Could a company remove an infrequent maintenance-agreement sale from an audit sample and waive compliance and amnesty penalties?

Plain-English summary

Virginia upheld the sampled maintenance-agreement sale, the compliance penalty, and the post-amnesty penalty. The paid assessment was not refunded.

The company called the maintenance-agreement sale isolated and asked to remove it from the audit sample. Virginia found that software and hardware maintenance agreements were integral to its normal business even if sold infrequently. Removing the transaction could understate similar untaxed sales outside the sample period.

The customer's self-paid use tax did not create double taxation because the auditor credited that payment against the liability. The sale still remained in the sample for projecting other likely errors.

On this third-generation audit, the company's use-tax compliance ratio was 18%, far below the regulation's 85% threshold. Corporate restructuring and employee turnover were not exceptional mitigating circumstances. The 20% amnesty penalty also stood because the company could have reviewed its own records during the amnesty period; the audit's later completion did not establish sufficient justification for waiver.

What this means for you

• An infrequent transaction can remain in an audit sample if it is part of normal operations.
• Credit for tax paid on the sampled item does not necessarily remove that item from the projection.
• Repeat-audit compliance penalties depend heavily on the measured compliance ratio.
• A liability discovered after amnesty can still carry the post-amnesty penalty.

Citations and references

• Va. Code §§ 58.1-635 and 58.1-1840.1(F)(1).
• 23 VAC 10-210-2032(A).
• Virginia Tax Amnesty Guidelines § C(4)(k).
• The source discusses P.D. 99-66 and P.D. 04-204.

Subject

Request for waiver of the Amnesty penalty is denied

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 06-127

Original ruling text

October 25, 2006

Re: § 58.1-1821 Application: Retail Sales and Use Tax

Dear *:

This is in response to your letter in which you seek correction of the retail sales and use tax assessment issued to * (the "Taxpayer") for the period April 2001 through July 2004. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer is a designer, manufacturer and supplier of telecommunications and information technology equipment and services. The Department's audit disclosed that the Taxpayer sold a software and hardware maintenance agreement to a customer and did not collect tax. The auditor included the sale in the audit sample and assessed tax. The Taxpayer disagrees with the audit results, stating that the identified sale is isolated in nature and not a normal part of its operations. The Taxpayer believes the charge for the maintenance agreement should be taxed separately and not included in the audit sample. In addition, the Taxpayer requests abatement of the compliance and amnesty penalties.

DETERMINATION

Sampling

Sampling is an audit technique of significant value that is widely used in both the public and private sectors for all types of audits where a detail audit would not prove beneficial to either the auditor or the client. When sampling techniques are applied, the final result should be within a narrow percentage range of the actual amount that would be determined by a detail audit. The purpose of the audit sample is to determine a factor for errors within a representative select period. Once the error factor is determined, the factor is extrapolated over the entire audit period. The purpose of the projection is to account for likely similar transactions on which Virginia tax has not been paid.

For an item to be removed from the audit sample, the taxpayer must show that the transaction is isolated in nature and not a normal part of the Taxpayer's business activity. While the Taxpayer in this case claims that the contested sale does not represent a typical sale, this claim does not, by itself, render the sample inaccurate. It may well be that sales of software and hardware maintenance agreements are infrequent, but such sales appear to be an integral part of the Taxpayer's normal business. Although such sales to its customers may not be typical, there are likely similar transactions outside the sample period in which other customers have not paid the sales tax. Therefore, to remove the sales in question from the sample base would skew the sample and nullify its validity.

Public Documents 99-66 (4/15/99) and 04-204 (11/23/04) are on point with the facts of the Taxpayer's case. These documents explain that an item cannot be removed from the audit sample unless the transaction is isolated in nature and not a normal part of the taxpayer's operation, regardless of whether the item is a large dollar transaction or that it may constitute a large percentage of the taxable measure in the audit sample.

The Taxpayer asserts that including the contested sale in the sample results in double taxation because its customer self-assessed and paid use tax on the same transaction. I do not agree that double taxation exists in this case. The auditor granted a credit against the audit liability for the amount of tax paid by the customer on this transaction. As mentioned above, the sale at issue is included in the sample to account for similar transactions outside the sample period in which other customers have not paid sales tax.

Compliance Penalty

Virginia Code § 58.1-635 mandates the application of penalty to tax deficiencies. Title 23 of the Virginia Administrative Code (VAC) 10-210-2032 A states, "The application of penalty to audit deficiencies is mandatory and its application is generally based on the percentage of compliance determined by computing the dealer's compliance ratio." With regard to third generation audits, the regulation states that penalty will generally be applied unless the taxpayer's compliance ratio meets or exceeds 85% for use tax. For the audit at issue, the Taxpayer's use tax compliance ratio is 18%. Because the Taxpayer failed to meet the required 85% use tax compliance ratio for a third generation audit, the penalty was properly applied.

Title 23 VAC 10-210-2032 A also states that the application of penalty to audit deficiencies will not be waived on second or subsequent audits for "other than exceptional mitigating circumstances." A change in corporate structure and employee turnover are not considered exceptional mitigating circumstances. Because the Taxpayer has not presented evidence of exceptional mitigating circumstances, there is no basis for waiver of the compliance penalty.

Amnesty Penalty

Virginia Code § 58.1-1840.1 F 1 provides:

If any taxpayer eligible for amnesty under this section and under the rules and guidelines established by the Tax Commissioner retains any outstanding balance after the close of the Virginia Tax Amnesty Program because of the nonpayment, underpayment, nonreporting or underreporting of any tax liability eligible for relief under the Virginia Tax Amnesty Program, then such balance shall be subject to a 20 percent penalty on the unpaid tax. This penalty is in addition to all other penalties that may apply to the taxpayer.

Because the Taxpayer's outstanding balance for amnesty-eligible periods was due after the close of the Virginia Tax Amnesty Program, the balance is subject to a 20 percent penalty on the unpaid tax. Therefore, the imposition of the amnesty penalty in this case is valid.

The Virginia Tax Amnesty Guidelines state in Section C 4 k that the 20 percent amnesty penalty will not apply to:

Any assessment for an Amnesty-eligible period for which the Tax Commissioner determines that sufficient justification exists for waiver of the 20 percent post-Amnesty penalty.

The Taxpayer maintains that the Department's audit did not conclude until July 2005, one year after the expiration of the tax amnesty compliance period. The Taxpayer states that the additional tax liability resulting from the audit was not known until the conclusion of the audit. I do not agree. The Taxpayer had sufficient time to review its records to determine if a liability existed during the Amnesty period, but failed to do so. Based on the use tax compliance ratio and the Taxpayer's failure to provide sufficient justification for waiver of the Amnesty penalty, the request for waiver of the Amnesty penalty is denied.

CONCLUSION

Based on the foregoing, the assessment is correct as issued. I note that the assessment has been paid in full. Based on this determination, the Taxpayer is not entitled to a refund.

The Code of Virginia sections, regulations and public documents cited, along with other reference documents, are available on-line at www.tax.virginia.gov in the Tax Policy Library section of the Department's website. If you have any questions about this determination, you may contact *, in the Department's Office of Policy and Administration, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/57153.i