Senate Bill 1319
The Texas Limited Sales and Use Tax
Advantages of Managed Compliance
Disadvantages of Managed Compliance
Limited Scope Applications
Informal Managed Compliance Procedures
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.
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 APPLICATIONS
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.
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.