STATISTICAL AND BLOCK SAMPLING Tax School II... · STATISTICAL AND BLOCK SAMPLING Slide 1 I....

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STATISTICAL AND BLOCK SAMPLING SALES TAX SCHOOL II THEORY AND PRACTICE FOR THE EXPERIENCED SALES AND USE TAX PROFESSIONAL

Learning Objectives At the end of this section, the learner will be able to:

Define the following terms:o Confidence intervalo Confidence levelo Homogeneityo Meano Measure of taxo Stratification

Recognize the use of stratification in tax audits and characteristics commonly used forstratifying populations for sampling.Identify the advantages and disadvantages of audits conducted using:

o Reviews on an actual basiso Block samplingo Statistical sampling

Recognize how to project the results of a sample to the population usingo Ratio estimation, i.e., projection using a percentage of erroro Difference estimation, i.e., projection based on error per sample unit

Identify the techniques used to analyze the accuracy or adequacy of sampling results.Recognize the alternatives when a confidence interval in a statistical sample is wide or asample has missing items.Recognize that different populations and confidence levels require different sample sizesKnow how to compute the multiplication factor and how it applies to sampling analysis.

STATISTICAL AND BLOCK SAMPLING

Slide 1

I. INTRODUCTION

A. What do we want to accomplish?

B. What do you want to take away from this session?

Slide 2

C. Let’s look at some basic definitions:

1. Unit - a member of a population

2. Population - everything or all of the units, items, elements of some group


• Introduction• First steps – before your audit begins• Looking at organized groups of transactions

- Stratification• Looking at every transaction - 100%• Looking at a specific group of transactions

- Block Sampling• Looking at a random set of transactions

- Random Statistical Sampling• What to do with the results


• Definitions– Unit– Population– Sample– Stratification– Homogeneity– Mean

3. Sample - a subset of the universe from which one will infer a characteristicabout the universe of which it is a subset

4. Stratification - a way to divide a universe into homogenous, non-overlappinggroupings, called strata, to improve reliability

5. Homogeneous or homogeneity - composed of similar or identical elements,e.g., apples, pears, peaches are homogeneous within the grouping fruit; add trucksand the grouping fruit is no longer homogeneous

6. Mean - the arithmetic average; the sum of the scores divided by the number ofscores.

Slide 3

Slide 4

7. Materiality - the level at which the specific amount of something beingexamined is considered significant. In a population being examined, an item’s materiality is the amount below which the item will not be considered important.

Sample MeanSample Items 10

20253515

1055

25Total of sample items 240Divided by # of items 8Sample mean or average 30


• Definitions (continued)– Materiality– Absolute Value– Inference– Measure of Tax (Tax Base)

For example, an audit result may be considered immaterial if less than three errors in a sample are found.

8. Absolute value - the value of a number without consideration for its arithmeticsign. The absolute value of a credit represented as ($200) or -$200 is $200.

9. Inference - Predictions about a population based upon information contained ina sample or samples drawn from the population

10. Measure (Tax base) - the amount of purchases or sales subject to tax; theamount to which the tax rate will be applied.

Additional terms are in the Glossary following the text.

II. BEFORE YOU GET STARTED

Slide 5

A. Know the rules

Research the state’s statutes, rules and administrative policies, and practices on audit sampling before your audit starts. Some states make their audit manuals available on line or for purchase. A useful starting point for your research is a publication entitled “Sampling for Sales and Use Tax Compliance, Appendix A, written and compiled by the Federation of Tax Administrators, available on the web at: http://www.taxadmin.org/fta/pub/Samp2004.pdf


• Before your audit starts– Know The Rules!

• Statutes & rules• Administrative practices• Audit manuals & operations memos• Federation of Tax Administrators

– Sampling for Sales & Use Tax– Auditing Electronic Data– Model Record Keeping & Retention Reg.

FTA Appendix A-Summary- State Sampling Practices

1. Does the state have the right to sample?

2. Are the auditors required to provide a written sampling agreement?

3. What is the state’s minimum, maximum, or average number of strata?

4. How is the sample size calculated?

5. What is the minimum number of errors needed to project a sample result?

6. Does the state set a specific confidence level or precision for the sample?

7. How will missing documents be handled?

8. Are overpayments projected? If not, how will overpayments be handled?

9. What sampling techniques are allowed or preferable?

10. Does the state make a brochure or instruction manual available?

11. Do the auditors have the authority to require you to turn over data tapes?

B. Know your business, your records and your IT department

As discussed in the earlier section on auditing, the keys to a successful audit include: 1. The amount of knowledge you have about your business’ structure and its

operations,

2. Your company’s record retention practices

3. The extent of your contact and relationship with your company’s ITdepartment

C. Negotiate your best audit strategy

Negotiate details early in the audit. Timing is everything … Try to negotiate prior to providing data tapes

D. Documenting the Audit Plan

Some states have prescribed forms used to document and/or notify taxpayers of audit and sampling procedures.

Examples: Texas & California

1. Texas Form: Notification of Sampling Procedures for State Tax Audit

The Texas Controller of Public Accounts makes its training materials for audit sampling available on its web site:http://www.cpa.state.tx.us/taxinfo/audit/sampling/sampling.pdf

The Texas Sampling Manual was revised in April 2012.


• Before your audit starts (review)– Know your business– Know your records– Know your IT department– Negotiate your best audit strategy

including the use of audit sampling agreements

Slide 10

The Texas Notification of Sampling Procedures (Exhibit 1) is used by Texas auditors to notify formally taxpayers of their intended sampling method and projection. Ideally, the tax manager has negotiated all aspects of the sampling methodology long before this form is received. A copy of this form follows this page.

Compare this form with the California Audit Sampling Plan form and you will note that the California form allows the auditor and tax manager to record in detail the methodology to be used in specific situations frequently encountered in sales and use tax audits.

Exhibit 1 The Texas Notification of Sampling Procedures

Texas Sampling NotificationObjective of the sample1. The records to be examined in

performing the sample will include: 2. The sampling unit will be:3. The method of selecting the units will be:4. The sample size will be:5. If a time period is used, the selected

periods will be:

Texas Sampling Notification

6. The sample base will be:

7. The population base will be:

8. The results of the sample will beapplied to the population using thefollowing procedures:

2. Example: California Sampling Plan and Form: BOE 472

The California form shown on the next page as Exhibit 2 differs from the Texas form in that it includes additional space for documenting procedures in situations often leading to disagreements later as the sample is conducted. For example, the CA form includes a section on how credits will be handled in the sample. Another difference is that this form requires the auditor and the taxpayer to sign indicating that they have worked together to determine the most efficient method of sampling. The State of California revised its Field Audit Manual on Chapter 13, Statistical Sampling, Rev 8, February 2012. The CA audit manual is available at: http://www.boe.ca.gov/sutax/staxmanuals.htm.

Exhibit 2: California Sampling Plan and Form: BOE 472

Slide 11

Slide 12

3. If the state does not have an official sampling form, consider documentingyour understanding of the agreed upon sampling procedures with the auditor, and having both parties sign it as early in the audit as possible.

Slide 13

Slide 14

California Board of Equalization

"The auditor should aid the taxpayer in gaining a correct understanding of the law and demonstrate that we are as willing to recommend a refund of an overpayment as we are to propose a deficiency determination.“

Field Audit Manual, Chapter 1, Section 101.20(b), revised January 2000.


How can the auditor possibly use block or statistical sampling if some invoices are $200,000 and some are $20?

Isn’t that like comparing apples and oranges?

III. STRATIFICATION

A. Definition

The stratification of a population into two or more substrata is simply the separation of the original population into two or more smaller, more homogeneous populations.

The concept of using stratification to divide the audit population into smaller, logical subgroups was introduced in the earlier audit session. Let’s continue that discussion.

B. Selecting the strata in each population

1. Determine the number of strata for each test or exam population:

The stratification of a selected population can be as simple as dividing the population into two strata, for example:

a. items a certain dollar value to be reviewed on an actual basis, andb. items under the dollar value to be sampled

For large populations, numerous strata can be employed with the highest dollar value population being evaluated on an actual basis, and lower value strata using sampling methods.

For example, on a sales test:

a. Strata 1: items $100,000 to be reviewed on an actual basis,b. Strata 2: items $50,000 but less than $100,000 using samplingc. Strata 3: items $10,000 but less than $ 50,000 using samplingd. Strata 4: items from zero but less than $10,000 using sampling

Slide 15

>$100,000.00<-$100,000.003000 invoices

$50,000.00 to $99,999.99-$50,000.00 to -$99,999.99

200,000 invoices$10,000.00 to $49,999.99

-$10,000.00 to -$49,999.991,000,000 invoices

0 to $9,999.990 to -$9,999.99

10,000,000 invoices

Actual BasisReview all 3000 invoices

Statistical Sample0.1% sample 1000 invoices



MULTI-STRATA EXAMPLE

2. Carefully analyze each stratum

Analyze each new substratum (population) for how to sample or whether to review this stratum on an actual basis.

3. More strata, fewer sample items, and better results?

In theory, stratifying populations into more homogeneous substrata enables smaller sample sizes and more accurate results. Some states may employ as many as 8 to 10 strata in an AP exam with each stratum having only 100 sample items.

4. Additional random items?

Consider pulling additional sample units for each stratum to hold in reserve in case additional sampling is needed to reach satisfactory results.

5. Caution – stratification on accounts of interest

Consider whether stratification based on general ledger accounts of interest is helpful in your audit. Remember that you or the auditor will need to compute the total for each account for each period in order to establish that stratum’s population. Do not allow the auditor to exclude accounts where overpayments may have been made as this is not usually in your best interest. Overpayments can be used to offset any underpayments in the same stratum. Further discussion is included in Section VI. Analyzing Sample Results.

CONSIDERATIONS WHEN STRATIFYING A POPULATION

1. Determine number of strata2. Analyze each stratum for best

method of auditing3. More strata & fewer sample items?4. Selecting additional random units5. Caution about accounts of interest6. Stratification of negative entries?7. Should you leave credits & offsetting

items in the population?

6. Stratification of negative entries?

Stratification of offsetting (negative) transactions generally will have no impact on your audit’s results but ensure that the population and the sample are properly computed if this is agreed upon.

7. Should you leave credits and offsetting items in population?

Stratification of transactions resulting in tax credits or transactions on which your firm has paid tax to the vendor or to the state generally is not in your best interest as these may result in offsetting credits in the sample. Unless you have a strategic reason to remove these from the sample, such as you believe the credits will result in a larger credit if sampled separately, insist that they be left in the population.

IV. ACTUAL EXAMINATIONS

Slide 17

A. Reasons to use

1. Re-billing your customers for the tax

2. Limited number, infrequent or unusual transactions

3. Large dollar size of transactions

4. Eliminates possibility of non-representative sample

ACTUAL EXAMINATIONS

Isn’t a detailed review of all transactions the best audit approach?

B. Reasons to avoid

1. Population too large to review on an actual basis

2. Actual review of a large number of transactions can result in more error thanan effective sample

3. Cost (time and money) vs. benefit (certainty of the result)

C. State laws regarding rights of taxpayers to insist on actual review

D. Determining liability with actual review - easy to do!

1. Auditor reviews all items in the population

2. Liability determined by adding all errors

3. Verify accuracy of items deemed taxable errors by auditor

4. Review for credits or offsets to reduce overall liability

E. Example: Mega Computer Corporation

You are the tax manager or the consultant for Mega Computer Corporation. The tax auditor has indicated the following areas that he plans to audit. In your opinion, which audit methodology do you prefer for each of these areas?

Slide 18

Actual basis examinationor sampling?

1. The sale of your software division toanother company last year

2. General purchasing activity over theaudit period

3. Sales at retail for the audit period4. One-time sale of obsolete inventory to

a foreign entity5. An asset purchase agreement

executed two years ago

V. BLOCK SAMPLING

Slide 19

A. Types of block samples

1. Group of sampling units taken from specific period of time

Examples: year, month, week, day, batch of days

2. Combinations of several block samples

a. One month drawn from each year of audit

b. 10 batch weeks selected throughout audit period

c. 30 batch days selected in last year of audit

3. Law changes

If the law has changed during the audit period, you can either:

a. Calculate two different percentages of error from a single sample, or

b. Separate the population into two different samples: the period beforeand after the law change.


The auditor claims a block sample is the simplest sample approach. Is that correct?

B. Choosing a representative period as the sample

1. Block period sampled must be representative or the sample error projectionwill result in an incorrect liability. Block sampling results may be positively or negatively impacted by:

a. seasonal or business cyclesb. unusual or non-recurring transactionsc. special projectsd. organizational changes, i.e., mergers, new or discontinued operations,

etc.e. changes to product lines, business operations and/or types of

transactionsf. additions or deletion of business locationsg. changes in accounting or billing methodsh. personnel changesi. computer system changesj. record keeping changes

2. Pre-audit preparation is critical to choice of good sample period(s).

C. Determining sample size for block samples using ratio estimation

Your records will generally have the sample totals needed if the block selected is a month, week, day, or other standard reporting period.

Example D. Calculating percentage of error

Example: Sample errors = $35,000 Sample size = $1,000,000 % of error = 3.5%

E. Projection of percentage of error to population Example:

% of error = 3.5% Population = $20,000,000 Projected error in population = $20,000,000 * .035 = $700,000

F. Advantages of block samples

1. Sample period is often selected near end of audit period

a. More convenient to locate recent records & secure information

(1) for you & others in your company

(2) for vendors and customers

Generally, if the sampled items are from recent years, then your customers or vendors are more willing to help you because their records are more accessible plus they are more likely to remember a recent transaction than one which occurred several years ago.

b. Fewer customers/vendors will have gone out of business or havemoved.

2. Usually easy to calculate sample size because the totals may already be in yourrecords, i.e., daily, weekly, monthly or quarterly totals.

3. Missing items in a block sample may not be as easy to detect compared withmissing items from a statistical sample. This may be advantageous since auditors often attempt to include missing items as taxable errors in the audit.


Why not do block sampling?It seems pretty easy and straight forward.

Besides, I don’t understand statistics.

G. Disadvantages of block samples

1. Block samples cannot be evaluated statistically

a. other validity checks and evaluation can be done

b. compare average sample unit to average population unit

2. If error rate or population changed dramatically over audit period, then blocksample will yield biased and unrepresentative results

H. Block Sampling Problem [Exhibit 3]

I. Class Exercise: Illustration of Frequency Distribution [Exhibit 4]

2015 SALES TAX SCHOOL IIREGISTRANT STATISTICS

Total Enrolled 133 Registrants by StateAlabama 1

Women 75 Alberta, Canada 1Men 58 Arizona 1

Arkansas 1Age California 7

Colorado 421-30 33 Florida 531-40 45 Georgia 1041-50 24 Illinois 1451+ 12 Iowa 1No Answer 19 Louisiana 1

Michigan 4Education Minnesota 3

Missouri 2No College 3 Mississippi 1Some College 4 New York 8Associate degree 4 North Carolina 4Baccalaureate degree 68 Ohio 5Advanced degree 43 Oklahoma 3No response 11 Oregon 1

Pennsylvania 5Type of Business by Industry Tennessee 10Accounting 8 Texas 29

6 Virginia 4Consulting (Tax) 36 Washington 5Energy 10 Wisconsin 3Fast Food/Restaurant 1Finance 2 Degrees Held By RegistrantsHealthcare 4 Accounting 35Leasing 3 Actuarial Science 1Legal 2 Business 21Manufacturing 16 Economics 1Motel/Hotel 2 Finance 4Oil and Gas 5 Law 3Retail Distribution 22 Marketing 1Technology 1 2Transportation 8 1Utility 1 Taxation 1Wholesale 4 Zoology 1

Joined IPT with Registration - 3

Sales Tax Experience0-5 years 386-10 years 4811-15 years 2016+ years 16

Communications/Telecom

PsychologyPublic Administration

VI. STATISTICAL SAMPLING

Slide 21

A. Define the population

It is critical to specifically identify what types of transactions are included in the population to be examined as well as to specifically identify any transactions that are being excluded, either because they are being examined on a detail basis or because neither the auditor nor the taxpayer desire these transactions to be in the population.

1. Items of interest

a. General ledger accounts

b. Divisions

c. Products sold

d. Customer type

e. Sales/purchases for that individual state

2. Negative or minus transactions

Auditors will frequently attempt to eliminate negative or minus transactionsfrom the population being tested. Is this in the taxpayer’s best interest?

a. Reversing entries

b. Credits allowed on accounts

3. Should one eliminate from the sample items on which:

a. Sales tax was paid to the vendor?

b. Use tax was accrued?


The auditor says a stat sample with random selection is easy, accurate and efficient. I’ll bet the auditor also sells ocean front property in Kansas!

Auditors will frequently attempt to eliminate items where tax was paid or accrued from the population being tested. Is this in the taxpayer’s best interest? No, generally your best strategy is to keep the credits in the sample to minimize the percentage of error.

B. Define the sample unit

1. Key field for record retrieval

a. Voucher number?

b. Invoice number?

c. Line item in population selected?

d. Check number?

2. Selection by line items

a. Tax line?

b. An invoice may have lines charged to a variety of accounts, not all ofwhich are selected as accounts of interest.

3. Ensure all sample units are part of the population as defined above.

C. Selection of sample units

1. All items must have an equal chance of being selected

2. Selection must be determined randomly to prevent bias

3. Sample unit selected should relate to key field needed to retrieve documents

When deciding upon a method to select the sample units from the population, you must choose a method that will allow you to re-create the sample if needed.

D. Systematic sampling with a random start

1. Selection process

a. Selecting sample items at a given interval, i.e., every “nth” item

(1) terminal digits on invoices or vouchers - Using last 1 digit = 10.0% sample - Using last 2 digits = 1.0% sample - Using last 3 digits = 0.1% sample - Can use several 2 or 3 digit terminal #s to make any size sample deemed appropriate. For example, selecting vouchers ending with digits "53" and "37" will generate a 2% sample of the population.

(2) selecting every "nth" line item in a sales journal

(3) selecting the 5th item on every 10th page

b. Must begin selection by drawing a random starting number

c. Sample must be able to be recreated & verified

d. Avoid introducing bias into the sample

2. Example of Systematic Sample Using Terminal Digits

Suppose your firm has approximately 100,000 sales invoices in a four-year period under audit. The invoices are numbered from A-150000 to A-250000. Both you and the tax auditor agree that he or she should examine 1,000 invoices, or 1% of your sales invoices.


If it’s random, how can it also be systematic?

What’s wrong with this picture?

One way to select 1000 invoices from this population is to choose invoices by their "terminal digits”, i.e., the last one, two or three digits in an invoice or check number sequence. The randomly selected terminal digits are usually chosen from a random number table or from a random number generator.

If the randomly selected terminal digits are "98", then all invoices ending with "98" will be included in the sample, i.e.:

A-150098, A-150198, A-150298, A-150398, A-150498, A-150598, A-150698, A-150798, A-150898, etc.

E. Random number selection 1. Selection process defined: a. sample units chosen randomly using: (1) random number table (2) computerized random number generator

i. Commercially available software Examples include ACL and SAS ii. Programs used by states Some states employ commercially purchased software

Other states have developed their own custom programs in house

b. Each sample unit is selected individually c. Key to random statistical sampling is the proper documentation of the

sample selection process Consider having an additional random group of check numbers selected by the auditors at the same time that the original sample is drawn. You may wish to expand the sample if the results are disagreeable or are non-conclusive.

F. Factors influencing sample size

Slide 23

1. Sample size is influenced by three factors: the confidence level, the confidence interval and the homogeneity of the population.

a. Desired confidence level (example: 80%).

Confidence Level: An inference from a sample that tells us the proportion of times a statement about the universe is likely to be true. How confident do you want to be in the results of the sample reflecting, to a certain degree of accuracy, the true error in the population? Typically state auditing programs use 80% or 90% confidence levels for their statistical samples. The higher the confidence level, the larger the sample size will need to be to achieve a certain confidence interval. The following slide shows the increase in the sample size if, at a set confidence interval, in this case +/- 75%, the confidence level is raised from 80% to 90%. Notice that the higher the confidence level is increased, the more dramatically the sample size increases. Raising the confidence level from 80% to 85% will result in a 39% increase in the sample size, but increasing the confidence level from 80% to 90% results in a 192% increase in the sample size.

b. Desired or given confidence interval (example: +/- 75% of the sample mean) Confidence Interval: A confidence interval gives an estimated range of values which is likely to include an unknown population parameter, the estimated range being calculated from a given set of sample data.1

The confidence interval is one measurement of how accurately the sample results estimate the true error in the population at a specified level of confidence. The confidence interval is a statistical measure of the inability to predict the true population error because the test is based on a sample, rather than a census The confidence interval can be expressed as a range of values wherein the true error in the population will occur at a given or set confidence level. Alternatively, the confidence interval can be expressed as a +/- percentage from the mean which is the point estimate of the measure of tax resulting from the sample.

Example: Audit liability is: $200,000 (mean or point estimate)

In this example, the confidence level is set at 90%. Note that the confidence level will be established at the onset of the audit usually by the state’s sampling policy.

Once the sample has been completed and the taxable errors known, the sample size, population size and taxable errors in the sample are statistically analyzed to calculate the confidence interval.

Interval as a percentage of mean difference is plus or minus 40%

The taxable measure can be expressed as $200,000 + 40% Confidence Interval expressed as a range of values:

Lower limit: mean – CI = $120,000 ($200,000 – 80,000) Upper limit: mean + CI= $280,000 ($200,000 + 80,000)

Given a 90% confidence level, the confidence interval, or range of values is between $120,000 and $280,000, with $200,000 (mean) being the most likely result. So, you would be 90% confident that the true audit liability will fall between $120,000 and $280,000. There is also a 5% chance that the true audit liability is less than $120,000 and a 5% chance that the liability is more than $280,000. Exhibit 5: Impact of sample errors on confidence interval.

Scenario 1: If there are only a few errors found in the sample, then the

confidence interval could be quite large.

Scenario 2: The more errors found, and the more homogenous the errors, the smaller the confidence interval will be.

Scenario 3: If there are numerous errors but they vary greatly in size, then

the confidence interval will be large. Additional stratification could produce a better result that will evaluate better.

Scenario 4: If there are plus and minus errors in the sample, such as in a

Paid Bills test with credit errors in addition to the debit errors, then the confidence interval will tend to be larger. If the sum of the plus and minus errors tends toward zero, the projected measure of tax could be correctly quite low, but the resulting confidence interval could correctly be quite large. This is an example of a scenario where you would want to accept a large confidence interval as it is due to the plus and minus errors canceling each other out and reducing the measure of tax.

Scenario 5: Let’s make the minus errors in Scenario 4 positive. Does that

affect the size of the confidence interval?

Scenario 6: Many similar negative items will result in a small confidence interval.

We will demonstrate the above examples using an EXCEL template.

Scenario# oferrors

StandardDeviation

ConfidenceInterval

ProjectedMeasure

1 1 error 1 10.00 122.00% 1,200.002 10 similar errors 10 30.15 36.60% 12,000.003 Many dissimilar errors 10 1,006.29 94.69% 154,920.00

42 positive & 2 negativeerrors 4 25.12 610.00% 600.00

5 4 positive errors (from #4) 4 24.72 66.89 5,400.00

6 10 similar negative errors 10 30.15 36.60% 12,000.00 You have to consider both the confidence interval and the confidence level at the same time to determine whether your sample is acceptable or not.

c. Variability in the population

(1) The more homogeneous the population is, the smaller the sample size needed. Conversely, more diverse populations will require larger samples or stratification.

(2) Example: A population consisting of individual sales of shrink-wrapped software is more homogenous than a population of all paid invoices for a manufacturing company.

(3) Impact of Sample Variability on the Confidence Interval

a. Homogenous populationsSlide

Given a homogenous population, if you were to select and plot all possible sample results, the curve will be narrow because the values will be close in size. The interval necessary to reach an 80% confidence level of is smaller because the curve is narrow.

b. Less homogeneous populations

In less homogenous (diverse) populations, the curve resulting from arraying or plotting all possible sample results will be flat. Because the possible results are more spread out, the interval necessary to include 80% of the sample results will be larger. Slide:

80%

Minus interval Plus interval

4. Impact on the Confidence Level on the Confidence IntervalWhat if we are willing to settle for have a 50% confidence level?Slide:

The lower confidence level means we can narrow the interval. We can get 50% of possible answers with the + / - confidence intervals closer together. If you raise the confidence level, then the interval will become larger.

2. Determining number of sample units

There are formulas that can be used statistically to determine the optimal sample size, but they require an estimate of the sampling error to complete the calculation. Generally, you do not know the sampling error until after the sample has been completed.

You may use the percentage of error from a prior audit provided that the population and the error rate have not changed significantly since the last audit period. For example, the State of California may allow the use of a percentage of error from a prior audit in sales tests or paid bills tests if the taxpayer concurs.

80%

Minus interval Plus interval

50% 50%

Auditor’s and/or taxpayer’s judgment is the most common method employed in selecting the number of sample units in statistical samples. Many states have policies that address minimum and maximum sample sizes.

The following guidelines may be helpful in determining sample size:

a. generally not less than 300 invoices or units, though some statesemploy the use of multiple strata with only 100 units per strata

b. generally not more than 2000 invoices or units

c. small samples of 30 or less are easily biased and are not recommended.

3. Example of use of judgment in sample selection

Suppose the auditor has decided to audit your company’s sales, of which 30% are taxed transactions and 70% are reported as exempt. Your firm has 98% of the exemption documents on file. You believe that you can secure another 1% of the exemption documents during the audit, but that the remaining 1% of the claimed exemptions may be found taxable. The auditor wants to sample 1000 invoices out of a population of 250,000 invoices. The sales population is very homogeneous.

The sample will likely consist of:

300 taxed invoices

686 exempt transactions for which the exemption documents are on hand

14 exempt transactions lacking exemption documents (2% * 700)

Of the 14 unsupported transactions, you feel that you can secure about 7 more exemption certificates. The other 7 invoices may end up being taxed in the audit. The question to ask yourself is: Will you be comfortable having the results of this sample projected against the population for the audit period?

How certain are you that the error noted in the sample will fairly represent the total error in the population?

G. Exhibit 6: Statistical Sampling Example: Sales Test – No Stratification

Suppose you have just been hired as the new tax manager or tax consultant for Mega Computer Corporation. You find out from the VP of Taxes that a state recently completed auditing Mega, leaving behind the worksheet shown in Exhibit 6, Page 1.

Your new VP of Taxes is anxious to have the audit completed and believes that the amount shown at the bottom of Page 1 is the total measure of tax due for the audit. He tells you: “I have enough reserves to easily cover the tax and interest on the taxable measure of $292,842. Then he adds, “I’m inclined to accept this auditor’s findings and move on.”

What do you think?

What additional information would you request to aid in your review and analysisof the auditor’s findings and questions?

H. Ratio Estimation

Ratio estimation is the most common projection method used in many sales tax audits.

Given these definitions:

d$ = dollar amount of errors in sample

n$ = dollar amount of sample units

N$ = dollar amount of the population

1. Calculating percentage of error

A percentage of error is calculated by dividing the dollar amount of the sample errors by the sample size in dollars.

Percentage of error = d$ / n$

2. Projection of percentage of error to population

The percentage of error determined from the sample is multiplied by the total dollar amount of the population.

Projection = Population (N$) * Percentage of error

3. Example of ratio estimation

Example Sample errors = $55,000 Sample size = $1,000,000 Population size = $200,000,000

% of error = $55,000 / $1,000,000 = 5.5%

Projected taxable measure in population = $200,000,000 * .055 = $11,000,000

I. Difference Estimation

In difference estimation, the average error of the sample units is multiplied by the total number of population units to determine the total errors.

This type of projection method is most commonly used when the dollar amount of the error is nearly the same for each invoice, irrespective of the total amount of dollars on each invoice. For example, if you did not charge tax on freight charges or shipping and handling charges, then difference estimation might provide a more accurate projection than ratio estimation.

Given these definitions:

d$ = dollar amount of errors in sample

n = number of units in the sample

N = number of units in the population

1. Calculating average error per sample unit

The average error per sample unit is calculated by dividing the dollar amount of the sample errors by the number of sample items.

Average error per sample unit = d$ / n (# of units in the sample)

2. Projection of taxable measure using difference estimation

The average error per sample unit is multiplied by the total number of units in the population to derive the projected measure of tax.


The auditor wants to multiply the amount of the $17 error on invoice N39948-49 times the number of similar invoices we wrote during the audit period. Is this really statistical sampling or just some cheap short cut?

Projection = Average error per sample unit * N (Units in Population)

3. Example of difference estimation

Example Sample errors = $20,000 (all errors are delivery charges) Number of sample items = 1,000 invoices Average error / invoice = $20 per invoice N of invoices in population = 30,000 invoices Projected error in population = $20/invoice * 30,000 invoices = $600,000

Slide 27


I still don’t believe statistical sampling really works. Let’s go over it one more time --advantages, disadvantages, accuracy, etc.

J. Advantages to use of statistical samples

1. Less prone to bias than block sample.

2. Can often use smaller sample size than block, saving time and money.

3. Multiple samples may be combined and evaluated.

4. Can be evaluated quantitatively.

5. Sample results are objective and defensible if sample is drawn properly.

6. Method provides for advance estimation of sample size.

7. Method provides an estimate of the sampling error.

K. Disadvantages to use statistical samples:

1. More effort is needed to calculate the sample size (unless the sample has beengenerated by computer).

2. Missing items are easier to detect when using a statistical sample because theauditor is generally checking all sample units off a controlled list.

3. Selection throughout audit period means more "older" records may beexamined as compared with a block sample.

4. Common problems when auditing "older" records:

a. Older records may be harder to find or may be incomplete

b. Employees may have left company or forgotten data

c. Data from customers or vendors is harder to get

d. May be harder to get electronically stored data for earlier periods

Exhibit 7: Statistical Sampling Example: Sales Test with Stratification

Compare Exhibit 6 and Exhibit 7. Note that stratification of the population in this instance provides for a more accurate and substantially cheaper result. Why?

VII. ANALYZING SAMPLE RESULTS

The following recommendations for analyzing sample results can generally be applied to both block and statistical samples, though Section D on confidence intervals will apply only to statistical samples.

A. Compare the average unit in the sample to the average in the population

Average sample unit = n$ / n (units)

Average population unit = N$ / N (units)

1. Significant difference means the sample is not representative

2. Consider possibility of stratification if one large item is skewing results

For example, the Texas sampling guidelines state: http://www.cpa.state.tx.us/taxinfo/audit/sampling/sampling.pdf, P 14

Compare the average dollar value of all sample units to the average dollar value of the same type of units in the population. Large differences in this comparison may indicate that the sample is not proportional to the population or that the sample units were selected from a sub-population rather than the population that generated the summary amounts. If the variation percentage is over 15 percent, the auditor should analyze both the population and sample to identify and verify the reason for the difference.

B. Compare range of values of all sample units to range of values in population

Slide 28


Okay, the auditor wants to use 2 errors to project an assessment. That doesn’t seem fair. Whaddya think? Am I crazy or is the auditor out to lunch?

C. Review of taxable errors in sample 1. Examine characteristics of sample errors a. range of errors (time, size, by person, etc.) b. dollar amount (size) (stratification) c. number of errors (minimum #) (1) minimum number of errors to project (2) consider stratification if one or two unusually large errors d. type of transactions, products, or services e. type of customers f. organizations, divisions, or product lines 2. Ensure that scheduled errors are part of the sample 3. Verify that scheduled “errors” are actually taxable

5. Consider the “multiplication factor” of each error in a sample

Which error is more important to investigate and resolve? o 1. $ 3,000.00 o 2. $12,000.00 o 3. $50,000.00 o 4. $90,000.00

Slide 29

HOW MUCH IS IT?

• 1. $ 3,000.00• 2. $12,000.00• 3. $50,000.00• 4. $90,000.00

It depends on the multiplication factor for each stratum. Slide 30

Slide 31

CALCULATING MULTIPLICATION FACTOR

• STRATUM SIZE $1,000,000• SAMPLE SIZE $10,000

• MULTIPLICATION FACTOR 100(Stratum Size/Sample Size)

• FOR EACH $5 OF ERROR THEREIS A PROJECTED ERROR OF $500

4. Are the errors your liability or that of the seller?

In seller privilege states, vendors are responsible for sales taxes. In these states, tax auditors should not attempt to collect sales taxes against a taxpayer in a test of accounts payable invoices unless the taxpayer has issued a resale or other valid exemption certificate.

5. Verify whether another party has already paid your liability!

Has the liability already been cleared?

a. by your customers who may have accrued and paid the tax: (1) directly to the state on a sales or use tax return (2) to the state as a result of an audit

(3) to you by adding it to their payment to your firm even if you did not bill the tax on the original sale.

b. by your vendors who may have:

(1) paid the tax on a return even though they did not bill you for the tax.

One example of a common situation in which a vendor may remit more tax to the state than he billed occurs when the vendor's billing software has not been updated for tax rate changes, but the vendor remits the tax at the correct rate when filing the return.

(2) been assessed the tax in an audit.


My vendor is being audited by my state. I just received a letter fromhim asking for tax on a three-year old transaction. Who’s on the hook?

6. Eliminate items that are inappropriate to project a. unusual, rare, and/or non-recurring transactions (1) sale of obsolete inventory (2) sale of assets from closed division

b. change in law makes projection unfair and unrepresentative

If a law change occurs during an audit period, you may select two different samples, one from before the law change, and one from after the law change. Alternatively, you can make adjustments in a single sample bridging the entire audit period to reflect a pre- and post law change percentage of error.

Slide 33

Slide 34


Isn’t a sample audit a two-edged sword?Doesn’t the state have to project

overpayments as well as underpayments?

Pennsylvania Supreme Court"The purpose of an audit is not to collect more tax -- it is to ascertain the amount of tax that the taxpayer should have paid and to require the taxpayer to correct its payment. It would be unfair to allow the Department to assess a deficiency for underpaid transactions but not allow the taxpayer to point to overpaid transactions, also covered by the same audit, to reduce the deficiency.“McNeil-PPC, Inc.v. Commonwealth of Pennsylvania, J-53-2003, No 99 MAP 2002

7. Review for credit errors which should be included in the sample

Important: Negotiate early in the audit to ensure that credit errors in the sample will be offset against the debit errors in the sample. Auditors may attempt to stratify credit errors out of the sample. Some may ask you to substantiate any credit errors on an actual basis. As mentioned earlier, be sure to document before the sample is drawn how credit errors will be handled in your audit plan or agreement.

Examples of credit errors in an accounts payable test include:

a. Tax-paid purchases resold credits not previously claimed, i.e., chemicals and shipping supplies.

b. Tax accrued and paid in error to state on purchases of nontaxable goods or services

c. In some states, taxes paid to vendors in error on nontaxable goods and services. Some states will allow vendors to assign the credit to the purchaser.

Slide 35


The auditor can’t find a document in the sample Why should that be an error?

8. Missing sample items - work out this issue in advance!

It is also important to negotiate what will be done with missing sample items early in the audit. Missing items should not be considered 100% taxable, though some auditors may make this argument. The error rate in the sample is supposed to approximate the error rate in the population. The missing items in the sample and in the population should have the same error rate as determined by the sample items for which the supporting documents were found.

a. Will every missing item be treated as an error?

b. One solution is to secure a copy of any missing items from your vendor or customer.

c. Another solution is to determine the probable taxability of any missing sample items using account and requester information, or similar invoices from the same vendor or customer. d. A third possible solution may be to verify data fields on the missing documents by using archived IS data tapes.

9. Voided Sample Items - work out this issue in advance!

a. Will the voided items be included in the test even though they will not be scheduled as errors?

b. If voided items are to be excluded from the sample, be sure you work out with the auditor a methodology for drawing a replacement item, if one is desired or needed.

10. Invoices for Tax Only - another issue to resolve in advance!

a. “Tax only” invoices in sales tests or paid bills tests should not be counted as errors.

b. If the sample item is taxable, and you have later corrected the error by billing your customer for the tax during the audit period, then the sample item should not be projected as an error.

11. Partial payments - Yet another issue to resolve in the planning stages!

a. It is important to define precisely the sample unit. If the sampling unit is the amount billed on the invoice, then the partial payment amount billed will constitute the sample item.

b. If partial payments are not considered test items, but final payments are, then the full purchase price would become the projected error when the final payment is made.

12. Bad Debts

a. If a sample unit in a sales test later results in a bad debt, some states will delete this item from the sample or count it as a “zero” error.

b. Some states consider bad debts as a distinct and separate test. In these states, the original sale on which a bad debt later resulted would count as an error in the sales test. A separate test or exam would be done for the bad debts.

13. Reversing and Correcting Transactions

As part of the audit plan, determine before the audit starts how you will handle credit memos, credit invoices and debit memos in the sample. For example, the State of California Audit Manual Chapter 13, Section 1305.25(f) was revised in 2002 to clarify various acceptable methods in California for dealing with these types of entries.

14. Tax Corrections Before and After Sample Selection

If errors are noted by the taxpayer and then corrected voluntarily either during the audit period or prior to a sample being drawn by the auditors, then these corrections should be taken into account by the auditor and any error found in the sample that is later properly corrected should be reduced to zero in the sample. The sample item should be considered zero even if the correction is done outside of the audit period provided it was corrected before the sample is drawn. However, if the errors are corrected by the taxpayer once the sample has been drawn, the items in the sample should remain as errors.

D. Review the confidence interval (range of values)

Slide 36

The confidence interval: 1. Provides the range of values between which the true mean of the population falls at a given level of confidence.

2. Measures the variability of the errors disclosed in the sample. 3. Also measures the variability of all the units in the sample.

4. The smaller the confidence interval, the sample more closely resembles the population.

States vary in their philosophy of how to project sample results. Some states will assess the mean value in sales and use tax audits, while others may chose to project the sample results using the lower or upper bound of the confidence interval.

Slide 37

5. Large confidence intervals a. May indicate that the sample is not representative b. May be acceptable if the sample contains: (1) Numerous negative and positive errors (2) Errors that range widely in size ($) 6. When confidence interval is too large, the auditor may: a. Accept the sample results by justifying the wide confidence interval

STATISTICAL AND BLOCKSAMPLING

I am not nearly as “confident” as the auditor that the projected assessment is correct? Who wins the day?

b. Stratify the population into substrata c. Expand the sample

d. Disregard the sample and decide to accept the reported amounts as correct

7. Review again Exhibit 5 to see various confidence intervals calculated on different sample results. Remember that to be informed; you must know both the confidence interval and the confidence level. They are directly related so if the confidence level is raised the confidence interval becomes larger.

E. Analyze the projected liability 1. Compare to the expected liability based on: a. Prior audit experiences b. Pre-audit preparation and reviews of the records c. Your knowledge of transactions in this audit period Slide 38

2. Consider alternative projection methods to % of error:

a. Projection based on number of units (tax due per unit), i.e., differences estimation

(1) Freight, handling, & other recurring errors (2) Set up or other service charges

STATISTICAL AND BLOCKSAMPLING

Isn’t there some other way to calculate the audit liability?

b. Projection based on selected GL accounts, i.e., use of stratification to narrow the population being tested.

F. Check with other resources Issues that you are facing in your audit’s samples may have occurred in other companies’ audits. Not all auditors approach sampling the same way. It is appropriate to find out if other solutions are available to reduce your projected audit liability.

1. Network with other tax professionals 2. Consider whether a consultant or specialist is needed

GLOSSARY Absolute value: indicates size but not direction from zero (positive or negative).3 Block sampling: sample taken from a specifically defined population (e.g., records of a

particular date range). Confidence interval: a confidence interval gives an estimated range of values which is

likely to include an unknown population parameter, the estimated range being calculated from a given set of sample data.1

Confidence interval describes the limits of accuracy of an inference. This precision interval is a statistical measure of the inability to predict the true population error because the test is based on a sample, rather than a census. 6

Confidence level: an inference from a sample that tells us the proportion of times a statement is likely to be true. 6

Difference estimation: the point estimate of the difference is equal to the average of the differences multiplied by the number of items in the population, and the point estimate of the actual total amount is the taxpayer’s recorded amount plus the point estimate of the difference. The average difference may be either positive or negative.6

Element (or unit): a single person, object, event, or observation within the population.3

Frequency distribution: a table showing the equivalence classes and the frequency of occurrence of their elements.3

Homogenous: composed of elements which are similar with low variability (homogeneity of variance; opposite of heterogeneous).2

Inference: inferring the properties of one or more populations from an inspection of samples drawn from the populations. 3

Mean: the sum of scores divided by the number of scores. 3 Population (universe): the collection of all people, objects, events, or observations having

one or more specified characteristics. 3 Random sampling: the method of drawing samples from a population such that every

possible sample of a particular size has an equal chance of being selected. The resulting samples are random samples. 3

Range The range of a set of n measurements Y1, Y2, Y3, … Yn is defined to be the difference between the largest and smallest measurement.5

Ratio estimation: the point estimate is calculated by multiplying the taxpayer’s total value by the ratio of the aggregate audited value of sample items to their aggregate book values.6

Sample: a proper subset of a population. 3 Stratification: to separate the population elements into non-overlapping groups,

called strata, and then selecting a simple random sample from each stratum. 5

1. Easton, Valerie J. & McColl, John H. (1997). Statistics Glossary. v1.1. http://www.stats.gla.ac.uk/steps/glossary/

2. Huck, S. W., & Cormier, W. H. (1996). Reading Statistics and Research. (2nd ed.) New York:

HarperCollins Publishers Inc.

3. Kirk, R. E. (1990). Statistics: An Introduction. (3rd ed.) Fort Worth: Holt, Rinehart, and Winston, Inc.

4. Mendenhall, William (1975). Introduction to Probability and Statistics. (4th ed.) Belmont, CA:

Wadsworth Publishing Company, Inc. 5. Scheaffer, R. L., Mendenhall, III, W., & Ott, R. L. (1996). Elementary Survey Sampling. (5th

ed.) Belmont, CA: Wadsworth Publishing Company.

6. State Board of Equalization Field Audit Manual, Ch. 13, Glossary of Statistical Terms & Exhibit 2, Statistical Sampling Audit Program, (2002). http://www.boe.ca.gov/pdf/fam-13.pdf

Exhibits

1. Texas Form: Notification of Sampling Procedures for State Tax Audit http://www.cpa.state.tx.us/taxinfo/audit/sampling/sampling.pdf

2. California Audit Sampling Plan & Form BOE-472 (Revised Feb 2012), BOE Field Audit Manual, Chapter 13, Exhibit 1 http://www.boe.ca.gov/sutax/staxmanuals.htm

3. Block Sampling Example – Purchases Test 4. Class Exercise: Illustration of Frequency Distribution 5. Impact of sampling errors on the confidence interval 6. Statistical Sampling Example – Sales Test with No Stratification 7. Statistical Sampling Example – Sales Test with Stratification 8. California Statistical Sampling Audit Program, BOE Field Audit Manual, Chapter 13,

Exhibit 2 (Revised August 2011) http://www.boe.ca.gov/sutax/staxmanuals.htm


Sales Tax School II

BREAKOUT SESSION

2 Problems

Block & Statistical Sampling

IPT, Sales Tax School II Breakout Session

1

STATISTICAL & BLOCK SAMPLING

PROBLEM 1 – SAMPLE PROJECTIONS & AUDIT ANALYSIS

The auditor has completed the audit of your company. He has provided you with copies of some of his work papers, requesting your reply by the end of the week as to whether you concur with his audit findings. Your company is located in a state that has a broadly written manufacturing exemption that includes exemptions for manufacturing equipment, parts, and supplies. Your state does not exempt purchases consumed in research and development. Section 1. Fixed Assets Purchases over $100,000 The auditor has stratified fixed assets over $100,000 from the AP exam and sampled them in this separate sample. Here are the scheduled items in the sample. Assume no exemption or resale certificates were provided. Taxable Errors in Sample of Fixed Asset Purchases over $100,000 Item Description Taxable Measure 1 Invoice from ABC Contracting for installation of a new

elevator in the main corporate HQ office charged to the facilities cost center (no tax is shown on the invoice)

$150,000

2 Scanning electronic microscope purchased from out-of-state – cost center charged is used exclusively for R&D purposes

$1,000,000

3 Special-use furnace used in the manufacturing process that was purchased from an out-of-country vendor

$500,000

4 Computer-aided manufacturing software used in the manufacturing process

$250,000

Total Taxable Sample Items (errors / differences) $1,900,000 Questions on Section 1:

A. Which items on the above test schedule would you dispute and why?

B. If you are disputing items in the sample:

1. What do you believe the true measure of taxable items in the sample to be?

2. How many taxable sample items do you think there are?

3. Should the sample result be projected? Why or why not?

Breakout Session IPT, Sales Tax School II

2

Section 2. AP Test All other AP items were examined in a single sample using a statistical sampling approach. The auditor has provided you a copy of his statistical sampling worksheet. Assume the numerical calculations are correct. You do not need to recalculate any of the numbers shown. Assume the population and the sample amounts shown are correct.

Units Dollars Average

N Population (Universe) Size N = 691,011 N$ = 1,584,301,526 2,293

n Sample Size n = 7,005 n$ = 15,976,595 2,281

�d Differences (Errors) d = 122 �d = 152,833

�d2 Sum of Differences Squared �d2 = 2,213,438,015

Mean of Differences = �d (in $) $21.82

xd

n (units)

[S]

Standard Deviation = n(�d2) - (�d)2

561.74

n(n-1)

[Sx]

Standard Error = [S] * N - n

+ $6.68

n N - 1

[I] Interval @ 80% Confidence Level = [Sx] * Z + $8.55

where Z = 1.28 @ 80% CL

Interval as a % of the Mean Difference = . (interval divided by the mean)

I xd�� + 39.18%

Percentage of Error = �d / n$ * 100% 0.96%

Measure of Tax [Projection] = % of Error * N$ $15,155,517


3

Questions on Section 2:

A. Is the average sample size approximately the same as the average population size? Why or why not?

B. The interval as a percentage of the mean difference (at an 80% confidence level) is +

39.18%. Based on the general session on sampling, would an interval of + 39.18% be considered acceptable by most states?

C. How would you research to find out whether your state will accept this interval?

D. Are there enough taxable errors (differences) resulting in this sample to project the results? Explain your answer.

E. What is the projected measure of tax, and do you agree with the results? Why or why not?

F. What is the lower bound of the confidence interval for this sample?

G. What is the upper bound of the confidence interval for this sample?

H. Would your answer to Question E change if this projection was for a refund of taxes as opposed to additional tax liability in an audit? Why or why not?


4

Section 3. Block Test of Sales

The auditor conducted a block test of your company’s sales using a randomly selected month within the audit period. You and the auditor agreed to the block test, as well as the test month selected. Sales from month to month at your firm are fairly standard, i.e., there are not any seasonal fluctuations. The auditor has given you this worksheet: Line# Taxable Measure 1 Sample errors in the block sample $100,0002 Total sample size $10,000,0003 Percentage of error 10%4 Total sales in the population for the audit period $390,000,0005 Projected taxable measure for sales sample: $39,000,000

Questions on Section 3: A. Is the calculation correct? If not, what is the correct projected measure of tax?

B. You have done further investigation on this sample and have reduced the amount of

sample errors in this block sample to $30,000. Calculate the revised measure of tax for the population.

C. Can you statistically evaluate a block sample’s results?


5

Section 4. Confidence Interval Calculation

A statistical sample was also conducted on service sales transactions. The audit liability disclosed was $300,000 (mean or point estimate). The statistical analysis reveals that the interval as a percentage of the mean difference is plus or minus 10%. The confidence level used by the state is 80%, which is the confidence level used in a number of states. For each statement, indicate true or false. A. The lower limit of the confidence interval is: $270,000.

B. The upper limit of the confidence interval is: $330,000.

C. Given the 80% confidence level, the range of values in the confidence interval is

from $270,000 to $330,000.

D. The correct audit liability must lie between $270,000 and $330,000.

E. An 80% confidence level is not high enough.

F. There is only a 5% chance that the true audit liability is more than $330,000.

G. There is a 10% chance that the true audit liability is less than $270,000.


6

STATISTICAL & BLOCK SAMPLING PROBLEM 2 – AUDIT PLANNING

Jurisdictions that perform periodic sales and use tax audits for their taxpayers often send auditors into the field who are less than well trained in the taxpayer’s business. As a representative for your company, it is incumbent on you to learn everything there is to know about your business (industry) to give you a very valuable advantage over your auditor. Select one of the four industries listed below and devise an audit plan for the sales section of the audit. Be sure to specify whether the various aspects of the business should be audited using block or statistical sampling, actual examination or some other audit technique. Consider these questions in developing your audit plan:

How would you stratify the universe of all types of sales of a large company in your selected industry?

What types of stratification of the sales data might make sense?

What specific exemptions, industry specific issues, or fact patterns do you need to

consider in devising your audit plan for the sales test?

Industries Considerations

Retail (e.g., either a major discount chain or a major department store)

Sales departments may include: household items, pharmacy, film development, restaurant, hot take-out food, groceries, clothing, high-end consumer items, jewelry, optical sales, services (auto repair), floral sales, etc. Some departments may be leased out. Delivery and installation charges.

Heavy Manufacturing (e.g., large truck, tractor or car manufacturer)

Types of sales may include retail direct, sales for resale to dealers, parts sales to dealers, parts sales direct to consumers Equipment financing, e.g., conditional sales contract Equipment leasing, e.g. true lease contacts Delivery & extended warranty charges


7

Hospitality (e.g., large hotel chain)

Sales include: room charges, telephone charges, movie charges, dry cleaning services, retail restaurant sales, bar sales, banquet, & catering services, gift shop sales, etc.

High tech Manufacturing & Sales (e.g., large vertically integrated computer manufacturer)

Sales include computers, printers and network products sold on a retail, online and resale basis, repair and warranty service sales, sales of software, installation, consulting services, sale of used demo equipment, free samples given to selected potential customers, and sales to international subsidiaries of products and equipment


8

NOTES

1

CMI – Sales Tax Candidate Orientation and Examination

Overview & Guidelines

This session is meant to give an overview of the requirements for earning the CMI designation and provide suggestions for study. It is not meant to be a teaching aid or a stand-alone study guide. It is suggested that you do not attempt the CMI Exam without further instruction and significant study and preparation.

I. Objectives of IPT A. Improve professional standards. B. Recognize individuals with a thorough knowledge of the principles and practices of sales

and use taxation. C. Support continuing education and professional development. D. Cooperate with government bodies to improve state and local tax administration. E. Establish and promote high standards of competence and efficiency in tax management. F. Review and disseminate information on existing and proposed state and local tax

legislation, regulation and administrative action. G. Inform the general public on matters related to state and local taxation and public finance. H. Promote the study of state and local taxation by encouraging research and conducting

conferences and symposiums.

II. Requirements for CMI DesignationA. MembershipB. ExperienceC. EducationD. ExaminationsE. Recommendation from Committee to BoardF. Board Approval and Conferral

III. Membership

Membership in the Institute shall be available to any employee of a business whose duties include managing or administering the state or local tax obligations of the business or providing tax-related services to other businesses. Any sales tax member of the Institute in good standing is eligible to become a candidate for the CMI professional designation.

A. Membership Types 1. Regular members2. Affiliate members3. Associate members4. Honorary members5. Retired members6. Academic members

2

IV. ExperienceA. A minimum of 5 years varied sales tax experience is required to take the CMI

examinations.

V. Education A. Mandatory IPT Program Requirement

1. Successful completion or challenge of Sales Tax School II. (Successful completionor challenge of Sales Tax School I is a prerequisite to attending or challenging SalesTax School II.)

2. Successful completion of an additional IPT sales tax program of at least 12 CE hoursin length. (If School I is attended, it can either fulfill this requirement OR be awarded5 education points.)

B. Approved Professional Education - must earn 25 Education Points from the following: 1. Bachelor’s Degree (Maximum of 10 Points)

a. 10 Points for a Bachelor’s degreeb. In lieu of degree:

(i) 2 Points per year for a maximum of 6 points(ii) 1 Point per year of full-time sales tax experience beyond the minimum 5 year

requirement. 2. Advanced Degrees (Maximum of 5 Points)

a. Examples: MA, MS, MBA, LLB, JD3. Professional Designations (Maximum of 5 Points)

a. Examples: CMI, CPA, Esq.4. Sales Tax Related Courses

a. IPT Courses(i) Sales Tax Symposium or Academy = 5 Points(ii) Sales Tax School I (if not used to meet IPT program requirement) = 5 Points(iii)Annual Conference = 5 Points(iv) Sales Tax Seminar = 2 Points

5. Approved Sales Tax Related Coursesa. Maximum of 5 Points per course with a written exam.b. Maximum of 3 Points per course without a written exam.c. A minimum of 6 instructional hours is required per point.d. Examples of Other Courses:

(i) Sales and use tax, gross receipts tax, excise tax, accounting, auditing,statistics, or tax research courses administered by recognized professional and education organizations and approved by the CMI-Sales Tax Committee.

(ii) Sales and use tax related courses, seminars, symposia, or conferences.

3

Courses submitted for consideration must include a descriptive program and a certificate of completion. Courses will not be approved without supporting documentation.

VI. Application DeadlinesA. Applications must be received in the IPT office 90 days prior to the examination date.B. Verification of final requirements met must be received in the IPT office 45 days prior to

the examination date. C. Intention to sit for exam must be received in the IPT office 30 days prior to the

examination date.

VII. Overview of Application ProcessA. Submit Application B. Application is reviewed by IPT Staff & CMI Committee C. Applicant notified of candidacy

1. Includes information on accessing study materialD. Applicant notified of eligibility

1. Met requirements – eligible to sit at next exam.2. Lacking requirements– ineligible to sit without further verification of requirements.

E. Eligible candidates will receive an email 6 – 8 weeks prior to each exam with the exam details.

F. Examinees are notified of the exam results in writing. 1. You may request a review of your exam with a committee member within 60 days ofthe exam. 2. New CMIs will receive a lapel pin and certificate via mail within 3 weeks of theexam.

G. Please Note: 1. Applicants have six consecutive testing opportunities from the date of application(not eligibility) to meet the requirements in effect for certification. 2. Applicants must notify the IPT office in writing to update their application asrequirements are met.

4

VIII. CMI Applicant Evaluation

CMI –Sales Tax Candidate Orientation and Examination Overview & Guidelines

CMI Applicant Evaluation1. Education

(a) Sales Tax School II Year ______ Passed _______ Challenged _______(b) Sales Tax School I or IPT Sales Tax Program

Year ______ Passed _______ Challenged _______

(c) Other approved professional education (Min. 25 points required) Points

(1) ____yrs. College (max. 10)Degree - Major & Type__________________________________________ _______

(2) Advanced degree ______________________________ (Max. 5 points) _______

(3) Professional Designation _____________ (Max. 5 points) _______

(4) Approved Sales tax related courses: (Max. 5 points per course)

Course Organization Year_________________________________________________________ ________________________________________________________________ _______

TOTAL POINTS: _______

IX. Sample CMI Applicant Evaluation

CMI –Sales Tax Candidate Orientation and Examination Overview & Guidelines

Sample CMI Applicant Evaluation1. Education

(a) Sales Tax School II Year _2008_Passed _______ Challenged ___X___(b) Sales Tax School I or IPT Sales Tax Program

Year _2007 Passed ____X___ Challenged ______

(c) Other approved professional education (Min. 25 points required) Points

(1) ____yrs. College (max. 10)Degree - Major & Type__ BS_- Acct _____________________________ ___10__

(2) Advanced degree ______________________________ (Max. 5 points) _______

(3) Professional Designation _____________ (Max. 5 points) _______

(4) Approved Sales tax related courses: (Max. 5 points per course)

Course Organization YearTax Association Seminar____ PWC__________________________2004__ ___3___Cost Basic School_________ _COST_________________________ 2005__ ___5___Cost Advanced School_______COST_________________________2005__ ___5___ Sales Tax Seminar____ ______IPT___________________________2004__ ___2___

TOTAL POINTS: ___25____

5

X. Study Material A. Available only to candidates - Includes chapters, breakout problems, breakout solutions

from each IPT Sales Tax School as well as the CMI-S orientation guide. B. To maintain the integrity of IPT’s educational programming, do not copy or distribute

these materials in any way.

XI. ExaminationsA. Written - will establish the experience and overall knowledge of the candidateB. Oral - will test the candidate’s overall knowledge of sales and use taxation,

professionalism, ethical requirements and IPT’s purpose/vision.

XII. Affirmation for Exam

CMI SALES TAX PROFESSIONAL DESIGNATION EXAMINATION CERTIFICATION

CANDIDATE'S NAME IMA SAMPLE CANDIDATE'S EXAM NO. 1234 CANDIDATES’S COMPANY OF RECORD: IMA COMPANY

Upon completing this form in conjunction with the CMI Sales Tax Professional Designation Exam, I hereby testify and affirm the following:

• The “Candidate Exam Number” listed above is the same as that listed on the front ofmy exam booklet.

• I am currently employed by the company listed above.• During the course of the examination, I will not communicate about the examination

nor solicit or utilize any unauthorized aid or assistance.• I will subscribe to the high ethical professional standards required by members of the

Institute for Professionals in Taxation.• I will not transcribe any part of this examination nor carry away with me any notes,

worksheets or comments that I might make. All written comments and assumptionswill be marked in the examination book and any work-papers will be surrendered tothe committee when I turn-in my exam.

• I will not consult any unauthorized written materials, digital media, or referencematerials during the course of this examination.

• I will not attempt to destroy the security of this examination by discussing orrelaying specific questions or answers to those whom I know have not previouslypassed this examination.

• I have a cumulative total of at least five years of full-time Sales Tax experience asdescribed in the CMI-Sales Tax candidacy application.

Signature Date_________

Grade_________

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XIII. Written ExaminationA. Generally, the exam includes:

1. True/False questions2. Multiple Choice questions3. Written Response/Short Answer questions4. Significant Court Cases5. Problem Solving

B. Written Examination Grading 1. Passing grade - 70% or higher2. Examinations are identified by a number, not by name, to ensure anonymity.3. All exams are graded by the Committee.4. To ensure objectivity, all exams below 10 points of 70% are re-graded by the

committee.5. Show all work on exam and state all assumptions to maximize scores.

XIV. Oral ExaminationA. Pass/Fail grading. B. Examination is given by two committee members. C. Exam primarily covers professional ethics and the candidates’ management/planning,

presentation and analytical skills. (refer to “About Us” section on www.ipt.org) D. A standardized set of questions is used by each exam team. E. Failing the ethics portion of the exam results in failure of the oral exam.

XV. Results and NotificationA. Written and oral exams are independent exams. B. CMI Candidates are notified in writing of their exam results.

1. Email: 1 week following exam2. Mail: 2-3 weeks following exam

XVI. Accessing Study MaterialA. To access the study material

1. Visit www.ipt.org2. Sign in, click on your name in the top right corner3. Scroll down to the “Professional Information” section.4. Click on the link for study materials.

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XVII. Contents of Exam

The topics and sample questions in these guidelines are representative of the knowledge tested on the exam and are meant to clarify the content. The following topics and review questions are not intended to limit the subject matter or be all-inclusive of what might be covered in the exam.

A. Institute for Professionals in Taxation 1. Objectives2. Code of Ethics

a. The Institute for Professionals in Taxation has established a CODE OF ETHICSto set forth ethical and professional guidelines for all IPT members.

b. IPT’s CODE OF ETHICS has been revised effective January 1, 2009. Pleaseverify you have the latest version to study.

3. ProfessionalismB. Sales and Use Taxes

1. Types of taxes possible2. Understand compensating taxes concepts3. Differences between types of taxes and how they apply4. Significance of tax department in making business decisions5. Terms, definitions and concepts related to administration and compliance

C. Constitutional Issues 1. Definition of nexus2. Different types of nexus (affiliated, attributional)3. Identify when does nexus exist4. Instrumentalities of interstate commerce5. Sales and use tax information exchange agreements6. Prospective only application of law7. Other constitutional considerations

D. State Administration of Sales/Use Taxes 1. Typical organizational structure2. Powers to impose and regulate tax laws3. Statutory authority vs. regulations, rules and administrative decisions4. Principles of tax collection5. Other duties possibly performed by tax administrators6. Principles of audit administration

E. Taxpayer Compliance 1. Registration requirements and processes2. Considerations for sales transactions3. Considerations for purchase transactions4. Considerations for transfer transactions5. Bulk sales provisions6. Taxpayer Rights

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F. Exclusions, Exemptions and Exemption Certificates 1. Exclusions2. Exemptions3. Exemption certificates4. Exemption certificate completion requirements5. Transferring assets between corporate entities

G. Tax Return Preparation 1. Measuring tax liability2. Preparing the return3. Penalties and interest4. Secrecy of returns5. Filing responsibilities and liability

H. Local Taxes 1. Origin vs. destination2. Difference among rates3. Differences among tax bases between state and local jurisdictions4. Coding issues5. Home-rule versus state administration

I. Mergers, Acquisitions, Consolidations 1. Bulk sale provisions2. Sale for resale3. Casual, isolated, or occasional sale4. Intangibles

J. Audits, Appeals Procedures and Claims for Refunds 1. Nature of the tax audit2. Authority for auditing of taxpayer’s records3. Managed audits4. Pros and cons of different sampling methods (block, statistical, systematic)5. Records and retention requirements6. Electronic data interchange (EDI) issues7. Auditor’s request for records8. Entrance interview with auditor9. Statute of limitations and waivers of statute10. Control of the audit and the auditor11. The hearing12. Appeals processes13. Claims for refunds

K. Industry - Manufacturing 1. predominant, exclusive, & direct use2. integrated plant theory3. exemptions, pollution control equipment4. industrial/enterprise zone5. ancillary equipment6. testing, storage, packaging, transportation, quality control, R&D, consumables

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L. Industry - Retailing 1. trade-ins, discounts, gifts, premiums, samples2. advertising and advertising supplements3. exemptions4. warranties5. shipping, transportation, handling charges, packaging6. drop shipments7. demonstration/display inventory8. mail order sales

M. Industry - Telecommunications 1. intrastate, interstate, international2. cellular phones & cellular services3. prepaid calling cards4. 900 service5. surcharges

N. Industry - Services 1. true object test2. computer services - software & hardware, installation, training, consulting, data

processing, internet, licensing agreements, service contracts, maintenance.3. construction contracting - types of contracts, types of contractors, agency clause,

consumer vs. retailer, new construction vs. remodeling, improvements to realproperty

4. leasing - operating leases, capital leases, sale-leasebacks, rental taxes5. enumerated services

O. Industry - Miscellaneous 1. hospitality2. health care

P. Special Applications 1. Procurement cards2. Printed materials3. Promotional items, samples and gifts4. Installation and repair charges5. Taxable/non-taxable labor and services6. Environmental taxes and fees

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XVIII. Significant Court Cases (including but not limited to the following):

A. National Bellas Hess v. Illinois Department of Revenue, 386 U.S. 753, 87 S. Ct. 1389, 18 L.Ed.2d 505 (1967)

B. D.H. Holmes v. McNamara, 486 U.S. 24, 108 S. Ct. 1619, 100 L.ED.2d 21 (1988) C. National Geographic Society v. California Board of Equalization, 430 U.S. 551, 97 S. Ct.

1386, 51 L.Ed.2d 631 (1977) D. Scripto, Inc. v. Carson, 362 U.S. 207, 80 S. Ct. 619, 4 L.Ed.2d 660 (1960) E. Complete Auto Transit v. Brady, 430 U.S. 274, 97 S.Ct. 1076, 51 L.Ed.2d 326 (1977) F. Goldberg v. Sweet, 488 U.S. 252, 109 S. Ct. 582, 102 L.Ed.2d 607 (1989) G. Tyler Pipe Industries v. Washington, 483 U.S. 232, 107 S.Ct. 2810, 97 L.Ed.2d 199

(1987) H. Exxon v. Wyoming, 783 P.2d 685 (1989) I. Quill Corporation v. North Dakota, 504 U.S. 298, 112 S.Ct. 1904, 119 L.Ed.2d 91 (1992) J. Associated Industries of Missouri v. Lohman, 511 U.S. 641, 114 S.Ct. 1815, 128 L.Ed.2d

639 (1994) K. South Central Bell v. Barthelemy, et al 643 So2d 1240 (1994) L. Navistar International Transportation Corp. v. California State Board of Equalization,

884 P.2d 108, 35 Cal.Rptr.2d 651 (1994) M. Oklahoma Tax Commission v. Jefferson Lines, Inc. 514 U.S. 175, 115 S.Ct. 1331, 131

L.Ed.2d 261 (1995) N. Itel Containers Int’l Corp v. Huddleston, 507 U.S. 60, 113 S.Ct. 1095, 122 L.Ed.2d 421

(1993) O. Borders Online, LLC V. State Board of Equalization, 129 Cal. App 4th 1179 (May 31,

2005) P. United States v. New Mexico, 102 S. Ct. 1373 (1982) Q. McKesson Corp. v. Division of Alcoholic Beverages, 110 S. Ct. 2238 (1990)

XIX. Selected References to Assist in Studying for Examinations (including but not limited tothe following):

A. IPT SALES AND USE TAXATION 2016 Edited by William F. Fox, Ph.D. (Available for order through IPT Office or via website at http://www.ipt.org)

B. IPT SALES & USE TAX SCHOOL BOOKS, SCHOOL I & II. INSTITUTE FOR PROFESSIONALS IN TAXATION. (Available through attendance at respective annual IPT sales & use tax schools – including glossary)

C. IPT SALES & USE TAX SYMPOSIUM BOOKS. INSTITUTE FOR PROFESSIONALS IN TAXATION. (Available through attendance at annual IPT sales & use symposiums)

D. SALES TAXATION, STATE AND LOCAL STRUCTURE AND ADMINISTRATION. John F. Due and John L. Mikesell. Johns Hopkins University Press. Baltimore and London, 701 W. 40th Street, Suite 275, Baltimore, MD, 21211, PH: 800-537-5487.

E. STATE TAX CASES REPORTER. Commerce Clearing House, Inc. (Available through your local CCH representative)

F. STATE TAX REPORT COMPILATION SECTION. Commerce Clearing House, Inc. (Available through your local CCH representative)

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G. STATE AND LOCAL TAXES WEEKLY. Research Institute of America. (Available through your local RIA representative)

H. SALES & USE TAX REPORT. INSTITUTE FOR PROFESSIONALS IN TAXATION. Published Monthly. (Included in IPT membership)


MERGERS & ACQUISITIONS SALES TAX SCHOOL II THEORY AND PRACTICE FOR THE EXPERIENCED SALES AND USE TAX PROFESSIONAL

Learning Objectives At the end of this section, the learner will be able to:

Identify the scope and records required to complete a due diligence review. Identify the potential consequences of not following bulk sale notification

requirements. Determine the allocation methodologies for a purchase price if a schedule is not

provided in the sale documents. Define and recognize casual, occasional, or isolated sale exemption requirements. Identify actions that could make an otherwise exempt transaction taxable.

IPT, Sales Tax School II Mergers & Acquisitions

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MERGERS AND ACQUISITIONS Slide 1

Slide 2

I. Overview Sales and use taxes are generally imposed on the sale, transfer, storage, consumption or other disposition, or use of tangible personal property, barring certain exclusions and exemptions. Thus, transactions that may be tax-free or tax-deferred for corporate income tax purposes may have sales and use tax implications. When considering the sales and/or use tax implications of a restructuring transaction, it is often more effective to focus on whether there has been an exchange of tangible personal property for consideration, rather than the federal income tax classification of the sale. In some states, however, the federal income tax treatment governs the sales/use tax treatment as well. For example, Arizona Administrative Code R15-5-103 states that “[g]ross receipts from the sale of a business as a going concern are not subject to tax if the sale is for the business as an operating enterprise.” The State of New York has similar language that exempts a statutory

Mergers & Acquisitions IPT, Sales Tax School II

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merger from sales tax. See N.Y. Comp. Codes. R. & Regs. Tit 20, §526.6(de)(1). However, for sales and use tax purposes, New York and other states have strictly construed statutes and regulations related to an exemption that is adverse to taxpayers. Always look for other potential exemptions that may apply to a particular transaction (e.g., manufacturing exemption). In reviewing the potential sales and use pitfalls of a business restructuring transaction, we will focus on the impact on both the purchaser and the seller. The normal focus in these types of transactions is centered on the purchaser, but depending on how the transaction is actually being handled; the seller could have some interesting issues and workflows to address as well. II. DUE DILIGENCE REVIEW Slide 3

A “due diligence” review must be undertaken in order to assess the potential impact of sales and use taxes on corporate transactions. A due diligence review is an examination of the target entity’s operations, including financial books and records, to identify and quantify business risks associated with purchasing the target entity. For tax purposes, the primary objective of the due diligence review is to identify hidden and unhidden tax exposures, quantify the amount of exposure, and assist in how this exposure is addressed. Generally, the chief concern is whether there are hidden tax liabilities that could emerge as “deal breakers”.


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Slide 4

It is the primary purpose in performing a due diligence review to determine whether the seller paid its tax liability as reported and that a reasonable reserve has been established for any contingencies. Depending on the size and complexity of a transaction and the available resources of the buyer, a sales and use tax due diligence review will include, at minimum, an analysis of the returns and recent audits. Also of primary importance is determination of tax exposures. The tax professional should also be looking for refund or planning opportunities which the target company may not have discovered. By gaining this additional understanding, the sales and use tax professional is able to provide valuable information to the team engaged in the purchasing efforts. Slide 5

As stated above, the due diligence review for sales/use taxes will include an examination of various records, as well as interviews with key personnel at the target company. At a minimum, a sales/use tax due diligence review should include the following:


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1. Learn as much about this target business as possible 2. Review and analysis of sales and use tax returns for all open years 3. Exemption documentation 4. Nexus related issues 5. Sales and use tax compliance system 6. Prior and current audits 7. Prior acquisitions and dispositions 8. Copy of the tax calendar 9. Understanding which department(s) is responsible for the tax status of customers and purchases in the ERP system 10. Working with IT

In a deal that is classified as a “carve-out” deal, it could be difficult to determine whether all taxes are up-to-date. A “carve-out” deal involves acquiring a portion of the seller’s business, such as line of business owned by a single entity or multiple entities. Also, these types of acquisitions generally cause additional concern with respect to the sales and use tax compliance process due to the “new company” lack of infrastructure. Slide 6


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In the world of M&A, one area that has been getting more exposure of late is Unclaimed Property (“UP”). Due to the aggressive nature of several states (e.g. Delaware), the exposure for non-filing and underpayment of UP can be substantial. If the transaction is a stock deal, UP filing requirements and outstanding assessments remain with the acquired business. This area of responsibility does not normally reside within a tax department, but during the Due Diligence process, most of the other Due Diligence team members will look to the tax organization to determine potential exposure. When looking at UP obligations, reviewing returns filed and understanding the status of any pending audits or issues raised on completed audits is essential. During the Due Diligence process, if UP exposures are determined to be a significant liability, the company should insist that some type of voluntary disclosure process is undertaken and that any liability is either paid directly by the seller or used to decrease the sales price. Other areas that should not be forgotten include property, employment and payroll taxes. III. SALES AND USE TAX TREATMENT OF SELECT BUSINESS RESTRUCTURING TRANSACTIONS Slide 7

Transfers of tangible personal property for consideration constitute “sale at retail” under the sales tax laws of many states. Accordingly, every transfer of tangible personal property is potentially subject to sales or use tax, unless a specific statutory exemption or exclusion (collectively referred to as “exemptions” herein) precludes taxation of the transaction. These exemptions may include a transfer or sale as a “sale for resale,” an “occasional sale”, a statutory exemption or a reorganization exemption.


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Slide 8

Slide 9

In Texas, “[t]he sale of the entire operating assets of a separate division, branch, or identifiable segment of a business is an occasional sale if, prior to the sale, the income and expenses attributable to the separate division, branch or identifiable segment could be separately established from the books of account or record.” See Tex. Admin. Code 3.316(d)(2). Even for those transactions that are otherwise exempt from sales and use taxes, transfers of registered or titled articles are often taxable. See Tenn. Comp. R. & Regs. 1320-5-1-.09.


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Slides 10

Slide 11

Slide 12


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A. Organization Transactions

1. Overview of Incorporation Transactions

Slide 13

Transfers of property upon the organization of a corporation that are tax-free for federal and state income tax purposes pursuant to Internal Revenue Code (I.R.C.) §351 are often exempt from sales and use taxes by reason of either specific statutory exclusions from the definition of a “sale at retail” or because they are treated as exempt “casual” or “occasional” sales. Although the general rule is to limit the exemption to incorporation transfers made to commencing corporations, some states may provide more liberal exemptions and permit I.R.C. §351-type transfers to pre-existing corporations to qualify for the exemption.

2. Overview of Partnership Organizations

Contributions of property to partnerships as contributions to capital or in exchange for a partnership interest that are free of federal (and generally state) income tax under I.R.C. §721 are exempt from sales and use taxes in most states. Although most states impose no timing requirements on the transfer (i.e., transfers are exempt regardless of whether made by existing or new partners), some states require that transfers be made to commencing partnerships. There are also states that require a transfer of assets to a corporation to occur upon its organization or within a certain time thereafter, but which do not impose the same timing requirements on transfers of assets to partnerships.

3. Nonstock or Other Consideration

a. Corporate Organizations


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The issuance of stock and other property by the new corporation may result in taxable consideration to the extent of the value of the nonstock or other consideration. When liabilities encumbering property contributed to a commencing corporation are assumed by the corporation, taxable consideration may result to the extent of the value of liabilities assumed. This can be the result, even if the liabilities assumed (or deemed assumed) are less than the basis of the encumbered asset transferred (so that there would be no income tax effect under I.R.C. §357(b) or (c)).

b. Partnership Organizations

The assumption of transferor liabilities (or the exchange of other consideration in addition to a partnership interest) also generally subjects transfers of assets to a partnership to sales or use taxes to the extent of the other consideration.

c. Allocating Taxable Consideration to Assets Transferred

Slide 14

If a corporate or partnership organization transfer is subject to sales and use tax (i.e., due to the receipt of other consideration or failure to satisfy timing or other requirements), the ultimate sales and use tax consequences turn on the types of assets that have been transferred and the allocation of consideration among assets transferred. Although the states do not generally provide clear guidance, most states subject only a portion of consideration to sales or use tax as a matter of administrative practice, and that is typically the portion of the consideration related to the transfer of tangible personal property. There is usually a purchase price allocation of the assets pursuant to the purchase agreement done for federal tax purposes, which relates to how the company records the acquisition price pertaining to the assets on its books. In the absence of such an allocation calculation, some states use formulas to calculate the allocable taxable


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consideration. Typically, the amount of taxable consideration is allocated to the assets transferred in proportion to a ratio of taxable assets transferred (e.g., assets for which no sales tax exemption applies) over the total assets transferred.

B. Asset Sales Slide 15

Slide 16


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Slide 17

The sales and use tax treatment of asset sales, whether part of or all of a business, is not always governed by specific statutory exemptions. Thus, the taxability of these transactions often turns on the application of “casual”, “isolated”, or “occasional” sale exemptions. In addition, the sale for resale exemptions, manufacturing machinery and equipment, and other exemptions may also be applicable.

1. Casual, Isolated, or Occasional Sales/Exemption

Slide 18

a. General

Most states do not subject the bulk sale of business assets to sales or use taxes, if the sale is of an occasional, infrequent, or nonrecurring nature outside the regular course of business.


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In the context of corporate transactions, some states require the sale of assets to constitute the sale of the entire operating assets of the business. A series of sales to one or more purchasers may disqualify the sale as an occasional sale. Additionally, some states limit the exemption to sale of property not held or used by the seller in the course of activities for which it is required to hold a seller’s permit. See Md. Code Ann. Tax-Gen §11-209(c)(2). Also, Illinois provides an exemption that isolated or casual sales of tangible personal property at retail does not constitute engaging in a business of selling such property, if the seller does not hold himself out as a retailer of such property. See Ill. Admin. Code 130.110.

b. Limitations

Many states subject the transfer of registered or titled vehicles, watercraft, or aircraft to sales and use tax, even if they are part of the casual bulk sale.

2. Sale for Resale Exemption

Sales or transfers of inventory will not typically qualify for casual sales exemptions, since such sales are made by persons in the business of selling such property. However, the transfer of inventory pursuant to an I.R.C. §351 transaction or other sale of assets may qualify for exemption as a sale for resale.

3. Manufacturing Machinery, Plant, and Equipment Exemption The sale of machinery and equipment for use primarily in the manufacturing, production, or assembling of tangible personal property for wholesale or retail sale is frequently exempt from sales or use taxes.

4. Research and Development

Some states may provide an exemption for the purchase of research and development (“R&D”) equipment. Certain types of industries, namely manufacturers, purchase a significant amount of R&D equipment.


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C. Select Corporate Reorganizations

Slide 19

Generally, a reorganization that qualifies as a tax-free reorganization under the Internal Revenue Code is exempt from sales and use taxes, since most states statutorily exempt transfers of assets pursuant to “business reorganizations” satisfying I.R.C. §368. For example, in Maryland, the sales tax does not apply to the transfer of tangible personal property made under a §368(a) reorganization. An IRS ruling or opinion of counsel as to the transaction qualifying under §368 is support for taking this exclusion. See Md. Regs. Code §03.06.01.13(C)(3). A number of states, however, provide no explicit statutory exemption for an I.R.C. §368 reorganization or impose additional requirements for the reorganization (in addition to the I.R.C. §368 income tax requirements) to qualify for exemption from sales and use taxes. As a result, the exemptions (e.g., casual sale exemption) discussed previously may have to apply for the reorganization to be exempt from sales and use tax.

1. I.R.C. §368(a)(1)(A) Mergers or Consolidations


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Slides 20

Slides 21

Slides 22


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Slides 23

Many states exclude transfers of tangible personal property pursuant to mergers or consolidations from sales tax by excluding such transfers from the definition of “retail sale.” A merger or consolidation may also be treated as an exempt casual sale. It should be noted that the receipt of boot or other nonstock consideration may trigger sales and use tax to the extent of such consideration. Boot is an old English term meaning “Something given in addition to.” “Boot received” is the money or fair market value of “Other Property” received by the taxpayer in an exchange. In tax law, the extra money, unrelated or non-like-kind property, or assumption of liabilities included in an otherwise like-kind nontaxable exchange of property. The boot is subject to income tax. Money includes all cash equivalents, debts, liabilities, or mortgages of the taxpayer assumed by the other party, or liabilities to which the property exchanged by the taxpayer is subject.


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Slide 24

Slide 25

2. I.R.C. §368(a)(1)(B) Stock for Stock Acquisitions

Since only stock is exchanged, there is neither an actual nor deemed transfer of assets. Thus, sales and use taxes should not apply. The requirement that the exchange be made solely in exchange for voting stock eliminates the boot issues present with other acquisitive reorganizations.


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Slide 26

Slide 27

3. I.R.C. §368(a)(1)(C) Acquisition of Assets of a Corporation Solely in Exchange for Voting Stock

While I.R.C. §368(a)(1)(C) requires that the assets be sold in exchange for voting stock, I.R.C. §368(a)(2)(B) relaxes this requirement, permitting money and other property to constitute 20% of the consideration. Thus, boot issues may arise in a “C” reorganization. I.R.C. §368(a)(1)(C) reorganizations are generally exempt from sales and use taxes.


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Slide 28

4. I.R.C. §368(a)(1)(D)

In a “D” reorganization, a transaction is tax-free for income tax purposes if all or part of a corporation’s assets are transferred to another corporation and, immediately after the transfer, the transferor and its shareholders are in control of the transferee corporation as long as stock transferred to the transferor corporation is distributed in a transaction qualifying under I.R.C. §§354, 355, or 356. States are generally silent with respect to sales and use tax consequences of a “D” reorganization, although those exempting any I.R.C. §368 reorganization generally will exempt “D” reorganization asset transfers from sales and use taxes. For other states, however, the asset transfer will have to fall within sales and use tax exemptions applicable to I.R.C. §351 transactions, casual sales, sales for resale, or transfers of manufacturing machinery and equipment. Additionally, if transferor corporation debt is assumed in the transaction, a taxable sale or transfer of assets may result.

5. I.R.C. §368(a)(1)(E) Recapitalization

Because the corporate form remains unaltered, a recapitalization should not create sales and use tax consequences as no transfer of title or possession of tangible personal property occurs.

6. I.R.C. §368(a)(1)(F) Change in Identity, Form, or Place of Business

Corporate changes governed by “F” reorganizations are often effected through corporate transactions which involve property transfers. For example, the legal domicile of a corporation may be changed by the statutory merger of the existing corporation into a newly formed affiliate legally domiciled in the desired state. See, e.g., Rev. Rul. 57-276,1957-1 C.B. 126. Assuming the legal form of the transaction governs rather than the federal income tax characterization, the


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reorganization rules analyzed so far must be referenced to determine the proper sales and use tax treatment of the transaction. Generally, “F” reorganizations should be exempt from sales and use taxes pursuant to one of the exemptions previously discussed. Re-registration requirements and other modifications must be considered in connection with any corporate name change. 7. I.R.C. §368(a)(2)(D) Forward Triangular Merger

Slide 29

Slide 30

Forward triangular mergers under I.R.C. §368(a)(2)(D) are considered mergers for federal income tax purposes within Section 368(a)(1)(A). In such mergers, a parent corporation forms a subsidiary, or has an existing subsidiary, that acquires the target corporation. Parent corporation then issues stock to the target’s shareholders. In some states, forward triangular mergers are subject to sales and use tax. For example, New York provides an exclusion for transfers of tangible personal property, solely in consideration for the issuance of stock, pursuant to a


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merger or consolidation. See NY CLS Tax §1101(b)(4)(iv)(A). In a forward triangular merger, the parent corporation’s stock is used as consideration for the transaction, but the subsidiary actually acquires the target corporation’s property. Because the corporation receiving the property is not issuing its own stock as consideration, the exclusion does not apply. See 20 NYCRR §526.6(d)(7), Example 10. 8. I.R.C. §368(a)(2)(E) Reverse Triangular Merger

Slide 31

Slide 32

Reverse triangular mergers under I.R.C. §368(a)(2)(E) involve the merger of a subsidiary with or into a target corporation. The target corporation shareholders receive parent corporation stock in exchange for target corporation stock, and the target becomes a subsidiary of the parent. A reverse triangular merger may seem very similar to a forward triangular merger; however, they have some important differences and potentially very different sales tax consequences. In a forward triangular merger, the subsidiary has essentially acquired the target corporation’s


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assets and sales tax liability may result. In a reverse triangular merger, the target corporation continues to own its assets and no taxable transfer occurs.

D. I.R.C. §338(h)(10) Election Slide 33

Slide 34

a. Overview of §338(h)(10) Election I.R.C. §338(h)(10) allows an election to be made to characterize certain stock sales as asset sales for federal income tax purposes. A §338(h)(10) election can be made in situations involving “qualified stock purchases” of target corporations formerly part of a consolidated group. “If the election is made, the target corporation is deemed to have sold all its assets to itself and must recognize gain or loss realized. This results in a stepped-up basis in the transferred assets for the acquiring corporation. A §338(h)(10) election must be made by both the acquiring corporation and the selling consolidated group.


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b. State Tax Treatment of §338(h)(10) Election The sales and use tax treatment of §338(h)(10) elections vary by state, although such elections generally are not subject to sales and use tax. In most states, there is an applicable statute that either excludes or exempts §338(h)(10) elections from sales and use tax. For example, in South Carolina, “[a] taxpayer making and Internal Revenue Code §338(h)(10) election is making an election to treat a stock purchase as an asset acquisition (i.e., a deemed asset sale) for income tax purposes only. For sales tax purposes, there is no asset sale. Accordingly, there is not South Carolina sales or use tax consequences from an Internal Revenue Code §338(h)(10) election.” South Carolina Revenue Ruling No. 09-4 III, 03/31/2009 In other states, rulings or policy statements have been issued that indicate that transactions involving §338(h)(10) elections are not subject to sales and use tax.

E. Liquidations

Distributions of tangible personal property in liquidation of a corporation are generally not subject to sales and use taxes, although a corporate liquidation must satisfy the general requirements of a casual sale in some states. Some states only exempt complete liquidations. Distributions of tangible personal property in liquidation of a partnership are generally subject to the same rules that apply to corporate liquidations.


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IV. Bulk-Sale Notification Requirements: Avoiding Successor Liability and Corporate Officer Liability Slide 35

Slide 36

A. General

Although a transaction may be exempt from sales and use taxes, sales of substantially all of the assets of a trade or business are subject to state bulk sale notification requirements. These requirements are designed to ensure that the state can collect outstanding sales and use tax liabilities of the selling corporation and to shield the acquiring corporation from these liabilities.

Purchasers of a business must plan in order to avoid liability for sales taxes which were a predecessor’s collection responsibility. For example, some states provide that, on the sale of a business, the purchaser shall withhold a portion of the proceeds sufficient to cover any unpaid sales and use tax, interest, or penalty. If the purchaser fails to withhold this amount, it becomes personally liable for these amounts.


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In the event bulk sale notification requirements are not strictly followed, the purchaser of an entire business or assets of a business inherits the potential sales and use tax liability of the seller. This liability may exceed the purchase price for the business or assets. Moreover, violation of the bulk sale notification requirements may subject the purchaser to criminal liability in some states.

See Decision, Hearing No. 105,502, Texas Comptroller of Public Accounts, December 7, 2011, where a successor was held liable for sales and use taxes of the Predecessor, even when the sales and use tax assessment was issued by the Comptroller after the sale was final. Successor did not request a certificate of no tax due. B. Procedures for Avoiding Successor Liability

Slide 37

Generally, the seller must file its final sales and use tax return within a short period of time after the date of sale. In the event a final return is not filed, a state may seek to hold the seller liable for future sales and use tax liabilities of the buyer (predecessor liability), although at least one state court has rebuffed the state’s attempt at holding the predecessor liable.

Several states require the buyer to give notice of its intention to acquire a business prior to the acquisition. The time period for notifying must be complied with in order to avoid successor liability.


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Slide 38

Almost every state requires the purchaser to withhold a sufficient amount of the purchase price to cover the predecessor’s potential prior sales and use tax liabilities unless or until the seller produces a receipt from the state revenue department that sales and use taxes have been paid or the buyer obtains a certificate from the revenue department stating that no sales and use taxes are due.

If a sufficient amount is not withheld (or a receipt is not obtained from the seller or a certification is not obtained from the state), the buyer is generally liable for the seller’s prior unpaid sales and use taxes to the extent of the purchase price. For example, in Bunting v. Director Division of Taxation, taxpayer filed the bulk sale notification, but did not file it within the prescribed pre-sale period. The Court held that the taxpayer was liable. This further illustrates that the filing must be made on a timely basis.

Slide 39


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Some states do not have specific statutory provisions imposing successor liability on the acquisition of a business with unpaid sales and use tax liabilities. Thus, these states seldom provide any procedure or notification requirements that can be used to avoid imposition of statutory successor liability. Despite the absence of statutory successor liability in some states, they could impose successor liability under one or more laws of general applicability. As a result, contractual indemnification, surety bonds, or insurance should be considered. C. Personal Liability of Corporate Officers

Slide 40

Some states may impose personal liability on corporate officers or other responsible persons for unpaid sales and use tax. In some states, personal liability may only be imposed if the corporate officer or other responsible person acted willfully. See, e.g., Cal Rev & Tax Code §6829(a).

In other states, however, a corporate officer or other responsible person may be liable even if they did not act willfully. For example, in Missouri, officers, directors, statutory trustees or employees of a corporation (including administratively dissolved corporations or foreign corporations which have had their certificates of authority revoked) who have direct control, supervision or responsibility for filing returns and paying taxes that fail to file and pay such taxes due may be personally liable for the amount of the tax including interest and penalties. See §144.157.3 R.S.Mo. In some cases, state courts have held corporate officers to be liable for payment of a corporation’s unpaid sales and use taxes. See Rucker v. Comptroller of Treasury, 315 Md. 559, 567, 555 A.2d 1060 (1989).


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V. ISSUES AND CONCERNS WHEN YOU ARE THE SELLER Slide 41

The majority of this discussion relates to the impact on the buyer, but issues can impact the seller in dealing with Business Restructuring Transactions. Some of the more common issues relate to resource allocation during the separation process, collection and payment of sales tax on the purchased, handling obligations as agreed to in any transition service agreements, dealing with carve-out issues, participation on future audits, and other general compliance issues. The seller of a US entity may have a considerable amount of time commitment involved in the disposition of an entity. The time requirements will depend upon the complexity of the legal structure and the contractual obligations of the sale. In many cases, the contractual obligations of the sale may not be known until the deal is signed.

A. Resources from within the tax department

1. The amount of resources required will depend upon the contractual

obligations and willingness of the seller to meet the requests of the buyer. Resources may be needed for (i) Pre and post-acquisition documentation of current processes and procedures, (ii) Production of recent filings (iii) Producing recent audits and reserves, (iv) Closing out open audits, and (v) Transaction service agreements (TSA)

2. Compliance requirements for a specified period – including return preparation and tax payments

3. Knowledge transfer – business, tax and IT. This includes the training of the buyers as to the sales tax process.


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B. Resources outside of the tax department

1. Proper tax functionality depends upon the coordination of many business functions. These functions may also be involved in the disposition of an entity including IT, purchasing, sales, and accounting (G/L accounting, accounts payable, credit, and account receivable)

VI. STOCK AND ASSET PURCHASE AGREEMENTS (“SAPA”) Slide 42

The SAPA is the legal agreement that is used when one entity is purchasing another entity. This document is extremely important and should be reviewed by the sales and use tax professional. Normally, the sales and use tax professional has very limited exposure to this document while it is being negotiated, but items that are included can have a very material impact on the individual’s future workflow. Normally, the first section lists all of the definitions and terms. Please take the time to review this section, as some of the definitions may be different than what each individual might expect. For example, Transfer Taxes can be defined as follows:

“Transfer Taxes” shall mean all stamp, transfer, real property transfer, recordation, grantee/grantor, documentary, sales and use, value added, registration, occupation, privilege, or other such similar Taxes, fees and costs (including any penalties and interest) incurred in connection with the consummation of the transactions contemplated by this Agreement.

It is also wise to take some time to look at other sections of the SAPA; one such area includes the following:

Resale or Other Exemption Certificates. At the Closing (or within such reasonable time thereafter as may be necessary to perfect the resale or other exemption certificates), Purchaser shall deliver to Seller fully completed and executed resale exemption certificates or other applicable exemption certificates for all jurisdictions identified by Seller in Schedule 5.13 of the Seller Disclosure Letter as jurisdictions in which Inventory


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is to be transferred. To the extent any jurisdiction refuses to accept any resale exemption certificate or other applicable exemption certificate provided by Purchaser, Seller and Purchaser agree that any Transfer Taxes (and related interest and penalty) assessed by such jurisdiction shall be borne by Purchaser.

The reason the definition have an impact can be found in the tax section of an SAPA. At times, the deal making teams will put language similar to the following that will have an impact on the sales tax professional when determining the payment or collection of taxes.

Any Liability for or with respect to Taxes of the Conveyed Companies with respect to any Pre-Closing Period (or portion thereof) attributable to any Tax sharing agreement or other Contract with respect to Taxes; provided, however, that (i) all Transfer Taxes shall be borne fifty percent (50%) by Purchaser and fifty percent (50%) by Seller except (A) as provided in Section 5.13 and (B) with respect to Transfer Taxes that are recoverable by Purchaser or any of its Affiliates under applicable Law, which shall be borne 100% by Purchaser), (ii) Seller’s Taxes shall not include any Taxes arising as a result of actions taken by any Conveyed Company or Purchaser or any of their Affiliates with respect to any Conveyed Company or Purchased Asset after the Closing Date of the Closing except as required by applicable Law, and (iii) Seller’s Taxes shall not include any liability for Taxes to the extent such Taxes are accrued Taxes included in Closing Working Capital. For the avoidance of doubt, the disclosure of the matters set forth on Schedule 3.16 of the Seller Disclosure Letter shall not alter Seller’s indemnification obligations under this Article VII, and Seller shall indemnify Purchaser for all losses arising from or related to such matters.

As most of you are aware, most states do not allow another entity to “pick up” the sales tax owed by the purchaser. For example, if one of the properties sold is in California and it has a fair market value of $1,000,000, and the taxing jurisdiction has a rate of 8.25%, the seller would be required to charge the purchaser $82,500. With an agreement to split the “transfer taxes” at 50%, each company would be required to pay $41,250. We will work with the accounting team to make sure we “collect” the $82,500 and then provide a credit to the purchaser. One more item that needs to be understood when dealing with a SAPA is a Transition Services Agreement between the buyer and seller. In most instances, this agreement requires the seller to perform certain services for a fee on behalf of the buyer. This allows the buyer the time to get its accounting and processing shop together to handle its future obligation. This agreement can cause quite a drain on internal resources; do not underestimate the amount of time this additional workload will take. Additional time is needed when dealing with a new or carve-out entity.

VII. CONCLUSION As illustrated herein, the sales and use tax consequences of mergers and acquisitions can be significant and even “deal breakers“. It is important to recognize that sales and use taxes associated with mergers and acquisitions can be planned for and avoided. However, the business must consider the sales and use tax consequences at the time the restructuring is being planned versus after the deal is closed.


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NOTES

Distribution or sharing of this material is strictly prohibited and may result in the assignment of a failing grade and/or termination of membership in the Institute of Professionals in Taxation®.

TAX PLANNING SALES TAX SCHOOL II THEORY AND PRACTICE FOR THE EXPERIENCED SALES AND USE TAX PROFESSIONAL

Learning Objectives At the end of this session, the learner will be able to:

Identify the importance of reviewing the entire contract for tax ramifications. Identify company characteristics and strategies that could have potential tax

ramifications. Analyze the benefits/issues present when working with procurement companies. Analyze the benefits of different tax planning strategies.

IPT, Sales Tax School II Tax Planning

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What is Tax Planning? Slide 1

The “Tax Planning” function centers on proactively adjusting business operations to minimize tax expense and cost against constant changes in law, regulation “clarifications” and court decisions. As such, Tax Planning is the systemic analysis of differing tax options aimed at the minimization of tax liability in current and future tax periods. Tax planning is one of the key day-to-day activities of an effective Tax Department, both as an independent function and as part of the other activities that tax professionals are likely to be engaged in on a daily basis, e.g. compliance, accounting and reporting, and audit defense. The cornerstone of successful Tax Planning is not only strong technical skills; Tax Planning requires an in-depth knowledge of the business and its day-to-day operations. The operational knowledge needed encompasses each and every step in the production of revenue (Procurement-to-Cash “P2C”) as well as the tax-treatment of each individual process. Without a deep understanding of the business (and the political pitfalls), Tax Planning only addresses the surface issues and does not correct the operational inefficiencies. Successful Tax Planning provides solutions to the fundamental issues of the business. In addition to understanding the P2C process of the business, Tax Planning must also find efficiencies that outweigh the cost of disrupting the current operational structure. If an opportunity exists to reduce tax cost by $1MM but costs the business $2MM to implement, the likelihood of success is very low. Beyond the limited value of the $1MM “solution”, the Tax Planning professional will more than likely lose credibility with the business operations owners. Why would Operations continue to engage Tax Planning if the “solutions” provided do not indicate a functional knowledge of Operations and are effectively without value to the business?

Tax Planning IPT, Sales Tax School II

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Slide 2

Tax Planning requires advanced skills in several different areas. First and foremost is a high degree of individual tax technical knowledge. As part of this skill set, the successful Tax Planning professional will possess advanced research abilities (proficient with multiple research tools such as CCH, RIA, Westlaw, Lexis/Nexus, etc.). . Tax Planning, as discussed above, requires an in-depth knowledge of business operations. To gain this knowledge, the tax professional must spend the time and energy to learn every nuance of Operations. A successful Tax Planning professional will have strong ties to Finance, Procurement, Traffic/Freight, Aftermarket, Production, Distribution, Business Development, Facilities, and on and on. These non-Tax groups are the single-best opportunity to affect real tax efficiencies. Successful Tax Planning professionals also must have advanced communication skills that encompass written, verbal and presentation. These skills are essential to “managing” the message to all of the different business groups. Written communication should be concise and on point be it by memo or internal email. Verbal communication should be provided in the context of the issue and possible solution(s). Excited language (“the sky is falling”) and/or too much detail should never be part of the communication. Finally, the ability to communicate to a larger audience, which may include Executive and Legal, are mandatory for successful Tax Planning. If presenting in front of large audiences gives someone pause, practice, practice, practice!! Ultimately, a successful Tax Planning professional will have the ability to leverage all of these attributes in their day-to-day activities.


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Slide 3

The scope of Tax Planning should always be focused on Tactical and Strategic timelines. Tactical Tax Planning is proactive but limited to 1- 3 years in the future. Tactical planning opportunities generally arise when there are “gray” areas of current tax laws and regulations. These areas typically issues under appeal (either by the company or someone in the comp set) and/or require some final adjudication. Tax Planning should provide briefs/memos to Operations as to the potential impact (cost!) as well as communicating any opportunities to adjust the P2C process to mitigate or eliminate the impact. Tactical Tax Planning should also be actively involved with proposed tax legislation that may negatively impact Operations. Revenue bills should be identified and the potential impact discussed with Operations and potentially Governmental Affairs. Strategic Tax Planning is much more involved with the business itself, rather than specific issues. Strategic Planning focuses on business operations 5+ years in the future. It is important to have a seat at the table during Operational planning discussions and thoroughly understand Business operating plans. Effective Strategic Tax Planning documents an efficient tax plan and identifies which codes and regulations would impact any new operations. The tax plan should quantify potential opportunities offered by state and local governments for relocation, expansion, and/or growth in a jurisdiction. Once documented, Tax Planning communicates the impact review to Operations. Strategic Tax Planning should also interact with Governmental Affairs if the codes and regulations identified have a negative impact to proposed Operational changes. By engaging Governmental Affairs, the business can decide what, if any, lobbying should be done to mitigate or eliminate adverse tax impacts. Tax Planning will play a critical role in providing talking points to engaged lobbyists. Tax Planning, however, does NOT include historical reviews such as reverse audits and VDAs. This function of the Tax Group, while potentially important, falls outside of the main focus of Tax Planning; the minimization of tax liability in current and future periods. Tax Planning may


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be involved with providing the Operational solution (minimization of tax costs) once historical errors have been identified. While Tax Planning identifies and communicates potential issues/solutions to the business, Tax Planning must also coordinate and oversee the implementation of solutions. Slide 4

Implementation of solutions requires the assistance of multiple groups; Legal, Accounting, Finance, HR and the other SALT disciplines. Legal is involved when the agreed solution requires the creation of a NewCo. While this seems to be a relatively easy step in the process, be warned that most businesses in today’s environment are eliminating entities rather than creating new ones. If the solution does require a NewCo, Tax Planning should have significant persuasive documentation that the cost and maintenance of a NewCo is immaterial to the value gained by Operations. Accounting must be engaged if the solution requires additional business units. Each new business unit may requires new G/L codes (which may require significant executive-level support) as well as establishing A/P and A/R, Tax Planning must ensure that the accounting of the solutions are properly documented to maximize the value of the solution to Operations. Finance must be engaged if the solution requires separate bank accounts, credit card processing and cash management. The solution may call for the business to contribute significant cash amounts to the creation of a NewCo. Again, Tax Planning must manage the communication between Finance, Legal, Tax and Operations to ensure a smooth transition. HR is a very important partner in the Tax Planning function. If the solution requires movement of employees to the NewCo, HR will be needed to properly document the transfer as well as ensure the transition of payroll and benefit cost. Finally, the implementation will require the assistance of other SALT Groups: Income/Franchise Tax, Payroll Tax, and Property Tax – both real and personal, Sales Tax compliance and Escheat. It should be noted the any Tax Planning solution has already been vetted by the various SALT


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disciplines. If not, the value created in transactional tax may well be eliminated by increases in the other taxes. As an example, the creation of NewCo (and the transfer of employees to the entity) may increase the experience rating for unemployment. As such, NewCo may incur much more cost related to unemployment insurance. Slide 5

Ultimately, Tax Planning will have defined “outputs”. These outputs will be the “product” that is provided to Operations. These outputs should include:

Early engagement in the business development cycle. Once a project is approved for further review, Tax Planning is on the “upside” of the project curve and provides impact to the decision process

Clear and concise communication to the business (Operations, Legal, Finance) that level-set proposed structure/change in Operations. The communication will include the 5 “W’s” – Who, What, When, Where and Why. If Tax Planning does not clearly communicate its understanding of the project (and receive concurrence from the other participating Groups), the value of the Tax Planning solution may be zero and cause significant rework and reputational damage internally to Tax Planning

Alternative solutions. Successful Tax Planning functions anticipate and overcome objections from other Groups. Objections require alternative solutions and time lag in providing an alternative solution may (again) cause reduced value, significant rework and reputational damage

Non-tax technical communication to decision makers. Simply stated, NO TAX GEEK LANGUAGE! Decision makers do not care why only what should be done. Think of a USA Today headline: do this, not that, because…


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Types of Tax Planning Slide 6

Tax Planning can take several forms. For the purposes of this session, we will focus on three types: Organic, “Off-the-Shelf” Products and Enterprise Value Creation. Organic Tax Planning refers to Tax Planning processes developed “in-house” and whose solutions are specifically designed for the business. Off-the-Shelf Products can be compared to canned software. These Products are programs or processes that can be used almost universally by businesses. Enterprise Value Creation refers to unique solutions created by leveraging Organic Tax Planning processes outside of the indirect Tax Planning function. Slide 7

When developing a Tax Planning function, it is critical to define and document the Tax Planning process. The concept of making an otherwise value-added function (which does not operate in a linear fashion) a structured process can be difficult to understand and/or appreciate. But


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documenting how Tax Planning operates creates the opportunity to define “inputs and outputs” as well as establish control functions for quality assurance. Defining the process does not require the individual to “think” or create solutions by predetermined methods. Rather, a defined process provides an opportunity to document what resources are needed to produce an output as well as documenting a timeline to produce the output. The first step in the process is to define exactly what types of functions would be deemed “Tax Planning”. In the accompanying slide, the functions identified are:

Business Unit (“BU”) Project Compliance Project Research SALT Project

There are 4 phases for all functions: (1) Scope Definition, (2) Data Collection, (3) Tax Determination, and (4) Communication and Implementation. While the phases apply to each function, the functions have unique processes to produce the required output. The functions also have a common set of resources; Inputs, Data Systems and Resources. Finally, each function has defined review and approval processes. A complete process map will also include a defined standard work for each step. This means that each “box” will have documented inputs, procedures, controls and outputs. Each process step will also identify potential errors (such as incomplete data, change request by the “client” or BU, change in laws, etc.) as well as establish tracking measures for errors. By doing so, the process provides data that can identify its own weaknesses. These weaknesses are then tracked and reviewed for process changes to eliminate/mitigate such errors. The value of defining the Tax Planning process is much more than just inputs and outputs. The real power is establishing “procedure” vs. “policies”. Effective procedures establish controls and eliminate/mitigate material errors. Policies, while very impressive on paper, do not provide real control of a function. A company may have hundreds of policies regarding Tax Planning, but if the policies are not incorporated into the day-to-day function of the department, the policies are essentially worthless. For US companies subject to SOX requirements, strength of procedural control is critical to functions that may rise to the level of disclosure.


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Slide 8

Procurement-to-Cash Review Procurement. A request for proposal (RFP) is an early stage in a procurement process, issuing an invitation for suppliers, often through a bidding process, to submit a proposal on specific tangible property or service. The RFP process brings structure to the procurement decision and allows the risks and benefits to be identified clearly upfront It also allows for supplier negotiation and assessing where to buy what, considering demand and supply situation.

CapEx. CapEx is the procurement of expenditures creating future benefits, such as property, equipment, or real estate and cost is capitalized and recorded as a balance sheet item on the financial statement. In general, most Companies will have an annual capital budget and a capital plan drafted in October to present for approval by year-end. Getting involved during the AR (acquisition request) planning sage or at the very beginning of the process is a great opportunity to ensure your Company minimizes its indirect tax cost on Capital Expenditures (CapEx).

Business expansion with planned capital investment in facilities, IT, manufacturing and equipment (M&E), R&D (M&E), etc. creates a great tax planning opportunity if the tax professional is involved in the front end discussion. This is an opportunity to present a business case to locate new or expanded business facilities in a state that offers sales and use tax exemptions and local credit and incentives. There are many states that offer a manufacturing and/or R&D exemption for CapEx items and, in some states, M&E repair parts.

Bundling. Bundling occurs when you combine services, combine products, or combine services with the sale of tangible personal property. Two types of bundling are pure bundling and mixed bundling. Pure bundling occurs when a group of products are only available as a bundle and aren't sold separately. Mixed bundling is products sold both as bundles and as individual units. Examples of bundling are software applications like Microsoft Office and computer packages (includes monitor, mouse, keyboard, and


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preloaded software) for a single price. Bundling can be tangible items from one company, but cross-industry bundling is not uncommon. For example, combining airline tickets, hotels, and car rental in a vacation package.

Tax planning efforts begin with the submission of a RFP (front-end) and purchase order (back-end) to ensure major service efforts are procured separately from the major purchases of tangible items due to taxability differences. Taxability of services and tangible property differs and is govern by state law. The form of a transaction often determines its substance, and thus, its tax consequences. Is the intent of the transaction the performance of a service or the delivery of a tangible item? Is the true object of the contract the sale of tangible personal property as opposed to the provision of services? In general, service contracts are either not subject to sales and use tax or subject to tax on the cost of consumables used to perform the service. In contrast, contracts for the delivery of a tangible item qualifies for a “sale for resale” tax exemption and is not subject to sales and use tax. If this planning opportunity is missed, your Company’s procurement cost will be overstated by the value of taxes paid.

Consumables. Consumables are typically expense items used by service providers to perform a service. The cost is expensed and recorded as an income statement item on the financial statement. In many states, consumable items are subject to sales and use tax. Bulk purchasing of consumables is an opportunity to obtain vendor discounts for volume purchases, which reduces the tax measure and tax due.

Slide 9

Distribution. A distribution sale is defined as the movement of products or the availability of services to a final customer or user. An understanding of the distribution sales process is critical in Tax Planning.


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When tangible personal property is being sold to a customer, there can be a chain of intermediaries, each passing the product down the chain to the next organization, before it finally reaches the customer or end-user. Tax professionals must be integrated with sales management as a tax consultant to provide sales tax strategies to remain competitive. .

Distribution channels may not be restricted to physical products. For example, Hotels may sell their services (typically rooms) directly or through travel agents, tour operators, airlines, tourist boards, or centralized reservation systems to an end user. For economic reasons, Hotels are moving toward service integration, with services linking together, particularly in the travel and tourism sectors. For example, links/partnerships exist between airlines, hotels, and car rental services.

Bundling is a sales/marketing tactic involving two or more goods or services offered as a package deal for a discounted price. Bundling can provide economic value to customers, however, bundled transactions may have major tax consequences if the transaction is not structured and priced properly. A contract to integrate custom software into a computer system, maintain and operate the system for 2-years, and provide system training to the customer is an example of a bundled transaction. Is this bundled transaction a sale of tangible personal property or a sale of services? In most states, TPP and services have different tax treatment. The Tax Planning professional should proactively work with contract management to provide guidance on how to structure this bundled transaction to minimize tax risk and protect the contract profit margin.

The partnership with sales management will build awareness on new product and/or service distribution, marketing strategies, etc. Distribution sales can become very complex when engaging agents or independent contractors to market products and services. Look for opportunities to mitigate or eliminate the creation of affiliate, attribution, or economic nexus. If your Company is expanding its products and services to adjacent markets, get involved in the exploratory phase of new business engagement to identify potential nexus exposures. Also pay attention to acquisition activities and monitor intercompany sales. With state budgets in precarious positions, legislators are aggressively seeking to expand the nexus definition to include more taxpayers in their jurisdiction.

Remember – A Tax Planning professional with extensive knowledge of the industry; financial goals and annual operating plan (AOP) of the Company; product sales and sales process; procurement process; etc. is a valuable asset to an organization.


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Slide 10

Post-sale Operations “Maintenance/Repair Operation” (“MRO”) services are usually offered at the time of sale of manufactured or sold goods. These services can include parts, services or a combination of both. The rate structure of a MRO agreement can be based on a lump-sum (with an associated period to be covered), by-the-hour rate (utilization of the goods), monthly/quarterly or any other negotiated combination. MRO services can be generally grouped as:

Manufacturer’s Warranty Extended Warranty Service Agreements

Manufacturer’s Warranty obligates the manufacturer of the goods to repair or replace the goods for a set period of time. A Manufacturer’s Warranty is not typically a line item charge to the Buyer. Rather, the expected cost of the program (which is estimated by the manufacturer’s actuaries) is included in calculating the retail selling price of the item(s). As such, most jurisdictions do not tax (either as a sales or use tax) the cost of any replacement part or services provided under a Manufacturer’s Warranty. Tax Planning should be engaged in the Manufacturer’s Warranty program when the manufacturer utilizes a 3rd party to provide warranty services or goods. The driving issue is that many states do not have rules/regulations to allow the resale of services. By inserting a 3rd party service provider, the manufacturer may have an unexpected margin reduction if the service provided by the 3rd party (even if the service relates to a Manufacturer’s Warranty) is subject to sales tax. Additionally, the utilization of a 3rd party to perform warranty repairs may be regarded as a nexus-generating activity.

Extended Warranties generally provide the same services and goods as a Manufacturer’s Warranty. The difference is that an Extended Warranty covers periods outside the Manufacturer’s Warranty. Extended Warranties may be optional or mandatory charges to the Buyer at the time of purchase. Several states apply different rules between mandatory and optional Extended Warranties (taxable to the Buyer at the time of purchase or the repair/replacement parts provided by the manufacturer are subject to use tax). In addition, the


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insertion of a 3rd party to provide services or goods under an Extended Warranty may also trigger nexus for the Manufacturer. Again, Tax Planning should be engaged early the product development cycle so that Aftermarket Operations can price the product to include any tax cost to the manufacturer.

Service Agreements are typically sold at the time the covered goods are purchased. Service agreements function like Extended Warranty agreements. However, Service Agreements differ in the respect that the manufacturer of the goods covered is not always the service provider. Service Agreements also consider the day-to-day operation of the covered good(s). Instead of covering major components (under a Manufacturer’s Warranty or Extended Warranty), Service Agreement will cover consumable parts and regular maintenance services. For high-cost goods (machinery), a Service Agreement may call for the provision of on-site personnel. Additionally, a Service Agreement may also mandate that the provider of the service maintain an inventory of consumable parts at the site of the Buyer. If the manufacturer is the Service Agreement provider, Tax Planning should review for possible nexus and tax treatment of any goods and services provided under the agreement. If the Service Agreement as proposed does trigger nexus, Tax Planning may be able to mitigate/eliminate nexus by utilization of subsidiary with nexus in the jurisdiction. Nexus may also be mitigated by the utilization of a “Special Purpose Entity”. See discussion below.

Updates

In the software environment, Service Agreements typically include updates to the purchased software. Updates can be included as a separate line item, a bundled charge with support or as an undefined “Software Support” lump-sum. Each type of charge must be reviewed for taxability in the jurisdictions supported under the agreement.

Updates can be delivered in several ways but ultimately a jurisdiction will look to see if the update was delivered with TPP (disk, tape, etc.) or electronically. Historically, if an update was delivered in a tangible medium, sale tax applied to the charge associated with the update. If the update was delivered electronically, most jurisdictions did not tax the charge for updates delivered in the manner. However, due to severe fiscal constraints, many states have changed the taxability of electronically delivered goods (taxable). Tax Planning should be actively engaged in reviewing long-term Service Agreements which were entered into before taxability was changed. Tax Planning should look to see if the software in questions could be run from servers located in a non-taxable state. If so, tax Planning should look to see if the jurisdiction that taxes such updates allow for a proration based either on licenses or headcount.

Product Support

Product Support is another area of concern for the Tax Planning function. Product Support can be provided under several different models; remote, in-state, out-of-state and utilization of a 3rd party. Remote support is typically either telephone or electronic communication and can be exempt (if charged as a separate line item) and protects against nexus. In-state support does not provide nexus protection. However, the level of support (service only vs. service and parts) should be scrutinized and understood so that Aftermarket Operations can price correctly. Out-of-


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state support, if properly structured and effective controls are implemented, should provide nexus protection for the service provider against the Customer’s jurisdiction.

Finally, the utilization of a 3rd party is fraught with nexus challenges. Courts have consistently ruled that the utilization of a specific 3rd party to perform warranty work (and will maintain the warranty) will trigger nexus for the seller of the Product Support. Utilizing a 3rd party to perform non-warranty work may also trigger nexus for the seller of Product Support. Tax Planning needs to be embedded with Aftermarket Operations to ensure that the tax cost is properly accounted for in the pricing model.

Slide 11

Nexus From both compliance and planning perspectives, the first step to an effective state and local tax strategy is to understand the nexus footprint. It allows a Planning professional to identify areas of concern and possibly areas to consolidate in order to reduce tax liability. There is a general assumption that maintaining the lowest possible sales tax nexus profile is in the best interest of a business. The benefits associated with doing so could include: 1) a perceived pricing advantage versus your competitors (putting aside the consumer use tax

implications), 2) lower tax compliance costs, 3) lower tax audit costs, 4) lower IT costs, and 5) reduced customer contacts. In terms of Tax Planning, the tax professional must determine how much effort should be expended to minimize that nexus footprint. In order to do so, the tax professional must weigh those benefits against the associated costs – that is, what must be done to maintain that minimized nexus profile. Those costs could include:


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1) restricted business activities to avoid establishing a market in the applicable state, 2) monitoring compliance with the restricted activities, and 3) accumulated audit risk related to failure to adhere to those restrictions, or for misinterpreting what sorts of activities are permissible without triggering nexus. Once a business commits itself to taking specific actions to minimize its nexus profile, it has committed its Tax Department to having to be involved in virtually every activity of the business. Once approved by management, policies and procedures must be widely distributed and communicated across the entire business. The Tax Department needs to establish procedures for monitoring and enforcing those policies. Those procedures could include questionnaires, expense report reviews, or the use of the Internal Audit function. Enforcing operational restrictions can be very difficult. It can be especially difficult to effectively communicate or monitor compliance with the policies and procedures in highly decentralized businesses. Even if the policies and procedures were effectively communicated when first established, they may degrade over time with personnel turnover. Specific Exemptions / Enterprise Zone (“EZ”) / Credits & Incentives Being successful in business today means taking advantage of every resource available to positively affect your bottom line. Tax Exemptions and Credits & Incentives are among those resources available to help businesses. Effective Tax Planning occurs when all applicable state tax exemptions are being utilized by a Company. Specific exemptions are defined by statute and vary from jurisdiction to jurisdiction; however, the definition of what property qualifies for exemption may be similar in nature. For example, states offering a manufacturing exemption have similar definitions and similar items qualify for the exemption. A Planning professional should always look for exemption opportunities for tax relief or tax at a reduced rate or tax on only a portion of the items subject to tax. Identifying and implementing specific exemptions in a jurisdiction is a way to quickly add value – identification of low hanging fruit. When exemptions are overlooked or implemented years after inception, there is an opportunity to identify and recover sales and use tax overpayments for periods within the statute of limitations. States require submission of a refund claim or amended returns, along with all supporting documentation. Once the state has validated the refund claim, it may issue a tax credit or tax refund. Be aware of statutory provisions in some states allowing interest to be paid on sales and use tax refunds. Each State Department of Revenue has a documented sales and use tax refund policy that provides guidance on the refund procedures and requirements. Federal, state and local governments have instituted different tax credit and incentive programs as a way to stimulate the economy. Most tax incentives offered to businesses are based on creation and preservation of jobs; geographic locations when locating, expanding, relocating or consolidating; and capital expenditure activity. A comprehensive understanding of the tax incentive details creates an opportunity to maximize on the amount of the tax credit and/or refund realized by an organization.


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Companies that invest in or operate within an Enterprise Zone (EZ) or designated economically distressed areas may qualify for various tax incentives including a state sales or use tax credit. In addition, the local governments may also offer their own incentives. The requirements for qualification vary by jurisdiction. Most jurisdictions allow an EZ incentive based on a certain level of for job creation, job retention, and/or capital investment within a zone. Some state and local incentives may be applied as a credit to income, payroll, property, or sales and use tax. Many incentives require a strict set of qualifications and compliance and adequate records to substantiate the credit or refund. In most cases, the Planning professional will be involved in the business strategic planning, incentive negotiation with local government agencies, and incentive administration.

Slide 12

Structured Transactions “Structured Transactions” are transactions in the P2C process that are modified to mitigate tax costs. The benefit may be derived by Seller, Buyer or both. Critical to the success of Structured Transactions is documentation and understanding of what goods and/or services are being sold/purchased, the selling/buying entities, title transfer identification, and the delivery channel utilized. Special Purpose Vehicle/Entity Structured Transactions often utilize a “Special Purpose Entity” (“SPE”) or Special Purpose Vehicle” (“SPV”). While these terms sound very complicated, what is really happening is that Seller/Buyer are using specific entities to complete the transaction. SPE/SPVs generally come into play to protect Seller/Buyer from nexus (both indirect and direct tax) or to protect TopCo from potential commercial liability. As an example:


16

TopCo’s manufacturing and sales are restricted to State A

TopCo sells TPP to a Customer located in State B As part of the sale, TopCo will provide long-term MRO parts and services to Customer in

State B (which will also include long-term on-site engineers) TopCo has a corporate policy mandating “no nexus” in any other state except A. In order to fulfill TopCo’s MRO obligations, TopCo creates MROCo (to be registered in State B) and assigns its MRO obligation to Customer. TopCo will also second the on-site engineers to MROCo. Finally, TopCo will enter into a written agreement regarding MRO activities (establishing price for parts, services, etc.). Please note that very careful consideration must be given to the creation of the agreement between TopCo and MROCo (agency, affiliate, and attributional nexus). Title Transfers Structured Transactions must also be scrutinized for title transfer issues (assume the same facts as above). In the initial sale of the TPP between Customer, title transfers at TopCo’s location in State A (FOB Dock) and the goods are placed into interstate commerce via common carrier.


17

TopCo has not created nexus by this transaction. However, what if title to the TPP was transferred after delivery and/or commissioning/testing acceptance at Customer’s location? If title is not transferred until delivery and/or acceptance, TopCo may have triggered nexus in State B. A potential solution would be that TopCo assigns the sale of TPP to MROCo. TopCo sells the TPP to MROCo (FOB TopCo dock) and MROCo would transfer title (and receive payment from) Customer. The final consideration is when does title to the MRO TPP occur? In most high-value machinery, Seller is required to provide repair/replacement parts as part of the sales agreement. However, title transfer to the repair/replacement TPP does not occur until Customer replaces the TPP as part of the regular maintenance. As such, title to TPP has been deferred and actually occurs in State B (potentially giving rise to nexus for TopCo). Again, the potential solution may be for TopCo to sell the TPP to MROCo and then title will transfer from MROCo to Customer. There is one final note regarding Structured Transactions and title transfer. The utilization of a SPE/SPV may lead to a “flash title” concern. Flash title usually occurs in 3-party transactions. Under the same facts above, in order for MROCo to transfer “good and clear” title to TPP, MROCo must have title at some moment in time. Flash title refers to that moment in time that Seller has title. What happens if TopCo does not “sell” or transfer title to the repair/replacement parts until the parts are pulled from inventory at Customer’s location? Structured Transactions must consider and provide title transfers that do not give rise to nexus. CONTRACT REVIEW There are Tax Planning opportunities during contract review when the Planning professional is integrated in the front-end process of procurement and distribution.

For distribution, involvement must occur in the initial stages of contract negotiations to provide input related to the statement of work, contract classification, contract type, segregation of pricing for bundled transactions, contract tax language, indemnification and other relevant clauses, and other standard language. The goal is to ensure the sales contract is setup in manner that minimizes tax risk.

For procurement, involvement must occur during the vendor contract bid review. The goal is to ensure proper sales and use applicability on the purchase of tangible personal property and/or services. For bundled transactions, segregation of pricing may minimize tax cost.

Standard Language

Product or Service Acceptance Criteria Pricing Payment Due Date Assumption of Liabilities Tax Language Indemnification Termination Provisions


18

Other Key Terms and Conditions Particular to the Customer or Vendor Required “Sign-off” Companies that really value Tax Planning efforts will require the Planning professional to review and sign-off on the final contract draft as to confirm accuracy from a tax minimization prospective. However, the contract “sign-off” process is not used universally, which may cause tax risk and reduced profit margins. Slide 13

ENTERPRISE VALUE CREATION “Enterprise Value Creation” occurs when Tax Planning leverages its operational knowledge and process controls to issues outside of sales and use tax. One of the more pressing recent corporate issues is “entity rationalization”. “Entity rationalization” is quite simply the elimination of corporate subsidiaries, JV, SMLLC and other entity structures that have outlived their usefulness. Tax Planning should have a seat at the table when these discussions begin. Tax Planning, because of the deep understanding of the business and the downside tax risk if current operations are changed, has the knowledge to provide real-value cost to the rationalization process. Tax Planning can also provide real-time value to any project related to registration eliminations or compliance redundancies. Tax Planning can also provide insight and value to the entity rationalization process when unemployment experience rating optimization is also a stated goal. Unemployment experience rating relates to what percentage an employer must pay for state unemployment insurance. The rate is based on the employment history of the business. If a business is stable with few or zero layoffs, the rate (and therefore cost) is lower than a business with high layoffs. Tax Planning’s value to this type of project is it’s (again) insight and understanding of the day-to-day operations of the business. Tax Planning should have intimate knowledge of any Structured Transactions as well as the post-acquisition operations from M&A activity. A change in payroll entities may have a material impact to a Structured Transaction.


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Entity rationalization may also impact “unitary” filing jurisdictions. “Unitary” filing typically relates to state income tax. Effectively, a large corporation with several subsidiaries would be required to report all of the corporation’s revenues as the Line 1 of a unitary state’s income tax return, not just the subsidiaries that are active in the state. As discussed above, Tax Planning owns the operational information of the business structure and can provide cost-impact to any changes in the corporate structure. Another aspect of Enterprise Value Creation is “tax efficiency maximization”. What this means is that the time/value of every tax dollar spent of collected is utilized in the most efficient way (pay the government or cash sweep to overnight interest accounts). The first step is to analyze the impact of payment terms (both as Buyer and Seller). As Buyer, Tax Planning should consider the impact of trade terms (2/10/net 30) and the associated tax cost to cash. If the tax jurisdiction reduces the taxable amount by the cash discount, Tax Planning should provide the tax “savings”. If this amount is greater than the internal rate of return for cash over 30 days, Tax Planning has discovered a hidden value to the business. As Seller, Tax Planning may also impact cash by reviewing trade terms as well as invoice dates. Most state sales tax codes are written for accrual-based taxpayers (IL is written for cash). As such, the sales tax charged is due in the period in which the invoice was generated. There is a potential to add value by moving invoice dates from month end to the next period (only within each quarter reporting period – never move revenue to a forward quarter unless the business approves). Again, Tax Planning should analyze the cash impact and deliver value if present. Slide 14

In an effort to drive maximum value from the supply chain, US multinationals are moving towards global procurement models. By “going global”, US companies are foregoing procurement responsibilities based on business units, country or region of operations. The new global-facing procurement agreements are being negotiated and entered into by the multinational’s US TopCo/parent entity. However the purchase of goods and services under these agreements is made by several or all of the TopCo/parent entity’s subsidiaries. The supplier entity that is party to these global agreements may be either a US multinational or a non-


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US entity. Regardless of the supplier’s profile, global procurement creates a plethora of potential pitfalls for the purchaser. Slide 15

Purpose of Global Procurement The stated reasons for migrating to a global procurement function can be few or many. Ultimately, the primary driver is the opportunity to identify, document, mitigate, or eliminate costs of the current state versus the estimated costs of the proposed future state. The more obvious types of costs targeted may include:

Per piece volume discounts (single source supplier or limited supplier base) Low cost raw materials FTE (“Full Time Employee”) reductions due to:

o Redundant Procurement staff at each business unit or Region o Redundant Payables staff at each business unit or Region o Improvement in Procurement process (elimination of manual workflow) o Roll up of special purpose commodities into overall commodity Procurement

group Foreign exchange (“FX”) risk


21

Other less obvious value drivers of centralized global procurement include:

Improvement of cash-flow via maximizing: o Just-in-time (“JIT”) inventory (shortening the time between paying for

materials/components and selling the final product) o Material tolerances and overall quality (mitigating the impact of non-conforming

materials – both in size specifications and material composition - to the production schedule)

Preferential tariff/import duty and tax treatment As always, the aggregate of these cost improvements becomes the comparative value against current state costs, systems improvement and internal disruptive costs. Unfortunately, most companies do not include a detailed review of indirect taxes impact to the proposed future state. With domestic indirect tax average rates well above 7% and average worldwide VAT rates inching ever closer to 20%, the estimated value of converting to a global procurement model can be significantly impacted by triggering unforeseen sales or use tax obligations or unrecoverable VAT costs to the US TopCo/parent entity. Slide 16

How Centralized Procurement Works Centralized procurement eliminates redundancies of having several purchasing agreements with a single vendor. Instead of each business unit (“BU”) setting terms and conditions (see discussion below) and more importantly piece prices/rates, the ParentCo/TopCo is the single party to the vendor agreement. As such, there is no opportunity for variation of terms between the various BUs. These centralized procurement contracts are typically known as “Master Terms Agreements” (“MTAs”). MTAs are almost exactly like the historical local agreements except that MTAs generally do not provide a predetermined spend commitment of the Buyer. Rather, MTAs set the commercial terms (Ts&Cs, pricing, Seller and Buyer obligations, etc.) that the Buyer’s entire


22

organization will enjoy. Depending on the size and potential volume of the Buyer, MTAs may also have a “MFN” or Most Favored Nation clause. A MFN clause guarantees that the Buyer listed in the MTA will receive the best price available for a specified period of time. If the Seller offers the same product to another Buyer but for less than the terms of the MTA, the Seller is obligated to reduce the price to its existing clients. If the Seller is obligated to adjust historical spend, the indirect tax group must have robust procedures in place to adjust use tax accrued or input VAT. Otherwise the Buyer will overstate the true taxable measure. POs are issued by each BU with reference to the MTA. However, the BU may not process payment or even be invoiced by name. Global procurement drives cost down by centralizing the AP process to the ParentCo/TopCo. The ParentCo/TopCo will pay the invoice but then either issue a miscellaneous invoice or some other document to charge the BU for the value of the order. Again, this is an area that can potentially trigger a nexus (or “domestic transaction) for the ParentCo/TopCo. Under the MTA, the “Buyer” is the ParentCo/TopCo. If the goods or services are booked to the BU, a jurisdiction could assert that the title passed from ParentCo/TopCo to the BU in their jurisdiction. Terms and Conditions Terms and conditions (“Ts&Cs”) are generally the standard contract language for all agreements made by the corporation or even standard language related to a particular type of purchase. For global procurement agreements, Ts&Cs should include:

Pricing (inclusive or exclusive of VAT) Shipping terms (see Incoterms discussion below) Title transfer provision (see discussion below) Tax terms (both indirect and direct if there is potential for withholding)

From a pricing perspective, it is very important that the parties to the agreement agree to whether or not indirect tax is included in the stated price (either as the total value of the agreement or as a per piece price). If inclusive, any purchase order (“PO”) issued under the agreement would not account for additional monies to be paid for indirect taxes. If exclusive, the PO should account for the expected indirect tax amount. This is one of the most common errors of centralized global procurement. If the invoice amount is greater than the PO due to an indirect tax charge, the company would most likely short-pay the tax as the PO did not match the invoice amount. As to tax terms, many companies have basic language to cover direct tax withholding but little in regards to indirect tax. Depending on the complexity of the company’s procurement, indirect tax language guidance can be as little as a few paragraphs to several pages. Regardless of complexity, standard tax language should include guidance on how indirect taxes are defined, how indirect taxes are identified on the invoice, and which party has the obligation to pay the indirect taxes.


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Slide 17

Global Procurement Management One of the consequences of moving to global procurement is that the other company functions, such as accounts payable (“AP”) and record retention, are impacted. Often both of these functions are housed in a shared service center (either in the US or overseas). If so, global procurement will trigger a requirement to review these processes. For AP, one of the first questions will revolve around the timing of payment (not all VAT regimes define the taxable event as the supply of goods or services). Other issues to consider include:

Are invoices maintained as hardcopies, imaged copies or electronic invoices What are the procedures to retrieve invoices Are electronic invoices maintained on the companies’ servers or by third parties How long are invoices kept

If AP’s standard work mandates that invoices are either electronic or imaged copies, there are potential VAT compliance issues (certain jurisdictions require invoices be maintained in original form). If the company has taxable activities in a jurisdiction that requires original invoices, additional workflow processes must be inserted into AP’s standard work to maintain the original invoices. Lastly, procurement may be partially or completely outsourced to a third party provider. Functionally, the third party provider may act as a processor of invoices and submit to the client for payment, the direct payment agent (funded by the client) or some combination of the two. However, from a VAT perspective, the same issues are present as if the process was completed in house.


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International Trade and Practice As US multinationals enter into global procurement contracts, international trade law and practices will become part of the contract whether expressly written into the contract or can be inferred due to commercial usage. Incoterms 2010 International Commerce Terms (“Incoterms”) are internationally recognized standard trade terms that set out buyer and seller responsibilities. Incoterms are maintained and developed by the International Chambers of Commerce (“ICC”). Each Incoterm establishes who is responsible for costs and risks such as transport costs, insurance, import VAT & customs duties payable, and who is responsible for customs clearance formalities in the country of import. Incoterms are accepted by governments, legal authorities and businesses worldwide for the interpretation of most commonly used terms in international trade, if the contract is silent on these matters. This reduces or removes uncertainties and often costly misunderstandings arising from different interpretation of such terms in different countries. Incoterms apply to both domestic and international sale and purchase contracts. ICC has updated the Incoterms to be used in international contracts and the new 2010 Incoterms effective January 1, 2011 are: INCOTERMS and Potential VAT Implications1

Abbreviation Term Potential VAT Implications CIP Carriage and

Insurance Paid To (... named place of destination)

The seller can sell goods VAT zero rated (either as an export or an intra-EU transaction, if both seller & buyer are in the EU) provided all conditions are met. Both the seller and the buyer can be the importer of record. However, if the seller imports the goods it must pay import VAT and customs duties (if applicable) in the country of import and then make a domestic sale and charge local VAT. Depending on local VAT registration requirements, seller may be required to register and charge VAT and also comply with the applicable VAT compliance obligations. In practice, the buyer in the country of import will often be the importer of record.

CPT Carriage Paid To (... named place of destination)

The seller can sell goods VAT zero rated (either as an export or an intra-EU transaction, if both seller & buyer are in the EU) provided all conditions are met. Both the seller and the buyer can be the importer of record. However, if the seller imports the goods it must pay import VAT and customs duties (if applicable) in the country of import and then make a domestic sale and charge local VAT. Depending on local VAT registration requirements, seller may be required to register and charge VAT and also comply with the applicable VAT compliance obligations. In practice, the buyer in the country of import will often be the importer of record.

1 This is a general VAT guidance on parties in global procurement contracts party that could be liable import VAT and Customs Duties payments in the country of import. VAT advice should be obtained regarding the VAT implications of Incoterms to be adopted.


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DAP Delivered at

Place (...named place of destination)

The seller can sell goods VAT zero rated (either as an export or an intra-community transaction, if both seller and buyer are in the EU) provided all conditions are met. The buyer will be the importer of record in the country of import.

DAT Delivered at Terminal (...named place of destination)

The seller can sell goods VAT zero rated (either as an export or an intra-community transaction, if both seller and buyer are in the EU) provided all conditions are met. The buyer will be the importer of record in the country of import.

DDP Delivered Duty Paid (... named place of destination)

The seller transfers own goods from the country of origin to the country of import. No local VAT is due in the country of origin provided all conditions are met (i.e. proof of export). In the country of import, the seller must pay VAT at import (or account for acquisition VAT if both country of dispatch and country of acquisition are in the EU). Subsequently, the seller makes a domestic sale in the country of import of the goods. Depending on local legislation, VAT must be charged on this sale. It is likely that the seller may be required to register for VAT and comply with corresponding VAT compliance obligations.

EXW Ex Works (...named place)

The seller should in practice charge VAT (if a VAT system exists in the seller's country) on this sale. If certain conditions are met, the sale can be VAT zero-rated. However, the seller has the burden of proving that the goods are actually shipped abroad (which is difficult, since the seller delivers locally to the buyer in the supply chain). The buyer would be the importer of record in the country of import.

FCA Free Carrier (….named place)

The seller can zero-rate the sale provided it can prove that the goods actually leave the country of origin (the seller cleared the goods for export). The buyer would be the importer of record in the country of import.

CFR Cost and Freight (...named port of destination)

The seller can zero-rate the sale (either as an export or an intra-EU transaction, if both seller & buyer are in the EU) provided all conditions are met. Both the seller and the buyer can be the importer of record. However, if the seller imports the goods it must pay VAT at import and customs duties (if applicable) and the sale becomes a domestic sale in the country of import. Depending on local VAT registration requirements, seller may be required to register and charge VAT and also comply with the applicable VAT compliance obligations. In practice, the buyer in the country of import will often be the importer of record

CIF Cost, Insurance and Freight (... named port of destination)

The seller can zero-rate the sale (either as an export or an intra-EU transaction, if both seller & buyer are in the EU) provided all conditions are met. Both the seller and the customer can be the importer of record. However, if the seller imports the goods it must pay VAT at import and the sale becomes a domestic sale in the country of import. Depending on local VAT registration requirements, seller may be required to register and charge VAT and also comply with the applicable VAT compliance obligations. In


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practice, the buyer in the country of import will often be the importer of record.

FAS Free Alongside Ship (... named port of shipment)

The seller can zero-rate the sale provided that it can prove that the goods actually leave the country of origin (either as an export or an intra-community transaction, if both seller and buyer are in the EU). The buyer would be the importer of record in the country of import.

FOB Free On Board (... named port of shipment)

The seller can zero-rate the sale provided that it can prove that the goods actually leave the country of origin (either as an export or an intra-community transaction, if both seller and buyer are in the EU). The buyer would be the importer of record in the country of import.

Potential Indirect Tax Pitfalls to be Avoided in Global Procurement Contracts Potential pitfalls to global procurement contract include, but are not limited to, the following:

1. Review the parties to the contracts to ensure that the buyer does not create any additional indirect tax registration obligation, permanent establishment (or PE) and potential income tax filing obligations due to the sourcing of the goods and services and the subsequent distribution thereof.

2. Review the Incoterms agreed to in the contract and the practical usage adopted therein; which often times is inconsistent with the general usage of Incoterms.

3. With the growth of enterprise reporting platform systems to streamline processes and create global oversight, management and control, good supplier data is necessary to ensure that the supplier master file has the correct data elements required to automate procure-to-pay processes and the corresponding indirect tax due on global contracts.

4. With the advent of the centralization of procurement function, there is an increasing need to have a dynamic automated tax determination tool to ensure that indirect tax is being calculated on transactions at the correct rate, correct amount at the correct time and posted into the appropriate general ledger account.

5. Invoice is “king” and if the invoice is issued to the incorrect legal entity, which is not registered for VAT in the country where the goods or services are to be utilized, that entity may not be able to recover the VAT; consequently, the VAT becomes trapped and added to the cost of doing business.

6. Another pitfall to avoid is disruption to the buyer’s supply chain process due to unpaid indirect tax on a supplier invoice. This typically happens, where due to incorrect invoice and indirect tax validation process, the buyer short-pays on a supplier invoice and no control point is put in place to catch such short payment on supplier AP invoice.

7. Due to the structure of global procurement contracts, US multinationals will enter into the contract for the procurement of services and will incur the cost and seek to “push down”


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the cost through an intercompany billing processes. The pushed down cost could give rise to potential transfer pricing issues, and withholding tax in the country of the recipient of the services which may not be factored into payment to be made to the parent company. There could be potential VAT on locally sourced goods and services, which if not structured properly, could be pushed down and thereby trigger additional indirect tax costs.


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NOTES

Sales Tax School II

Tax Planning


Sales Tax School II

BREAKOUT SESSION

2 Problems

(Mergers and Acquisitions, Tax Planning)


1

Mergers and Acquisitions – Problem

Sales and Use Tax Implications of Select Corporate Transactions

Facts Sun-Must-Shine, Inc. (SMS), manufactures solar-powered hand garden tools and lawnmowers. SMS is comprised of two divisions, the Research Division and the Product Division. The Research Division's primary responsibility is the development of the technology and design specifications needed by the Product Division to produce SMS's garden equipment. This includes the development of new products, as well as improvements to SMS's existing product line. The Product Division's primary responsibility is the production of SMS's entire product line. Because of the potential for personal injury, SMS has become increasingly concerned with product liability. As a result, the Board of Directors has voted to drop the Research Division's operations into a separate corporation. SMS plans to transfer the entire Research Division to Dormant Co., an existing shell corporation that it established approximately 2 years ago, in a transaction that will qualify for tax-free treatment under Internal Revenue Code §351. SMS has also decided to dispose of some of its outdated equipment and during the last 10 months has sold a few of its personal computers to employees. The Research Division's business assets that are to be transferred are as follows: Office furniture and fixtures. Computer hardware, 15 percent of which is used for administrative purposes and 85 percent

is used in research and development activities. Intangible assets comprised of the following technology:

Computer software programs developed in-house by the Research Division. Approximately 80 percent are engineering and basic research programs used in product design and testing and contain trade secrets, the remaining 20 percent are used in administrative activities.

Drawings and designs which embody technology developed by the Research Division for the manufacture of SMS's garden products. They set forth confidential trade secrets and depict patented components.

Manuals and procedures containing engineering specifications prepared by the Research Division engineers, who used them as technical guidelines.


2

Accounts Payable Although the Controller knows that the transaction is not the type to result in a sales tax liability, he has requested that you, the Director of Sales Tax, perform a quick review of the transaction in conformity with office policy. Discussion Questions 1. Is there a potential sale for purposes of imposing a sales tax?

2. Identify the sales tax exemptions that SMS may be able to avail itself of.

3. Identify the potential sale tax problems that may prevent SMS from utilizing the

exemptions identified in Question 2 above.

4. What can SMS do to reduce or eliminate its potential tax liability?

5. Simultaneous with the inquiry from the Controller, the CFO has requested you be part of a team performing a due diligence on a potential acquisition target. Due to secrecy about potential insider trading problems, the CFO cannot provide you with any information about the target.

All the CFO can disclose is the following:

The Company was spun off from a Fortune 500 Company six years ago.

The Company was at $100 million in Revenue in 1999. For 2005, revenue is forecasted at $250 million.

Several acquisitions occurred to spur that growth as well as the development of a new

product that generated $50 million in revenue in 2003.

The Company operates with separate legal entities and discrete divisions.

The CFO will likely have less than one hour to focus on this aspect of the transaction. What the CFO is requesting from you is to prepare a list of questions to ask and items to review so that they can estimate and/or evaluate potential sales tax exposure.

Prepare your list while taking into account the time constraints of the CFO so that you highlight your concerns in descending order of importance.


1

2. Breakout Problem - Tax Planning Making Your Sales Tax Department Proactive

Case Study At 4:30 p.m. on Wednesday, the Tax Vice President of your Company, WeHaveItAll, Inc. (“WHIA”) comes into your office to discuss several key initiatives for the upcoming budget. In general, he explains to you that Senior Management has historically viewed the tax department as purely a cost center and that he wants to change that perception and believes that the tax department should be seen as a key operations center that increases shareholder value by reducing overall company expenses, without hindering the company’s overall growth plans. That being said, he indicates that the company is looking to the tax department for some key tax savings strategies related to (i) the pending sale of a major division within the corporate organization and (ii) overall reduction is total sales taxes paid. Since sales tax is included in Earning before Interest, Taxes, Depreciation and Amortization (“EBITDA”), these savings are essential to assisting the business attain its overall plan. Although the deal for the sale of the major Division is almost finalized, you are asked to “just skim” the Agreement and let them know if any material issues are involved in the deal. The buyer has requested that his deal be constructed as a sale of assets and your federal group believes that your company is best served by having it treated as an asset deal and will be using a typical Asset Purchase Agreement (“APA”). Once you have finished the review of the APA, the Tax Vice President, has requested a business plan from the sales and use tax group to assist the company in its overall tax savings strategies. Synopsis of the Asset Sale General Information This Agreement is between your company, WHIA and an unrelated corporation that is purchasing a major division of your corporation, Manufacturers-R-Us (“MRU”). MRU sales are currently included in the sales tax returns filed by WHIA. MRU has physical presence in all fifty states, with its most significant operations in New York, Texas, and California. Asset Purchase Agreement The APA as currently constructed indicates that the “Agreement contemplates a transaction in which Buyer will purchase all of the assets (and assume certain of the liabilities) of the MRU division of WHIA in return for cash and the Buyer Notes.”


2

Tax Provisions The total amount of the purchase price is inclusive of sales tax, but not any other type of transaction type taxes (real estate transfer taxes, etc.) The purchaser will be responsible for all real estate transfer taxes. Allocation Provisions The allocation provisions of the APA indicates that “the purchase Price (and all othe capitalizable costs) among the Acquired Assets for all purposes (including financial accounting and tax purposes) in accordance with the allocation schedule attached.”

Asset Location Real Property Tangible Personal Property

Intangible Property

New York State

2,500,000 3,000,000 250,000

Texas 500,000 2,000,000 1,800,000

California 5,000,000 7,500,000 500,000

Other Locations

250,000 750,000 750,000

Total 8,250,000 13,250,000 3,300,000

The above totals were determined based on a review of the books and records of the division. The total amount being paid for the divisions is $24,800,000. In determining the total purchase price of these assets, the real estate appraised value was utilized and any premium over the net book value was allocated to the tangible personal property based on revenue generated. The Net Book Value for the tangible personal property was $1,200,000 in New York, 1,750,000 in Texas, and 3,000,000 in California. The NBV and the allocated price for other locations were not changed. Case Study Question – Part I 1. After reviewing the facts of this proposal, what analysis is required to determine potential

sales tax exposure related to this agreement? 2. How can we restructure this agreement or allocation to reduce or eliminate the sales tax

exposure?


3

Business Plan For submission to the Tax Vice President, you have decided that implementing a global centralized procurement strategy would drive material cost reductions from WHIA’s supply chain. Please provide a detailed analysis of potential savings (tax and non-tax) as well as identify potential exposures and solutions. Facts Even after the sale of MRU, WHIA will have multiple locations within its overall organization (both subsidiaries and divisions) that directly purchase capital items and supplies. You have discussed this with your purchasing group and they have indicated that by centralizing the purchasing function, this group believes it will be able to save the company 5% of its total costs by centralizing the purchasing function. However, whenever this has been brought up before, the operations group “nixed” the centralized purchasing function because they did not want to lose control of process. You have also determined that by having the purchasing function done at each location, the additional time and energy it has caused with respect to the use tax calculation and sales and use tax audits has added at least two full head counts to the tax department. Finally, based on several “reverse audits” performed by outside consultants, you have determined that the payment of sales tax on certain purchases has cost the company approximately $1,500,000 per year in sales tax overpayments (and if the refunds are recovered by the consultant, you have to pay the consultant 30% of total savings). Case Study Question – Part II 3. After reviewing the facts, please prepare an outline that supports your rationale for

suggesting this type of organization structure change.


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NOTES

STATISTICAL AND BLOCK SAMPLING Tax School II... · STATISTICAL AND BLOCK SAMPLING Slide 1 I....

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