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In-Depth Coverage of Issues Surrounding State and Local Tax
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In-Depth Coverage of Issues Surrounding State and Local Tax
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OTA Finds CDTFA’s Audit Methodology Arbitrary

By , , and on Jul 24, 2023
Posted In , ,

In Appeal of Colambaarchchi (OTA Case No. 21017152; 2023-OTA-302), a California-based retailer was audited by the California Department of Tax and Fee Administration (CDTFA) for years 2016 through 2019. Upon audit, CDTFA determined that taxable sales went unreported. In calculating the extent of the underreporting, CDTFA used various indirect methods for different periods in the audit years and applied a method to each period that maximized the amount of tax due. The Office of Tax Appeals (OTA) found that this methodology was utilized simply to create the largest underreporting, was inconsistent and lacked the required minimum rational and reasonable basis.

Colambaarchchi operated two perfume retail stores. During its audit, CDTFA performed various sales tests that suggested unreported sales. To compute the taxable measure, CDTFA used a combination of the federal income tax returns (FITR) method and the bank deposits method. Specifically, CDTFA used the bank deposits method for 2016, switched to the FITR method for 2017, then switched back to the bank method for 2018 and Q1 2019. In the audit work papers, CDTFA noted that the “[a]uditor used the higher of FITR or bank deposit difference to arrive at audited taxable sales.” In other words, CDTFA alternated between the two methodologies simply to maximize the tax liability.

CDTFA subsequently issued a notice of determination, which the company timely appealed. At the prehearing conference, OTA placed the parties on notice that, in deciding the appeal, the OTA may consider “[w]hether respondent was justified in selecting the bank deposit method for 2016, 2018 and the first quarter of 2019 and gross receipts from the [FITR] for 2017.” Accordingly, bearing the initial burden of showing that its decision to switch between two methods was reasonable and rational, CDTFA argued that it “selected the FITR method for 2017 because ‘the bank deposits may not have all cash deposited into the bank’ in 2017, and that it may have selected the bank deposits method for 2016, 2018 and 1Q19 because the income tax returns ‘may not be accurate because obviously there are additional [bank] deposits in addition to what they reported on their income tax returns.’”

OTA rejected this argument because it found “no support in the record for CDTFA’s assumption that the bank deposits method is less accurate in 2017 than in the other periods such that it would be reasonable and rational for CDTFA to switch to the FITR method in 2017.” According to OTA, CDTFA “cannot assume that one indirect audit method is more accurate in one period than another just because it produces a higher result.” OTA further stated that “this arbitrary selection made solely to increase unreported taxable sales is not reasonable and rational. Where CDTFA alternates between indirect audit methods because one method produces a higher result, CDTFA is no longer attempting to estimate the correct measure of tax but instead is arbitrarily increasing the tax measure.” Consequently, OTA held that CDTFA failed to meet its burden of proof, and CDTFA was ordered to utilize the bank deposits [...]

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California Supreme Court Lets It Stand That CDTFA Can Decide Who Is and Is Not a Retailer

By , and on Apr 28, 2023
Posted In , , ,

On April 26, 2023, the Supreme Court of California declined to review the Second District Court of Appeal’s decision in Grosz v. California Dep’t of Tax & Fee Admin. In the underlying case, Stanley Grosz, a business owner based in Fresno, California, filed suit seeking a declaration that the California Department of Tax and Fee Administration (CDTFA) has a mandatory duty to collect sales and use tax from an internet retailer for sales that were made by third-party merchants on the retailer’s website, but fulfilled by the retailer. Grosz also sought an injunction requiring the CDTFA to collect the sales and use tax.

The internet retailer’s service allows third-party merchants to outsource their order fulfillment to the retailer. As part of the service, the internet retailer stores the merchants’ products at one of its fulfillment centers. According to Grosz, the provision of these services necessarily defined the internet retailer as a “consignment retailer” responsible for remitting sales tax on transactions facilitated through its website. (18 CCR § 1569.) The CDTFA disagreed and counter-argued that the determination of who constitutes a “retailer” under California sales and use tax law is a decision that is within its sole discretion to make.

The Second District Court of Appeal, in analyzing the statutory definition of “retailer” contained in Section 6015(a) of the Revenue and Taxation Code, concluded that it was “clear” that both the internet retailer and the third-party merchants could be regarded as retailers for purposes of transactions conducted under the service. The Court then agreed that the CDTFA has broad discretion to determine who constitutes a “retailer” under California’s sales and use tax laws.

It is important to note that the facts in this case occurred before the enactment of California’s Marketplace Facilitator Act (MFA). Under current law, marketplace facilitators generally are responsible for collecting, reporting and paying the tax on retail sales made through their marketplace for delivery to California customers. Thus, the current statutory scheme has greater clarity concerning the sales tax collection and reporting requirements for marketplace facilitators and sellers. Nevertheless, this case highlights the exposure some sellers may have for sales made before the MFA went into effect if tax was not properly collected and remitted.



Massachusetts Department of Revenue Releases Guidance on a De Minimis Exception for Use Tax on Rolling Stock

By , and on Mar 28, 2023
Posted In , , , ,

The Massachusetts Department of Revenue (DOR) recently released Directive 23-1, which outlines the conditions for a de minimis exception where the Commissioner will not require a taxpayer to pay the use tax for rolling stock used or stored within the state. This directive comes at a time when the DOR is auditing many companies that use trucks and trailers and is currently assessing use tax on rolling stock if no sales tax was collected at the time of sale.

Directive 23-1 provides that “the Commissioner will consider the in-state use [of rolling stock] to be de minimis and will neither impose, nor require the taxpayer to pay, use tax on the use or storage of the rolling stock” where the taxpayer can prove “that the rolling stock that it owns or leases for 12 months or longer was used or stored in Massachusetts for no more than six days during a 12-month period” (emphasis added).

Companies “can demonstrate the frequency with which rolling stock was used or stored in Massachusetts through sufficient records that show the dates of travel into and in Massachusetts, such as GPS logs.” Additionally, a credit against the Massachusetts use tax is allowed if the taxpayer has paid a sales tax legally due to another state and that state allows a corresponding credit for sales or use tax paid to Massachusetts.



Pennsylvania Supreme Court Rules Coupon Amounts Are Not Subtracted from Sales Tax Base Unless Sales Receipt Adequately Describes Taxable Item and Coupon

By and on Feb 24, 2023
Posted In , , , , ,

Overturning a 6-1 en banc decision by the Pennsylvania Commonwealth Court, the Pennsylvania Supreme Court held that a coupon does not reduce the price upon which sales tax must be collected unless the coupon is adequately described and “linked” with the taxable item in accordance with Pennsylvania Department of Revenue (DOR) regulations. The case was brought by a retail customer seeking a sales tax refund on the difference between the retail price of the product and the discounted price as the result of a coupon. The decision instructs retailers on the application of coupon discounts when collecting sales tax. The decision may also provide comfort to retailers facing class action lawsuits in Pennsylvania for collecting sales tax on full invoice prices without taking discounts from coupons into account.

The case examined three transactions between a retailer and customer. In two of the transactions, the customer purchased a single taxable item and used a single coupon. In the other transaction, the customer purchased six taxable items and used five coupons of varying amounts. The receipt provided in each transaction identified each coupon as a “SCANNED COUP” and identified the discount provided with each coupon but did not further describe the coupon nor link the coupon as a discount to any specific item purchased. In all three transactions, the retailer collected sales tax on the full purchase price without taking the coupons into account. The customer sought a sales tax refund from the DOR, maintaining that sales tax should have been collected on the discounted price. The DOR denied the refund claim.

The Pennsylvania Supreme Court agreed with the DOR’s position that under Pennsylvania regulations, “sales tax is owed on the full purchase price” (disregarding any coupons) unless an invoice or receipt (1) separately states and identifies the amount of the taxable item and the coupon and (2) provides a description of both the taxable item and the coupon. Further, the Court agreed that a satisfactory description in the receipt must contain a “linking” element, meaning the coupon must be adequately described to show that it applied to a specific item. The Court explained that such a description on the receipt was necessary because, under Pennsylvania law, “there are discounts or coupons that do not establish a new [taxable] purchase price, such as a discount for shopping on a specific day, discounts from a minimum purchase amount, and sales tax absorption coupons.”

In recent years, state tax departments have been very aggressive in asserting that coupons and discounts do not reduce the sales tax base. This decision serves as a reminder to retailers that the description of coupons on invoices is critical in determining the amount of sales tax to collect. In Pennsylvania, the coupon must be separately identified and “linked” to the taxable product upon which the discount is applied.

This decision highlights the dilemma many retailers face when collecting tax on discounted products: if they collect on the full retail price, they face the potential for customer class action suits [...]

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Is California Picking the Pockets of Other States?

By , , and on Oct 21, 2022
Posted In , , , ,

In Matter of Body Wise International LLC (OTA Case No. 19125567; 2022 – OTA – 340P), a California-based retailer collected amounts designated as “tax” related to jurisdictions where it was not registered to collect tax. The California Office of Tax Appeals (OTA) held that the retailer must remit those amounts to California, even though the sales were not taxable in California, because the retailer did not actually pay the “tax” amounts it collected to the other states nor did it refund those amounts to its customers.

Body Wise International, LLC sold weight loss supplements to customers across the country and shipped the products directly to customers via common carrier from its warehouse in California. During the periods at issue, Body Wise’s tax software program charged a “Tax Amount” on all sales to customers located in various states based upon the respective tax rates in those other states. In states where Body Wise had not registered to charge or collect tax, Body Wise did not remit the “tax” collected to those states.

On audit, the California Department of Tax and Fee Administration (CDTFA) determined that the “Tax Amounts” Body Wise collected in those other states constituted excess sales tax reimbursements under California Revenue & Taxation Code (R&TC) section 6901.5, which provides that a retailer who collects a sales tax reimbursement exceeding the amount of the sales tax liability imposed upon the sale must remit the excess to the customer or to the state. CDTFA concluded that those amounts collected but not paid over to the other states must either be returned to the customer or remitted to California.

Upon appeal, the OTA agreed with CDTFA. OTA first observed, “it is not necessary for a sale, purchase, or any other type of transfer for consideration to be subject to California’s sales tax in order for the excess tax reimbursement provisions of R&TC section 6901.5 to apply.” Rather, OTA then stated, the requirement to remit or refund excess sales tax reimbursement to CDTFA applied to Body Wise even where the underlying transaction was nontaxable or exempt in California. Based upon this, OTA concluded that Body Wise must remit those amounts collected to California. OTA supported its conclusion by observing that Body Wise was not registered to collect sales tax in some or all of the other states.

However, logically, the excess tax reimbursement covered by the statute must be excess California tax reimbursement in the first instance. Indeed, the statute by its own terms expressly applies to “taxes due under this part [the California Sales and Use Tax Law].” (Cal. Rev. & Tax. Code § 6901.5.) Because these were not taxes due to California but ostensibly to the other states, California’s attempt to abscond with revenues belonging to another state would appear to be unconstitutional as violating the sovereignty of that other state.

The OTA’s conclusion would seem to be at odds with the important maxim of statutory construction to avoid an interpretation of the statute that would render it [...]

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More than Tax Compliance: California Legislation Requires Marketplace Facilitators to Track “High-Volume” Seller Information

By , and on Oct 7, 2022
Posted In , , ,

The responsibilities of marketplace facilitators operating in California are expanding under legislation recently signed by Governor Gavin Newsom. Starting on July 1, 2023, an “online marketplace” will be required to collect and maintain specified contact and financial information related to its “high-volume third-party sellers.” The legislation is intended to “provide greater tools for law enforcement to identify stolen items” being resold through online marketplaces.

Under the legislation, a “high-volume third-party seller” is defined as any seller who, in any continuous 12‑month period during the previous 24 months, has entered into 200 or more transactions through an online marketplace for the sale of consumer products to buyers located in California, resulting in a total of $5,000 or more in gross revenues. While the legislation includes its own definition of an “online marketplace,” the definition will likely reach most (if not all) businesses classified as “marketplace facilitators” for California sales tax purposes.

An online marketplace will be required to collect information about any high-volume third-party seller on its platform, including the seller’s name, tax ID number and bank account number (presuming the seller has a bank account), along with certain government-issued records or tax documents if the seller is not an individual. For those sellers making at least 200 sales totaling at least $20,000 in gross revenues to buyers in California, an online marketplace must collect additional information, disclose certain contact information to consumers and provide a means to allow users “to have direct and unhindered communication with the seller.”

Information collected about sellers must be verified within 10 days and be maintained for at least two years, and the online marketplace must suspend sales activities of a high-volume third-party seller out of compliance with the requirements of the legislation. An online marketplace not in compliance with the legislation will be subject to a penalty of up to $10,000 for each violation.

Businesses impacted by this legislative development or with questions about marketplace facilitators are encouraged to contact the authors of this article.



New Mexico Proposes Regulations Addressing Gross Receipts Tax Treatment of Digital Advertising Services

By , , , and on Aug 11, 2022
Posted In , , , , , , ,

On August 9, 2022, the New Mexico Taxation and Revenue Department published proposed regulations addressing the gross receipts tax (New Mexico’s version of a sales tax) treatment of digital advertising services. The Department states the proposed regulations do not reflect a change in policy but instead ensure the rules are consistent for all advertising platforms.

While the proposed regulations provide some clarity regarding the taxation of digital advertising services under preexisting rules, they introduce several inconsistencies and other gaps, particularly with respect to the finer details of the sourcing provisions. For example, we believe the proposed regulations leave ambiguity regarding whether gross receipts from the provision of digital advertising services should be sourced to:

  1. The purchaser’s address
  2. The server’s location
  3. The viewer’s location

Separately, the proposed regulations would allow a deduction for gross receipts from national or regional advertising. However, the deduction is not allowed if the purchaser is incorporated in or has its principal place of business in New Mexico. While this significantly narrows the base for the tax, it injects complexity by requiring that the seller know the state in which its purchaser is incorporated or has its principal place of business, information not likely available in the context of internet-based advertising platforms.

Collectively, these inconsistencies and lack of clarity could lead to future compliance issues, which we hope will be mitigated as part of the Department’s regulatory approval process.

The Department scheduled a public hearing on the proposed rules for September 8, 2022, at 10:00 am MDT, which also is the due date for submission of written comments. The proposed regulations would be effective upon publication in the New Mexico Register, which could happen as soon as October 11, 2022 (or thereabout).

Please contact the McDermott Will & Emery State & Local Tax team if you have any questions about the potential impact of these proposed regulations on your company. In the meantime, we will be monitoring the regulation approval process and participating in next month’s public hearing.



CDTFA Proposes Significant Revisions to Chapters 4 and 13 of the Sales Tax Audit Manual

By , , and on Feb 10, 2022
Posted In , , , ,

On February 2, 2022, the California Department of Tax and Fee Administration (CDTFA) held an interested parties meeting (IPM) to discuss proposed amendments to sales tax audit manual (AM) Chapter 13, “Statistical Sampling,” and Chapter 4, “General Audit.”

Prior to the IPM, the CDTFA released a lengthy discussion paper outlining the extensive proposed changes to the AM, which includes:

1. Removing the three error rule. The current text of AM 1308.05 explains that when a sample produces only one or two errors, the auditor must evaluate whether these errors are representative or whether it is possible they indicate problems in certain areas that could be examined separately. Under the proposed amendment, the same evaluation standards would still be in place without the minimum error requirement. According to the CDTFA, the proposed removal of the three error rule is because of the fact that “the number of errors identified in a sample does not give any indication whether the sample is representative or not…If the combined evaluation evaluates within Department [CDTFA] standards, it is justified to project the results even if one or two errors are found.”

2. Requiring 300 minimum sample items per stratum unless the auditor obtained approval from CAS to select fewer than 300. Currently, the “minimum sample size of at least 300 items of interest is to be used in all tests, except where the auditor can support a smaller sample size and it evaluates well.” (AM 1303.05) Under the new subsection titled “Materiality,” a minimum of 300 sample items per test stratum is recommended. Computer Audit Specialist (CAS) approval is required for selecting less than 300 sample items per test stratum.

3. Refunding Populations: A minimum of 100 sample items per stratum is required. In the section addressing sampling refund populations (AM 1305.10), the proposed amendment would permit auditors to select as few as 100 sample items per test stratum without CAS approval, provided the expected error rate is sufficiently high (greater than 20%). No such rule exists under the current text of Chapter 13.

4. Contacting CAS when the prior audit had 300 hours charged to it is now mandatory. In contrast, under the current rule, it is mandatory that CAS be contacted when the prior audit expended 400 or more hours or if CAS was involved in the prior audit.

5. Replacing Credit Methods 1, 2 and 3 with one recommended approach to handling credits in a statistical sample. The subsection (AM 1303.25) currently lists three types of credit methods that can be used for a statistical sample. The CDTFA now only recommends one credit method for use in a stratified statistical sample, which is referred to as “Method 1” in the current AM text. When auditors review electronic data, attempts should be made to match credit invoices to original invoices (including partially) if it is certain that the credit invoices are related to the original invoice. For all credit memos that are not matched to original invoices, those credits will be removed from [...]

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Texas Comptroller Announces Medical or Dental Billing Services are Not Taxable, Effective Immediately

By and on Jul 29, 2021
Posted In , , , ,

On June 4, 2021, the Texas Comptroller issued a policy statement (Accession No. 202106003L) announcing that it is not going to enforce its previously stated policy of taxing medical billing services. This guidance comes in response to a sales and use tax bill that was signed into law April 30, 2021, which excluded “medical or dental billing services” performed prior to the original submission of a medical or dental insurance claim from insurance services. The Comptroller states that it will immediately treat medical or dental billing services as excluded from the definition of insurance services even though the bill is not effective until January 1, 2022. It remains to be seen if the Comptroller’s interpretation of medical billing services, which has been defined through decades of policy and guidance, is aligned with the legislature’s view of “medical or dental billing services.” Some commentators have suggested there may be points of divergence that will need to be worked out over time. For additional information on this topic, please see our prior blog post.



Massachusetts Supreme Judicial Court Approves Sales Tax Apportionment for Software

By , , and on May 25, 2021
Posted In , , , , ,

On May 21, 2021, the Massachusetts Supreme Judicial Court issued a decision affirming the Massachusetts Tax Appeal Board’s decision in favor of Microsoft and Oracle, ruling that the companies may apportion sales tax to other states on software purchased by a Massachusetts company from which the software was accessed and seek a tax refund.

The case involved a claim by vendors for abatement of sales tax collected on software delivered to a location in Massachusetts but accessible from multiple states. The Massachusetts Department of Revenue (DOR) claimed that the statute gave it the sole right to decide whether the sales price of the software could be apportioned and, if so, the methods the buyer and seller had to use to claim apportionment. Under rules promulgated by the DOR, there are three methods to choose from, such as the purchaser giving the seller an exemption certificate claiming the software would be used in multiple states, none of which the purchaser used. The DOR argued that if a taxpayer did not use one of the methods specified in the rule, no apportionment was permitted. The vendors sought abatement of the tax on the portion of the sales price that could have been apportioned to other states had one of the methods specified under the rule been used. The DOR claimed the abatement procedure was not a permissible method of claiming apportionment.

The court held: (1) the statute gave the purchaser the right of apportionment and it was not up to the DOR to decide whether apportionment was permitted; (2) the abatement procedure is an available method for claiming the apportionment; and (3) the taxpayer was not limited to the procedures specified in the rule for claiming sales price apportionment.

The court’s decision was based in part on separation of powers: “Under the commissioner’s reading of [the statute], the Legislature has delegated to the commissioner the ultimate authority to decide whether to allow apportionment of sales tax on software sold in the Commonwealth and transferred for use outside the Commonwealth.” The court found such a determination represented “a fundamental policy decision that cannot be delegated.”

The Massachusetts rules reviewed by the court have their genesis in amendments to the Streamlined Sales and Use Tax Agreement (SSUTA) (that never became effective) providing special sourcing rules for, among other things, computer software concurrently available for use in more than one location. Even though Massachusetts is not a member of the SSUTA, officials from the DOR participate in the Streamlined process and apparently brought those amendments home with them and had them promulgated into the Commonwealth’s sales tax rules.

Practice Notes: This case addresses one of the issues with taxing business models in the digital space. This important decision makes clear, at least in Massachusetts, that taxpayers have post-sale opportunities to reduce sales tax liability on sales/purchases of software accessible from other states where tax on the full sales price initially was collected and remitted by the seller.

Taxpayers may have refund opportunities related to this [...]

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