Baker Tilly refers to Baker Tilly Virchow Krause, LLP,an independently owned and managed member of Baker Tilly International
© 2010 Baker Tilly Virchow Krause, LLP
Managing Sales and Use Tax Risk in a Financial Services Environment
Insurance Accounting & Systems Association
September 19, 2016
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Jon P. Skavlem, CPAFirm Director – State & Local Taxes
Contact information: E-mail: [email protected]: (414) 777-5333
See LinkedIn profile for additional information.
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“The retail sales tax in its current form is a complex, uncertain, and profoundly flawed mechanism that is peculiarly unsuited to an increasingly service-oriented, digital, and borderless economy.”
- Jerome Hellerstein, “State Taxation” (WG&L)
Agenda
> Current sales and use tax landscape> Definitions> National Developments and Nexus> Use tax> Sales tax> Audits, Appeals & Refunds> Compliance and Planning > Questions
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Sales and Use Tax Landscape
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Sales and Use Tax Landscape
> The battle over sales tax nexus continues to grow in intensity e.g. AL, SD
> Federal action to overturn Quill and allow states to tax internet sales still percolating. Est. $25 billion in uncollected sales tax
> States compelling registration/compliance with non-tax initiatives e.g. CO vendor notification requirements
> Complex areas of sales and use tax e.g., digital goods, cloud computing, information services, are evolving.
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Sales and Use Tax Landscape
> States eye taxing more services as their need for revenue persists
> With almost 7,500 state and local sales/use taxing jurisdictions in the US, compliance costs are growing for many businesses.
> Efforts to simplify sales and use tax laws e.g. Streamlined Sales & Use Tax Agreement have largely failed to create uniformity among states.
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Sales and Use Tax Landscape
> State tax agency investments in “big data” will likely lead to new, more extensive records requests and intrusive audits. Gartner, Inc. defines “big data as: high volume,
high velocity, and high variety information assets that demand cost-effective, innovative forms of information processing which enable enhanced insight, decision making, and process automation.
Cross-matching tax and other business registrations, connecting seller and purchaser audit results, information sharing among states, etc
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Sales and Use Tax Landscape
> State and local revenue agencies dialing up sales and use tax audits WDOR’s ROI - $8 assessment per $1 of
auditor payroll cost Over 100 new WI audit and discovery
personnel hired > Imposition of penalties e.g. 10%-25% in audits
becoming “coin of the realm”.
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Insurance industry’s sales anduse tax environment
Factors impacting the tax compliance burden:> Heavy investment in real estate and
consumption of related services e.g. construction, repair, maintenance
> Software, computer hardware and related IT consulting are critical element to delivering insurance services
> Telecommunications and data transmission services developing rapidly; increasingly tied into software.
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Insurance industry’s sales anduse tax environment
Factors impacting the tax compliance burden:> Important, although declining role of printed materials
and advertising> Rapidly growing reliance on electronic channels of
policy-holder and agent services, and marketing. Interactive websites E-mail blasts, e-confirms
> Shared service centers> Outsourced services
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Definitions
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Sales tax
> Tax imposed on retailer’s (seller’s) gross receipts from sales and leases to consumers of tangible personal property, software, taxable services, etc.
> Seller may collect tax from customer Separately stated on invoice (or) Tax included price
> If a retailer fails to collect sales tax, it is liable pay the tax due based on its taxable receipts
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Use tax
> A tax on the use, storage, rental or consumption in a state, of tangible personal property, software, taxable services, etc., upon which a sales tax has not been paid by the buyer
˃ Example: Company purchases a computer from New York seller who in turn ships it to Maryland and does not charge sales tax. Company owes use tax.
˃ Reasons why vendor may not apply sales tax e.g. lacks nexus
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What’s taxable?
> Tangible Personal Property (TPP) is subject to tax unless an exemption applies. May include digital (electronic) goods
> Services specified in the statutes as taxable.> Prewritten software is subject to tax in most states> Situs of Transaction – Usually where buyer takes
possession of TPP or services are received by customer Typically, no temporary storage exemption for
TPP
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What’s exempt?
> Property/services purchased for resale> Nontaxable by nature of transaction (real estate or
intangible asset, e.g. trademark)> Services not specifically identified as taxable> Statutory exemption (e.g. manufacturing
machinery and equipment)> Digital goods? Depends on state.> Custom software
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What is included in amountsubject to tax?
> Sales price on invoice with adjustments> Certain repair and maintenance contracts> Warranties – look to underlying TPP> Installation (varies by state)> Shipping (not all states)> Handling fees> Fuel surcharges> Manufacturers’ rebates> Certain taxes e.g. personal property taxes
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What is NOT Included inamount subject to tax?
> Retailer discounts and coupons (vs. mfgs.rebate)> Refunds, returns, and allowances> Insurance on product merchantability when
separately stated> Warranties and service contracts on exempt tangible
personal property> Separately stated charges for installation of exempt
TPP > Trade-ins (generally must be directly with retailer)> Bad debts
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Baker Tilly refers to Baker Tilly Virchow Krause, LLP,an independently owned and managed member of Baker Tilly International
© 2010 Baker Tilly Virchow Krause, LLP
National Developments and Nexus
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Nexus
Nexus - term used to describe the economic connection between a business and a state. It is a critical concept since it determines whether a state or local government can impose tax filing requirements on a business.
˃ U.S. Constitution Due Process and Commerce Clauses
˃ Federal laws (Internet Tax Freedom Act)> Federal court cases e.g. Quill> State constitution > State statutes> State administrative rules and informal policies
Limits on state nexus authority
˃ Quill Corporation v. North Dakota; US Sup. Ct. Dkt. No. 91-194 (5/26/94): A business must have physical presence in a state for sales tax nexus to exist
> Examples; employees working in a state, visits by sales personnel or independent reps, office space, rented equipment.
> Economic presence alone was thought to be insufficient to create nexus until recently
> Many states have adopted nexus standards that circumvent Quill in the last 5 years
Quill and physical presence test
> Click-through nexus e.g. NY, CA, IL> Affiliate nexus e.g. WI> Economic or “Bright Line” nexusAL - $250,000 annual sales or more in stateSD - $100,000 annual sales or more in state
> Out-of- state seller notification requirements e.g. CO
> Streamlined Sales & Use Tax Agreement
State challenges to physical presence
Activities that might create sales tax nexus:> Retail sales above specified $ threshold> Providing services from outside a state to in-state
customers> Operating a related company in the state i.e. affiliate
nexus> Making internet sales using third-party website links that
involve a commission arrangement i.e. “click-through” nexus
> Owning or leasing a server within a state> Trade show participation (Note “safe harbor” states e.g.
CA, MN)
Nexus-Creating Activities
Would Repeal Physical Presence> On-line Sales Tax Simplification Act of 2016 – H.R.
5893> Marketplace Fairness Act of 2015 – S. 698> Remote Transactions Parity Act – H.R. 2775Would Mandate Physical Presence for Nexus> No Taxation Without Representation Act of 2016-
H.R. 5893> Business Activity Simplification Act 0f 2015 – H.R.
2584
Proposed legislation on nexus
> Discovery units of state revenue agencies with broad powers of assessment and levy
> Nexus questionnaires> Information sharing agreements > Consequences of failure to register and collect
sales/use tax Statute of limitations does not close back years Penalties for negligence and non-filing Delinquent interest e.g. 18% Financial statement impairment
Discovery & Enforcement
Baker Tilly refers to Baker Tilly Virchow Krause, LLP,an independently owned and managed member of Baker Tilly International
© 2010 Baker Tilly Virchow Krause, LLP
Use Tax
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Sales vs. use tax:Who is responsible for the tax?
> If sales tax is not collected by the vendor, the purchaser must self-assess use tax.
> Why isn’t it only the seller’s responsibility to collect and pay the tax? States maximize their ability to obtain the tax. WI places burden on buyer to determine if sales
tax was paid by seller upon audit. MI will not assess use tax if purchase made
from in-state vendor.
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Financial services:TPP commonly subject to tax
> Office equipment and supplies> Janitorial, cleaning and building maintenance
equipment and supplies> Computer hardware and IT networking costs> Computer software (see next section)> Telecommunications equipment> Digital goods e.g. downloads of books, videos> Training materials e.g. manuals, DVDs> Advertising and promotional materials> Motor vehicles
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Leases – general tax framework
> Lease as continuing sale of TPP – tax due on stream of rent payments. (most common method) Lessor purchases TPP exempt from sales tax
> Lessor pays tax on cost of TPP when purchased Lessee is not liable for sales or use tax on rent
but lessor may pass the tax cost through. Illinois follows this approach. Pennsylvania
applies it to construction equipment.˃ Potential WI – IL tax trap for lessors
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Leases – general tax framework
Operating vs. capital lease:> Classification can impact timing of tax> Operating: Tax paid by customer on the lease
charges> Capital: Treat as sale. Tax immediately due (sales
tax by the vendor or use tax from buyer)> No uniform definition of capital/operating lease
among states e.g. GAAP, IRS guidelines.> Use of TPP by a customer may be treated as
taxable rental even when transfer agreement is not structured as a lease.
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Lease rental of TPP vs. service
> If an operator is provided with equipment, transaction will be treated as a service by many states Streamlined Sales & Use Tax Agreement method
followed by WI and over 20 other states> When an operator is provided with equipment, the
transaction is considered a service If a service, treatment depends on whether it is
classified as taxable by statute Property is taxable when purchased by
owner/service provider
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Services – Rule of Thumb
˃ Services ordinarily not taxed unless state statutes enumerate them as such
˃ States with broad-based sales and use taxes that presume services are taxable Hawaii New Mexico South Dakota West Virginia
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˃ Telecommunications e.g. telephone, paging, video conferencing, EDI.
˃ Internet access (WI and 11 other states)˃ Repairs, maintenance, installation and other
services to taxable tangible personal property ˃ Janitorial services (not in WI if regular and routine)˃ Building maintenance e.g. CT, MN, NJ, PA, TX˃ Sale of landscaping/ lawn care e.g. DC, WI˃ Photographic services e.g. WI˃ Parking
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Financial services:Services potentially subject to tax
˃ Advertising services e.g. CT, MD˃ Information services e.g. DC, NJ, NY, TX˃ Credit reporting e.g. FL, MD, NJ, NY, PA, WA˃ Security and private investigation e.g. FL,NJ, TX˃ Payroll processing e.g. CT, DC, OH, ˃ Temporary help e.g. DC, IA, OH, PA˃ Printing and other fabrication services
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Financial services:Services potentially subject to tax
Real property
˃ Land, land improvements, buildings and structural components permanently attached to the real estate
˃ Sale of real property and related construction services generally non-taxable with exceptions e.g. WA
˃ Contractor must pay sales or use tax on building materials and components of real property
˃ Structural components and services to real property are taxable in many states
WI – taxes materials and equipment retaining character as TPP after installation in real estate
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Real property or personal property?
˃ Leasehold improvements
˃ Signage – internal and external
˃ Security systems – IT components, wiring, cameras
˃ Cabinets, counter-tops, bathroom and break-room fixtures
˃ Built-in appliances
˃ Specialized lighting or HVAC (e.g. computer rooms)
˃ Back-up electrical generators
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Real property or personal property?
˃ Practical difficulties in determining what construction charges are taxable
˃ TPP may be subject to use tax when construction contractor fails to assess sales tax
˃ WI is an especially challenging state – See Wisconsin Publication 207
˃ Other states - TX taxes real estate repair and remodeling contracts on commercial property
˃ Special contractor taxes may add to RE tax costs e.g. SD 2% contractor’s excise tax
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Baker Tilly refers to Baker Tilly Virchow Krause, LLP,an independently owned and managed member of Baker Tilly International
© 2010 Baker Tilly Virchow Krause, LLP
Computers and Software
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IT spending – Key area of sales and use tax risk
What’s at stake for businesses?˃ Expanding and uncertain potential tax base˃ Gartner anticipates worldwide IT spending to equal $3.49 trillion in
2016˃ A Goldman Sachs study forecasts worldwide SaaS sales to reach
$106 billion in 2016, a 21% increase from 2015 ˃ Cisco predicts by 2018, 59% of total cloud workspace will be SaaS
Increase from 41% in 2013˃ Tax and financial impacts
Audit assessments including penalties and interest Risk management e.g. ASC 450 – contingent liabilities.
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The basics
Software – What are we talking about? > Computer programs – system software, application
software, web-based applications and all other forms e.g. ERP, Software as a Service, custom programs, prewritten (canned) software
> Related IT services - design, installation, modification, maintenance, support, training, monitoring, security, data back-up and processing, etc.
> Bundled software – service offerings such as SaaS, PaaS, IaaS and others.
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Factors affecting taxation of software
Key State Tax Factors:> Nature of software: prewritten, custom, SaaS, etc.> Terms of agreement or contract: sale vs. license> Fee arrangement: license payment, user fee, etc.> Mode of delivery> Bundling of software, hardware and services
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Software taxation framework
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> Prewritten (Canned) Computer software, including prewritten upgrades, that
is not designed and developed by the author or other creator to the specifications of a specific purchaser.
> Custom Computer software created to the unique specifications
of a user. Not sold or licensed to more than one party (under SSUTA rules).
> Modified prewritten software (Can it become “custom”?)
Software taxation framework
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> Cloud Computing Range of software applications, services and hardware
capacity that are hosted or available over the internet on a fee or license basis.
Includes SaaS, PaaS, IaaS and other packages Key characteristic – possession, direction and control
is NOT with the user / customer> Embedded software – resides as firmware within a
device and has one, or a few uses e.g. cars, phones> Related IT services – line is becoming increasingly
blurred between software and hardware
Software taxation framework
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> Sales and use tax significance (generally) Prewritten software - assumed to be TPP Embedded software – integrated with and inseparable
from device, product or hardware Custom software - treated as service or intangible
asset SaaS – varies e.g. prewritten software, non-taxable
service, taxable telecommunication service, lease of TPP.
IT services – taxation tends to follow overall state framework for taxing services
Taxability of computer hardware and software
Examples of Taxable Sales:> Computer hardware> Network components> Prewritten computer software in most states Services to canned software e.g, installation Exempt in certain states if electronically delivered e.g.
CA, FL> Note: Planning opportunities regarding unbundling IT
charges
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Taxability of computer hardware and Software
Examples of Nontaxable Sales:> Custom software (but see OH)> Optional training on how to use software or hardware > Writing queries on databases > Data reformatting, migration, back-up, recovery, etc.> Hosting, testing, and security charges> Caution: Some may treat as taxable information
services in select states e.g. TX,
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Cloud computing - SaaS
Software as a Service > Definition of SaaS> Software not on user’s server, but accessed over the
internet> Customer does not have custody and control of the
software; does not have physical access to the vendor’s server; and does not have the responsibility to maintain, upgrade or repair the software
> Taxable in some states as prewritten software e.g. NY, PA
> Exempt in other states as a service e.g. WI
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Software Tax Specific States Summary
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Baker Tilly refers to Baker Tilly Virchow Krause, LLP,an independently owned and managed member of Baker Tilly International
© 2010 Baker Tilly Virchow Krause, LLP
Sales Tax
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Sales tax – financial services
> Less of a concern for insurance companies since do not generally sell taxable TPP or services
> Areas of concern Services or TPP furnished to agents Sales to employees Intercompany transactions e.g. allocated
software charges Incidental fixed asset sales Leasing?
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Sales tax – focal points
˃ Nexus˃ Registrations Treatment of disregarded entities
˃ Defining taxable receipts˃ Exemptions available e.g. resale, affiliated entities˃ Certificate management and documentation
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Sales tax – focal points
˃ Sourcing of receipts˃ Local and special district taxes˃ Electronic filing and payment required in many
states˃ Nature of compliance system e.g. manual,
automated
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Baker Tilly refers to Baker Tilly Virchow Krause, LLP,an independently owned and managed member of Baker Tilly International
© 2010 Baker Tilly Virchow Krause, LLP
Audits, Appeals, and Claims For Refund
Audit process
> How are taxpayers selected for audit? “Preferred customer” – typically large companies Audit history – likelihood increases with significant
prior year assessments Referrals from other audits Information sharing / data mining Special projects (programmatic)
> Field vs. office audit> Written notice of intent to audit is almost always
required by law or TBOR
Audit process
> How many years will be audited? Four years in WI covers open statute ol limitations Longer if no return has been filed (6 years for WI
use tax)> Option to have field audit occur offsite e.g. office of
CPA or attorney> Representation –POA required. Early involvement will likely produce better results
and avoid friction with the auditor
Records
Records likely to be reviewed for financial services company:> Tax returns and workpapers> Fixed asset records –acquisitions and disposals> Capital and expense invoices including other
documents e.g. purchase orders.> Leases> Software contracts
Records
Records likely to be reviewed for financial services company:> Credit / Procurement card statements and support> Chart of Accounts> Trial balance data – likely in electronic form> Journal entries> Sales invoices > Exemption certificates
Sampling methods
> Non-statistical Alpha sample Month per year Select GL accounts> Statistical sample – used less than 5% of time by
WDOR. Higher degree of accuracy and reliability Stratification and specified error parameters Will not necessarily lead to smaller sample size
Audit exposure areas for financial service companies
Use tax:> Failure to register for and accrue use tax> Missing records> Purchases from out-of-state vendors (office
supplies, promotional materials, digital goods)> Prewritten software and related consulting > Shipping, freight and handling charges on taxable
TPP (WI taxes but exempt in other states if separately stated)
> Leased equipment
Audit exposure areas for financial service companies
Use tax:> Information services> Other services e.g. landscaping, repairs and
maintenance to TPP, telecommunications, temporary help
> Construction, repair and maintenance of facilities and attached personal property
> Absence of temporary storage exemption> Local and special district taxes not applied > Vendor applies incorrect state tax e.g origin. Credit
not available in state of use or consumption
Audit exposure areas forfinancial service companies
Sales tax:> Exemption certificates missing or incomplete> Sales to affiliates> Sales to employees> Sale of used equipment> Improper treatment of leases > Failure to account for local and special district
taxes
Audit planning and strategy
˃ Request formal notification and record requests˃ Conduct preliminary review ˃ Set expectations for timing, records, access in
opening meeting˃ Negotiate sampling techniques and parameters˃ Initiate regular communications with auditor ˃ Set a protocol for fielding questions and for
responding˃ Conduct review for potential refunds
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Audit process
> Closing meeting with auditor Request meeting with supervisor if necessary
˃ WI Notice of Proposed Report: Agree or disagree? Prepayment option to reduce 12% interest
˃ Notice of Field Audit Action – Assessment or Refund
Appeal process
˃ Administrative appeal to WDOR Resolution Unit Informal – proceedings not official record for
subsequent litigation Must file Petition for Re-Determination 60 days after receiving Notice of Field Audit
Action Can make deposit to stop interest
˃ WI Tax Appeals Commission˃ Circuit Court, Court of Appeals and Supreme Court˃ Other states – “Pay to Play”?
Penalties – Are You at Risk?
> 25% negligence penalty (1of 3 audits)> Filing late return – 5% penalty per month > 50% fraud penalty – WDOR has started to impose
when no intend to defeat or evade is present.> Delinquent fee – greater of $35 or 6.5%> 25% penalty - failure to keep records> Interest of 18% on delinquent taxes, 12% if not
delinquent
Penalties – Are You at Risk?
Failure to produce records:> Disallow deductions, credits, exemptions> $500 or 25% penalty for each violation> Certain exceptions to penalty – reasonable cause,
etc.
Claims for refund - the process
Who may file a claim?:> Sales tax Seller – must return tax and interest to buyer.
Amend sales tax return(s) Buyer – file directly with WDOR
Can file electronically Vendor waivers Tax paid to seller: $50 or more
˃ Use tax – amend use tax return or direct audit offset
Claims for refund – potential areas for financial service companies
˃ SaaS and custom software Downloaded prewritten software in select states e.g
CA, FL˃ Printed advertising including direct mail ˃ Non-taxable services˃ Resale˃ Real property construction and related services
Claims for refund
˃ Seller: Form ST-12 or letter> Buyer Tax paid to seller: Form S-220 Tax paid to DOR: Form ST-12 or letter
> Interest – 3% per year> Penalties for incorrect claim or failing to return tax
and interest to buyer 25% negligence 100% fraud
> DOR action on claim – 1 year
Compliance and Planning
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Compliance and planning
˃ Conduct a sales and use tax policy and procedures review to ensure: Sales and use tax registrations held in appropriate
jurisdictions Written procedures are in place Exposures are identified and quantified Employees with appropriate responsibility and
training are assigned to compliance˃ Analyze compliance resources: Automated compliance Research services e.g. RIA, CCH
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Compliance and planning
˃ Follow-up on audits after completion Amend returns to stop interest and forestall
penalties Examine adjustments and make corrections
˃ Build taxability review into purchasing and capital budgeting processes
˃ Tax group review of leases and software contracts˃ Examine use of procurement and T&E cards for use
tax implications˃ Advanced planning strategies – purchasing
company, percentage use tax reporting
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Questions?
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