research Agreements, study protocols and patient-level drug records — referenced but absent
• 1990 annual-report pages 20–21 and worldwide-rights agreement — referenced but absent
• Product identities, composition, batch and raw-material records — redacted or absent
• Invoices, consideration, shipping and in-state/out-of-state use records — not supplied
• January 14, 1992 audit Schedules 2 and 2B — cited but absent
• October 14, 1992 reaudit report and Schedule R2B — cited but absent
• Appeals-conference evidence and transcript — not supplied
• Final Board action, allowed-refund computation, payment and later appeal — not supplied
• Annotation 440.1860 text — cited but absent from the current official collection

Verbatim support

From the official April 2, 1994 decision and recommendation:

Thus, the drugs are within the definition of medicines and used in an exempt manner, as provided by section 6369 and regulation 1591.

However, the analysis does not end here because the Department assessed the use tax on the “consumption” of the raw materials used to produce these drugs, not on the “use” of the drugs themselves.

I further understand that claimant did not sell either drug during the period in issue.

Allow the claim according to the Department’s reaudit report of October 14, 1992, and deny the claim in all other respects.

Citations and references

• California Revenue and Taxation Code §§ 6009.1, 6369, 6369.4(a), 6369.5, and 7054 — out-of-state use, medicine, manufacturing-input and audit provisions discussed in the recommendation
• California Sales and Use Tax Regulations 1591 and 1525(b) — medicine and incorporation-into-finished-product rules applied in the recommendation
• Annotation 425.0050 — experimental-drug guidance cited in the recommendation
• Annotations 440.1860 and 440.1880 — finished-product incorporation guidance relied on by the claimant
• Purdue Frederick Co. v. State Board of Equalization, 218 Cal.App.3d 1021 (1990)
• Standard Oil Co. v. State Board of Equalization, 39 Cal.App.3d 765 (1974)
• H. J. Heinz Co. v. State Board of Equalization, 209 Cal.App.2d 1, 4 (1962)
• Estate of Simpson, 43 Cal.2d 594, 602 (1954) — reporter-name difference disclosed above
• J. C. Penney Insurance Co. v. State Board of Equalization, 94 Cal.App.3d 685, 693 (1979) — source prints Penny
• Marchica v. State Board of Equalization, 107 Cal.App.2d 501, 510 (1951)
• Paine v. State Board of Equalization, 137 Cal.App.3d 438, 445 (1982)
• Riley B's, Inc. v. State Board of Equalization, 61 Cal.App.3d 610 (1976)

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Live annotation: Annotation 425.0045
• Original decision and recommendation: 425.0045 PDF
• Cited live authority: Annotation 425.0050
• Current manufacturing collection containing 440.1880 but not 440.1860: 440.0000 all annotations

Original ruling text

STATE OF CALIFORNIA

425.0045

BOARD OF EQUALIZATION
BUSINESS TAXES APPEALS REVIEW SECTION
In the Matter of the Claim
for Refund Under the Sales
and Use Tax Law of:
REDACTED TEXT Corporation
Claimant

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DECISION AND RECOMMENDATION
No.

REDACTED TEXT-001

The Appeals conference in the above-referenced matter was held by Paul O. Smith, Staff Counsel on September 23, 1993, in Sacramento, California. Appearing for Claimant:

REDACTED TEXT
Controller
REDACTED TEXT,
CPA

Appearing for the
Sales and Use Tax Department:

Michael P. Kitchen
Tax Auditor
Subject of Claim

Claimant seeks a refund of tax for the period July 1, 1987 through March 31, 1991, measured by: Items Subject to Claim B. Section 6009.1 credit on tax-paid purchases of raw materials used in the clinical testing of drugs. C. Cost of raw materials consumed in the clinical testing of medicines in California. Total

Amount
$111,525

$ 32,828
$144,353

REDACTED TEXT

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April 2, 1994
425.0045

Claimant’s Contentions
Claimant contends that the raw materials incorporated into [A]tm and [B]tm should be classified as nontaxable “medicines” pursuant to Revenue and Taxation Code Section 6369, and Sales and Use Tax Regulation 1591. Claimant also contends that it used [A]tm and [B]tm in the exempt manner prescribed in this section and regulation, and Sales and Use Tax Annotation 425.0050. Claimant, citing Sales and Use Tax Annotations 440.1860, and 440.1880, also contends that its raw material purchases are exempt because of incorporation into a finished product. Claimant contends, in the alternative, that it is entitled to an additional Revenue and Taxation Code Section 6009.1 deduction for raw materials used outside this state. Summary Claimant REDACTED TEXT Corporation is a leading biotechnology company developing therapeutic products using monoclonal antibody and recombinant DNA technologies. During the period in issue, claimant entered into Clinical Research Agreements (agreements) to conduct controlled studies to investigate the safety and efficacy of [A]tm and [B]tm in the treatment of patients with suspected Gram Negative Sepsis and various immune related disorders. 1 In June 1987, claimant entered into an agreement for the transfer of the exclusive worldwide rights to [A]tm in exchange for funding clinical testing and development activities by claimant. For this right claimant received an initial fee of $2.0 million in 1987, and research development fees in 1988, 1989, and 1990. There was no mention of any revenue being generated by [B]tm. (REDACTED TEXT Corporation Annual Report, 1990, p. 20-21.) The Federal Drug Administration (FDA) has not approved either drug for marketing. While the FDA continued its review, the products were made available to patients in clinical studies under claimant’s “compassionate use program”. The studies were conducted by an “Institution” and a “Principal Investigator”. 2 Under the agreement claimant made payments to the Institution and Principal Investigator that varied depending on whether a patient received one complete infusion of the drug, some study drug but less than one complete infusion of study drug, or no drug at all. Some studies were conducted outside this state.

The 1990 annual Report provided by claimant only makes reference to [B] Plus(tm). For purposes of this Decision and Recommendation I am assuming that [B](tm) and [B] Plus(tm) are one and the same. 1

The agreement defined a "Principal Investigator" as one who directs the clinical study in accordance with the protocol. Claimant has submitted agreements effective August 9, 1990, with REDACTED TEXT, as the Institution, and REDACTED TEXT, M.D., as Principal Investigator; and effective February 1, 1989, with REDACTED TEXT, Inc., as the Institution, and REDACTED TEXT, M.D., as Principal Investigator. The agreements also provide that the study group would be placed in a protocol entitled "Double Blind Randomized Placebo Controlled Group Comparative Study of the Safety and Efficacy of [A](tm) in Patients with Suspected Gram Negative Sepsis." 2

REDACTED TEXT

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April 2, 1994
425.0045

The Sales and Use Tax Department (Department) examined claimant’s returns for the period in issue, and determined that the raw materials used to produce the above drugs were subject to use tax because they were not purchased for resale, and failed to qualify as a “medicine”. Most of the suppliers of the raw materials were located outside the state, and most collected the use tax on their sales. The Department gave claimant credit for the cost of raw materials processed in this state and subsequently sent outside the state for use in claimant’s clinical testing program. On October 14, 1992, the Department completed a reaudit. Analysis and Conclusions Revenue and Taxation Code section 6369 provides in relevant part that there are exempted from the sale and use tax, the gross receipts from the sale, and the storage, use, or other consumption, in this state of medicines (1) prescribed for the treatment of a human being by a person authorized to prescribe the medicines; (2) furnished by a licensed physician and surgeon for his or her own patient; (3) furnished by a health care facility for treatment of any person; (4) sold to a licensed physician and surgeon; or (5) sold to this state. Section 6369, subdivision (b) provides in relevant part that “medicines” means and includes any substance or preparation intended for use by application to the human body in the diagnosis, cure, mitigation, treatment or prevention of disease that is commonly recognized as a substance or preparation intended for that use. (See also Sales and Use Tax Reg., § 1591, Subd. (b)(1).) Claimant argues that the raw materials incorporated into [A]tm and [B]tm should be classified as “medicines”, and are therefore nontaxable. The facts establish that [A]tm is used in the mitigation, treatment, or cure of gram-negative sepsis, a serious complication of certain bacterial infections, and the drug [B]tm selectively eliminates T lymphocytes involved in immune system disorders. The facts also show that these drugs qualify as experimental drugs, and are furnished by a licensed physician paid under contract by claimant, to his or her patient engaged in the studies. Thus, the drugs are within the definition of medicines and used in an exempt manner, as provided by section 6369 and regulation 1591. (Cf. Sales and Use Tax Annon. 425.0050; Purdue Frederick Co. v. State Bd. of Equalization (1990) 218 Cal.App.3d 1021.) However, the analysis does not end here because the Department assessed the use tax on the “consumption” of the raw materials used to produce these drugs, not on the “use” of the drugs themselves. It is well settled that exemptions from tax are strictly construed against the taxpayer who has the burden of proving that the statutory requirements have been satisfied. (See Standard Oil Company of California v. State Bd. of Equalization (1974) 39 Cal.App.3d 765; H. J. Heinz Co. v. State Bd. of Equalization (1962) 209 Cal.App.2d 1, 4.) Any doubt must be resolved against the right to an exemption. Estate of Simpson (1954) 43 Cal.2d 594, 602; J. C. Penny Insurance Company v. State Bd. of Equalization (1979) 94 Cal.App.3d 685, 693.) Petitioner’s argument that its purchases of raw materials incorporated into [A]tm and [B]tm are exempt from tax is not supported by the clear and unambiguous language of section 6369.

REDACTED TEXT

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April 2, 1994
425.0045

Section 6369, upon which petitioner relies, when enacted in 1961, exempted medicines dispensed on prescription by a registered pharmacist. This statute has undergone numerous amendments since its enactment. One such amendment extended the exemption to cover medicines furnished by persons other than a pharmacist, another amendment exempted medicines furnished by dentist, and expanded the definition of medicines to include items such as sutures and bone screws, and another amendment substituted the term “health facility” for “hospital”. 3 As I have stated above, the gross receipts from the sale, and the storage, use, or other consumption, in this state of medicines such as [A]tm and [B]tm are exempt from tax. However, in no instance did any of the many amendments to the statute extend its provisions to items and materials consumed in the manufacture of [A]tm and [B]tm. Nor has claimant directed me to any other authority that provides such exemption. (See e.g. Rev. & Tax. Code, §§ 6369.4, subd. (a), and 6369.5.) Further, the raw materials in question are not “medicines” within the meaning prescribed by section 6369, subdivision (b), nor commonly recognized as a substance or preparation intended for use as a medicine. (See also Sales and Use Tax Reg., § 1591, subd. (b)(1).) Therefore, I must conclude that the Department properly denied classification of the materials as exempt medicines. Claimant also argues that its raw material purchases are exempt because of their incorporation into a finished product. Claimant relies on Sales and Use Tax Regulation 1525, subdivision (b), and Sales and Use Tax Annotations 440.1860 and 440.1880, which provide for the exemption of raw materials incorporated into the manufacture of articles to be sold. Claimant’s reliance on this authority is misplaced because in each instance the materials must be incorporated into a product that is ultimately sold. As set forth above, both [A]tm and [B]tm were used in human clinical trials under petitioner’s compassionate use program, and the FDA had not approved either drug for marketing. I further understand that claimant did not sell either drug during the period in issue. Therefore, it must be concluded that since neither [A]tm or [B]tm were sold, the authority relied on by claimant is inapplicable. Claimant contends in the alternative that it is entitled to an additional section 6009.1 deduction for raw materials used outside this state.

Added by Stats. 1961, chap. 866, p.2273, § 1. Amended by Stats. 1962, chap. 7, p.12, §1; Stats. 1963, chap. 716, p.1723, § 1; Stats. 1970, chap. 1511, p. 2999, § 1, operative July 1, 1971; Stats. 1972, chap. 877, p. 1549, § 1, eff. Aug. 14, 1972, operative Oct. 1, 1972; Stats. 1977, chap. 1245, p. 4220, § 1, eff. Oct. 1, 1977, operative Oct. 1, 1977; Stats. 1978, chap. 229, p. 485, § 1, eff. June 13, 1978; Stats. 1982, chap. 1530, p. 5954, § 1, eff. Sept. 30, 1982, operative Jan. 1, 1983; Stats. 1982, chap. 1589, p. 6281, § 12.3. 3

REDACTED TEXT

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April 2, 1994
425.0045

Sections 6009.1 provides in relevant part that “storage” and “use” do not include the retaining or exercising any right or power over tangible personal property that is subsequently transported outside the state for use solely outside the state, or for manufacture into other tangible personal property to be transported outside the state and used solely outside the state. Section 7054 authorizes the Department to conduct investigations to verify the accuracy of sales and use tax returns. Further, there is the presumption that the Department’s determinations as to the amount of tax owed is correct (Marchica v. State Bd. of Equalization (1951) 107 Cal.App.2d 501, 510), and the burden of overcoming this presumption is on the taxpayer. (Paine v. State Bd. of Equalization (1982) 137 Cal.App.3d 438, 445; Riley B’s, Inc. v. State Bd. of Equalization (1976) 61 Cal.App.3d 610.) Here, claimant argues that it is entitled to an additional section 6009.1 deduction for taxpaid purchases of $111,525. I disagree. In the conduct of its audit the Department made two findings of fact regarding consumable materials used in the production of [A]tm and [B]tm. The first was that claimant consumed ex-tax materials of $32,828, and received credit for tax-paid materials of $579,033. (See Audit Sch. 2, Jan. 14, 1992.) The second was that claimant had taxpaid material purchases of $690,558, of which $111,525 was consumed within the state. 4 (See Audit Sch. 2B, Jan. 14, 1992.) Since the Department determined that the $111,525 had been consumed within this state, and claimant has not established otherwise, this amount is not within the exclusion provided by section 6009.1. Recommendation Allow the claim according to the Department’s reaudit report of October 14, 1992, and deny the claim in all other respects.

Paul O. Smith, Staff Counsel

Date

The difference is the $579,033 that claimant received credit for against its ex-tax purchases. Also Schedule R2B in the reaudit workpapers shows tax-paid purchases of $680,956 and materials consumed in California of $109,974 (net difference of $570,982 for tax-paid materials as compared to $579,033 in the original audit). 4