Unlike in a court of law, even when you are doing everything right, you have to pay to prove it. As a result, the best defense is a good offense. In the case of indirect sales tax, having a good offensive plan requires the right processes, technology and domain expertise.
Indirect tax, also known around the world as transaction tax, value added tax (VAT), goods and services tax (GST) or sales & use tax, is one of the top revenue sources for local and national governments worldwide. With many governments still struggling to address massive budget shortfalls, it is not surprising that they are tinkering with indirect tax rules in order to extract more revenue. As a result, the sheer number and variety of indirect tax changes are on the rise.
What does this mean for businesses chartered with collecting these taxes on behalf of government?
We know that errors frequently arise when rates change, resulting, for example, from incorrect product or tax codes. Many predict that this will inevitably result in more companies being audited and assessed penalties due to non-compliance.
In a recent survey of indirect tax professionals in 39 countries, a large majority of respondents said tax audits have increased in recent years and are likely to increase in the future, and 27 of 39 countries reported increased penalties.
This is not welcome news for businesses that are barely recovering from the recession. Not only do companies have to navigate through the current complexity of the law, they also have to stay on top of new global tax laws and trends, preserve cash in the face of proliferating audits, and figure out how to reduce operational costs, while still covering all their audit risks. Tax audits require weeks of effort and distraction, and come with the potential for tens of thousands of dollars in penalties and fees that bite into the bottom line.
The Most Common Audit Pitfalls
If you have to undergo an audit, keep in mind that the auditor’s job is to capture additional tax revenue. They know that each new tax law change, product launch, or taxable item or service increases a company’s odds of having errors and therefore being non-compliant, so they have a specific list of common errors to look for. But if you know what auditors look for, you can take preventative measures to ensure compliance.
Based on data from current and former auditors, here are the top 10 pitfalls that are most likely to be raised in an audit and how to address them:
1. Use tax.This is an easy and substantial “hit” for an auditor. Use tax applies to the routine purchase of such items as consumables and office supplies as well as large fixed assets, which creates the potential for the state to assess a very large fee. Unfortunately, most people don’t know this until it’s too late, i.e., when the auditor has come in, looked at a certain period of time, and then assessed back taxes and penalties retroactively.
The only way to fight this is to maintain domain expertise to determine use tax applicability—an expensive proposition for businesses of all sizes. The more locations a business has, the more complex use tax becomes.
2. Exemption and resale certificates.If you don’t possess proper exemption certificates, some auditors will let you go back and try to get them retroactively, but you shouldn’t count on it. As for resale certificates, if they’re not on file, the auditor will typically determine an error rate and project backwards to assess tax and penalties. If it’s proven that a resale certificate has been used improperly, the penalties can be substantial.
To avoid these situations, companies need an automated process to enforce exemption and resale certificate compliance for each tax jurisdiction in which they do business.
3. Unreported sales.Mistakes happen and certain sales can go unreported. Sometimes even entire divisions get left out due to human error.
The remedy is to rely on systems, not people, i.e., let automated systems determine and calculate tax.
4. Charging wrong rates.In 2012, there were over 2,500 tax rate changes across the globe. Staying on top of these changes and instituting new rates at the right time is extremely difficult, especially when districts get re-aligned.
The only good answer is to have real-time rates applied automatically from the day they are effective.
5. History of audits and assessments.Bureaucracies have the memory of an elephant. Once flagged, you’re under the microscope for life and can expect repeated audits. Most auditors will cite an error, and you might not have the time, energy or resources to address it going forward. Then, upon the return audit, auditors can easily find the exact same infraction and assess penalties on it.
The defense here is to have iron-clad processes and procedures and good documentation. Adequate documentation makes an audit go much more smoothly, while poor record keeping will prolong an audit and ultimately sink you. Lacking documentation, an auditor will try to get a visual sample—which for a retailer just might end up being the day after Thanksgiving or the week before school starts—and then extrapolate that sample across your business year, potentially to your disadvantage.
6. Unique rules and regulations.Each region has its own special twists to its indirect taxes. Auditors are highly tuned into these, particularly when the rules are new, and are quick to spot non-compliance. Tax authorities, for example, often have special taxes that apply to specific goods. There are many food/beverage, gambling, cigarette/tobacco, soft drink, timber, and fuel taxes that can be uncovered during an audit. Tax authorities will also audit specifically for these types of taxes from time to time, which can open you up to a full-blown sales tax audit if it appears there is weak recordkeeping.
As with the issues above, adequate documentation and automated processes are necessary to keep you out of trouble. Specialized domain expertise in determining taxability for specific items is also requisite.
7. Sales tax accruals.Many companies don’t properly remit the sales taxes they’ve collected. An auditor will look at federal tax returns, the general ledgers, invoice register, actual invoices, sales journals and summaries of sales by state to identify and reconcile disparities, and will then use the number that provides the best assessment.
The best advice here, obviously, is to do the same thing yourself—exhaustively and comprehensively—before you report and remit.
8. Acquisitions.A business acquisition can really roil the waters when it comes to sales and use tax compliance. For one thing, if an acquisition brings you into new markets, you can be creating nexus and thus opening the door to new tax liabilities and an increased number of audits. Then there is the issue of previous liability: When you acquire a company, you must immediately notify all states where the new combined company is doing business; if you don’t do this, you automatically assume all previous tax liabilities.
Specialized expertise is required to ensure that you are properly reporting pre- and post-acquisition taxes. After all, you are dealing with the potential for new nexus as well as material changes to your business.
9. Internet sales.It used to be that the physical presence nexus standard determined if you were required to register to collect and remit taxes. However, New York and numerous other states have required online retailers—that meet specific requirements—to collect sales tax for items sold to consumers within their respective states. As states continue adopting similar click-through-nexus laws and with the potential for passage of the Marketplace Fairness Act, nexus standards have been continuously changing. An online business may never have a physical presence in a state, but now may have a sales/use tax collection requirement. With a registration requirement, comes the potential for an audit.
Domain expertise is required to stay abreast of the so called “Amazon tax laws.” These laws are changing quickly, which requires diligent legislation tracking, tracking sales while monitoring threshold amounts, and eventual real-time sales tax rates fed into your operational system to minimize the chance for error and ensure timely compliance.
10. Business Activity Questionnaires.These questionnaires are issued by Tax Discovery Auditors. The audit world’s version of the Marines, they are much tougher than your normal tax auditors as they are tasked with uncovering unregistered businesses and businesses engaged in fraudulent activities. As with other Informational Document Requests (IDRs), it’s easy to check the “yes” box next to the general questions on these questionnaires, but doing so may well create nexus.
Hence, be sure to seek counsel before filling out these or other IDRs.
Guilty until Proven Innocent
Unlike in a court of law, even when you are doing everything right, you have to pay to prove it. As a result, as the adage goes, the best defense is a good offense. In the case of indirect sales tax, having a good offensive plan requires the right processes, technology and domain expertise.
By formulating a sound offensive program, you gain a proactive shield against audits in the form of accurate calculation and determination and, when they do occur, you are equipped with the documentation and expert counsel required to minimize their impact in terms of penalties, time and effort, and diversion of internal resources.
Carla Yrjanson, CPA, is vice president of tax research & content for indirect tax for Thomson Reuters.