November 16, 1999
FOR IMMEDIATE RELEASE
Texas Sales & Use Tax Managed Compliance:
Advantages and Disadvantages.
By G. Brint Ryan
Senate Bill 1319
Background
The Texas Limited Sales and Use Tax
Advantages of Managed Compliance
Disadvantages of Managed Compliance
Limited Scope Applications
Informal Managed Compliance Procedures
Conclusion
SENATE BILL 1319
The 76th Texas Legislature enacted Senate Bill
1319, effective October 1, 1999, to specifically
authorize certain taxpayers to report taxes
using a percentage-based reporting method. This
legislation was part of the Comptroller of Public
Account's ("Comptroller") taxpayer
reform package and provides statutory authority
for managed compliance agreements. Managed compliance
agreements were previously administered under
a pilot program initiated by the Comptroller
at the request of taxpayers in order to evaluate
percentage-based reporting.
The bill provides that the percentage used to
determine tax liability will be derived from
an agreed upon sample of invoices in a specified
category or categories of taxable transactions.
The authorized percentage is used for a specified
three-year period, unless revoked by the Comptroller
because the percentage is no longer representative
due to a change in tax law, rule, or the taxpayer's
business operations.
BACKGROUND
As part of the Comptroller's pilot program,
several large taxpayers, including Marathon
Oil Company, Occidental Petroleum Corporation,
and Du Pont Dow Elastomers, L.L.C., adopted
managed compliance arrangements with the Comptroller.
This arrangement allows taxpayers to make use
tax payments using an effective taxable percentage
applied to certain transactions incurred at
each site. Ryan & Company is currently assisting
several of the largest taxpayers in Texas with
implementing managed compliance. In fact, our
informal application of Texas managed compliance
was recently profiled by the Institute of Professionals
in Taxation.
1
The main objective of managed compliance is
to reduce the cost and complexity of tax compliance.
These arrangements are not necessarily designed
to reduce or minimize a company's tax liability.
Although the specific implementation steps may
vary, Texas managed compliance arrangements
generally include the following specific elements:
1. An effective taxable percentage is developed
for a plant site, group of accounts, or cost
centers using a non-statistical sampling procedure.
2. The taxable percentage is used for a three-year
period unless revoked by the Comptroller because
of a change in tax law, rule, or the taxpayer's
business operations.
3. The Comptroller agrees not to audit the
amounts paid under the managed compliance arrangement
except that the taxable percentage is audited
on a prospective basis.
4. Retroactive adjustments to amounts paid
using taxable percentages, including refunds,
are not allowed unless a taxpayer makes specific
provisions for such adjustments in the managed
compliance agreement.
5. Construction transactions are excluded from
the managed compliance arrangement and are audited
under normal procedures.
THE TEXAS LIMITED SALES & USE TAX
The Texas Limited Sales & Use Tax was enacted
in 1961. It is a consumption-based tax, generally
paid at the time a taxable item is purchased.
The sales tax is the state's largest tax revenue
source, accounting for two-thirds of all state
tax revenues. During the 1996 state fiscal year,
the 6.25 percent state sales tax generated almost
$12.5 billion for the state treasury. Additionally,
the local sales tax generated approximately
$2.6 billion in funds for local government.
Texas is unique among the states in its degree
of reliance on the sales tax.
Texas has one of the nation's highest sales
tax rates and taxes several types of services
that many states do not tax. The tax is considered
one of the most complicated of any state and
can be particularly difficult to administer
since taxable services are not specifically
defined in statutory law, particularly in the
area of construction services. In addition,
the tax has been in a constant state of change
since it was enacted. In fact, since 1961, every
major piece of tax legislation has involved
some change to either the sales tax rate or
the tax base.
ADVANTAGES OF MANAGED COMPLIANCE
The specific benefits most taxpayers expect
to gain through the adoption of a managed compliance
arrangement include the following:
1. Reduced Administrative Cost of Tax Compliance
One of the most significant advantages of managed
compliance is the reduced administrative cost
associated with determining the tax treatment
of individual transactions. Traditional tax
compliance systems are expensive to develop
and maintain and are generally dependent upon
some degree of user interface for successful
operation. Managed compliance eliminates the
need for determining the tax treatment of all
transactions on a detail basis. Managed compliance
also reduces or eliminates the administrative
cost related to entering and reviewing tax codes
on a taxpayer's purchase order system.
2. Effective Management of Personnel Reduction
Managed compliance is often implemented due
to mandated personnel reductions that eliminate
the personnel required to determine the tax
treatment of transactions, entering and reviewing
transactions in traditional purchase order systems,
and maintaining current tax compliance related
information. The reduction of personnel at both
the corporate tax department level and the operating
level is one of the most often cited benefits
of managed compliance.
3. Elimination or Reduction of Personnel Training Costs
In addition to the reduction of personnel, managed
compliance reduces the ongoing training requirements
for operating site personnel, such as the accounts
payable and purchasing staff. This cost savings
also extends to the cost of updating and maintaining
site level tax compliance guidelines and training
manuals. Although some advocates of managed
compliance argue that the cost of training personnel
and updating site level tax compliance guidelines
can be eliminated, in practice, this is generally
not possible for reasons discussed herein. Additionally,
in many cases, the reduction in training and
compliance costs is partially offset by the
cost of maintaining two separate compliance
systems.
4. Simplification of Future Texas Sales &
Use Tax Audits.
Another commonly cited benefit of managed compliance
is the simplification of future Texas sales
and use tax audits. As addressed below, managed
compliance will only simplify Texas sales and
use tax audits for taxpayers in relatively uncomplicated
and static industries. Taxpayers in complex
industries or taxpayers with dynamic business
plans may find that managed compliance actually
complicates future audits. Managed compliance
arrangements are difficult to implement for
taxpayers in complex industries and are unstable
at best for taxpayers operating in dynamic business
environments. The value of managed compliance
is questionable if a taxpayer's operating environment
causes taxable percentages to change constantly.
5. Avoidance of Penalty and Interest Assessments
Another significant benefit of managed compliance
is the avoidance of assessed penalty and interest
on tax deficiencies. Under the managed compliance
agreement, provided that the taxpayer has adhered
to the terms and conditions of the agreement,
should a deficiency assessment result, the Comptroller
agrees to waive penalty and a portion of the
interest on such deficiency. Of course, penalty
and interest assessments can always be avoided
by overpayment of tax. To the extent that the
adoption of managed compliance results in an
overall increase in tax liability, the value
of penalty and/or interest waiver is greatly
diminished.
DISADVANTAGES OF MANAGED COMPLIANCE
1. Difficulty in Handling Disputed Transactions
In order to compute an agreed percentage, the
taxpayer and the Comptroller must agree on the
treatment of all sample transactions or agree
to separately account for disputed transactions.
In cases where few disputed transactions exist,
the agreed percentage may be reached without
significant difficulty. In cases where a significant
number or dollar amount of disputed transactions
exist, managed compliance is not practically
or economically feasible.
2. Excluded Groups of Transactions or Accounts
Most jurisdictions, including Texas, do not
permit construction transactions to be included
in a managed compliance arrangement. The very
nature of construction transactions, including
the irregular frequency, lack of uniformity,
and size of major construction projects make
such transactions unsuitable for managed compliance.
This exclusion of accounts creates one of the
greatest disadvantages of managed compliance.
The disadvantage lies in the need to maintain
two compliance systems instead of one, a traditional
purchase order system for construction transactions
and a managed compliance system for other transactions.
Further compounding this disadvantage is the
fact that construction transactions fall within
perhaps the most complex and disputed area of
Texas sales and use tax law. As a result, much
of the anticipated benefit of managed compliance,
such as "eliminating" the traditional
audit and minimizing the complexity of tax compliance,
cannot be achieved in practice.
3. Cost of Implementation
The cost of implementation of managed compliance
is not insignificant. Although cost is also
a factor in the implementation and development
of legacy systems, this cost is generally considered
a sunk cost at the time managed compliance is
considered. Additionally, due to the exclusion
of certain types of transactions, the cost of
implementing managed compliance is in addition
to the cost incurred to implement and develop
the taxpayer's traditional legacy system.
The cost to implement managed compliance for
a medium-sized manufacturing facility or other
operating segment can range from $125,000 to
$250,000 or more. Recently, some taxpayers have
attempted to leverage the cost of implementing
managed compliance by using transaction samples
developed as part of an audit examination. Superficially,
this appears to be an attractive methodology.
Unfortunately, in many cases, this approach
is not feasible or will not produce reliable
results for the following reasons:
- Audit samples do not generally include all
accounts where taxable transactions may occur.
- Audit samples are drawn from historical
populations and contain transactions which
may be three, four, five years or more from
the periods for which the managed compliance
will be used. In many cases, these transactions
are simply not representative of current business
operations.
- Tax law, rules, and policy often differ
from one audit period to the next and decisions
made regarding tax treatment are often not
applicable to prospective periods. Texas manufacturing
exemption changes are a clear example of this
fact.
- Accounting systems also may vary significantly
from one audit period to the next. In many
cases, the groupings and accounts used during
a historical audit will not transfer readily
to prospective periods.
4. Risk of Invalidation due to Tax Law or Regulatory
Changes
Compounding the cost disadvantages of implementing
managed compliance is the risk that law changes,
rule changes, or changes in tax policy will
invalidate the transaction sample upon which
the managed compliance agreement is based. In
such cases, virtually the entire cost of managed
compliance implementation must be incurred again.
5. Instability and Risk of Invalidation due
to Business and Economic Changes
Changes in the nature of a taxpayer's business,
sale of part of a taxpayer's business, or expansion
of the taxpayer's business will also invalidate
the transaction sample upon which managed compliance
is based in most cases. In a very dynamic business
or economic climate, the determination of representative
taxable percentages could become a constant
task.
The accuracy and stability of managed compliance
arrangements is inversely related to the simplicity
of such arrangements. The simpler the application
of managed compliance, the less stable it is.
For example, a single taxable percentage for
all eligible accounts at a plant site is inherently
simpler than four separate taxable percentages
applied to the major cost centers for that site.
This is true because implementation and application
of one percentage is much more efficient than
implementation and application of four percentages.
Unfortunately, using a single taxable percentage
is inherently less accurate and much less stable
than using taxable percentages for distinct
cost centers. Changes in the normal relationship
of activities between cost centers will quickly
render a single percentage invalid (
e.g.,
cost center A with more taxable transactions
than cost center B doubles in activity). This
would have no effect on a managed compliance
arrangement using separate percentages for each
cost center or segment. Additionally, using
four percentages is more stable than using one.
In the event cost center C was sold or discontinued,
the taxpayer's managed compliance arrangement
would be unaffected if developed using cost
center or segment based percentages. In a managed
compliance arrangement using a single percentage,
the entire managed compliance arrangement would
be compromised. In such cases, virtually the
entire cost of managed compliance implementation
must be incurred again.
6. Treatment of Retroactive Tax Law, Regulatory,
or Policy Changes
A significant disadvantage of first generation
managed compliance agreements was failure to
provide for retroactive refunds. Most first
generation agreements either did not provide
the taxpayer the ability to adjust or take advantage
of retroactive refund opportunities or limited
such adjustments to legislative changes only.
We are aware of at least one case where a taxpayer
lost over $3,500,000 due to the poor implementation
of a first generation managed compliance agreement.
Initially, concern over the need to re-engineer
managed compliance agreements for retroactive
adjustments was dampened by the misconception
that retroactive refund opportunities were generally
offset by retroactive assessment risks. We conducted
a study in 1997 that clearly indicated that
no such offset occurs, particularly in states
that rely heavily on sales and use taxes or
states that employ aggressive audit programs.
Generally, taxpayers that have adopted managed
compliance arrangements have stipulated that
the approach was not necessarily designed to
reduce tax liability. In fact, in our experience
with managed compliance arrangements, just the
opposite has occurred. Generally, these plans
have tended to increase tax liability because
they require advance agreement on disputed transactions
and because they may eliminate a taxpayer's
ability to benefit from retroactive refund opportunities
unless careful modifications are made to the
standard managed compliance agreements.
As previously indicated, Texas is unique in
the complexity of its sales tax laws, particularly
as they relate to construction services. Historically,
the Comptroller has aggressively interpreted
taxing statutes resulting in substantial court
review of Texas sales and use tax statutes.
Almost universally, the Comptroller attempts
to broadly apply taxing provisions and construe
exemptions as narrowly as possible. As time
passes, taxpayers successfully challenge these
aggressive interpretations resulting in substantial
retroactive refund opportunities. We have witnessed
this fact time after time through the roughly
one hundred major Texas audit defense projects
we conduct each year.
In order to illustrate this fact, consider the
hypothetical adoption of a prospective only
Texas managed compliance arrangement effective
January 1, 1990. We reviewed the more notable
developments resulting in retroactive refund
opportunities since January 1, 1990 and compiled
the partial list below. Although all of these
changes may not apply to every company, the
vast majority of them do. The following opportunities
for retroactive tax reduction
would have
been lost to the hypothetical company
adopting a prospective only managed compliance
arrangement in Texas:
Sharp v. Tyler Pipe Industries, Inc.,
919 S.W. 2d 157 (Tex. App. – Austin 1996,
writ denied), which exempts manufacturing
equipment, parts, and labor previously classified
as "one or more steps removed" by
the Comptroller.
Sharp v. Chevron Chemical Company,
924 S.W. 2d 429 (Tex. App. – Austin 1996,
writ denied), which exempts pipe and pipe
related equipment used in the production process.
Comptroller's Hearing No. 34,263
which held that real property maintenance
and/or repair contracts where contractor employees
were permanently assigned to a taxpayer's
manufacturing plant are not subject to Texas
sales or use tax prior to December 6, 1991.
Amended Comptroller's Rule 3.319
which provided that prior contract exemptions
apply to contracts, including contracts with
price changes, evergreen contracts, and contracts
signed by one party and accepted, through
performance, by another party.
Comptroller's Hearing No. 28,070
which held that the replacement of a stand-alone
processing unit in a refinery which performed
a specific process was new construction, not
taxable real property repair or remodeling.
Comptroller's Hearing No. 31,904
which held that the installation of an underground
scale added new cubic footage rather than
square footage to an existing structure was
non-taxable new construction, not taxable
remodeling.
Comptroller's Microfiche No. 9004L1018G08
which provided that hydroblasting, chemical
cleaning, and tank cleaning services are not
taxable real property repair or remodeling
services even though they may not be performed
on a scheduled and periodic basis.
Amended Comptroller's Rules 3.330, 3.333,
3.342, 3.343, 3.354, 3.355, 3.356 and 3.357
(1995) which provided for the separation of
non-taxable charges for unrelated services
subsequent to the execution of a contract
that includes taxable services (the "5%
rule").
Gulf Marine Fabricators, Inc. v. Sharp,
Cause No. 93-08377, which held that winches
and "heavy" cranes, plus related
supplies, used as vice-grips during the manufacturing
process qualified as exempt manufacturing
equipment.
Amended Comptroller's Rule 3.357(a)(2)
(1992) which provided that minor repairs performed
during routine and scheduled maintenance services
were exempt maintenance, not taxable repair.
Texas Instruments, Inc. v. Sharp,
345th Dist. Ct., No. 91-2823, which held that
tax overpayments to vendors must be included
in the error rate computed in a sample and
projection audit.
Comptroller's Hearing No. 33,081
(1994) which held that sale-leaseback transactions
involving operating leases that are merely
"financing arrangements" are not
subject to tax.
Comptroller's Hearing Nos. 30,695 &
32,269 which held that inventory counting
services, and other similar services, performed
with small electronic multi-memory calculators
were not taxable data processing services
merely because a computer was used to perform
the service.
Comptroller's Hearing No. 30,730
which held that motor vehicle accessories
added to a leased motor vehicle may be purchased
tax-free for resale by the lessor and are
not taxable to the lessee.
Comptroller's Hearing No. 29,276
(1996) which held that digging a hole and
use of a vacuum truck in the repair of a pipeline
were unrelated services and not subject to
tax. This decision affected a wide range of
services.
Ecolochem, Inc. v. Bullock which
held that machinery and equipment used to
regenerate resins used in the process of deionizing
water was not taxable as machinery and equipment
"one or more steps" removed from
the manufacturing process since the resins
became an ingredient in the deionized water.
Comptroller's Hearing No. 27,336
which held that fixed term operating leases
are considered one transaction, not a series
of transactions; therefore, the tax rate in
effect at time of consummation applies for
the entire lease period.
Comptroller's Hearing No. 28,748
which held that the painting of a motel facility,
and by extension other real property facilities
such as chemical plants, every three to four
years, constituted non-taxable real property
maintenance, not taxable repair or remodeling.
Austin Diagnostic Clinic v. Sharp,
53rd Dist. Ct., No. 95-00394, which ruled
that medical transcription services (and perhaps
other similar services) were distinguishable
from mere data processing because such services
required the application of specialized knowledge
of complex medical terminology and were, therefore,
exempt.
Direct Resources for Print, Inc. v.
Sharp, Tex. App.- Austin, No. 3-94-599-CV,
which held that, under the essence of the
transaction test, a printing and mailing service
was a non-taxable direct mail service and
not a taxable data processing service.
Comptroller's Hearing No. 28,577
which held that sanitizing manufacturing equipment
was not considered taxable maintenance of
tangible personal property or a taxable real
property service because the service hastened
the deterioration of the machinery.
During this same period of time, only one notable
final decision resulting in the retroactive
application of tax occurred. That decision,
Comptroller's Hearing No. 27,509 (1992),
held that an increase in capacity is taxable
remodeling rather than non-taxable new construction.
Prior to this decision, which was applied retroactively,
the Comptroller had treated increased capacity
as new construction. Clearly, prospective only
arrangements will serve only to increase tax
liability over time.
LIMITED SCOPE APPLICATIONSbr>
Managed compliance type techniques have been
used by taxpayers in a variety of situations
long before the implementation of formal procedures.
These situations include studies to support
effective taxable percentages for supply inventory
purchases, corporate procurement card purchases,
and contract maintenance/repair service purchases.
Managed compliance techniques generally work
well in these situations because the transactions
are not complex and remain relatively consistent.
Additionally, using effective taxable percentage
techniques for these types of applications are
comparatively inexpensive and do not require
a formal agreement with the Comptroller, although
it is possible to obtain such an agreement.
INFORMAL MANAGED COMPLIANCE PROCEDURES
Managed compliance techniques can also be used
by a taxpayer on an informal basis. Such procedures
can avoid many of the disadvantages of formal
procedures while still providing most of the
benefits of formal agreements. Informal techniques
can be used in a broader fashion than formal
agreements and can be effective provided they
are used to accomplish achievable goals. Such
goals include eliminating the requirement to
determine the tax treatment of each individual
transaction, eliminating the requirement to
enter tax codes on a purchase order system,
eliminating or reducing the need for training
site personnel, and reducing site personnel
associated with these activities. Informal procedures
can be implemented with the following general
provisions:
1.Effective taxable percentages are developed
for specified groups of transactions based upon
historical correlation of purchase activity
to tax reported and assessed, adjusted for law
changes, etc.
2.No formal agreement with the Comptroller is
necessary. Interest and penalty may be avoided
by adjusting tax reported to include a small
reserve for error.
3.The audit is conducted under normal procedures.
The auditor schedules all taxable items and/or
transactions in the audit and gives credit for
all tax payments.
4.To account for contingencies, a reserve amount
is determined and the tax amount reported is
adjusted by that amount.
In addition to the advantages or formal managed
compliance, the advantages of informal managed
compliance include the coverage of construction
transactions, the avoidance of the cost of negotiating
a formal agreement with the Comptroller, the
avoidance of the risk of instability, and the
avoidance of the cost of developing precise
taxable percentages.
CONCLUSION
Managed compliance can be effective in certain
specific cases. Factors that favor use of managed
compliance include:
- Static Business Environment
- Little or No Plant Expansion or Capital Investment
- Tax Laws and Regulations Remain Relatively Unchanged
- Accounting System Remains Unchanged
- Relatively Uncomplicated Operations or Industry
In other cases, however, managed compliance
can be unstable, ineffective, and very expensive
to implement if multiple implementations are
required. Factors that do not favor managed
compliance include:
- Dynamic Business Environment
- Plant Expansion or Other Significant Capital Investment
- Complex and Fluid Tax Laws and Regulations
- Accounting System Changes
- Complex Operations or Industry
In some instances, these cases can benefit
from limited scope applications or from more
informal managed compliance techniques. If you
have questions about whether managed compliance
can work for you, please ask a Ryan & Company
representative for more information.
1Sales Tax Report, Institute of Professionals
in Taxation, January – February 1999, pp 2-5.