WHAT IS TAX BASE? DEFINING THE SALE.

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1 WHAT IS TAX BASE? DEFINING THE SALE. IPT SALES TAX SYMPOSIUM 2013 Presented by: B.J. Pritchett, CMI Pritchett Sales & Use Tax Consulting Susan Haffield, CPA PriceWaterhouseCoopers, LLP

2 TAX BASE Sales and use taxes vary from state to state and locality to locality. When blanketing the sales and use tax arena for a basic definition, Investopedia.com provides a very amusing but factual definition of tax base: Anything that can be taxed has a tax base. The tax base is the value of an item subject to sales and use tax. The problem all businesses face is that each state has a different tax base. There is no uniformity when discussing tax base over all states imposing sales and use taxes. The statutes/laws and ordinances of each taxing jurisdiction determine what is subject to the tax. Businesses also have the problem of having states with localities that have different tax bases. While most states define the tax base as the total amount of the sales price, without any deduction for the cost of goods sold, interest paid, freight/transportation, the tax base is not a standardized set of rules for all states and localities. Twenty-four states have joined what is now considered the Streamline Sales Tax Project (SSTP). The following states that have passed legislation to conform to the Streamlined Sale and Use Tax Agreement: Arkansas, Georgia, Indiana, Iowa, Kansas, Kentucky, Michigan, Minnesota, Nebraska, Nevada, New Jersey, North Carolina, North Dakota, Ohio, Oklahoma, Rhode Island, South Dakota, Tennessee, Utah, Vermont, Washington, West Virginia, Wisconsin and Wyoming. One of the key features of SSTP is a creation of uniform definitions and rate simplification. Those states that are full members of SSTP have passed legislation that conforms to the SSTP Agreement. Under SSTP local taxing jurisdictions must have the same common tax base as the state unless federal law prohibits the local taxing jurisdiction from taxing a transaction taxed by the state. Most states impose the tax base on tangible personal property. Tangible personal property is defined as property which can be seen, weighed, measured, felt or in any other manner perceptible to the senses. If one can smell it or taste it, it is tangible personal property. To provide a picture for the layperson to imagine, if the item can be picked up and carried away, it is tangible personal property; even if you had to have a crane or forklift truck to drag it. Once the tax base imposes tax on tangible personal property, it subjects all tangible personal property to the tax unless a specific exemption is provided in the laws of the state or locality. Some states provide reduced taxes on specific tangible personal property which allows another layer of confusion to the tax base issue.

3 When reviewing tax bases for state and local taxes, there are exclusions from the tax base which also are due consideration. If the issue is a service rather than tangible personal property, it may be excluded from the tax base. This means it is not mentioned as taxable or exempt, simply excluded. Exemptions from the tax base are in each state and local statutes and rules. Some states and localities include the following as exclusions from the tax base: 1) Bad debts 2) Carrying charges 3) Discounts 4) Finance charges 5) Freight 6) Interest 7) Installation charges 8) Other taxes (federal excise, property) 9) Other licenses 10) Refunds 11) Returns 12) Trade-ins 13) Transportation charges Businesses that use terminology such as shipping and handling may invoke a tax because the transaction does not provide a separation of shipping from handling. The shipping charge may not be subject to tax while the handling charge is considered to be part of the tangible personal property sold. In states where shipping/freight is part of the tax base, businesses must be wise in developing the transaction as to avoid the tax on the shipping/freight charges. The independent hiring by the business of a common carrier to pick up and deliver the items may avoid the tax on shipping/freight charges. The common carrier will independently bill the business rather than having the vendor charge the tax on their invoice to the business. Businesses need to review each state s definition of a sale in order to properly assess the sales and use tax. Most states define a sale as the transfer of title or possession and may include leases, rentals, giveaways, barter or exchanges. The state of Illinois does not include the term possession in the definition of a sale so true leases are not taxable at the state level but are taxable in the city of Chicago which includes possession in the local definition. The tax base of one state may be different than the tax base of another state. Discounting an item by businesses in order to draw new customer bases in will vary from state to state. An example of this type of transaction would be the sale of a cellular telephone for one dollar with the signing of a two

4 year agreement for service. In Alabama, Illinois and Colorado the tax base would be the one dollar; however, in California the tax must be paid on the normal retail price of the cellular telephone. Arkansas requires tax to be paid on the cost of the item that is being sold at a discounted amount. Texas requires tax to be paid on the cost of the item if the sales price is less than 25% of the dealer s acquisition cost. limited to: Generally, intangible items are not subject to sales and use tax. Examples include but are not 1) Stocks 2) Bonds 3) Goodwill 4) Patents 5) Mineral Rights 6) Copyrights Intangible personal property has been subject to litigation in many states. Tax auditors would like all personal property to be considered tangible so the tax rates will be imposed. However, each state generally defines what is considered intangible personal property. The tax base could be upon the media on which such intangible personal property is transferred. The sale or purchase of software has been argued from state to state. The arguments range from type of delivery (CD-ROMs, magnetic tapes, diskettes, internet, load and leave) to the type of end result received by the buyer/purchaser. Some states insist the download of upgrades to software over the internet constitutes an enhanced value of the software and thus should be taxed on that basis. Some states assert that the receiving of a physical manual to a software program which was downloaded over the internet is now entirely taxable as the physical manual creates a continuation of the initial transaction for software. Some states claim that licenses are tantamount to a lease and are strictly part of the initial software as the right to use computer programs is part and parcel of the purchase of the software. Taxpayers have argued the license agreement is a right to use intellectual property. Most courts have sided with the state interpretation of this debate. Each state has its own interpretation of what is considered real property. Tangible personal property is characteristically movable and not attached or fixed to the land or dirt. In other words, real property in the truest nature is affixed to or attached to the land. Real property transactions generally

5 result in contractor controversies. The issues arising from real property transactions include but are not limited to: 1) Fixtures 2) Leasehold Improvements 3) Foundations for specific machinery 4) Incorporation of tangible personal property to real property Example: In Arkansas there is a specific provision within the manufacturing exemption for special foundations for machinery and equipment used in the direct line of manufacturing. However, the foundation must be separately stated from the pouring of the flooring or the exemption is not granted. Contractors are generally perceived as the consumer of all materials used in real property repairs, and thus, are subject to taxation on those materials. However, there are several states that tax remodeling and real property maintenance in their statutes (Texas). In these instances, the contractor must hold a retail permit and may purchase tax-free the materials used in the taxable service. The sale of buildings, as realty, is not classically held to be subject to sales tax. However, there are instances such as Florida which taxes the rental of real property. Most states specifically tax services. Not all services are subject to tax. Some services also convey a transfer of tangible personal property with the service. The tax base for services depends on the specific state and the statutes that govern those services. Some states interpret the service that conveys some tangible personal property to be the sale of property altering what a business may consider to be nontaxable into a taxable transaction. Example: The use of CD-ROMs or paper as a medium to deliver software may make the transaction taxable. It is important to keep in mind when searching the definitions of each state and locality to specifically associate the type of transaction with a mixture of services with tangible personal property. The invoice may provide a lump sum price but the transaction may hold both nontaxable and taxable elements. The taxpayer must prove a dollar amount for each of the bundled items to determine the true nature of the transaction. Some states impose a threshold as to the percentage of tangible personal property included in a transaction that is predominately service.

6 Examples: 1) Texas 5% 2) Illinois 35% 3) Others 10-50% Strict notations should be made for businesses instructing their buyers/purchasers to indicate the separation of tangible personal property and services by applying a dollar amount to each line of the transaction or contract. Example: Separately stating Hardware from Software along with any of each component. Some states use the true object test to identify the components of the transaction as to whether the contract is for incidental service or incidental property. The real question to ask: Is it the service the business is after or is it the property the business wants? Examples: 1) Photographic Services A photographer is hired for a wedding. The photographer rents props such as silk flowers, lighting, canopy, chairs, etc. The photographer uses special film with exacting digital shutter speed. The end result, however, are the wedding pictures. Thus, everything that went into creating the pictures is subject to the tax as the end result is tangible personal property. 2) Accounting Services Each year a Certified Public Accounting firm is hired to conduct an audit of the financial records of a business. The long and tedious hours of accountants reviewing and examining these records end with a disclosure statement written on a piece of paper and included in the annual report of the business. The end result, however, is a service of financial recording. The piece of paper providing the disclosure of the results of the audit is not the true intent of the request for service. Most states have used services to expand their tax base. Services are generally not subject to taxation unless specifically taxed in the statutes of a state or locality. Some states have expanded their

7 tax base to include taxes on amusements, telecommunications, repair and maintenance of tangible personal property, parking fees, cable television, janitorial services, data processing services and remodeling of real property. This list by no means includes all states but a sampling of the types of services for which the tax base of a state has been expanded. Examples of Service Taxed States: Hawaii, New Mexico, South Dakota and West Virginia Businesses should always strive to have services separately stated from all other components of the transaction such as tangible personal property, freight, handling, etc. Services should be separately stated with dollar association made for each line item. Separately stating services with dollars associated will allow a business to achieve a nontaxed transaction where a lump sum contract will be fully taxed because there is no separation of services from tangible personal property. Businesses that provide services that are subject to tax may or may not be allowed to purchase the materials used in the service tax-free. The statutes and rules will provide the business with the information for the purchase of those materials as tax free or not allowed to be purchased tax free. Example: Arkansas taxes both janitorial services and pest control services. While pest control businesses are allowed to purchase their chemicals tax free as the chemicals are used in the taxable service; janitorial businesses must pay tax on the chemicals used in the taxable service and tax the chemicals used in that service. When businesses are united under the same federal identification number, the transfer of tangible personal property from one division to another division invokes a tax base of the transferred amount as some states see this as a withdrawal from inventory. Such intracompany transfers have a tax base on the value carried on the transferring company s books. When business are united but hold different federal identification numbers, the transfer of tangible personal property from one subsidiary to another subsidiary is considered a legal transaction subject to the laws of the state and are subject to sales tax. Some states impose tax on such intercompany transfers have a tax base on the retail value of the item sold (such as California). The tax base for the resale of services and related materials used in providing the service may be purchased tax free with a resale certificate if the item is passed on to the customer. An example would

8 be an automobile dealer purchases the service of a repair business to repair a radio in the vehicle. The automobile dealer will eventually sale the vehicle and thus may render the repair business a sale for resale exemption certificate. The majority of taxing jurisdictions provide for exemptions which carve out of the tax base specific issues for which the legislative intent was not to tax in the first place. Exemptions are a removal from the tax base of specific items. Exemptions are specifically spelled out in the statutes and rules of a taxing jurisdiction. Exemptions may include based on use or purchaser: 1) Agricultural Machinery and Equipment 2) Federal Government 3) Manufacturing Machinery and Equipment aka Industrial Processing Machinery and Equipment 4) Pollution Control Machinery and Equipment 5) Sale for Resale 6) Specific Purchasers or Organizations Example of Specific Purchaser: In Arkansas, new automobiles for blind veterans are exempt from the tax base. Generally, the tax base for gifts and donations lie with the donator of the tangible personal property. State statutes must be reviewed with a keen eye to determine if consideration must be paid for the purchase and whether there must be a sale. Some states provide exemptions for donated items during disasters. These exemptions are generally limited to a set time frame.