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Tax law casts doubt on stem cell royalties: State may not reap billions promised to voters last fall

by Bernadette TanseySan Francisco Chronicle
October 25th, 2005

The billion dollars in royalties that voters were told could flow to the state if they passed California's $3 billion stem cell research funding initiative in 2004 may turn into an empty promise.

Researchers and business groups are raising a host of reasons the state should claim no portion of the revenue from inventions produced under the stem cell program created by Proposition 71.

For one thing, they say, requiring that the state get a share would hinder work toward disease cures by removing some of the incentive for private investors.

But perhaps their strongest argument is that the state might actually be forbidden from sharing royalties by federal tax laws -- that is, if California chooses to finance the program by the cheapest possible route: tax-exempt bonds.

Whether those tax laws actually would be an obstacle, however, is by no means certain. And yet no one with responsibility for the $3 billion in bonds -- not the main author of the initiative, Robert Klein, who now chairs the state's stem cell institute, nor state Treasurer Phil Angelides, who is running for governor -- has promised to make sure the question is answered.

Some Prop. 71 critics now wonder whether Klein ever intended the state to receive royalties.

"It starts to have the look of a bait and switch," said Jesse Reynolds, a spokesman for the Center for Genetics and Society, an Oakland nonprofit organization that supports genetic technology but advocates ethical constraints. It was Klein, the architect of the Prop. 71 campaign, who persuaded voters to commit billions to research during a state budget crisis by saying that the universities and private firms that received stem cell grants would share as much as $1 billion or more in royalties with the state. Newspapers and news services reported that claim, and Klein aired it on PBS' "NewsHour With Jim Lehrer.''

But what Klein knew before the election was that such royalty-sharing by the state might be hampered by federal regulations, according to an attorney who helped Klein draft the initiative. Yet he didn't tell voters.

Klein and officials from the stem cell institute, the California Institute for Regenerative Medicine, declined repeated interview requests for this report.

"Voters were told they would benefit from stem cell research, but if the drug companies own the treatments, it will be the top executives and shareholders that will profit,'' said Jerry Flanagan, health care policy director for the Foundation for Taxpayer and Consumer Rights, which opposed Prop. 71. Now members of the biomedical industry -- which stands to benefit from the funding and which avidly supported Prop. 71 -- argue that the state should allow researchers and their corporate partners to keep all intellectual property rights to the stem cell discoveries.

Critics of the proposition fear the stem cell institute will move quickly to adopt the proposals of an advisory panel of the California Council on Science and Technology, made up of business and academic officials, whose report will be heard by a committee of the stem cell institute today. The panel contends that a state stake in the royalties could slow medical progress by discouraging investors from putting up their own money to help research treatments.

The panel also argues that a state share would be unworkable under federal tax laws. They base this conclusion on discussions with the law firm that helped Klein write Prop. 71. The firm, Orrick, Herrington & Sutcliffe, also serves as the state bond counsel, advising the treasurer's office and the Legislature on the issue.

But the treasurer's office, an Orrick attorney and other finance experts told The Chronicle that it's impossible to say for sure how the Internal Revenue Service would apply the law to California's stem cell effort. The IRS doesn't comment in general on such questions, a spokesman said.

The potential problems have to do with a complex and unsettled question: how federal tax law will apply to a novel state research venture, supported by tax-exempt bonds, that involves a state split of private profits.

In general, federal law allows state and local governments to finance public projects such as bridges and roads with tax-exempt bonds. Investors are attracted to those bonds because they don't have to pay income tax on the proceeds and so are willing to accept lower interest rates. Those lower rates make the bonds a cheap revenue source for the states.

A publicly funded project could be used by individuals and businesses alike. But IRS rules largely forbid the states to use tax-exempt bonds to benefit specific private enterprises rather than serving a general public good -- and to share revenue from an enterprise to the extent that the state becomes like a business partner.

The extremely complex rules revolve around the extent to which public money is used to fund essentially private enterprises and whether the state would share revenue from the project.

Many of the regulations that could apply are untested when it comes to state funding of scientific research, but theoretically, they could limit the state's right to a stake in the royalties.

Outside experts say the state should ask the IRS for an advisory opinion, a common practice.

But the IRS may never have the chance to answer the question if the stem cell institute adopts the advisory panel's proposal to forgo all royalties.

Robert Feyer, an Orrick attorney, said the state will go to the IRS for a private letter of approval, but only after the stem cell institute has set its royalty policies and has a specific program of bond issuances in mind.

Without question, the state could preserve its royalty rights by issuing taxable bonds instead of tax-exempt bonds. But it would have to pay investors a higher interest rate on the taxable investments.

Aides to the gubernatorial campaign of Angelides, who is running for governor and was a prominent endorser of Prop. 71, did not respond directly to questions of whether he is making personal efforts to resolve the uncertainty over possible limits on tax-free bonds.

Nick Papas, a spokesman for the treasurer's office, said that office's role is to help the stem cell institute, after it has set its policies, to get the best bond rates.

Klein, who promised that the state would receive royalties, declined to say whether he would urge the stem cell institute's board to go to the IRS first with a proposal allowing both royalties for the state and tax-exempt bonds.

Klein's campaign had commissioned a study that estimated Prop. 71 might return even more to California than it would cost -- an estimated total of $6 billion to pay off the bonds.

On the Prop. 71 campaign's Web site and in press releases, Klein said the study found that the project could stimulate the biomedical industry in California and reduce state health care costs by eliminating chronic diseases. In addition, the state would collect, conservatively, $537 million to $1.1 billion in royalties, according to the campaign's study, by the Analysis Group, a Menlo Park consulting firm, and Laurence Baker, an associate professor of health research and policy at Stanford University.

Klein, on the Jim Lehrer news show the week before the 2004 election, said, "The state of California will gain jobs, new tax revenues and intellectual property revenues to pay back the taxpayers."

Under Prop. 71, however, the governing body of the institute that is distributing the grants can waive the state's right to royalties if they could be seen as hindering medical progress.

The body is made up of representatives from state universities, private research institutions, biomedical businesses and patient advocacy groups. Many of those institutions have a direct stake in stem cell research.

After the election, a prominent supporter of Prop. 71, state Sen. Deborah Ortiz, D-Sacramento, tried to pass legislation to make royalties for the state mandatory. At that point, the Orrick firm told legislators about the possible legal obstacles under federal tax laws.

Klein had retained the Orrick firm with Angelides' permission to help write Prop. 71 -- not unusual when an initiative could create financial obligations for the state.

Klein was briefed on the possible tax problem before the election, Feyer said. Angelides' office briefed the legislative analyst's staff on the issue. But no one let voters know. Whether Klein should have told voters depends on how you look at it, said Robert Stern of the Center for Governmental Studies in Los Angeles, a nonprofit institute focused on government reform.

"A legal obligation? No," Stern said. "A moral obligation? Sure" -- if the campaign was misrepresenting the facts, he said.

That the federal tax questions might have a severely restrictive effect on the stem cell program was never predicted by the legislative analyst's office, said Brad Williams, who wrote the analysis of Prop. 71 that guided voters. Williams said he saw it as a "glitch'' that didn't need to be mentioned. His summary anticipated that the state would get royalties in an amount that was "unknown, but could be significant."

The possible impact of the tax law hinges on the difference in interest rates between taxable and tax-exempt bonds -- an issue now muddled by conflicting information.

Sen. Ortiz said her understanding from the Orrick firm was that taxable bonds would cost almost $1 billion more than tax-free financing. Feyer said taxable bond rates would be 2 percent higher.

Ortiz said she concluded that state royalties were impossible because taxable bonds would be too expensive. But treasurer's office spokesman Nick Papas said the interest rate difference is only half a percent. In addition, he said, it's not necessary to choose between the bond types in an "all or nothing'' financing program. They could be mixed to achieve the institute's goals -- including state royalties, he said.

Some public finance experts say they're not convinced that tax-free bonds will substantially limit the state's right to royalties.

"I will be astonished if they can't figure out a way to get these bonds issued," said Robert Doty, president of the Sacramento consulting firm American Governmental Financial Services Co.



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