Sales and Use Tax Implications for Purchasing Card and Compliance Strategies

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1 Sales and Use Tax Implications for Purchasing Card and Compliance Strategies First Edition July 2016 Advancing Commercial Card and Payment Practices Worldwide

2 Table of Contents About the NAPCP... 3 Acknowledgement... 3 Introduction Distinguishing Between Sales and Use Tax... 4 General Information Collection of Sales Tax Exemption to Sales Tax Documentation... 6 How Purchasing Card Differs from the Traditional Accounts Payable Process... 7 Comparison of Approaches to a Tax Compliance Model Selecting a Tax Compliance Model Risk Tolerance Desired Level of Cardholder Involvement Reporting Capabilities of Card Issuer Establishing Internal Policies and Procedures Educating Suppliers The Good News Conclusion References NAPCP. All Rights Reserved. 2

3 About the NAPCP The NAPCP is a membership-based professional association committed to advancing Commercial Card and Payment professionals and industry practices worldwide. The NAPCP is a respected voice in the industry, serving as an impartial resource for members at all experience levels in the public and private sectors. The NAPCP provides unmatched opportunities for continuing education and peer networking through its conferences, Regional Forums, webinars, website, virtual demonstrations, newsletters and regular communication. The association sponsors research and publishes timely and relevant white papers, survey results and other documents. The NAPCP offers a Certified Purchasing Card Professional (CPCP) credential. Web: Acknowledgement The NAPCP thanks members of an early Best Practices Task Force who contributed to this document. The members were Susan Borelli, Helen Connor, Suzanne Plant, Larry Twito and Tom Wissel. Introduction John Maynard Keynes, possibly the best known economist of all time, once said that the avoidance of taxes is the only intellectual pursuit that carries any reward. Managers of companies that have been assessed adjustments and penalties resulting from tax compliance audits in recent years will most likely find the irony in Keynes statement. They may feel more in tune with Benjamin Franklin s assertion that in life, nothing is certain but death and taxes. To be sure, state governments depend on a variety of taxes and license fees as the lion s share of their revenue. Sales and use tax accounts for nearly one-third of the total state tax collections. In 2014, states collected $270 billion in sales and use taxes. 1 Agencies responsible for tax compliance now have more sophisticated tools at their disposal to identify areas of underpayment. And with state budgets suffering as they do today, auditors have taken a more aggressive stance in recovering revenue due from businesses and individuals failing to properly self-assess state use tax. The issue of tax collection has been complicated by the nature of today s business, in which goods can be secured from suppliers nearly anywhere in the world with minimum lead time. When dealing with local suppliers or those with a legal presence in the state in which both the seller and buyer are located, collection of sales tax is usually done at the point of sale by the seller. The ultimate burden of tax payment; however, is the responsibility of the purchaser. When a tax liability exists, and sales tax is not collected by the seller, the buyer must remit use tax to the proper taxing jurisdiction. In organizations with limited purchasing, this task may be more manageable than in organizations with high purchasing activity. Smaller organizations may be able to assess each transaction on an individual basis; higher volumes often make some form of sampling or compliance model necessary to estimate tax due. Purchasing Cards are frequently the settlement method of choice for both buyers and sellers in the business-to-business world. The Purchasing Card s ability to capture information about the tax collected at the point of sale helps organizations identify those purchases for which use tax must be paid. Experienced card program administrators will readily point out that enhanced data capture is not a perfect system, and each organization must adopt a strategy for the assessment of use tax. To complicate this issue, certain items are sometimes exempt under certain circumstances, and sometimes are taxed at a rate different than the general sales tax rate. Certain organizations also may be exempt from the payment of sales tax. It is 2016 NAPCP. All Rights Reserved. 3

4 important that managers of Purchasing Card programs understand the tax liability for their respective federal, state and local jurisdiction. This document is intended to serve as a guide to help administrators of Purchasing Card programs understand the issues surrounding sales and use tax compliance, and to help guide their organization in selecting a compliance strategy appropriate for them. Several alternative methods and approaches to tax compliance will be discussed. Tax liability and compliance, however, is complex, involving a changing set of rules that vary between jurisdictions. Any course of action should be reviewed and agreed to by your organization s Tax department or outside tax advisor. Distinguishing Between Sales and Use Tax A sales tax is a tax on the transfer, sale, exchange, lease or rental of property, or performance of a taxable service imposed on in-state sales. Sales tax may also be referred to as an excise, gross receipts, retailers, consumer, gross income or privilege tax. Sales tax is collected by the seller on behalf of the purchaser and paid to the state. A use tax complements the sales tax and is imposed on transactions that would have been subject to the sales tax if both the buyer and the seller were located in the same state. Use tax also equalizes the tax burden on the in-state purchases by taxing out-of-state purchases when the property is consumed in the state. Use tax is paid by the purchaser to the state. As these apply to Purchasing Card transactions, the issues will focus on use tax. Because sales tax is collected at the time of purchase, the correct amount should be charged. This is not usually an issue unless the purchase involves an item that is taxed at a rate different than the general sales tax rate. These are frequently referred to as apportioned tax rates. Another possible complication that may arise is when the purchase is exempt from tax based on the use. Managers should educate employees responsible for purchasing in the tax issues applicable to their business. General Information Collection of Sales Tax The purchaser is the party responsible for payment of the tax. Technically, sales tax is paid by the merchant on the purchaser s behalf. If audited, the purchaser must be able to prove that: 2016 NAPCP. All Rights Reserved. 4

5 As a general rule, the seller is required to collect and remit sales tax on a good or service if the ship from and ship to addresses are in the same state. The purchase amount should contain sales tax. For example, a buyer in State A goes to a local office supplies store to purchase binders for a presentation. The store will charge State A sales tax on the transaction. Use tax is paid by purchaser if no sales tax was paid if a seller ships goods or provides services across state lines and does not charge/collect sales tax, the buyer will be required to accrue and remit the tax directly to the ship to state s taxing authority. In this example, a buyer in State A purchases binders through an online supplier. The supplier ships the binders from State B and does not charge sales tax. The buyer will be required to report and remit use tax to State A. The situation that causes merchants to charge sales tax for some states and not others has to do with their legal presence within a state. For each state where a seller has a direct link or connection, such as property (an office or warehouse) or employees, the seller should collect and remit sales tax. This presence, legally referred to as nexus, can also be determined by the seller s state of incorporation and/or its registration status. If the seller does not have nexus with a particular state, the seller is not, in most cases, obligated to charge sales tax. Example: Our buyer in State A orders paper and toner for delivery to its operations in State B and State C. The seller has a distribution facility in State B, which it ships from, to each of the buyer s locations. The seller is considered to have nexus with State B, therefore, it is obligated to collect sales tax on the State B orders only. Since the seller does not have nexus with State C, and is not obligated to collect sales tax, the buyer should accrue and remit the use tax to State C. Note: The tax is owed to the ship to state, rather than the buyer s state. Exemption to Sales Tax There are some purchases that are exempt from sales and use tax. However, taxability of items/service varies significantly among states; therefore, it is recommended that you work with your tax authorities to determine taxability in the states in which you operate. Below are common exemptions: States That Do Not Assess Sales Tax Alaska, Delaware, Montana, New Hampshire and Oregon do not collect sales and use tax. Items and services purchased in, or shipped to, these states generally will not be charged sales tax. Exempt Purchasing Entities Certain organizations are exempt from paying sales tax. They may include: Federal, State and Local Governments Non-profit Organizations Purchases Enumerated as Exempt Most states tax codes list specific items that are not taxable. Examples of these include items such as: Prescription medication and medical supplies Occasional and personal sales (e.g., sale of personal car) Unprepared food is exempt in about half of the states, or taxed at a lower rate in some others (Please note the above examples may not be exempt in all states) 2016 NAPCP. All Rights Reserved. 5

6 Uses for Purchases That Are Exempt In certain situations, items that may be normally taxable will be exempt when they are: Raw materials used in manufacturing Components that are resold as a part of integrated system Machinery and equipment used directly in the manufacturing process (Again, please note these exemptions may not apply in all states or tax jurisdictions) Documentation To quote the Federation of Tax Administrators, Hard copy records generated at the time of a transaction using a credit or debit card must be retained unless all the details necessary to determine correct tax liability relating to the transaction are subsequently received and retained by the taxpayer. If audited, it is key to prove to a Taxing Authority that a reasonable effort was made to pay tax, either through the merchant (sales), or by self-assessing (use). Purchasing Card transactions are generally audited separately from traditional A/P data on a test basis the auditor selects a sample, and all purchases in the sample are reviewed in detail. Any deficiencies found are projected over the audit period. Although retention of hard copy receipts has withstood the test of time as one means to prove payment of tax, it is not the most efficient method available. Costs are incurred to transport the receipts to a central collection point, control, auditing and storage. A more efficient means to support payment of sales tax or the assessment of use tax is through reporting, where allowed by state tax code or allowed by private letter rulings. The details needed for a sales/use tax determination should include vendor name, date, item description, quantity, price, ship-to-location, sales tax included and accounting code. All states accept merchant card provider reports and have prescribed certain criteria regarding reporting to safeguard the integrity of the data and to thwart alteration of the information. In addition, although each state may accept electronic reporting as documentation, not all suppliers can pass this level of data as part of the credit card transaction. In addition to using reporting provided by the card issuer, some companies develop and implement compliance models, which are simply documented plans designed to test Purchasing Card transactions for tax compliance. These models could be compared to internal audits. If an organization has a compliance model, and can demonstrate the effectiveness of the model to an auditor, this may serve as sufficient documentation that correct tax has been paid. If an organization has neither issuer-provided reporting, nor a compliance model, the Taxing Authority may require detailed transaction receipts as the only alternative NAPCP. All Rights Reserved. 6

7 How Purchasing Card Differs from the Traditional Accounts Payable Process In the traditional process, an invoice is reviewed and paid by Accounts Payable (AP). If sales tax was not paid, use tax is then assessed by AP or forwarded to the Tax department for their review. Although a manual process, the information needed to determine if use tax should be paid, is typically shown on the invoice. This includes: However, in the Purchasing Card process, the cardholder collects receipts, and these receipts are retained in accordance with the organization s Purchasing Card program guidelines. With the exception of relatively smaller Purchasing Card programs, physical review of every receipt to determine if sales tax was paid is impractical or, at best, time-consuming. Therefore, a tax compliance model must be established for Purchasing Card transactions. To develop this model, it is recommended that the Purchasing Card program administration team solicit input from several other functions, including Accounts Payable, the Tax department and cardholders NAPCP. All Rights Reserved. 7

8 Tax Compliance Models Table 1, which follows, compares several different approaches to developing a tax compliance model. These approaches include the methodology by which use tax liability is assessed, using a combination of assumptions, data, reports, statistical sampling and line-item review. The pros and cons of each approach are evaluated. Table 1 Comparison of Approaches to a Tax Compliance Model Approach Pros and Cons Remarks Reduce exposure by only allowing card to be used for one of the following: In-state vendors Vendors which can report payment of tax (i.e., Level 2 or 3) Taxable purchases Pros: Sales tax will be paid, negating the need to pay use tax Cons: Must verify compliance Limits use of P-Card and associated benefits Not all states accept Level 2 or 3 data in lieu of receipts Although this approach may be considered by conservative organizations, it will negatively impact the effectiveness of a P-Card program. Additionally, it requires extensive cardholder training. Pay use tax on all out-of-state purchases, without checking whether the vendor charged sales tax. Presume sales tax is paid on all in-state purchases. Pros: Easy to implement No impact on cardholders Cons: Overpayment of tax could be material for larger programs This method is most applicable for small or pilot programs. Estimate use tax after filtering out transactions where: Purchase was made in-state Out-of-state vendors have paid tax Purchase was tax-exempt Eliminating transactions where the organization knows that tax is collected at point of sale (i.e., Wal-Mart, Grainger, large national chains that have built in sales tax processing systems) Pros: Identifies more exempt purchases than the approach above Cons: Requires adequate data, resources and tax expertise Requires cardholders to enter tax (if not reported by vendor) and/or other information to enable proper filtering. Software developed by card issuers or third parties can do these types of calculations NAPCP. All Rights Reserved. 8

9 Approach Pros and Cons Remarks Statistically accrue use tax based on a representative sample. Transaction-by-Transaction Review by cardholders, AP or Tax department. Pros: Straightforward Approach accepted by many states Cons: Will not be accurate if program grows or changes Do not have audit trails to specific transactions Pros: Highly accurate Cons: Requires a lot of time that could be better applied to other activities Accuracy would depend on re-sampling transactions periodically. The burden of doing this will limit program growth. Use Direct Pay Permits that allow the organization to pay taxes directly, instead of having vendors collect it. Pros: Effective approach for large facilities Well suited where organization operates in a limited number of states Cons: Must manage vendors to ensure they do not collect sales tax Requires significant involvement of Tax department Alternative offered in 33 states. Approach should be consistent with other means of settlement with suppliers (purchase order, check, ACH, etc.). Selecting a Tax Compliance Model Several factors should be considered in selecting the best strategy for your organization. It is important to remember that whatever compliance model is used, tax auditors will need to understand the method, how it was derived, what sample was used, and the documentation to support the inferences made from the sample. The auditor will check the method for accuracy. Risk Tolerance Each alternative should be evaluated for the cost/benefit weighed against the risk. Inspection of each transaction based on the receipt to determine the need to accrue use tax is highly accurate and typically results in negligible tax adjustments, fines and penalties. It is, however, extremely time-consuming and 2016 NAPCP. All Rights Reserved. 9

10 expensive. On the other hand, accruing use tax on all Purchasing Card transactions involving out-of-state suppliers is simple and minimizes payroll costs, but may result in overpayment of tax. Labor costs, tax overpayment amounts, and possible fines and penalties should all be considered in evaluating the proper tax compliance alternative. It is important that the risk assessment involve your Tax department and other stakeholders within your organization. Desired Level of Cardholder Involvement Not all suppliers will pass sales tax information as part of the credit card transaction (Level 2 data). Respondents to the Sales and Use Tax Survey 2 conducted by the NAPCP and Application Design Resource, LLC (ADR), reported that 27% of respondents noted that less than 5% of card transactions include a tax amount (accurate or not). This gap can be covered by the cardholder reporting sales tax charged or by auditing of the receipts. Some organizations require the cardholder to record on a log or in an online application the amount of tax charged at the point-of-sale or to check a box if tax was charged at all. While this method is highly accurate for use tax accrual, the limiting factor is the accuracy of the information provided by the cardholder. This issue could result in quality checks of the employee-provided information, thereby increasing labor expense for program administration. If audited, inaccurate reporting may also result in the assessment of adjustments and penalties based on the exception frequency found in the audit sample. Reporting Capabilities of Card Issuers The use tax estimation model utilizing the filtration of records (sometimes referred to as a step-down methodology see graphic to the right) requires robust reporting provided by the card issuer. The availability of data by supplier, including the supplier s location, as well as the amount of sales tax, is critical to eliminate those transactions for which you can be reasonably sure the correct amount of sales tax was paid or the transaction is exempt. Ideally, you should be able to download this information into a database to facilitate identification of those records requiring line-item review. Download capability becomes increasingly important as the number of transactions increase. Other information that will facilitate minimizing the number of transactions that require line-item review includes cost center, expense code, Merchant Category Code and cardholder location. This data can be linked to internally maintained tables to identify suppliers who can be filtered out by individual review NAPCP. All Rights Reserved. 10

11 Once those records for which sales tax can be assumed to have been paid have been identified and eliminated from the data, the review of the remaining transactions will most likely result in the identification of use tax liability. The data provided by your card issuer can assist in determining the use tax accrual. Examples of useful information for this process include: Establishing Internal Policies and Procedures Regardless of the approach, tax compliance model procedures should be distributed within the groups responsible for tax estimation, accrual, reporting and auditing. These procedures may not be well-suited for distribution to cardholders; however, they will be critical if audited by tax authorities for sales and use tax compliance. There are several groups in most organizations that should be considered stakeholders when defining policies and procedures. Involvement by Tax, Internal Audit, Purchasing, Accounts Payable, the Purchasing Card administrator, and any others that might be appropriate will help ensure consensus. Each one of these groups will play a part in limiting exposure to tax audit exceptions and adjustments. Procedures should be documented and spell out the method used for calculating use tax. In the event of an audit, you will most likely be required to produce this documentation. The procedures for cardholders should incorporate your receipt documentation requirements. The retention of reports provided by your card issuer should also be part of your procedures, following, at a minimum, the same record retention requirements as accounts payable detail. Another topic that might well be covered as part of your procedures is your internal audit program or work papers used to monitor for compliance. Audit criteria will depend on your industry tax requirements, complexity, risk aversion and overall tax strategy. Educating Suppliers Because the data passed by your suppliers and reported back to you by your card issuer is so important to tax compliance, dealing directly with your suppliers to educate them on your requirements is worth evaluating. You may consider segmenting your suppliers into their existing enhanced data capture abilities NAPCP. All Rights Reserved. 11

12 Level 1 supplier strategy Analyze these suppliers to determine where you need tax data broken out from the transaction amount (because you cannot assume tax is or is not collected) and those where you can safely assume tax is being collected (e.g., Wal-Mart, Target, etc.). Work with your Purchasing Card provider to upgrade the suppliers data capture capabilities where tax amount is required. Level 2 supplier strategy Educate large transaction volume suppliers about how you would like them to report tax to you. Spot audit these transactions to ensure suppliers are providing a tax amount separate from transaction amount accurately. Work with your Purchasing Card provider to educate suppliers reporting inaccurate tax amounts. Level 3 supplier strategy Identify suppliers where tax reporting is dependent upon knowing the line items within the transaction. Work with your Purchasing Card provider to enable the ability to provide line item tax detail where necessary/possible. Be advised that not all Purchasing Card providers can enable suppliers to pass this data nor are all suppliers willing to enable this capability. The Good News While penalties for underpayment range between 5% and 25%, according to a recent NAPCP poll 3, 40% of respondents have been audited at least once since the inception of their Purchasing Card programs, and 10% of the audits resulted in no change or a refund of sales or use tax. Fifteen percent resulted in some findings, but no penalties occurred where only 5% reported significant tax adjustments. Nevertheless, penalties are punitive by nature and are seldom planned expenses. Key items that should be followed in developing a successful sales and use tax compliance strategy include: Senior management support Documented, up-to-date policy and procedures Clearly defined roles and responsibilities of participants Education and training for suppliers and cardholders Forums for discussion and problem solving Internal audits and reviews Review of your strategy with taxing authorities Conclusion Sales and use tax requirements are not unique to Purchasing Card programs. Compliance to requirements are, however, a necessary element to a sound Purchasing Card program. Understanding the relevant issues and how they pertain to your organization is critical. Reoccurring themes include that organizations need to understand the requirements, the implications, have a strategy for compliance, and can support that the organization is following appropriate policies and procedures to support compliance. Your Tax department is a critical partner in determining the appropriate strategy for compliance. You will find quite often that reviewing sales/use tax issues related to your Purchasing Card program will be an opportunity for 2016 NAPCP. All Rights Reserved. 12

13 you and your organization to educate employees who have a role in sales/use tax compliance in general, whether as a player in the Purchasing Card program or within the purchasing and accounting processes in general NAPCP. All Rights Reserved. 13

14 References 1 U.S. Census Bureau, Governments Division, State Government Tax Collections Summary Report: 2014, released April 16, 2015, (accessed May 20, 2016). 2 Application Design Resource, LLC., & NAPCP. (2011). Sales and Use Tax Survey Results and Recommendations for End-User Organizations. Retrieved May 20, 2016, from 3 "Experiences with Sales and Use Tax." NAPCP. Web. 20 May NAPCP. All Rights Reserved. 14