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Reverse Sales and Use Tax Audits
Tthe reverse sales and use tax audit is identical in many respects to the sales and use tax audits conducted by state auditors, except the reverse auditor looks for overpayment of tax.
Several factors may cause sales and use tax overpayments. In many states, the field auditors have become very aggressive in assessing taxes, penalties and interest. This environment has caused retailers to be aggressive in charging tax, because of the fear of a state audit deficiency. Often, tax is charged even when the sale would be exempt.
In many cases, suppliers and distributors are aggressive in charging sales tax on every sale, even when the sale may be exempt. Usually, their motivation is to avoid the responsibility for tax, because most state laws will hold the seller responsible for the tax if not paid. Other times, they will inappropriately charge the tax because there is no (or an invalid) exemption claim. Either way, the purchaser may pay tax not due.
Finally, an inadequate sales and use tax compliance system may allow tax to be paid in error. Normally, it is the responsibility of the purchasing function to make a claim for exemption (industrial processing or agricultural production). If this is not done (either through miscommunication or negligence), the supplier will normally charge the tax. A second line of defense is the accounts payable function. If an invoice that includes tax is presented for payment, the accounts payable department should omit the tax if the purchase is exempt. Inadequate compliance in the purchasing and accounts payable areas can cause the overpayment of tax.
Performing a Reverse Audit
The first step in a reverse audit is to perform a complete study of the taxpayer's business activities. It is important to identify what line of business the taxpayer is in and how it is taxed. More important is the determination of which exemptions may apply. In the case of manufacturing or industrial processing, it is important to identify when the exemption starts and ends.
The second step is a complete study and evaluation of the sales and use tax compliance system. The acquisition of property is traced from the purchasing function through the payment and accounting for the acquisition. Particular attention should be paid to the sales tax and use tax compliance function. Reverse auditors look for weaknesses in the system that would allow for the overpayment of tax. Often, a sample review of invoices will be made to identify adherence to company policy.
After completion of the business and compliance system reviews, an audit program is prepared. The audit program will almost always require a review of all capital acquisitions and other large dollar amount purchases made by the taxpayer during the audit period. The audit program will require the review of some other purchase invoices based on the compliance review if the auditor believes there is a high probability for the overpayment of tax.
State-of-the-art computer database analysis software can be used to assist in analyzing purchases to identify those in which tax was paid in error. When combined with statistical sampling, these programs can substantially reduce the time required to complete a reverse audit. The database software (ACL or Monarch) can analyze the accounts payable data files to identify purchases in which an overpayment of tax would most likely occur. The software can also stratify a population of purchase items for review and scientifically select a random sample of invoices for review. The reverse auditor can then review the selected invoices and identify those containing an overpayment of tax. Mean estimation can then be used to scientifically project the tax overpayment to the entire population. The scientific tools give the reverse auditor a method to quantify the precision and reliability of the scientific projection.
When the review is completed, the information is assembled and claims for refunds can be made to the vendors or the state. The auditor must check with each state involved to determine if it will refund overpaid tax directly to the consumer taxpayer or whether it will be refunded only to the retailer taxpayer.
Final Report and Recommendations
After completion of the reverse audit, a written report is given to the taxpayer. The report identifies the audit procedures completed and the findings. To the extent the auditors believe improvements can be made to the system of compliance for sales and use tax, specific recommendations will be made and will become a part of the written report.
From Edward S. Kisscorni, CPA, Grand Rapids, MI
What's Next in South Central Bell?
In March 23, 1999, the Supreme Court released its long-awaited decision in South Central Bell Telephone Co. v. Alabama. The Court rejected Alabama's Eleventh Amendment challenge to the Court's jurisdiction, and upheld the taxpayer's Fourteenth Amendment due process rights and the Commerce Clause restriction against nonresident discrimination. (For a discussion, see News Notes, "Alabama Foreign Franchise Tax," TTA, May 1999, p. 284.) Bell marks the second time in 14 years that the Supreme Court has struck down an Alabama tax designed to impose a heavier tax burden on nonresident businesses. As in its earlier decision in Metropolitan Life Insurance Co. v. Ward, 470 US 869 (1985), the Court remanded the case to the state court to determine an appropriate remedy.
At this time, there can only be speculation as to what the remedy might be. The plaintiffs in Metropolitan Life settled their refund claims outside the court system, with the state agreeing to redesign the objectionable taxing system. This redesigned system of taxation was implemented eight years after the Court directed the state to develop a solution. If Alabama is to achieve a similar resolution of the current issue, it will likely be more difficult. To begin with, unlike the tax involved in Metropolitan Life, the corporate franchise taxes are imposed by the state constitution. The state constitution restricts the taxation of both domestic corporations and foreign corporations to the scheme found objectionable by the Federal court. Therefore, one or more constitutional amendments will be required to eliminate the existing taxing system. An amendment removing the constitutional provisions related to corporate franchise taxes has already passed the first steps in the process. Assuming the proposed amendment is ultimately approved, it will then be up to the Alabama legislature to craft a replacement for the lost revenue. Presumably, this will be in the form of a constitutionally acceptable replacement corporate franchise tax.
Will the plaintiffs in Bell eventually abandon their claims for refunds in exchange for a prospective remedy? Certainly, the state will correct the taxing system with or without an agreement from the Bell plaintiffs to abandon their claims. One initial proposal would have limited the tax to an amount less than $9,000, regardless of the assets the corporation employs in Alabama. To taxpayers like the plaintiffs in Bell, this limitation most likely is very attractive and may well be the incentive needed for them to drop their claims.
The Court's earlier decision in Newsweek, Inc. v. Florida Department of Revenue, 118 SCt 904 (1998), would appear to require Alabama to refund this tax. In Newsweek, the Court stated, "We emphasized a State 'has the flexibility to maintain an exclusive predeprivation remedial scheme, only so long as that scheme is clear and certain.''' Absent such a clear and certain predeprivation remedial scheme in Alabama, the Bell decision seems to require a refund.
Regardless of whether the Bell plaintiffs drop their claims for refund, will other taxpayers petition for a refund and, if necessary, carry their petitions to the courts? Clearly, it would be less expensive to litigate such a claim than the total cost to Bell plaintiffs. Alabama Code Section 40-2A-7(c)(1) provides that "[a]ny taxpayer may file a petition for refund with the department for any overpayment or other amount erroneously paid." It is difficult to contend that an unconstitutional tax paid is neither overpaid nor paid in error. Therefore, any taxpayer that has paid an Alabama foreign corporation franchise tax during a period currently open under the Alabama refund statute may submit such a petition. The Alabama Department of Taxation has six months to grant or deny the petition. If the Department fails to grant a refund within the six-month period, it is deemed to have been denied. On denial of the petition, the taxpayer has two years to submit an appeal.
While the Bell plaintiffs might receive significant benefit from any prospective amendment of the corporate franchise tax, what are the chances that similar prospective relief will be provided outside a compromise with the plaintiffs? Would increasing the tax on local businesses to the level the previous tax imposed on nonresidents be sufficiently unpopular for the citizens to demand change? It is precisely this power of the local electorate that the Supreme Court has cited for not objecting to taxing schemes that tax citizens of the state more heavily than nonresidents. We can logically presume the elected legislators are not oblivious to this power.
Analyzing the proposal, the upper limit on its assessment clearly favors local business, albeit seemingly within constitutional restrictions. Clearly, any cap on a tax benefits those with higher tax bases in the state over those with a minimal presence. It is doubtful that anyone would claim such a scheme does not favor large corporations domiciled within the state. However, this same benefit would also be available to corporations domiciled in other states with significant property and payroll in Alabama. This situation seems to provide a solution to Alabama's constitutional issue without increasing the tax on local businesses to the relative levels assessed by the prior scheme on many out-of-state corporations doing business in the state. Elected officials can protect their electoral base if they can convince their electorate to accept a limited tax increase. It would seem a lower tax rate with a higher upper limit may be more attractive to the business community in Alabama. The tax rate and the minimum and maximum tax base may vary significantly from the initial proposal, but something similar to this proposal seems a most likely replacement.
What will other corporations subjected to this tax now do? Many will weigh the benefit of potential refunds against the expense and cost of attempting to obtain them, possibly proceeding to make applications for refunds. It remains to be seen how difficult and costly this process will be. However, those applying for refunds should be prepared to stay the course or walk away from their investment at some point in the process.
From Richard H. Griffen, CPA, Elkhart, IN TTA
