Can I get a Virginia use tax refund by recalculating my own error factor under a direct pay permit, without a Department-approved front-end agreement?

Plain-English summary

This is the third of a cluster of nearly identical rulings issued the same day to a Virginia coal-products manufacturing subsidiary that has operated since 1996 — see also companion rulings P.D. 23-89 (2013-2015) and P.D. 23-90 (2013-2017), and the related P.D. 23-108 for an affiliated successor entity. This one covers the narrower period January 2013 through March 2016. As in the companion rulings, the company sought a refund of use tax it said it overpaid under its direct pay permit, based on a recalculated "error factor" it believed corrected a percentage inherited from a Department audit conducted in the late 1990s.

The Department reached the same result as in the companion rulings: a self-calculated error factor is only valid if backed by an actual front-end agreement with the Department — a court-recognized (though not statutorily defined) simplified reporting method available to direct-pay permit holders and manufacturers. Even without a surviving copy of any 1990s agreement, the company's decades-long practice of remitting tax based on an audit-derived factor was itself evidence some agreement existed — but that doesn't give the company authority to unilaterally revise the factor and claim a refund on its own new estimate. The Department also rejected the argument that earlier approved refunds validated the approach, since those were processed automatically below the dollar threshold that triggers an audit. Because the Department itself hadn't kept up a regular audit cycle, the case was remanded for a full audit of the January 2013-March 2016 period rather than a flat denial.

What this means for you

Businesses using a direct pay permit with a legacy error-factor methodology

An error factor set decades ago in a single audit isn't a fixed, self-adjusting number you can revise on your own — you need an actual front-end agreement, and the Department expects a recurring audit cycle to keep the factor accurate as your business changes. Don't assume a long history of using an old percentage authorizes you to update it unilaterally and claim a refund based on the new figure.

Businesses whose past small refunds were processed without review

A track record of refunds under a given methodology isn't proof the Department approved that methodology on the merits — smaller claims are often processed automatically below an audit threshold, without substantive review.

Accountants and tax professionals

This ruling, alongside its companions P.D. 23-89, 23-90, and 23-108, shows the Department applying the same front-end-agreement framework consistently across a family of related entities and overlapping audit periods within the same corporate group — useful evidence this is settled Department policy, not a one-off determination that might vary by auditor.

Common questions

Q: What is a "front-end agreement"?
A: It's a written agreement, not defined in the Code of Virginia or regulations but recognized by Virginia courts, letting certain manufacturers and direct pay permit holders report use tax using a negotiated error percentage instead of tracking each item.

Q: Can I revise my own error factor and claim a refund based on the new number?
A: Not under this ruling — without an actual front-end agreement covering the revised factor, or a Department audit confirming an overpayment, a self-calculated refund claim will be denied.

Q: What happens if the Department never regularly audited me?
A: As here, the lack of recurring audits was itself a problem, leading the Department to order a full audit of the period at issue rather than simply denying the refund outright.

Q: Does this ruling apply to my company?
A: Not automatically. This is a published ruling based on this taxpayer's specific facts and audit history; another taxpayer's front-end agreement history may differ.

Citations and references

• Va. Code § 58.1-624; 23 VAC 10-210-920 F (direct pay permits)
• Va. Code § 58.1-1823 (refund claim deadline; refund denial/inaction deemed an assessment)
• 23 VAC 10-210-3040 (refund limited to net tax remitted on exempt transactions)
• Va. Code § 58.1-634 (assessment statute of limitations)
• Va. Code § 58.1-1821; 23 VAC 10-20-165 (appeal procedure)
• Reynolds Metals Co. v. Commonwealth of Virginia, Dep't of Taxation (Augusta Cir. Ct. 2000), published as P.D. 01-11
• P.D. 17-98 (Guidelines for Retail Sales and Use Tax Refund Claim Procedures)

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 23-91

Original ruling text

August 3, 2023

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

Dear * :

This is in response to your letter submitted on behalf of * (the “Taxpayer”) in which you request a refund of the Virginia retail sales and use tax paid for the period January 2013 through March 2016. I apologize for the delay in responding to your refund appeal.

FACTS

The Taxpayer, a Virginia based subsidiary of a coal company that manufactures products derived from coal, filed amended returns for the periods at issue. The Taxpayer claims it overpaid its use tax under its direct pay permit on purchases of tangible personal property that were eligible for the manufacturing exemption. Since its inception, the Taxpayer had been accruing use tax based on an error factor developed by an earlier audit performed by the Department. Based on a more recent review of its purchasing, the Taxpayer believed the error percentage was overstated, resulting in the refund claim.

The Department granted a portion of the refund, but denied the majority of the claim because it was based on a revised error factor that was not supported by a “front-end-agreement.” The Taxpayer filed an appeal contending that the absence of a front-end-agreement is not supported by the Code of Virginia and is not relevant to the determination of the tangible personal property’s qualification for a refund.

DETERMINATION

Direct Pay Permits

The Taxpayer was authorized to use a direct pay permit by the Department in 2016. Virginia Code § 58.1-624 and Title 23 of the Virginia Administrative Code (VAC) 10-210-920 F allow certain taxpayers to apply for and use a direct pay permit to pay the Virginia retail sales and use tax directly to the Department when it is not possible at the time tangible personal property is purchased to know how it will be used. When a direct pay permit is granted, the taxpayer must file copies of the permit with dealers in order to make purchases without paying retail sales and use tax. The validity of such a permit is perpetual unless surrendered by the taxpayer or cancelled for cause by the Department.

Under a direct pay permit, a taxpayer usually makes purchases exempt from the tax and then accrues tax on taxable items when they are put into use or consumed. The accrual is based on the cost price of the specific item used in a manner that is taxable under Virginia’s sales and use tax statutes.

In this instance, instead of accruing tax based on the use of taxable items, the Taxpayer used an error factor to estimate the amount of tax remitted to Virginia. As indicated above, no basis for such a computation is permitted under the statutory framework for direct pay permits. The only taxpayers permitted to use such a method are those that have executed front-end agreements with the Department.

Front-End Agreements

Front-end agreements have been used for taxpayers that are manufacturers or holders of direct pay permits. The agreement usually covers the expense purchase portion of the audit. Under a written agreement with the Department, a direct pay permit holder may agree to remit tax based on an error factor on certain accounts payable data for which taxability cannot be determined at the time of purchase, and for amounts in certain accounts in which all the activity is deemed taxable.

The initial agreement is based on audit findings by the Department. In subsequent audits, limited procedures are performed to verify if the agreement is being followed and determine whether or not the error factor or accounts need to be adjusted. Negotiations with the direct pay permit holder would fix the agreement for the subsequent audit cycle.

In this case, the Taxpayer has been operating since 1996. Since then, the Taxpayer had been computing its use tax liability based on an error factor from an audit completed in the late 1990s. Based on a more recent review of its purchasing, the Taxpayer concluded the error factor was overstated. It recalculated its error factor for the period at issue and applied for the refund based on its internally calculated overpayments using the recalculated error factor.

The Taxpayer argues that the auditor’s denial based on the lack of a front-end agreement is not supported by Virginia statute. It is true that front-end agreements are not provided for in the Code of Virginia or the Virginia Administrative Code. However, in Reynolds Metals Company v. Commonwealth of Virginia, Department of Taxation, (Augusta Cir. Ct., March 21, 2000), published as Public Document (P.D.) 01-11 (10/19/2001), the Circuit Court concluded that front-end agreements can be a simplified method for certain taxpayers to report sales and use tax liability. Under such an agreement, a taxpayer is allowed to assume a certain percentage of its transactions will be taxable and to calculate and pay its liability using an error percentage or factor. Thus, while not specifically supported by statute, the court recognized their value to taxpayers and the Commonwealth.

While neither the Department nor the Taxpayer have been able to produce a copy of a front-end agreement executed in the 1990s, the fact that the Taxpayer has been remitting tax based on an error factor determined by a prior Virginia audit is a strong indication that an agreement of some nature was implemented.

According to the “Sampling & Front-End Agreements” section of the Department’s Sales & Use Tax Audit Procedures (the “Procedures”), front-end agreements have traditionally been used for recurring three-year cycle audit candidates that hold direct pay permits. When an audit is conducted, the auditor can determine if the agreement is being followed, resulting in either an assessment or refund, and determine whether the error percentage or factor needs to be adjusted for the next audit cycle. Here, the Department did not audit the Taxpayer frequently. As confirmed by the Taxpayer, a business’s spending habits will change in accordance with economic and operational changes, business reorganizations, and amendments to the statutes enacted by the General Assembly. Under such circumstances, recurring audits ensure accurate compliance with the Virginia retail sales and used tax statutes.

Refund Claim

Based on its estimated accrual method, the Taxpayer timely filed a refund request with the Department. Under Virginia Code § 58.1-1823, a refund request must be made by a taxpayer within “three years from the last day prescribed by law for the timely filing of a return….” Pursuant to Title 23 VAC 10-210-3040, a refund of retail sales and use tax is limited to the net amount of tax remitted to the state on an exempt transaction. Neither the Code of Virginia nor Virginia regulations permit use tax refund requests based on estimated accruals. Thus, in order to be eligible for a refund, a taxpayer must be able to show that either tax was accrued and paid on specific exempt transactions or, in the case of a front-end agreement, an audit by the Department reveals that the amount of tax remitted exceeds the amount of tax that should have been accrued on taxable transactions.

The Taxpayer’s allegation that its approved refunds for a previous period indicates the Department’s approval of its estimated methodology is not supported by the facts. Previously approved refund amounts requested pursuant to the Taxpayer’s amended returns were below the threshold that required an audit and, thus, issued without review or approval of the Department.

In addition, the Taxpayer disagrees with the Department’s use of a previous period in its refund application review. As indicated above, the Taxpayer timely filed a refund claim for the period at issue. The Department’s Guidelines for Retail Sales and Use Tax Refund Claim Procedures, issued as P.D. 17-98 (6/12/2017), provides that when taxpayers seek a refund from the Department, “[a]dditional information may be requested by the Department as needed, including, but not limited to system access, contracts, and any information deemed necessary to validate refund payments.” I do not find that the inclusion of the period is improper. It appears the auditor included the period to establish the Taxpayer’s transaction history.

Further, the Taxpayer contends there was no formal denial of the refund. The Department’s records indicate its standard refund notice dated January 19, 2022, was delivered to the Taxpayer. Regardless, under Virginia Code § 58.1-1823, “[a]ny order of the Department denying such reassessment and refund, or the failure of the Department to act thereon within three months shall, as to matters first raised by the amended return, be deemed an assessment for the purpose of enabling the taxpayer to pursue remedies allowed under this chapter.” Either the refund denial or the time limitation of the statute established an assessment upon which the Taxpayer was entitled to file an appeal in accordance with Virginia Code § 58.1-1821.

CONCLUSION

Because the Department did not regularly perform audits to determine if the error factor used by the Taxpayer accurately estimated its sales and use tax liability, the sales and use tax paid by the Taxpayer for the period January 2013 through March 2016 is likely not in compliance with Virginia’s existing sales and use tax statutes and must be audited to determine the extent to which the tax, if any, may have been overpaid.

In accordance with this determination, the refund request will be returned to the audit staff to conduct a complete audit of the Taxpayer’s sales and use tax accruals and remittances for the period at issue. The audit staff will contact the Taxpayer to schedule the audit and request specific records for review. The Taxpayer will have 30 days from the date of contact to provide such records and all supporting documentation.

Audit staff will review the Taxpayer’s records, make adjustments as appropriate, and issue an updated audit report. If the audit results in an overpayment, a refund will be issued along with any refund interest in accordance with the refund guidelines (P.D. 17-98). If the audit results in an underpayment, the Department will only be permitted to issue assessments within the statute of limitations provided under Virginia Code § 58.1-634. If the Taxpayer disagrees with the audit, it may submit an appeal within 90 days of the updated audit report in accordance with Virginia Code § 58.1-1821 and Title 23 VAC 10-20-165.

The Code of Virginia sections, regulations, and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions and Guidance Documents sections of the Department’s web site. If you have any questions about this response, you may contact * in the Department’s Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/4173.W

Related Documents

01-11

15-106

17-98