Sales and use tax compliance is not a simple process. In the United States, there are over 11,000 taxing authorities with constantly changing sales tax rates and laws. The rules and regulations for each taxing jurisdiction are slightly different from the next, resulting in mounting complexities when it comes to compliance. With respect to purchases of products and services, the vast majority of companies rely on their vendors to assess any applicable sales taxes due on a particular transaction.
However, some companies choose to exercise more control over the payment of taxes on their purchases by making arrangements with the taxing jurisdictions to remit any taxes due directly to the jurisdiction. When taxes are directly remitted to the taxing jurisdiction, the tax is no longer deemed a sales tax, but rather becomes a "use" tax.
Direct Payment of Use Taxes — The Benefits
In most jurisdictions, a company must obtain approval to "direct pay" taxes to the jurisdiction. Some jurisdictions require a company to demonstrate its ability to fulfill several qualifications imposed by the jurisdiction. Once the company obtains approval to direct pay use taxes on its taxable purchases, the company may issue a direct payment exemption certificate to a vendor for the purchase of taxable items and services that are purchased for its own use and that will not be resold. The primary advantages of obtaining a direct payment permit are as follows:
- Companies have direct control over the payment of taxes.
- A company can control the timing of tax paid on items purchased.
- In some states, a company can maintain a tax-free inventory so tax is not paid on items that are ultimately used in another state.
- Local tax savings — for instance, in Texas, local taxes are based on the location where a taxable item is first used. Therefore, local taxes may not be due on purchases shipped outside a local taxing jurisdiction for first use.
Direct Payment of Use Taxes — Potential Drawbacks
Along with the benefits of direct pay privileges, there are also obligations that come with self-assessing tax on purchases:
- Taxing jurisdictions typically conduct regular audits (three-year cycle) on all direct pay permit holders.
- The company must implement procedures (with potential additional resource cost) for identifying transactions that require a tax decision to be made.
- The company may lose timely filing discounts that it may have been otherwise eligible for when filing use taxes on a sales tax permit.
- Many companies invest in a software package to accommodate the increased burden of self-assessing and remitting tax directly to jurisdictions. (This option is discussed in more detail below.)
When considering whether to continue to rely on the vendor to assess the appropriate amount of tax or whether to exercise more control over the payment of taxes and self-assess, a company should prepare a cost-benefit analysis in consideration of the following factors:
- The current state of the sales and use tax function.
- Past audit history — have there been large assessments resulting in substantial penalties and interest charges?
- The volume of purchase transactions processed by the company.
- The volume and dollar value of purchases from out-of-state vendors for which the company must self-assess tax.
- The feasibility of automating the use tax function. (Does the current ERP system contain enough valuable information to make an accurate tax determination?)
- Maintenance of an automated use tax function.
- The fully loaded cost of automation.
- Elimination of manual processes.
- The ability to self-assess and accrue use tax on vendor invoices, inventory movements and adjustments to projects in project accounting.
- The reallocation of staff to other activities.
Automating the Sales and Use Tax Determination Function
Once a company determines that the payables process should be automated, the first consideration is typically whether to automate using the functionality of an enterprise resource planning (ERP) system or acquire a third-party tax calculation package designed specifically for the purpose of indirect tax calculation.
The unfortunate reality is that ERP systems have difficulty handling the sales and use tax compliance process. With effort, ERP systems can be configured and combined with various work-arounds to deliver an indirect tax software solution. Nonetheless, businesses often struggle with the continued maintenance of the ERP systems, and the limitations of the system quickly become obvious.
There are several stand-alone tax engines (bolt-on indirect tax software solutions) that are typically used by businesses to compensate for the gaps in ERP systems. While these bolt-on systems have the ability to handle the sales and use tax compliance process with greater accuracy and provide regular statutory updates and regular rate changes, they too come with a price.
Described below are various reasons companies choose to move to a specific indirect tax engine solution:
I. Maintain Tax Content
The most common reason for a business to move to an automated tax solution is for maintained tax content. Within the United States alone, there were over 750 tax rate changes and over 200 additional tax authorities added in 2009. With a tax engine, the change is as simple as a monthly automatic download of content. It is a far less time-consuming process to stay up-to-date and accurate.
II. Correct Tax Calculation
There are limits to how effectively ERP systems can be programmed to "think" like a tax professional. ERP systems were not designed as an indirect tax calculation tool, and the functionality required to handle complex tax decisions is limited. A tax engine looks at all of the available tax independent transaction information and determines the proper tax outcome by using if/then logic or third-party system information to make a tax determination.
In addition, a tax engine makes it possible for the tax department to actually make the tax decisions. Rather than have the accounts payable department making tax decisions and directing the determination, a tax engine will look at tax-independent information and determine the appropriate tax. The expectation is that tax decisions become more consistent, accurate and justifiable.
III. Efficiency in Tax Compliance
Businesses often look to tax engines for improvements and time savings in compliance through improved reporting capabilities, fewer required manual work-arounds and reduced costs for labor. Again, ERP systems are not designed as an indirect tax calculation tool. The reports generated are simply not nuanced enough to ease the compliance process. An indirect tax engine can ease this process by generating reports that are specific for tax jurisdictions and, depending on the tax engine, can even generate signature ready returns.
Time savings are often significant. Tax departments find themselves no longer struggling to keep up, but rather working ahead and able to focus on review, audit strategy and other important tax department activities that are often set aside.
IV. Other Benefits
The use of a tax engine has the potential to greatly reduce the reliance on IT resources and allows the tax department to configure and monitor the tax automation. In addition, as stated above, the company could realize local tax savings when using the direct pay permit. The local tax savings may exceed the added cost of using the direct pay permit.
Lastly, as a company grows, the possibilities of new product lines or the incorporation of additional ERP systems becomes more feasible. Most tax engines can bolt-on to multiple ERP systems and are far more configurable as a centralized tax policy center than multiple ERP systems.
Alvarez & Marsal Taxand Says:
As you can see, several important considerations must be taken into account as a company evaluates whether it should self-assess tax on purchases of products and services. At a minimum, each company must carefully evaluate its business operations, the history of its compliance function and the costs associated with implementing such a process.
As a company encounters the challenges of determining how to handle its sales and use tax process for payables, it is important to note that automating the use tax determination process is not always the best option. Automation of the tax function requires the company to train many layers of personnel to properly code transactions. It is only with the proper coding on the front end that the tax automation software will derive the proper tax determination on the back end. In addition, procedures must be put in place to review transactions of a certain materiality level to avoid significant errors due to miscoding and/or incorrect taxability determinations within the matrix.
When making the choice to self-assess tax (with or without an automated system), the benefits must greatly outweigh the negative aspects, as this option increases the tax responsibilities for a company.
As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer.
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.