Mitigating sales tax exposures through participation in voluntary disclosure programs
Almost three years after the U.S. Supreme Court issued its seminal decision in the Wayfair case, 45 states have enacted economic nexus rules and require remote sellers to register and remit sales tax if their activity exceeds a certain threshold (i.e., volume of sales (e.g., USD 100,000) and/or transactions (e.g., 200), generally measured within the past or current year. Many inbound companies are discovering that they have established economic nexus in U.S. states over the last few years and failed to collect sales tax on their products and services. Additionally, some of these companies had created physical nexus before the Wayfair decision by having employees or independent agents working on their behalf in the U.S., soliciting in-person sales across state lines, participating in tradeshows, and/or maintaining inventory in warehouses or through fulfilment programs (e.g., Fulfilment by Amazon).
Failing to comply with sales tax collection and filing obligations can lead to serious sales tax exposures and penalties. However, prior to getting back on track and registering with the relevant states for prospective collection of sales tax, affected inbound companies may wish to quantify their historical exposures and take steps to potentially mitigate historical liabilities through voluntary disclosure agreement (VDAs) programs. VDAs are designed to promote compliance and to benefit taxpayers that discover a past filing obligation and liability that has not been discharged — a VDA will limit exposure for retroactive tax liability and/or penalties/interest.
A VDA is a contractual agreement between the company and the taxing jurisdiction where, in exchange for voluntarily coming forward to settle prior tax liabilities, the taxing jurisdiction will make concessions such as providing a reduced filing period (look-back period), generally three to four years, and a reduction/abatement of late filing and late payment penalties. While most states will allow the company to apply for a VDA on an anonymous basis, there are a few states such as California, Illinois and New York that require the company’s identity to be disclosed during the initial VDA proposal process.
In most states, a company is disqualified from the VDA program if it was previously contacted by the Department of Revenue (DOR) regarding issues relating to the voluntary disclosure, the taxpayer is already registered for the type of tax involved in the disclosure or if the tax was collected. In some states, receiving a nexus questionnaire from the DOR for one company in the group may disqualify the entire group from pursuing a VDA.
As part of the disclosure, the company will generally need to provide the following information:
- Background of the company, including the state of incorporation, principal business activity and description of its products.
- The date on which nexus first arose.
- Information about how nexus was created, including whether the company owned or leased tangible or real property or maintained inventory in the destination state, the number of resident employees, the scope of solicitation and post-sale activities, or whether the company had independent contractors/agents who provided technical assistance or services in the destination state.
- Volume of sales into the state and estimated tax liability.
- Whether the company collected but did not remit sales tax from its customers.
- Whether the company is qualified to do business with the state, is registered with the secretary of state or is registered with the DOR for any other taxes.
Many states use this disclosure as an exhibit to the contract. As part of the VDA, states reserve the right to examine the company’s records and verify the amount of the liability and the accuracy of the company’s representations. A VDA may be voided if relevant information is omitted from the disclosure or if the exposures are improperly quantified. In this case, the state may assess any tax determined to be due that was not discharged under the VDA and impose all applicable penalties and interest on additional taxes discovered to be due that have not been paid.
There are several other nuances inbound companies should be aware of when considering a VDA:
- Inbound companies without a Federal Employer Identification Number (FEIN) will generally not be allowed to register with the DOR as part of completing the VDA program. Subsequent registration will be required if the foreign company continues to have nexus and make taxable sales in the state post-VDA. Ongoing compliance is tracked by the VDA auditors, and any failure to abide by the terms of the agreement may result in further investigation or audit.
- Several states require companies to consider and include other taxes in the VDA. For instance, Pennsylvania may ask the company to complete income tax returns for the past five years, including returns of nonresident individuals. In Ohio, Texas and Washington state, sufficient sales into the state may also have nexus implications for gross receipts-based taxes. Even if the activities of the inbound company may not rise to the level of a permanent establishment, it may establish nexus for state and local tax purposes. Engaging a firm that only specializes in sales tax and cannot address other state tax compliance obligations, such as income tax or gross receipts, may prevent the company from successfully completing the VDA.
- VDAs are deadline and form driven. The windows to research the rules and provide customer exemption documentation and registration and to file tax returns may be as short as 30 days. Missing a deadline may lead to cancellation of the VDA, which can serious consequences since the state now knows the identity of the taxpayer. Knowing who and when to request an extension can save the VDA.
- Most VDAs do not allow companies to amend their returns or request refunds for tax periods that fall within the look-back period. Thus, if an inaccurate amount of tax is reported on the return, or through further research the company determines that it did not have nexus with the state or if its product is exempt from tax, it cannot thereafter recover money paid under the VDA.
With post-pandemic revenue shortfalls afflicting many states and with economic nexus laws in place, states are becoming aggressive in their pursuit of noncompliant companies. Companies doing business in several states may find themselves having to complete several VDAs to become compliant with their sales tax obligations. Having long-term relationships and experience in working with state and local tax administrators on a regular basis, knowing the amount of detail to include in the applications and how the forms work, being able to comply with additional tax obligations, and managing the process within strict deadlines is critical to ensure the successful completion of a VDA.
Ilya A. Lipin