Model recordkeeping and retention regulation: a report of the Steering Committee Task Force on EDI Audit and Legal Issues for Tax Administration.

Over the past 18 months the Task Force on Electronic Data Interchange Audit and Legal Issues for Tax Administration, consisting of representatives from Tax Executives Institute, the Federation of Tax Administrators, the Committee on State Taxation, the Institute of Property Taxation, and the Multistate Tax Commission, has been examining the impact of various electronic technologies on the tax administration process. The chair of the EDI Task Force is Stanley R. Arnold, Commissioner of the New Hampshire Department of Revenue Administration. The first work product of the Task Force, the Model Recordkeeping and Retention Regulation, together with the Steering Committee's Report and Explanation and Commentary, is reproduced below.

TEI representatives on the Steering Committee include Manuel Davila of AT&T Corporation, Mark V. Beshears of Sprint Corporation, and Jeffery P. Rasmussen of TEI's staff. TEI representatives on the Workgroup for Legal and Recordkeeping issues that generated and refined the Model Recordkeeping and Retention Regulation and related Commentary included Bill Zornes of Western Auto Supply Co., chair of TEI's Tax Information Systems Committee, and Barbara Timek of AT&T Corporation.

Foreword 

Over the past 18 months, the Task Force on EDI Audit and Legal Issues for Tax Administration, consisting of representatives from the Committee on State Taxation, Federation of Tax Administrators, Institute of Property Taxation, Multistate Tax Commission, and Tax Executives Institute, has been examining the impact of various electronic commerce technologies on the tax administration process. This report presents the first work product of the Task Force, a model state administrative regulation to govern taxpayer retention of books and records, particularly electronically generated and retained books and records, for tax administration purposes.

The regulation, and the Task Force process as a whole, reflects a considerable amount of work by a large number of taxpayers and state administrators. It also reflects a substantial effort by parties on `both sides of the table' to understand the needs of their counterparts and to work together to fashion solutions that are satisfactory and acceptable to all. As such, the process has been a healthy one which will pay rewards in many other areas.

The Steering Committee is optimistic that states will understand the importance of facilitating an efficient and effective tax administration process and will use the model regulation as a starting point when defining the record retention and maintenance requirements imposed under state tax statutes. However, the model regulation, as presented in this report, is not binding on any one state or taxpayer organization.

The Steering Committee wishes to acknowledge the contributions of all individuals who devoted their time and effort in developing and refining the Model Recordkeeping and Retention Regulation and related materials.

Stanley R. Arnold, Steering Committee Chair

Commissioner, New Hampshire

Department of Revenue Administration

March 1996

Introduction

U.S. businesses are increasingly employing electronic data interchange (EDI)(1) technology in the conduct of commerce. The EDI Group, Ltd. estimates that in 1995, nearly 100,000 U.S. businesses utilized EDI technology. Growth in the EDI market is expected to average in excess of 15 percent per year to the year 2000.(2)

At its simplest level, EDI involves the exchange of information and documents necessary to a transaction between trading partners via computerized or electronic means rather than the exchange of paper documents. For example, an EDI transaction might involve ordering products through the electronic transmission of a purchase order to a supplier, providing an electronic invoice to the purchaser and paying the invoice through electronic funds transfer once receipt of the product is acknowledged. In this manner, the entire transaction can take place without creation of a paper document detailing the commodity purchased, the price of the commodity, identification of the seller and purchaser, location of delivery and whether or not tax was paid on the transaction.(3)

Companies (and governments)(4) employ EDI technology for a number of reasons. It can reduce costs of operations and allow more rapid and accurate transmission and capture of important commercial information. One effect of EDI, however, is to eliminate the paper records and detail source documents traditionally used in the tax administration process. The increased use of EDI in the conduct of normal business accordingly raises a number of issues and concerns for state tax administrators and taxpayers alike.

From a taxpayer perspective, the absence of traditional paper records raises issues such as policies regarding the retention and availability of EDI transactions and records for administration purposes, the retention and availability of other electronically generated records, the availability of electronic records for audit purposes, and the educational needs of auditors and taxpayers.

State tax agencies are likewise concerned with the impact of EDI on tax administration. A recent survey of revenue agencies indicated that they were generally concerned about developing approaches to the audit of EDI-based companies and securing the appropriate training and education for their auditors. Specific concerns of the states include (1) potential alteration of electronic records; (2) state access to electronic records; (3) the ability to audit the taxpayer's system and access the system documentation; and (4) training of state auditors.(5)

Task Force on EDI Audit and Legal Issues for Tax Administration

Taxpayers and tax administrators alike agree that the nature of the issues involved makes it desirable that taxpayers and tax administrators work cooperatively to identify and examine the impact of EDI on tax administration and audit.

In November 1994, the Federation of Tax Administrators (FTA), after discussions with various taxpayer groups, facilitated the formation of a task force of state tax administrators and taxpayer representatives to address the issues posed by the use of EDI technology and other similar business processes. Formally titled the Task Force on EDI Audit and Legal Issues for Tax Administration, it consists of representatives of the Committee on State Taxation (COST), Institute of Property Taxation (IPT), Tax Executives Institute (TEI), Multistate Tax Commission (MTC), FTA and Commissioners from several state tax administration agencies.

Mission and Objectives. The general mission of the Task Force is to coordinate efforts between the business community and tax administrators in analyzing and addressing the issues posed for tax administration by electronic data interchange and related business processes. The Task Force is responsible for making recommendations to the governing bodies of the participating organizations on the actions states and taxpayers should take in addressing those issues.

Organization. The work of the Task Force has been accomplished by a Steering Committee and two Work Groups focusing on specific areas and issues.

The Steering Committee is chaired by Stanley R. Arnold, Commissioner of the New Hampshire Department of Revenue Administration, and consists of twenty-two persons, including tax administrators and business representatives from each of the participating organizations. The Steering Committee is responsible for establishing the scope of work of the Task Force, providing an initial identification of the issues to be addressed by the Work Groups, and providing overall direction and assistance to the effort. The Steering Committee serves as the final reviewing entity for recommendations developed by the Work Groups.

Two Work Groups have been formed. The Work Groups are comprised of tax agency employees and taxpayer representatives with expertise in required areas, e.g., auditors, lawyers, tax managers, systems/technology people, etc. Each Work Group has co-leaders -- one tax administrator and one taxpayer representative.

* The Legal Requirements and Recordkeeping Work Group has generally focused on the legal issues involved in the taxpayer movement to EDI, with a particular focus on recordkeeping and retention issues. It is co-chaired by Lloyd Callaway, Coca-Cola Co., Atlanta, Georgia, and Marjorie Welch, Assistant General Counsel, Oklahoma Tax Commission.

* The EDI Audit Approaches Work Group has focused on identifying the issues involved when auditing electronic records and assessing alternative approaches to the audit of such records. The Group has been chaired by Stan Borawski, Michigan Bureau of Revenue, and B.J. Denton, Koch Industries, Wichita, Kansas.

The Federation of Tax Administrators has provided general staff support to the Steering Committee and Work Groups.

Current Status. To this point, work of the Task Force has focused on two issues deemed by the Steering Committee to be of most immediate interest: (1) records retention requirements, including general legal requirements surrounding electronic records and the nature and availability of records necessary for tax audit purposes; and (2) the approaches available to states in auditing a taxpayer using EDI technology and other electronic recordkeeping and accounting systems. Within the latter area, there are a number of issues including the nature of the records required, use of computer auditing techniques, access to the taxpayer's system and source documentation, confidentiality requirements and the like.(6)

Model Recordkeeping and Retention Regulation

The remainder of this report presents the initial work product of the Legal and Recordkeeping Work Group, namely a model state administrative regulation to govern taxpayer retention books and records, particularly electronically generated and retained records, for tax administration purposes. The text of the model regulation is presented in Appendix A, and a detailed explanation and commentary is presented in Appendix B.

The model regulation draws on a variety of sources, including existing state regulations, IRS Revenue Procedure 91-59 governing automated recordkeeping and accounting systems, suggested revisions to Rev. Proc. 91-59 which had been developed by the Tax Executive Institute, and a draft regulation by the California Board of Equalization. It was originally drafted by the Legal and Recordkeeping Work Group and substantially revised during several meetings of tax administrators and business representatives from both the Work Group and the Steering Committee. A draft was also circulated among all state tax agencies. The final version was adopted by the Steering Committee at a meeting on November 15, 1995, in Salt Lake City, Utah.

Basic Framework. In reviewing the regulation, the reader should keep in mind several general principles regarding what the regulation is intended to be and what it is not intended to be. More specifically:

* The regulation has been developed as a "model" regulation to allow it to be modified to meet certain particular requirements of various state laws such as retention periods and penalties for noncompliance. The regulation also allows states to identify specific records or documents they require to be retained in addition to the general requirements specified in the regulation. No attempt was made to address the nuances of each individual state statute regarding each type of tax. The general requirements of the regulation should, however, apply across all types of taxes, and specific details can be addressed by states individually.

* The regulation is designed to cover not only the retention of records created using EDI technology, but also the retention and access to records generated through other electronic means and maintained by taxpayers in various computerized accounting systems. This approach was chosen for two reasons. The retention of EDI records is so intertwined with other electronic systems for maintaining accounting records that it cannot be realistically divorced from the subject of computerized accounting systems. In addition, state recordkeeping regulations did not appear generally to have been updated so as to capture the widespread use of such accounting systems by all types of taxpayers. In addition to the actual retention of records, the regulation addresses such topics as access to the records during a tax audit, maintenance of the records over time, and conversion of hard-copy records to other storage media.

* The regulation attempts to balance the interests of taxpayers and tax administration authorities and to create an environment which will make the tax administration process efficient for all parties. As a general approach, the regulation is focused on clearly identifying the responsibilities and obligations imposed on taxpayers to provide the books and records necessary to verify that the correct tax liability has been reported and paid. Beyond this, the regulation tends to provide a taxpayer with considerable flexibility in the manner in which it wishes to meet the obligations.

* The regulation does not address the issue of tax authority access to the taxpayer's EDI processing, accounting or other systems for purposes of verifying or evaluating the integrity and reliability of those systems to provide accurate and complete records. While most observers consider that such evaluations are important to the tax administration process, it was considered beyond the scope of this effort to specify any regulations governing those evaluations. The Audit Work Group is developing suggested approaches to conducting such evaluations, however. Moreover, it was agreed by members of the Steering Committee that state ability to conduct such evaluations was within the general authority of the states under their authority to examine the books and records of the taxpayer to determine tax compliance.

Specific Elements. Following is a summary of the most significant particular aspects of the regulation:

* The general requirement imposed on taxpayers is to retain those records necessary to verify that the correct tax liability has been reported and paid by the taxpayer.

* If a taxpayer maintains records in both hard copy and machine-sensible (i.e., electronic) forms, the taxpayer must provide the state taxing authority with access to the records in machine-sensible form at the time of an audit if so requested by the taxing authority.

* Taxpayers may in all instances demonstrate tax compliance through traditional paper records, but this does not eliminate the requirement to provide access to machine-sensible records if requested.

* Access to machine-sensible records may be accomplished in a variety of ways, but taxpayers must have the capacity to extract required records and convert them to a standard record format at the request of the taxing authority.

* Individual EDI transactions need not be retained in their original format if the data elements required to be retained under the regulation are captured from the EDI transaction and maintained in the taxpayer's accounting and recordkeeping systems in accordance with the regulation.

* Original hard-copy records may be converted to alternative storage media such as microfilm, microfiche or various "storage-only imaging systems," provided that certain standards regarding access, readability, and integrity are met.

Once converted, the original hard-copy documents need no longer be retained for tax administration purposes.

Conclusion

The model recordkeeping regulation represents the considerable work product of a large number of tax administrators and taxpayer representatives. It attempts to achieve a realistic balance between the needs of tax administrators and the needs of taxpayers. Above all, it is aimed at facilitating an efficient and effective tax administration process.

(1) For purposes of this document, the term EDI means the computer-to-computer exchange of business documents in a structured format.

(2) The EDI Group, Ltd., "1995 U.S. EDI Market Forecast Summary," November 1995.

(3) For an excellent description of EDI technology and its use in various business processes, see Richard Bort and Gerald Beilfeldt, Handbook of EDI, New York: Warren, Gorham and Lamont, 1994. The discussion here and throughout the report is primarily oriented toward transactional taxes such as sales and use taxes; it is equally relevant to operational (e.g., income taxes) where transactional detail is examined to determine the accuracy of reported income details.

(4) Government use of EDI is not the subject of this report. For a discussion of this topic, however, see Jonathan Lyon, "Cooperation a Key to Successful EDI Implementation," Tax Administrators News, September 1995, p. 86.

(5) "State Audit Concerns on Business Use of EDI Paperless Processes," FTA Bulletin B-436, February 4, 1994. Available from Federation of Tax Administrators.

(6) The EDI Audit Approaches Work Group has completed a draft of recommendations for states and taxpayers on a series of issues it identified regarding the audit of taxpayers in an electronic environment. Those draft recommendations and related discussions are currently (March 1996) circulating among Work Group members for review and comment. It is expected to be presented to the Steering Committee for review, revision and ultimate approval in a May 1996 time frame.