Use tax automation - the new tax frontier.

As more states pass legislation adopting the necessary provisions of the Streamlined Sales Tax Project (SSTP), the idea of automating the calculation of sales tax on sales invoices becomes less novel. The momentum behind the SSTP is to overcome the barrier that Quill Corp. v. North Dakota places on states' efforts to require remote sellers to collect sales tax. (For background on the SSTP, see Naghavi et al., State & Local Taxes, "Streamlined Sales Tax: Accomplishments and Outlook" TTA, June 2003,p. 364.) If a state overcomes the barrier, the process is simplified for retailers. Most of the current proposals are for automating the sales tax collection process by using sales and use tax software.

Background

In the rush to streamline sales tax collection, the SSTP seems to have left out the most difficult sides and use tax choice that companies face--compliance for companies required to self-assess use tax.

Use tax is the little-known first cousin to sales tax. States with a sales tax have a compensating use tax to protect in-state sellers from unfair competition. Sales tax applies to intrastate sales of taxable goods; use tax applies to use, storage or consumption of taxable goods or services in a state other than the state in which purchased. Thus, in-state businesses cannot escape sales tax by importing taxable property from outside the state; once they use the property within a state, they accrue a use tax liability.

Theoretically, if all sellers collect sales and use tax in all states, purchasers would have little need to determine whether to self-assess use tax. Unfortunately, even if all retailers collected tax, purchasers would still face a myriad of difficult questions to determine whether to pay sales tax on certain purchases.

For example, several states allow sales tax exemptions for manufacturing equipment used in manufacturing. The rules for determining whether this exemption applies vary tremendously from state to state; many states' rules provide that if the equipment has a dual use, with only one use qualifying as manufacturing, then tax applies to the extent the equipment performs nonmanufacturing tasks.

Retailers who collect sales or use tax must collect either all of the tax charged on the invoice or none. Thus, the purchaser must decide whether to pay tax to the vendor and claim a refund on the exempt portion, or to pay no tax to the vendor, but self-assess use tax on the taxable portion. In addition, it must also determine the extent to which it uses the equipment in an exempt or taxable manner.

Indiana and Ohio

A typical manufacturer must make these decisions daily, with little or no guidance from the states; the SSTP specifically did not define manufacturing. In Indiana, the largest percentage of all dollars assessed is on manufacturing-related purchases, but, like many states, it has issued no guidance on the manufacturing exemption. Indiana is typical of most states with a manufacturing exemption.

Indiana also has an informal program to simplify use tax compliance. It allows taxpayers to enter into an agreement with the department of revenue to determine a single effective use tax rate that applies to all purchases. The program was supposed to simplify compliance, but taxpayers achieve it at a cost, because the state has to perform a stratified statistical sample to determine an overall taxability percentage Once the state determines the percent age, the taxpayer applies it to all put chases. Every three years, Indiana repeats the sampling process to revalidate the taxability percentage.

The formulary agreement process is virtually identical to the stratified sampling process Indiana auditors use to determine audit assessments. Essentially, Indiana's program moves the audit process to the beginning of the audit cycle, rather than to the end. Further, the process guarantees that participants will undergo an audit every three years.

Ohio has a managed-audit process, formalized in a departmental publication revised in April 2001. Its program is similar to Indiana's, but has more for real guidelines for applying the process. Specifically, it warns that manage audits are not appropriate for taxpayers with a number of issues with potential interpretive differences. Ohio seems admit that within the managed audit process, auditors will assume state-favorable positions.

As with most state-managed compliance programs, neither Ohio nor Indiana allows for an informal issue resolution process, nor do they contemplate compromise on gray issues. To achieve the peace of mind that most companies crave from managed-compliance agreements, companies must give up much of their right to protest or take correct (but aggressive) positions.

Whether or Not to Automate

Companies have to decide whether they want to automate, within the purchasing and accounts payable processes, the decision to pay sales or use tax. To automate, they have to determine the information available from these systems and use that data to automate the decision.

In most cases, the company achieves automation through implementing third-party software that determines taxability and rates based on an internal decision matrix. For the software to be worth the cost, a company would have to save more than $30,000 per year by using it. Smaller companies may not have $30,000 in annual sales and use tax compliance costs. As an alternative, however, they can automate the use tax accrual process, by using spreadsheet or database applications that calculate tax based on a data extract from their financial accounting system.

When faced with the decision how to automate, some companies have implemented formulary use tax calculations similar to those employed by states in using managed-compliance agreements, without entering into formal agreements. If a state can audit based on a stratified statistical sample, why not use the same approach to determine the company's current liability?

Companies can achieve process efficiencies, improve accuracy and reduce audit defense costs by automating their use tax calculations. Managed compliance agreements can be very effective. If companies want to control their tax determinations, the same techniques the state uses might work to automate use tax decisions.

Conclusion

The idea of using computer technology to improve process efficiency is clearly not novel; however, the application of database technology, combined with tax technical knowledge, to automate a previously purely human decision, is clearly forging new ground for companies (mainly manufacturers) faced with difficult sales and use tax decisions.

FROM JEFFREY GREENE, J.D., INDIANAPOLIS, IN