When a company is undergoing a sales and use tax audit, the use of sampling procedures by the auditor can be daunting and can sometimes result in unplanned difficulties for the company. It is extremely important to get ahead of the game and to ensure that the use of sampling procedures does not inadvertently create undue problems for the company. This edition of Tax Advisor Weekly addresses what a company can do to add some amount of “certainty” to an audit that involves the use of sampling procedures.
So, what problems do most companies encounter?
Problems can start with the methodologies used by a taxing jurisdiction’s auditor. Or a problem can relate to how an auditor verifies that the results of the sample review “accurately” represent the population. However, we find that typically it is the uncertainty of whether the auditor understands how to properly apply sampling procedures to the various set or subset of electronic data.
When the auditor performs a transaction-based sample, it is critical that you take the time to understand the overall sample design. This includes, but is not limited to:
- The manner in which a “strata” range has been adopted;
- The methodology used by the auditor to determine the sample population when the population of data does not specifically identify the jurisdiction where an item was purchased or will be used; and
- The plan for handling extraordinary items.
Negotiating how to treat extraordinary transactions with an auditor can lead to many challenges but is necessary to make sure the rest of the population is not tainted.
Should you insist that sampling not be used by the auditor?
For most companies with a significant amount of sales or payables transactions, the use of sampling in a sales and/or use tax audit is a necessity. Additionally, in many instances, the taxing authority has statutory authority to perform the review in any manner they deem necessary. Based on our experience, we find that properly employed sampling procedures can be both effective and efficient. Of course, this assumes that the auditor has adequate knowledge of how to properly employ sampling techniques.
Unfortunately, the area where a company feels it has the least amount of control relates to the use of sampling by a taxing jurisdiction in generating a tax assessment. The ability to understand the goals of the sampling design and to provide input will greatly reduce the uncertainty associated with sample projections. Being involved in the decision-making process on the front end will produce confidence on the back end when potential errors are projected against the sample population. After developing a sound knowledge of sampling, it is also possible to use those same guidelines to perform a self-review for overpayments.
So how can the company get ahead of the situation?
It starts with participation. Assisting the auditor in the planning and design of the sample can be very beneficial. Proper sampling technique requires thorough planning and preparation for both the auditor and the company under audit. The availability and integrity of the company’s accounting records, electronic data and supporting documentation has a significant impact on the quality of a sample review. Gathering the electronic data and verifying the completeness and accuracy of that data takes a considerable amount of time and effort. This is the one step that should not be disregarded. Given the internal obligations placed on most companies' information systems departments, there can often be delays in responding to data requests by the tax department. If this is an area where the company does not have experience, then they would be wise to hire an experienced consultant to assist them.
With respect to potential sampling problems inadvertently created by the taxpayer, most problems occur when data is unavailable or difficult to obtain. Space limitations require that data be archived or maintained in a data warehouse of some type. In many instances, decisions are made to archive only certain fields or tables rather than keeping the entire record of information. It is critical that the tax department be involved in decisions regarding the storage of transactional data so that valuable information is not lost. Conservation of transaction detail is necessary to allow for the sampling and projection of transactions and the retrieval of source documentation to support the transaction being reviewed.
For the auditor, proper preparation begins with the understanding of the company’s business operations. A clear understanding of the business operations will allow the auditor to segregate the population in a manner that is representative of the business activities. Of equal importance is verifying the completeness and integrity of the electronic data to be used in the sample, defining the population that will be sampled, and developing and communicating a sample plan.
A company can significantly minimize the uncertainty and better control the outcome of a sampled audit if it begins by simply asking questions of the auditor. Ask the auditor to explain in detail the sampling methodology that will be used. If the auditor cannot thoroughly explain the sampling procedures in a manner that is logical, ask for someone else in the organization to participate in the discussion. Better yet, have someone from your information systems department and the taxing authority’s counterpart participate in the meeting to discuss the taxing authority's planned sampling procedures.
Generally, a taxing jurisdiction will use either statistical or nonstatistical sampling procedures. Statistical sampling is a method of sampling that permits the estimation and quantification of some population value based on the results of a sample drawn from that population. It allows the auditor to objectively determine the precision of any estimate that is made and the confidence that may be placed in the result. A nonstatistical sample relies on the judgment of the auditor as to whether the sample is representative of the population. Although a jurisdiction that allows for nonstatistical sampling procedures has well-defined techniques and guidelines, the auditor uses their own “judgment” in making certain decisions regarding the sample population — inclusion and exclusion of specific accounts, grouping of those accounts, and determining whether the sample is performed correctly.
We have encountered many sampling “issues” in assisting companies with audit assessment reviews. One problem that we see (which can easily be avoided) is that companies often wait until the audit is complete to raise questions about the auditor’s sampling methodology. If the company waits to raise concerns, the typical outcome is that unnecessary time is spent evaluating the sample, and if it is necessary to file a protest, the possibility that the sample must be redrawn can be high. Therefore, it is extremely important that the auditor explains the testing procedures that will be used at the start of the sampling process, that the company completely understands the sampling design and procedures, and that the company agrees that the sample selected will be representative of the population.
Most taxing jurisdictions have the auditor document the sampling procedures that they intend to use in conducting the audit. If they do not offer any documentation, you should ask the auditor to provide a detailed statement describing the procedures that they intend to use. This documentation should include how the sample was designed (e.g., which accounts were selected, the time period of the review, the field that will be used to establish the time period, etc.) as well as how the results of the sample review will be projected across the audit population.
Do not let the auditor give you a “canned” or short response. In addition, there are questions you must ask regarding the way an auditor will treat certain types of transactions and issues. These include, but are not limited to, negative transactions, credit transactions, missing documents, missing data for a period of time, tax erroneously paid on purchases, tax law changes and accounting system changes.
Alvarez & Marsal Taxand Says:
Be proactive: anticipate problems before they occur. One of the areas where we typically see auditors take shortcuts is when they are explaining the results of the sample to the taxpayer at the end of the audit and providing evidence that the sample results accurately represent the population of transactions sampled. As stated above, it is important from the onset to obtain a thorough understanding of the techniques that the auditor will use. With proper preparation, the use of sampling will result in a fair and accurate assessment or refund, and will significantly improve the efficiency of the review.
The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.
About Alvarez & Marsal Taxand
Alvarez & Marsal Taxand, an affiliate of Alvarez & Marsal (A&M), a leading global professional services firm, is an independent tax group made up of experienced tax professionals dedicated to providing customized tax advice to clients and investors across a broad range of industries. Its professionals extend A&M's commitment to offering clients a choice in advisors who are free from audit-based conflicts of interest, and bring an unyielding commitment to delivering responsive client service. A&M Taxand has offices in major metropolitan markets throughout the U.S., and serves the U.K. from its base in London.
Alvarez & Marsal Taxand is a founder of Taxand, the world's largest independent tax organization, which provides high quality, integrated tax advice worldwide. Taxand professionals, including almost 400 partners and more than 2,000 advisors in 50 countries, grasp both the fine points of tax and the broader strategic implications, helping you mitigate risk, manage your tax burden and drive the performance of your business.