How did Virginia resolve an audit appeal challenging the purchase sample, software transactions, fixed assets, and compliance penalty in P.D. 08-73?

Subject

Sales and use tax audit sampling and purchase adjustments

Plain-English summary

Virginia upheld the audit's purchase-sampling method and most challenged transactions, but directed several specific adjustments. The taxpayer's alternative computations produced a lower liability, but that did not prove the Department's selected expense accounts or extrapolation were unrepresentative. The taxpayer's representative had also verified the accounts, balances, and final sample results during the audit.

The Department granted relief where the records established it. A software purchase shown by its invoice to have been delivered electronically, without a tangible copy, was removed from the sample. A jellybean purchase was recalculated using the lower food sales-and-use-tax rate. Fixed assets purchased outside the audit period could be removed if the auditor also reviewed assets acquired during the period but booked afterward; without adequate records, the existing assessment would stand.

Other claims failed for lack of documentation. The invoices did not establish the printed-material exemption for labels and promotional stickers, did not prove three purchases were recorded as fixed assets, and did not adequately support claimed software-maintenance or electronic-delivery treatment for two fixed-asset items. Use tax paid on separate returns was not credited because the taxpayer did not connect those payments to transactions included in the audit.

Finally, taxes erroneously paid to vendors could not be counted in the alternative compliance-penalty ratio. The Commissioner reasoned that the ratio measures payment of tax legally due to Virginia, while erroneous payments are refundable amounts that were not legally due.

What this means for you

• A lower result under an alternative sampling method does not, by itself, invalidate the Department's audit sample.
• Transaction-level records matter: invoices, accounting classifications, contracts, and delivery terms controlled several outcomes here.
• Electronic software was exempt only where the invoice established electronic delivery and no tangible medium.
• Correcting out-of-period fixed assets may permit a corresponding review of later-booked assets so the audit is treated consistently.
• Tax paid in error to vendors does not count as compliant payment of tax due when Virginia computes this alternative penalty ratio.

Common questions

Was the entire purchase sample thrown out?

No. The taxpayer did not prove the selected accounts or extrapolation were flawed, so the sample remained valid subject to transaction-specific adjustments.

Which purchase received a complete exemption?

Line item 10, computer software whose invoice established electronic download without a tangible copy, was removed from the sample.

Did every claimed electronic-software purchase qualify?

No. For line item 15, a statement that software was available for download did not prove that the taxpayer actually received it electronically without a tangible medium.

Could assets invoiced before the audit period remain assessed?

The Commissioner agreed to remove assets purchased outside the period only if the auditor could also examine assets acquired before the period ended but booked afterward. Inadequate records would leave the assessment in place.

Citations and references

• Va. Code § 58.1-1821.
• Va. Code § 58.1-205.
• Va. Code § 58.1-609.6(4).
• Va. Code § 58.1-609.5(1) and (9).
• P.D. 96-180 (July 10, 1996); P.D. 01-33 (Apr. 9, 2001); P.D. 05-44 (Apr. 4, 2005); P.D. 97-265 (June 12, 1997).

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 08-73

Original ruling text

June 6, 2008

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

Dear *:

This will reply to your letter in which you seek the correction of a retail sales and use tax assessment issued to your client, * (the "Taxpayer"), for the period July 2000 through December 2004. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer was audited by the Department and assessed use tax on various untaxed purchases. The Taxpayer maintains that the expense purchases sample used in the audit is invalid and that certain purchases in the sample are not taxable. The Taxpayer suggests that some expense purchases should be taken out of the audit sample and treated as fixed assets. The Taxpayer claims that it is due a credit against the audit liability for use tax payments made with sales tax returns filed with the Department. The Taxpayer further maintains that the invoice dates of certain fixed asset transactions occur before the start of the audit period and that these transactions are barred from assessment under the statute of limitations. The Taxpayer requests a ruling from the Department concerning the inclusion of sales taxes erroneously paid to vendors in the computation of the alternative method for computing use tax compliance.

DETERMINATION

Sample Protection

The Taxpayer contends that the entire population of purchase invoices for the sample period was examined but only specific purchase accounts were used to compute and project the error factor. The Taxpayer maintains that the error factor used to project the expense purchases sample is too high. To support its contention, the Taxpayer has computed an error factor using other methods such as gross receipts, aggregate expenses and a simple roll-up method. Each of these methods results in a lower tax liability than the liability computed in the audit.

In this case, the sample of purchase transactions was not conducted on the entire population of purchases made during the sample period. Rather, the population of purchases examined in the audit sample came from expense accounts that were selected prior to the actual review of the Taxpayer's purchases. The expense accounts were selected based on their potential to contain transactions that were subject to sales and use tax. The error factor was computed by dividing the total amount of untaxed transactions charged to the selected expense accounts by the sum of the account balances for those same expense accounts during the sample period. The error factor was then extrapolated over the audit period using the annual account totals of the selected expense accounts.

Virginia Code § 58.1-205 provides that tax assessments issued by the Department are deemed prima facie correct. With regard to audit sampling, a taxpayer must demonstrate that a sample used in an audit is not representative of the audit period or that it is flawed in some other manner to invalidate the sample.

In Public Document (P.D.) 96-180 (7/10/96), a taxpayer challenged the Department's use of certain purchase amounts to extrapolate an audit sample. The Department ruled that the sample was valid unless the taxpayer could provide documentation showing that the purchase balances used by the Department were incorrect.

While the Taxpayer has presented alternative methods of computing its audit sample that result in a lower tax liability, I am not persuaded that the use of these methods proves that the sample used by the Department is invalid. The accounts sampled and the bases upon which the error factor is calculated and extrapolated against should produce a more accurate result than the methods proposed by the Taxpayer. The Taxpayer's purchase activity for the accounts included in the sample was high for two of the years outside of the sample year, which would result in a higher taxable measure than the methods proposed by the Taxpayer. I also note that the Taxpayer's representative during the audit verified the accounts and balances used in the sample and agreed with the final results.

Based on the information presented, the Taxpayer has not met its burden of proving that the assessment is incorrect with respect to the sampling issue.

Purchase Transactions

Line items 48 and 50

These items were purchases of labels and promotional stickers. The Taxpayer maintains that the labels and stickers qualify for exemption under Va. Code § 58.1-609.6 4, which provides an exemption for catalogs, letters, brochures, reports, and similar printed materials when stored for 12 months or less in Virginia and distributed for use outside Virginia. The exemption also applies to envelopes and labels used for packaging and mailing qualifying printed materials.

The Taxpayer has provided the purchase invoices for these transactions but the invoices do not provide adequate information to support its claim for exemption. The assessment of the tax in this instance is correct.

Line item 52

This item was a purchase of jellybeans that was included in the calculation of the purchases sample. The taxable measure from the sample calculation was taxed at the standard sales tax rates in effect during the audit period of 4.5% and 5%, respectively. The Taxpayer requests an adjustment to the audit liability to reflect the fact that the lower food tax rate should apply to the cost of the jelly beans. Based on a review of the purchase invoice, the amount of this purchase will be reduced to * to adjust it for the food sales and use tax rate in effect at the time of purchase. The purchases sample will be recalculated to reflect this adjustment.

Line items 1, 40 and 63

The Taxpayer contends that these items should be removed from the purchases sample and treated as fixed assets. The auditor previously requested the Taxpayer to provide fixed asset information showing that these items were classified as fixed assets in the Taxpayer's accounting system. The Taxpayer has provided copies of accounting entries for line item 1, but has not provided information regarding line items 40 and 63.

P.D. 01-33 (4/9/01) is on point with this issue. In this determination, the Department ruled that certain purchases would be removed from an audit sample and treated as fixed assets if the taxpayer provided evidence that the purchases in question were treated as fixed assets in their accounting records or on their income tax returns. Although the auditor previously requested this information, the Taxpayer has not provided sufficient documentation that item 1 is classified as a fixed asset in the Taxpayer's accounting records. The Taxpayer has provided no documentation for items 40 and 63. The assessment with respect to items 1, 40 and 63 is correct.

Line item 10

This item is a purchase of computer software that the Taxpayer claims was delivered electronically. It is the Department's long-standing policy that the sale of prewritten software delivered electronically to customers does not constitute the sale of tangible personal property and is generally not subject to sales and use taxation. See Va. Code § 58.1-609.5 1 and P.D. 05-44 (4/4/05). This policy is conditioned on the fact that no disc, tape or other tangible medium is provided to the customer before or after the electronic download of the software.

The Taxpayer has provided a copy of the software vendor's invoice. Based on a review of the invoice, the software was delivered to the Taxpayer by electronic download and there was no provision of the software in tangible form. In accordance with the cited statute and P.D. 05-44, this software purchase is exempt from the sales and use tax. Line item 10 will be removed from the purchases sample, and the sample will be recalculated to reflect this adjustment.

Credit for Use Tax Paid on Returns

During the audit period, the Taxpayer filed three use tax returns with the Department and paid use tax on a total purchase measure of *. The Taxpayer states that a credit should be allowed in the audit for the use tax paid. The Taxpayer filed the returns in calendar year 2001, which was outside the audit sample period of January 2003 through December 2003.

The Taxpayer has not provided documentation showing that the purchases reported on the use tax returns were either fixed assets included in the audit or purchases that were expensed to accounts used in the purchase sample. I find no basis to allow a credit against the audit liability for the use tax paid on the returns.

Fixed Asset Invoice Dates

The Taxpayer maintains that certain fixed asset invoice dates were altered to include the transactions in the audit period. The Taxpayer suggests that, based on the invoice dates, the transactions are barred by the three-year statute of limitations and should be removed from the audit.

The auditor relied on fixed asset information that was extracted from the Taxpayer's fixed asset accounting records. The fixed asset purchase exceptions were listed in the audit using the dates that the fixed assets were booked to the Taxpayer's general ledger.

P.D. 97-265 (6/12/97) discusses a taxpayer that was assessed use tax on fixed assets purchased outside the audit period but booked in the taxpayer's accounting system during the period covered by the audit. The Department ruled that the assets should be removed from the audit because the taxpayer became liable for the tax based on the date the assets were purchased. However, the ruling also states that the Department can examine fixed asset transactions booked subsequent to the end of the audit period to ensure that the tax has been paid on all fixed assets purchased during the period of audit.

Based on the above, I will agree to remove the fixed assets purchased by the Taxpayer outside the audit period only if the Department's auditor examines the Taxpayer's fixed asset records for asset acquisitions made prior to the end of the audit period but booked after the audit period. This will ensure consistency in the audit results. The audit assessment will be revised to reflect any tax deficiencies found based on this review. If the Taxpayer does not provide adequate records for review, the assessment with respect to this issue will be considered correct.

Exempt Fixed Assets

Line item 1

The Taxpayer maintains that this fixed asset charge is for software maintenance and should be taxed at 50% of the purchase price in accordance with Va. Code § 58.1-­ 609.5 9. Based on a review of the invoice, it is not clear that charges for software maintenance were included in the taxable amount listed in the audit report. The invoice shows a total amount due of *. The audit exceptions list shows a taxable amount for this invoice of ***. The taxable amount listed exceeds the amount claimed by the Taxpayer as software maintenance charges.

The Taxpayer has not provided documentation to support its contention. Therefore, the assessment with respect to this transaction is considered correct.

Line item 15

The Taxpayer states that this software purchase qualifies for exemption because the software was electronically downloaded. The Department has ruled in P.D. 05-44, "At a minimum, a sales invoice, contract or other sales agreement must expressly certify the electronic delivery of the software and that no tangible medium for that software has been or is to be furnished to the customer." The invoice from this vendor indicates that the software is available for download from a particular website. This statement alone is not conclusive evidence that the Taxpayer received the software by electronic download.

The Taxpayer has not provided documentation to support its contention. Therefore, the assessment with respect to this transaction is considered correct.

Alternative Method of Computing Compliance Penalty

The Taxpayer did not meet the minimum 60% use tax compliance ratio required for second audits and was assessed compliance penalty. When taxpayers do not meet minimum use tax compliance levels under the Department's standard penalty calculation method, they have the option of using an alternative method. The alternative method includes sales and use taxes paid to vendors in the compliance ratio calculation. The Taxpayer indicated at the conclusion of the audit that it would use the alternative method for computing compliance penalty.

During the audit, the Taxpayer submitted to the auditor a refund claim for sales and use taxes erroneously paid on purchases made from some of its vendors during the audit period. The auditor indicated that the erroneously paid taxes could not be included in the calculation of the alternative method for computing compliance penalty. The Taxpayer disagrees with the Department's position and asks for a ruling on this issue.

The compliance ratio is a measure of a taxpayer's adherence to Virginia sales and use tax laws. Compliance is typically evaluated in terms of sales and use taxes that are due but not paid by taxpayers. In a broader sense, compliance includes the payment of taxes that are properly due to the state. Erroneous payments of sales and use taxes constitute payments that are not legally due to the Commonwealth of Virginia. For this reason, there are statutory provisions for the refund of the erroneous payment of taxes in the Code of Virginia and the Department's regulations. Therefore, I must conclude that erroneously paid sales and use taxes should not be included in the computation of sales and use tax compliance. Based on this conclusion, I agree with the auditor that the erroneously paid taxes are not to be included in the calculation of the alternative method of computing compliance penalty.

CONCLUSION

The audit will be returned to the Department's auditor to make the adjustments in this determination. A revised bill will be sent to the Taxpayer that includes accrued interest and should be paid by the Taxpayer within 30 days to avoid the accrual of additional interest. The Taxpayer should remit payment to: Virginia Department of Taxation, 3600 West Broad Street, Suite 160, Richmond, Virginia 23230, Attention: *. If you have any questions concerning payment of the assessment, you may contact at **.

The Code of Virginia sections 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 Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Janie E. Bowen

Tax Commissioner

AR/1-903446751S