Managing Sales and Use Tax Risk in a Financial Services ... Use Tax...Managing Sales and Use Tax Risk in a Financial Services Environment Insurance Accounting & ... increasingly service-oriented,

Baker Tilly refers to Baker Tilly Virchow Krause, LLP,an independently owned and managed member of Baker Tilly International

© 2010 Baker Tilly Virchow Krause, LLP

Managing Sales and Use Tax Risk in a Financial Services Environment

Insurance Accounting & Systems Association

September 19, 2016

1

Jon P. Skavlem, CPAFirm Director – State & Local Taxes

Contact information: E-mail: [email protected]: (414) 777-5333

See LinkedIn profile for additional information.

2

“The retail sales tax in its current form is a complex, uncertain, and profoundly flawed mechanism that is peculiarly unsuited to an increasingly service-oriented, digital, and borderless economy.”

- Jerome Hellerstein, “State Taxation” (WG&L)

Agenda

> Current sales and use tax landscape> Definitions> National Developments and Nexus> Use tax> Sales tax> Audits, Appeals & Refunds> Compliance and Planning > Questions

4

Sales and Use Tax Landscape

5


> The battle over sales tax nexus continues to grow in intensity e.g. AL, SD

> Federal action to overturn Quill and allow states to tax internet sales still percolating. Est. $25 billion in uncollected sales tax

> States compelling registration/compliance with non-tax initiatives e.g. CO vendor notification requirements

> Complex areas of sales and use tax e.g., digital goods, cloud computing, information services, are evolving.

6


> States eye taxing more services as their need for revenue persists

> With almost 7,500 state and local sales/use taxing jurisdictions in the US, compliance costs are growing for many businesses.

> Efforts to simplify sales and use tax laws e.g. Streamlined Sales & Use Tax Agreement have largely failed to create uniformity among states.

7


> State tax agency investments in “big data” will likely lead to new, more extensive records requests and intrusive audits. Gartner, Inc. defines “big data as: high volume,

high velocity, and high variety information assets that demand cost-effective, innovative forms of information processing which enable enhanced insight, decision making, and process automation.

Cross-matching tax and other business registrations, connecting seller and purchaser audit results, information sharing among states, etc

8


> State and local revenue agencies dialing up sales and use tax audits WDOR’s ROI - $8 assessment per $1 of

auditor payroll cost Over 100 new WI audit and discovery

personnel hired > Imposition of penalties e.g. 10%-25% in audits

becoming “coin of the realm”.

9

Insurance industry’s sales anduse tax environment

Factors impacting the tax compliance burden:> Heavy investment in real estate and

consumption of related services e.g. construction, repair, maintenance

> Software, computer hardware and related IT consulting are critical element to delivering insurance services

> Telecommunications and data transmission services developing rapidly; increasingly tied into software.

10

Insurance industry’s sales anduse tax environment

Factors impacting the tax compliance burden:> Important, although declining role of printed materials

and advertising> Rapidly growing reliance on electronic channels of

policy-holder and agent services, and marketing. Interactive websites E-mail blasts, e-confirms

> Shared service centers> Outsourced services

11

Definitions

12

Sales tax

> Tax imposed on retailer’s (seller’s) gross receipts from sales and leases to consumers of tangible personal property, software, taxable services, etc.

> Seller may collect tax from customer Separately stated on invoice (or) Tax included price

> If a retailer fails to collect sales tax, it is liable pay the tax due based on its taxable receipts

13

Use tax

> A tax on the use, storage, rental or consumption in a state, of tangible personal property, software, taxable services, etc., upon which a sales tax has not been paid by the buyer

˃ Example: Company purchases a computer from New York seller who in turn ships it to Maryland and does not charge sales tax. Company owes use tax.

˃ Reasons why vendor may not apply sales tax e.g. lacks nexus

14

What’s taxable?

> Tangible Personal Property (TPP) is subject to tax unless an exemption applies. May include digital (electronic) goods

> Services specified in the statutes as taxable.> Prewritten software is subject to tax in most states> Situs of Transaction – Usually where buyer takes

possession of TPP or services are received by customer Typically, no temporary storage exemption for

TPP

15

What’s exempt?

> Property/services purchased for resale> Nontaxable by nature of transaction (real estate or

intangible asset, e.g. trademark)> Services not specifically identified as taxable> Statutory exemption (e.g. manufacturing

machinery and equipment)> Digital goods? Depends on state.> Custom software

16

What is included in amountsubject to tax?

> Sales price on invoice with adjustments> Certain repair and maintenance contracts> Warranties – look to underlying TPP> Installation (varies by state)> Shipping (not all states)> Handling fees> Fuel surcharges> Manufacturers’ rebates> Certain taxes e.g. personal property taxes

17

What is NOT Included inamount subject to tax?

> Retailer discounts and coupons (vs. mfgs.rebate)> Refunds, returns, and allowances> Insurance on product merchantability when

separately stated> Warranties and service contracts on exempt tangible

personal property> Separately stated charges for installation of exempt

TPP > Trade-ins (generally must be directly with retailer)> Bad debts

18



National Developments and Nexus

19

Nexus

Nexus - term used to describe the economic connection between a business and a state. It is a critical concept since it determines whether a state or local government can impose tax filing requirements on a business.

˃ U.S. Constitution Due Process and Commerce Clauses

˃ Federal laws (Internet Tax Freedom Act)> Federal court cases e.g. Quill> State constitution > State statutes> State administrative rules and informal policies

Limits on state nexus authority

˃ Quill Corporation v. North Dakota; US Sup. Ct. Dkt. No. 91-194 (5/26/94): A business must have physical presence in a state for sales tax nexus to exist

> Examples; employees working in a state, visits by sales personnel or independent reps, office space, rented equipment.

> Economic presence alone was thought to be insufficient to create nexus until recently

> Many states have adopted nexus standards that circumvent Quill in the last 5 years

Quill and physical presence test

> Click-through nexus e.g. NY, CA, IL> Affiliate nexus e.g. WI> Economic or “Bright Line” nexusAL - $250,000 annual sales or more in stateSD - $100,000 annual sales or more in state

> Out-of- state seller notification requirements e.g. CO

> Streamlined Sales & Use Tax Agreement

State challenges to physical presence

Activities that might create sales tax nexus:> Retail sales above specified $ threshold> Providing services from outside a state to in-state

customers> Operating a related company in the state i.e. affiliate

nexus> Making internet sales using third-party website links that

involve a commission arrangement i.e. “click-through” nexus

> Owning or leasing a server within a state> Trade show participation (Note “safe harbor” states e.g.

CA, MN)

Nexus-Creating Activities

Would Repeal Physical Presence> On-line Sales Tax Simplification Act of 2016 – H.R.

5893> Marketplace Fairness Act of 2015 – S. 698> Remote Transactions Parity Act – H.R. 2775Would Mandate Physical Presence for Nexus> No Taxation Without Representation Act of 2016-

H.R. 5893> Business Activity Simplification Act 0f 2015 – H.R.

2584

Proposed legislation on nexus

> Discovery units of state revenue agencies with broad powers of assessment and levy

> Nexus questionnaires> Information sharing agreements > Consequences of failure to register and collect

sales/use tax Statute of limitations does not close back years Penalties for negligence and non-filing Delinquent interest e.g. 18% Financial statement impairment

Discovery & Enforcement



Use Tax

27

Sales vs. use tax:Who is responsible for the tax?

> If sales tax is not collected by the vendor, the purchaser must self-assess use tax.

> Why isn’t it only the seller’s responsibility to collect and pay the tax? States maximize their ability to obtain the tax. WI places burden on buyer to determine if sales

tax was paid by seller upon audit. MI will not assess use tax if purchase made

from in-state vendor.

28

Financial services:TPP commonly subject to tax

> Office equipment and supplies> Janitorial, cleaning and building maintenance

equipment and supplies> Computer hardware and IT networking costs> Computer software (see next section)> Telecommunications equipment> Digital goods e.g. downloads of books, videos> Training materials e.g. manuals, DVDs> Advertising and promotional materials> Motor vehicles

29

Leases – general tax framework

> Lease as continuing sale of TPP – tax due on stream of rent payments. (most common method) Lessor purchases TPP exempt from sales tax

> Lessor pays tax on cost of TPP when purchased Lessee is not liable for sales or use tax on rent

but lessor may pass the tax cost through. Illinois follows this approach. Pennsylvania

applies it to construction equipment.˃ Potential WI – IL tax trap for lessors

30

Leases – general tax framework

Operating vs. capital lease:> Classification can impact timing of tax> Operating: Tax paid by customer on the lease

charges> Capital: Treat as sale. Tax immediately due (sales

tax by the vendor or use tax from buyer)> No uniform definition of capital/operating lease

among states e.g. GAAP, IRS guidelines.> Use of TPP by a customer may be treated as

taxable rental even when transfer agreement is not structured as a lease.

31

Lease rental of TPP vs. service

> If an operator is provided with equipment, transaction will be treated as a service by many states Streamlined Sales & Use Tax Agreement method

followed by WI and over 20 other states> When an operator is provided with equipment, the

transaction is considered a service If a service, treatment depends on whether it is

classified as taxable by statute Property is taxable when purchased by

owner/service provider

32

Services – Rule of Thumb

˃ Services ordinarily not taxed unless state statutes enumerate them as such

˃ States with broad-based sales and use taxes that presume services are taxable Hawaii New Mexico South Dakota West Virginia

33

˃ Telecommunications e.g. telephone, paging, video conferencing, EDI.

˃ Internet access (WI and 11 other states)˃ Repairs, maintenance, installation and other

services to taxable tangible personal property ˃ Janitorial services (not in WI if regular and routine)˃ Building maintenance e.g. CT, MN, NJ, PA, TX˃ Sale of landscaping/ lawn care e.g. DC, WI˃ Photographic services e.g. WI˃ Parking

34

Financial services:Services potentially subject to tax

˃ Advertising services e.g. CT, MD˃ Information services e.g. DC, NJ, NY, TX˃ Credit reporting e.g. FL, MD, NJ, NY, PA, WA˃ Security and private investigation e.g. FL,NJ, TX˃ Payroll processing e.g. CT, DC, OH, ˃ Temporary help e.g. DC, IA, OH, PA˃ Printing and other fabrication services

35

Financial services:Services potentially subject to tax

Real property

˃ Land, land improvements, buildings and structural components permanently attached to the real estate

˃ Sale of real property and related construction services generally non-taxable with exceptions e.g. WA

˃ Contractor must pay sales or use tax on building materials and components of real property

˃ Structural components and services to real property are taxable in many states

WI – taxes materials and equipment retaining character as TPP after installation in real estate

36

Real property or personal property?

˃ Leasehold improvements

˃ Signage – internal and external

˃ Security systems – IT components, wiring, cameras

˃ Cabinets, counter-tops, bathroom and break-room fixtures

˃ Built-in appliances

˃ Specialized lighting or HVAC (e.g. computer rooms)

˃ Back-up electrical generators

37

Real property or personal property?

˃ Practical difficulties in determining what construction charges are taxable

˃ TPP may be subject to use tax when construction contractor fails to assess sales tax

˃ WI is an especially challenging state – See Wisconsin Publication 207

˃ Other states - TX taxes real estate repair and remodeling contracts on commercial property

˃ Special contractor taxes may add to RE tax costs e.g. SD 2% contractor’s excise tax

38



Computers and Software

39

IT spending – Key area of sales and use tax risk

What’s at stake for businesses?˃ Expanding and uncertain potential tax base˃ Gartner anticipates worldwide IT spending to equal $3.49 trillion in

2016˃ A Goldman Sachs study forecasts worldwide SaaS sales to reach

$106 billion in 2016, a 21% increase from 2015 ˃ Cisco predicts by 2018, 59% of total cloud workspace will be SaaS

Increase from 41% in 2013˃ Tax and financial impacts

Audit assessments including penalties and interest Risk management e.g. ASC 450 – contingent liabilities.

40

The basics

Software – What are we talking about? > Computer programs – system software, application

software, web-based applications and all other forms e.g. ERP, Software as a Service, custom programs, prewritten (canned) software

> Related IT services - design, installation, modification, maintenance, support, training, monitoring, security, data back-up and processing, etc.

> Bundled software – service offerings such as SaaS, PaaS, IaaS and others.

41

Factors affecting taxation of software

Key State Tax Factors:> Nature of software: prewritten, custom, SaaS, etc.> Terms of agreement or contract: sale vs. license> Fee arrangement: license payment, user fee, etc.> Mode of delivery> Bundling of software, hardware and services

42

Software taxation framework

43

> Prewritten (Canned) Computer software, including prewritten upgrades, that

is not designed and developed by the author or other creator to the specifications of a specific purchaser.

> Custom Computer software created to the unique specifications

of a user. Not sold or licensed to more than one party (under SSUTA rules).

> Modified prewritten software (Can it become “custom”?)


44

> Cloud Computing Range of software applications, services and hardware

capacity that are hosted or available over the internet on a fee or license basis.

Includes SaaS, PaaS, IaaS and other packages Key characteristic – possession, direction and control

is NOT with the user / customer> Embedded software – resides as firmware within a

device and has one, or a few uses e.g. cars, phones> Related IT services – line is becoming increasingly

blurred between software and hardware


45

> Sales and use tax significance (generally) Prewritten software - assumed to be TPP Embedded software – integrated with and inseparable

from device, product or hardware Custom software - treated as service or intangible

asset SaaS – varies e.g. prewritten software, non-taxable

service, taxable telecommunication service, lease of TPP.

IT services – taxation tends to follow overall state framework for taxing services

Taxability of computer hardware and software

Examples of Taxable Sales:> Computer hardware> Network components> Prewritten computer software in most states Services to canned software e.g, installation Exempt in certain states if electronically delivered e.g.

CA, FL> Note: Planning opportunities regarding unbundling IT

charges

46

Taxability of computer hardware and Software

Examples of Nontaxable Sales:> Custom software (but see OH)> Optional training on how to use software or hardware > Writing queries on databases > Data reformatting, migration, back-up, recovery, etc.> Hosting, testing, and security charges> Caution: Some may treat as taxable information

services in select states e.g. TX,

47

Cloud computing - SaaS

Software as a Service > Definition of SaaS> Software not on user’s server, but accessed over the

internet> Customer does not have custody and control of the

software; does not have physical access to the vendor’s server; and does not have the responsibility to maintain, upgrade or repair the software

> Taxable in some states as prewritten software e.g. NY, PA

> Exempt in other states as a service e.g. WI

48

Software Tax Specific States Summary

49



Sales Tax

50

Sales tax – financial services

> Less of a concern for insurance companies since do not generally sell taxable TPP or services

> Areas of concern Services or TPP furnished to agents Sales to employees Intercompany transactions e.g. allocated

software charges Incidental fixed asset sales Leasing?

51

Sales tax – focal points

˃ Nexus˃ Registrations Treatment of disregarded entities

˃ Defining taxable receipts˃ Exemptions available e.g. resale, affiliated entities˃ Certificate management and documentation

52

Sales tax – focal points

˃ Sourcing of receipts˃ Local and special district taxes˃ Electronic filing and payment required in many

states˃ Nature of compliance system e.g. manual,

automated

53



Audits, Appeals, and Claims For Refund

Audit process

> How are taxpayers selected for audit? “Preferred customer” – typically large companies Audit history – likelihood increases with significant

prior year assessments Referrals from other audits Information sharing / data mining Special projects (programmatic)

> Field vs. office audit> Written notice of intent to audit is almost always

required by law or TBOR

Audit process

> How many years will be audited? Four years in WI covers open statute ol limitations Longer if no return has been filed (6 years for WI

use tax)> Option to have field audit occur offsite e.g. office of

CPA or attorney> Representation –POA required. Early involvement will likely produce better results

and avoid friction with the auditor

Records

Records likely to be reviewed for financial services company:> Tax returns and workpapers> Fixed asset records –acquisitions and disposals> Capital and expense invoices including other

documents e.g. purchase orders.> Leases> Software contracts

Records

Records likely to be reviewed for financial services company:> Credit / Procurement card statements and support> Chart of Accounts> Trial balance data – likely in electronic form> Journal entries> Sales invoices > Exemption certificates

Sampling methods

> Non-statistical Alpha sample Month per year Select GL accounts> Statistical sample – used less than 5% of time by

WDOR. Higher degree of accuracy and reliability Stratification and specified error parameters Will not necessarily lead to smaller sample size

Audit exposure areas for financial service companies

Use tax:> Failure to register for and accrue use tax> Missing records> Purchases from out-of-state vendors (office

supplies, promotional materials, digital goods)> Prewritten software and related consulting > Shipping, freight and handling charges on taxable

TPP (WI taxes but exempt in other states if separately stated)

> Leased equipment

Audit exposure areas for financial service companies

Use tax:> Information services> Other services e.g. landscaping, repairs and

maintenance to TPP, telecommunications, temporary help

> Construction, repair and maintenance of facilities and attached personal property

> Absence of temporary storage exemption> Local and special district taxes not applied > Vendor applies incorrect state tax e.g origin. Credit

not available in state of use or consumption

Audit exposure areas forfinancial service companies

Sales tax:> Exemption certificates missing or incomplete> Sales to affiliates> Sales to employees> Sale of used equipment> Improper treatment of leases > Failure to account for local and special district

taxes

Audit planning and strategy

˃ Request formal notification and record requests˃ Conduct preliminary review ˃ Set expectations for timing, records, access in

opening meeting˃ Negotiate sampling techniques and parameters˃ Initiate regular communications with auditor ˃ Set a protocol for fielding questions and for

responding˃ Conduct review for potential refunds

63

Audit process

> Closing meeting with auditor Request meeting with supervisor if necessary

˃ WI Notice of Proposed Report: Agree or disagree? Prepayment option to reduce 12% interest

˃ Notice of Field Audit Action – Assessment or Refund

Appeal process

˃ Administrative appeal to WDOR Resolution Unit Informal – proceedings not official record for

subsequent litigation Must file Petition for Re-Determination 60 days after receiving Notice of Field Audit

Action Can make deposit to stop interest

˃ WI Tax Appeals Commission˃ Circuit Court, Court of Appeals and Supreme Court˃ Other states – “Pay to Play”?

Penalties – Are You at Risk?

> 25% negligence penalty (1of 3 audits)> Filing late return – 5% penalty per month > 50% fraud penalty – WDOR has started to impose

when no intend to defeat or evade is present.> Delinquent fee – greater of $35 or 6.5%> 25% penalty - failure to keep records> Interest of 18% on delinquent taxes, 12% if not

delinquent

Penalties – Are You at Risk?

Failure to produce records:> Disallow deductions, credits, exemptions> $500 or 25% penalty for each violation> Certain exceptions to penalty – reasonable cause,

etc.

Claims for refund - the process

Who may file a claim?:> Sales tax Seller – must return tax and interest to buyer.

Amend sales tax return(s) Buyer – file directly with WDOR

Can file electronically Vendor waivers Tax paid to seller: $50 or more

˃ Use tax – amend use tax return or direct audit offset

Claims for refund – potential areas for financial service companies

˃ SaaS and custom software Downloaded prewritten software in select states e.g

CA, FL˃ Printed advertising including direct mail ˃ Non-taxable services˃ Resale˃ Real property construction and related services

Claims for refund

˃ Seller: Form ST-12 or letter> Buyer Tax paid to seller: Form S-220 Tax paid to DOR: Form ST-12 or letter

> Interest – 3% per year> Penalties for incorrect claim or failing to return tax

and interest to buyer 25% negligence 100% fraud

> DOR action on claim – 1 year

Compliance and Planning

71

Compliance and planning

˃ Conduct a sales and use tax policy and procedures review to ensure: Sales and use tax registrations held in appropriate

jurisdictions Written procedures are in place Exposures are identified and quantified Employees with appropriate responsibility and

training are assigned to compliance˃ Analyze compliance resources: Automated compliance Research services e.g. RIA, CCH

72

Compliance and planning

˃ Follow-up on audits after completion Amend returns to stop interest and forestall

penalties Examine adjustments and make corrections

˃ Build taxability review into purchasing and capital budgeting processes

˃ Tax group review of leases and software contracts˃ Examine use of procurement and T&E cards for use

tax implications˃ Advanced planning strategies – purchasing

company, percentage use tax reporting

73

Questions?

74

Documents

Managing Sales and Use Tax Risk in a Financial Services ... Use Tax...Managing Sales and Use Tax Risk in a Financial Services Environment Insurance Accounting & ... increasingly service-oriented,