Document Number
10-179
Tax Type
Retail Sales and Use Tax
Description
Untaxed sales made to dentists and dental practices/prescription or nonprescription drug exemptions.
Topic
Appropriateness of Audit Methodology
Exemptions
Medicine and Drugs
Date Issued
08-16-2010


August 16, 2010




Re: § 58.1-1821 Application: Retail Sales and Use Tax

Dear *****:

This will reply to your letter in which you seek the correction of a retail sales and use tax assessment issued to ***** (the "Taxpayer") for the period June 2003 through March 2007. I apologize for the delay in responding to your letter.

FACTS


The Taxpayer is an out-of-state dental supply business that was audited by the Department and assessed use tax on untaxed sales made to dentists and dental practices. The Taxpayer maintains that the stratified random sample of sales conducted by the Department is flawed because proper sampling procedures were not used. The Taxpayer also contends many of the untaxed sales included in the sample qualify for either the prescription or nonprescription drug exemptions.

DETERMINATION


Sales Sample

Due to the Taxpayer's Iarge sales volume, the Department's auditor conducted a stratified random sample on one month of sales. The auditor eliminated from the sales population untaxed sales to entities that were confirmed to be exempt from the tax. The auditor also identified transactions in which the correct amounts of use tax were charged on the total sales amounts invoiced and excluded these from the sales population. After eliminating these transactions from the sales population for the sample month, the remaining sales were stratified and randomly selected for review using stratified random sampling procedures. The Taxpayer maintains that the Department's sampling techniques were not properly applied in the sales sample.

Sampling is an audit technique of significant value that is widely used in both the public and private sectors. The Department uses sampling in sales and use tax audits where a detailed audit would not prove beneficial to either the auditor or the taxpayer. When there is a large volume of transactions to review, the Department often uses stratified random sampling if taxpayers agree to its use and the records are in a format that allows the use of this sampling methodology. Regardless of the sampling method used, when sampling techniques are properly applied, the final results should be within a narrow percentage range of the actual amounts that would be determined by a detailed audit.

The Taxpayer states that the taxable sales measure produced by the audit sample is incorrect because the auditor improperly eliminated from the sales population the two categories of sales transactions discussed above prior to the random selection of the sales transactions that were reviewed. Based on a review of the sample methodology, I disagree that it was improper to remove the two categories of sales from the sales population prior to selection of sales from the sample population for review.

The sample month chosen was representative of the Taxpayer's sales activity during the audit period. The invoices that were properly taxed by the Taxpayer were excluded from the sample population because they were correct. The auditor's conclusion was based on confirmation that use taxes were charged on total sales amounts billed on these invoices. Untaxed sales made to exempt entities were treated in the same manner. The auditor verified that the customers in these transactions qualified for sales and use tax exemption and that these sales were not taxable. This group of sales transactions was also deemed correct and eliminated from the sales population to be sampled.

The Taxpayer suggests that the sample size did not meet Virginia auditing standards with respect to the number of items sampled and the dollar value of the items sampled. The Taxpayer computed percentages for the number of invoices and invoice amounts reviewed based on the entire sales population for the month. The Taxpayer incorrectly assumes that all the eliminated invoices would be pulled in the random sample. The Department calculates sample size percentages based on the total number of invoices and invoice amounts available for random selection in the sample. A review of these calculations shows that the sample's percentages meet the standards set out in the Department's sampling guidelines. Thus, I disagree with the Taxpayer's contention that the sample size is too small.

The Taxpayer states that credits for returned goods were excluded from the sales sample, which violates the concept of random sampling. Based on information in the audit report, the Taxpayer was unable to provide adequate records linking credits to specific sales transactions in the sample month. Regardless of this fact, the auditor agreed to perform a separate sample of these credits. The auditor calculated total credits for the sample month, computed the percentage of total credits to total sales for the month and extrapolated the resulting percentage against total sales for each month of the audit period. The tax on the resulting credit measure was applied against the sales liability in the audit. Thus, the Taxpayer received a sales credit totaling ***** in measure for the audit period.

The audit's sample results are further supported by filing statistics from returns filed by the Taxpayer after the conclusion of the audit. The Taxpayer began collecting and reporting the tax on a broad category of Virginia sales transactions found taxable in the audit that it had not previously taxed. The percentage of exempt sales to total sales fell from an average of 23.4 percent for returns filed during the audit period to an average of 10.9 percent for returns filed by the Taxpayer in the eight months after the audit was concluded. The difference in these percentages is 12.5 percent, which closely approximates the error factor in the sample of 12.7 percent. The Taxpayer's filing history subsequent to the close of the audit strongly suggests that the sales error factor computed in the Department's sample is accurate.

Despite the Taxpayer's contentions, I find no basis for recalculation of the sales sample. The courts have held that a tax assessment is prima facie correct and the burden is upon the Taxpayer to prove that the assessment is incorrect. See Va. Code § 58.1-205. Based on the information presented, the Taxpayer has not met this burden. While I understand the Taxpayer's concerns, the identification and elimination of the two groups of transactions from the sample's sales population reduced the number of invoices to be reviewed and streamlined the sampling process. However, it is important to note that the error factor used to extrapolate the results of the sample was calculated using total sales for the month, including sales in the two excluded categories.

Exemptions for Prescription and Nonprescription Drugs

The Taxpayer asserts that many of the sales held taxable in the audit qualify for either the prescription or nonprescription drug exemptions found in Va. Code §§ 58.1-609.10 9 and 58.1-609.10 14, respectively. The contested items include crowns, caps, alloys, cements, sealants, veneers, liners, resins, bonding agents and similar dental materials and supplies. Some of these items may include small quantities of drugs or medicines. For this reason, the Taxpayer believes that the items qualify for one of the cited exemptions. The Taxpayer also maintains that various definitions used by the Department to administer the prescription and nonprescription drug exemptions support treating the contested items as exempt drugs or medicines. The auditor deemed the contested items to be medical devices. Absent an applicable exemption, medical devices are generally subject to the tax.

Title 23 of the Virginia Administrative Code (VAC) 10-210-500 A states:
    • The tax applies to sales to a dentist by a dental laboratory or supplier of dentures, plates, braces and similar prosthetic devices, or the component parts thereof, unless such dentures, braces, etc. are purchased on behalf of a specific patient. If such items are purchased in bulk and then dispensed to a particular patient, the original purchase will be subject to the tax even if the items withdrawn from the bulk inventory are modified for a specific patient.

Title 23 VAC 10-210-500 C then states:
    • Dental supply houses are those businesses primarily engaged in selling fixtures, equipment, instruments, materials and supplies to both dentists and dental laboratories. Dental supply houses must collect and pay the tax on retail sales of tangible personal property to dentists, dental laboratories, and other users unless a properly executed certificate of exemption is furnished by the purchaser.

The cited regulations are clear that the tax generally applies to the Taxpayer's sales to dentists. The Department's longstanding policy is that crowns and other dental devices, and the supplies and component parts used with the devices, are taxable because they are classified by the United States Food and Drug Administration (FDA) as medical devices rather than prescription or nonprescription drugs. This policy is supported by Title 23 VAC 10-210-940 B, which defines "controlled drugs" as "those drugs itemized under § 54.1-3400 et seq. of the Code of Virginia, but shall include only medicines and drugs and not devices." (Emphasis added.) This policy is also set out in Tax Bulletin 98-4, which was issued by the Department on May 15, 1998 to announce the new exemption for nonprescription drugs and proprietary medicines. The bulletin specifically states that the nonprescription drug exemption does not apply to devices.

In Public Document 09-6 (2/4/09), the Department ruled that knee joint viscosupplementation devices did not qualify for exemption as a medicine or drug because the devices were classified as medical devices. P.D. 03-1 (1/15/03) discusses a joint fluid therapy device used to treat osteoarthritis of the knee. This device also did not qualify for exemption as a drug because it was classified by the FDA as a medical device. P.D. 09-4 (2/4/09) addresses injectable implants that could only be obtained by prescription. The implants contained the drugs collagen and lidocaine hydrochloride. While this document focuses on the application of the durable medical equipment exemption to the implants, it is noteworthy that the implants contained drugs. The Department ruled that the prescription and nonprescription drug exemptions did not apply to the implants. The cited public documents clearly indicate that the Department relies on the FDA classification of an item to determine if it qualifies for exemption as a medicine or drug. If the item is classified by the FDA as a medical device, it does not qualify for exemption from sales and use tax as a drug or medicine.

A review of the contested items on the FDA's website confirms the auditor's conclusion that these items are taxable because they are devices and not drugs. The auditor previously excluded untaxed prescription or nonprescription drug sales from the audit if it was confirmed that the products sold were classified by the FDA as drugs and not devices. The Taxpayer should note that sales of medical devices may qualify for the durable medical equipment exemption. In accordance with P.D. 07-169 (11/7/07), sales of dental crowns and similar devices qualify for the durable medical equipment exemption in Va. Code § 58.1-609.10 10 when purchased on behalf of specific patients. This document explains the requirements necessary to qualify for this exemption.

Based on the above, I find no basis to remove the contested exceptions from the audit. The Virginia courts have consistently required strict construction of sales and use tax exemptions. When there is any doubt as to the application of an exemption, the doubt is resolved against the one claiming the exemption. See Golden Skillet Corp. v. Commonwealth, 214 Va. 276, 199 S.E.2d 511 (1973). However, I am willing to allow the Taxpayer 45 days to submit documentation indicating that sales exceptions remaining in the audit are classified by the FDA as drugs or medicines rather than devices. This information will be reviewed by the Department and the audit adjusted accordingly. If no information is received within 45 days from the date of this letter, the audit will be considered correct with respect to this issue.

Credit for Erroneous Collection of Sales and Use Tax

The auditor did not allow credits in the audit for use taxes charged in error to customers on transactions the Taxpayer maintains were nontaxable. The Taxpayer believes that use taxes erroneously collected from its customers should be treated as credits in the sales sample, which would reduce its sales liability.

Virginia Code § 58.1-625 states in part:
    • Any dealer collecting the sales or use tax on transactions exempt or not taxable under this chapter shall transmit to the Tax Commissioner such erroneously or illegally collected tax unless or until he can affirmatively show that the tax has since been refunded to the purchaser or credited to his account.

The erroneous tax collected by the Taxpayer was remitted to the Department as required by Va. Code § 58.1-625. Based on the provisions of this statute, dealers are allowed a credit for erroneously collected tax only if the dealer first refunds the tax or credits the tax to the account of its customers. In P.D. 97-302 (7/11/97) and P.D. 93-78 (3/22/93), the Department denied taxpayers refunds or credits against their audit liabilities for erroneously collected taxes because the taxpayers had not refunded the taxes to their customers. Consistent with the public documents cited, the Taxpayer did not refund or credit the erroneously collected taxes to customers during the audit period. Thus, the Taxpayer is not entitled to credits in the audit for taxes erroneously charged to customers.

Further, the Taxpayer's contention is based on the premise that many of the items at issue qualify for exemption as prescription or nonprescription drugs (see previous section on this issue). However, as this determination states, the prescription and nonprescription drug exemptions do not apply to sales of medical devices. Many of the sales identified by the Taxpayer were not prescription or nonprescription drugs, but were medical devices, cleaning supplies, sterilization solutions and similar products. As these items were properly taxed, the tax was not erroneously collected. In summary, there is no basis to allow credits in the audit for the transactions at issue.

CONCLUSION


Based on the foregoing, the audit assessment issued to the Taxpayer as bill number ***** is correct. The Department's records indicate that the Taxpayer has paid ***** of the assessment. As previously noted, I will allow the Taxpayer 45 days to provide documentation to support the removal from the audit of sales exceptions that qualify for either the prescription or nonprescription drug exemptions. The audit assessment will be adjusted, if warranted, based on a review of any documentation the Taxpayer provides. If this information is not received within the allotted time, the assessment will become due and payable and an updated bill with accrued interest will be issued to the Taxpayer. The bill should be paid within thirty days to avoid the accrual of additional interest.

The Code of Virginia sections, regulations and public documents cited are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's web site. If you have any questions concerning this determination, please contact ***** in the Appeals and Rulings Division at *****.
                • Sincerely,

                • Linda Foster
                  Deputy Tax Commissioner




AR/1-2534016438.S


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46