Crucial to audit proofing exempt sales is retaining the supporting documentation. For resales, the required documentation is resale cards. For out of state sales, the required documentation includes bills of lading, shipping receipts, or other similar documents. These things seem pretty straight forward.

But what about trying to prove the negative. For example, a client was recently assessed use tax on a purchase from a California vendor. Since this was a sales tax transaction (sale was made in California), the purchaser would not be liable unless a resale card was issued. When I asked the auditor if a resale card was issued, she replied that it was. The client, of course, was certain that no resale card was ever issued. When I further questioned the auditor as to how she knew a card was issued, she stated that she called the client's vendor and had him read the client's permit number to her. She did not have a copy of the card sent to her. Later we found out that the taxpayer's vendor simply read the preprinted resale number from the purchase order. The purchase order was not designated "for resale" and no card was issued. Based on our persistence, the audit supervisor removed this item from the use tax test.

Other cases of trying to prove a negative have included:

Issue:

1) Sales invoices marked "Void"

Prove that sale was never consummated.

Solution:

The sales in question were progress billings on a job that was cancelled before completion. No transfer of any tangible property occurred. We were able to satisfy the auditor by finding a letter from the customer which stated the project was abandoned.

Issue:

2) Sales of preliminary art (by graphic artist)

Prove that tangible property was not transferred.

Solution:

This case went to an appeals level hearing where we argued that we could not prove something that didn't happen. The taxpayer's customer was out of business and even if they were able to produce a letter corroborating our story, it would probably have been looked upon as self serving. In any event, we noted that in most instances, the preliminary art charges were followed by a charge for finished art and in this case there was no subsequent invoice. Since the total sales were not deemed to be understated, the State should view the lack of a subsequent invoice for finished art proof that there was none. They acquiesced.

Issue:

3) Out of state sales to California residents

Prove that property purchased outside of California did not enter the state for at least 90 days.

Solution:

As mentioned in an earlier article, the certificate under R&TC 6247, relieves the retailer of any sales tax liability. As far as the purchaser goes, we had to prove use out of state for the first 90 days by retaining (in the case of vehicles, vessels, and aircraft) gas receipts, logs, etc.

Supporting documents of out of state usage for other property includes:

a) Travel itineraries.

b) Hotel bills and air fare bills.

c) Other corroborating information.

Issue:

4) Labor only invoices

Prove that no tangible personal property was transferred.

Solution:

Labor invoices showing no tangible property transferred were suspect because the auditor felt that some parts were included in the charge. We were able to satisfy the auditor by analyzing purchases. Purchases of parts were minimal and under Regulation 1546, if the parts cost is <10% of the total charge, the taxpayer is not required to separately state parts and labor on the sales invoice.

Issue:

5) Computer software transferred via remote telecommunications lines.

Prove no tangible personal property was transferred.

Solution:

Retain timely letters of agreement, detailed contracts, etc to substantiate these claims.

Issue:

6) Audits based on bank deposits

Prove that certain cash deposits are not from sales.

Solution:

When this last resort method is used for an audit, we have been, in some cases, able to prove the sources of non-sale cash receipts. These have included bank transfers, loans, lottery winnings, tax refunds, escrow proceeds, alimony, etc.

Issue:

7) Resales

Prove that the seller did not get a purchase order marked taxable.

Solution:

In one case, the auditor took the position that because the taxpayer had problems finding his customer's purchase orders, that purchase orders were issued by every customer and all were marked taxable. We were asked to prove this didn't happen - an impossible task. We were able to point out that in this case, the burden of proof that a purchase order was ever issued is on the buyer, not the seller. Therefore, we were off the hook.

Issue:

8) Sales were not made from a California location.

Solution:

This audit dealt with a company that had an out of state location but all invoices were printed at the headquarters located in California. The California invoices and the Arizona invoices were identical so the auditor took the position that we had to prove which ones were Arizona. In the case of taxable sales, it was obvious by the different tax rates charged. But in the case of exempt sales, the auditor wanted proof that these sales were not made in California. This presented quite a problem since all Arizona sales were picked up by the customers in Arizona. The auditor pulled a handful of these type of sales and let us conduct a test. For the ones tested, we traced the related purchases to the warehouse receipts showing the code for the Arizona warehouse. Fortunately, this solved what could have been a major problem.

Conclusion

Retention of documentation is necessary to support all exempt sales. Sometimes the type of support auditors want is not as straight forward or obvious as the usual resale cards, exemption certificates, or shipping receipts. Supporting things that didn't happen sometimes requires creative thinking. This is better done at the time of the sale if possible, rather than at the time of the audit.