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Extending by Implication—States Redefine Indirect Tax Base

Dec. 29, 2022, 9:45 AM

Most jurisdictions with a sales tax apply it to the sales price of tangible personal property and certain specifically enumerated services. Other indirect transaction-based taxes generally apply to designated goods or services. The characterization of a transaction is often debatable, but one foundational principle for determining what’s included in the tax base has been to settle ambiguities in favor of the taxpayer.

However, in recent state and local tax decisions and tax enforcement, authorities have taken steps to broaden the language of the law. Specifically, tax authorities have sought to include in the tax base consideration paid in tangential or concurrent transactions, even though such transactions wouldn’t be subject to tax on their own. This article looks at some examples of these attempts to expand the tax base and the challenges faced by those who litigate these cases.

It’s generally said that taxing statutes are to be strictly construed. A tax’s reach shouldn’t be extended by implication beyond the clear meaning of a statue’s language. Further, when a statute has no clear meaning, the ambiguity is to be resolved in favor of the taxpayer and against the taxing authority.

The legal canon of strict construction promotes several important guiding principles of tax policy: legal certainty, fairness, and efficiency. Taxpayers and their advisers should be able to determine the proper amount of tax owed with an appropriate degree of confidence that their determination is correct.

To ensure that similarly situated taxpayers will be taxed similarly, tax statutes and regulations should clearly articulate how the tax is to be determined and how regulatory and judicial discretion should be limited. Further, uncertain tax regimes are inefficient and impose significant public and private costs. Tax authorities expend additional time and effort considering the facts of any given case, and taxpayers face higher costs of compliance without any assurance that they achieve the correct result.

In many jurisdictions, the statute that imposes sales tax often states that the purchase price for the taxable good or service establishes the base and is thus the starting point for determining sales tax liability. This principle—that the price paid between two parties to a retail transaction forms the tax base—is clear, unambiguous, and consistently applicable across most transactions throughout the world.

When there are questions of unfair dealing or manipulation on the part of the parties involved, judicial precedent advises tax authorities to disregard a transaction for lack of economic substance. Once the transaction is disregarded, the taxing authority applies sales or use taxes to the preceding transaction, usually considered exempt from sales tax as a purchase for resale, as though such transaction were the final retail purchase. Again, the result references an actual sales price that has been paid between two parties for the taxable goods or services received.

State tax departments are delegated authority to issue regulations that clarify terms or procedures not fully described in the taxing statute. They also may exercise other discretionary administrative powers toassess and collect tax revenue. However, the exercise of discretion to determine tax liability should be limited. The more an agency is permitted to expand on a tax’s reach, the more likely the taxpayer will be less certain about the tax treatment of its transactions and forced to pay more for compliance, audits, and litigation.

Despite the principles laid out above, state and local taxing authorities may attempt to broaden the application of a tax, often by imputing the taxability of one transaction onto other transactions that occur concurrently or are otherwise tangentially related to the taxable transaction. The following are common examples of how taxing authorities have attempted to go beyond the language of tax statutes.

Interpreting the Definition Broadly

Even when a key term of a taxing statute does not expressly apply, taxing authorities may seek to broadly interpret the term to capture additional property or services. One common example: A tax authority may seek to expand the definition of tangible personal property to include intellectual property so it can apply sales tax to royalty streams generated from the use of such rights.

In addition, although telecommunications excise taxes or use taxes generally apply to telecommunications services, numerous taxpayers have been forced to litigate the imposition of telecommunications excise taxes or use taxes on sales of software, telecommunications equipment, and other services that are not telecommunications services. Revenue departments have become increasingly aggressive in expanding key definitions of the taxing statute, even when such position may be beyond the plain meaning of the words of the statute or inconsistent with prior determinations.

Imputing Taxability of Payments in Separate Transactions

Where parties to a taxable transaction engage in a separate transaction that is not taxable, taxing authorities may seek to connect the two transactions to apply the tax to both. For example, in September, the South Carolina Supreme Court affirmed the holding that proceeds from sales of book club memberships should be subject to South Carolina sales tax. The court concluded that the value of the club memberships originates from the sale of taxable goods (the books) because the only benefit to buying the membership is the discount on such taxable sales.

Although the memberships and their associated rights associated are intangibles and thus generally not subject to sales tax, the court found that sales of the memberships were captured by the South Carolina sales tax statute as value proceeding or accruing from sales of tangible personal property. The court noted that this specific language in the sales tax statute differentiated South Carolina from other states and gave the Department of Revenue clear authority to impose tax on the memberships.

A job seeker shakes hands with a recruiter during a HireLive career fair on June 4, 2015 in San Francisco.
Photographer: Justin Sullivan/Getty Images

Imputing Taxability With Other Parties

Tax authorities also may look at other transactions, which may occur with persons who aren’t party to the taxable transaction, to argue that sufficient connections exist to impute taxation on such separate transactions. In July, for example, the California Office of Tax Appeals held that commissions paid to an authorized third-party retailer should be subject to California sales tax. The retailer sold cellphones and accessories and activated telecommunications service for a telecommunications company.

Although the retailer originally provided the activation services for no additional charge, the telecommunications provider began paying commissions to the retailer for activation of the services. This change occurred while the company reduced the sales price of its handsets, effectively reducing the margin that the retailer would earn on such sales.

The OTA held that the commissions were a form of compensation for sales of the handsets and that they were at least partially intended to make up for the loss of handset margins. It determined this even after finding that the commission was not payable unless service was activated—that is, if the retailer sold a handset but didn’t activate service—then there was no commission. The commission was payable when service was activated but the retailer didn’t sell a handset, such as when a handset that had been active on another service provider’s network was activated on this provider’s network. A key factor cited by the OTA was that no evidence was presented to demonstrate that the retailer’s business practices had changed before or after the pricing change.

Strategies for Reducing Audit Risk

There are unique challenges in litigating a tax position that turns on the degree by which a court may deviate from the statute’s clear language and impute a tax on otherwise non-taxable transactions. However, some key strategies can reduce audit risk and successfully defend a tax position.

Develop consistent marketing messages and public statements. Tax authorities will often look for clues in language used to describe products and services to the public as to how that product may be taxed under existing law. Taxpayers should be aware of the risk of having their own words thrown back at them and develop marketing campaigns and public statements with state tax consequences in mind.

This is especially true for more complicated transactions or newer products where the taxation of the product or service is not well established. With the assistance of tax counsel, taxpayers may have knowledgeable employees explain the products or services in detailed terms so an analysis can determine the application of potential taxes. To the extent that taxing authorities later challenge the taxpayer’s position, a thoughtful and thorough description of the product or service and related tax analysis can be produced in short order.

Document separateness of non-taxable sales and taxable transactions. Documents that memorialize the separateness of transactions should be introduced as early as possible, if not at the outset of the company’s business transactions. Contemporaneous documentation is more widely accepted as being correct.

Further, when the transaction at issue is an intercompany transaction, contemporaneous documentation serves to memorialize and clarify the intent of the parties at a particular time, which is often subject to more scrutiny than in transactions between unrelated parties. Separate agreements, invoices, and receipts are some of the best documents to support a tax position that differentiates between taxable and non-taxable sales.

For transactions in which taxable and non-taxable items are sold at a combined price, taxpayers should look to the jurisdiction’s guidance regarding bundled transactions and what evidence the tax authority accepts for establishing the separateness of the transaction’s taxable and non-taxable elements.

Consider ramifications in other jurisdictions. Although a case may be strong on the merits, taxpayers should be strategic in how they handle any controversy that arises from their tax position. Tax authorities or courts across various states may be considering the same issue, and a negative result in one jurisdiction may be used as persuasive authority in another.

Taxpayers generally cannot control the speed or order in which litigation may progress, so the settlement of claims before reaching a final determination may be the best method for avoiding unfavorable outcomes. To the extent that the law in a particular jurisdiction is less favorable or there are additional state-specific issues that could muddy the waters, a taxpayer may seek to settle the claim in that jurisdiction.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Jeff Friedman is a partner at Eversheds Sutherland. He provides state and local tax planning, strategic advice, and advocacy to Fortune 100 and industry-leading companies.

Liz Cha is counsel at Eversheds Sutherland. She counsels clients on state and local taxation matters, including tax structuring and planning, and regularly advises on a full range of tax types such as income, franchise, sales and use, and property taxes.

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