It is a well-know axiom that purchasing executives, particularly in the retail industry, are trying to squeeze every conceivable dollar out of the supply chain. They have focused on process improvements such as total quality management, just-in-time, and Six Sigma. Further they are increasingly seeking to manage and integrate diverse functions to achieve organization-wide supply chain objectives. One of the critical supply chain management objectives is the saving of dollars for the organization and its customers. Particularly in the retail industry, where price is often the key factor in a purchasing decision, cost management is often the key objective. For certain purchases and operations there are "tax efficient" structures that should be considered. However, frequently, such structures are not considered. This article will examine those structures, discusses why such structures are often not utilized and also how utilizing such structures can provide a company with a competitive advantage.
What Is Tax-efficient Procurement?
If we were to discuss what an efficient supply chain means, most Supply Chain executive vice presidents (EVPs) would reference concepts such as driving enterprise cross-functional integration; producing the highest availability at optimal inventory carrying levels, transportation and warehousing investment; driving increases in economic profit; and increasing shareholder value.
Conversely, if we were to ask about "tax efficient procurement" we would likely get a blank stare from the same Supply Chain EVPs. Why? Because the integration of tax savings and efficiencies in the context of procurement are often not well understood by either procurement executives or corporate tax departments. While we could enumerate a myriad of tax decisions that impact supply chain efficiency, for purposes of this article we will focus solely on sales and use tax decisions.
Where Do Sales Tax Difficulties Arise in Procurement?
Primarily, tax inefficiencies emanate from the procurement of non-inventory items (often referred to as internal use assets or indirect purchases). To understand how these inefficiencies arise we need to explain the basics of sales tax mechanics.
The Basic Mechanics of Sales Taxes
In general, when a company purchases inventory items (items it intends to resell to third parties), such purchases are made under a resale certificate (a form provided to the vendor with the relevant tax identification information and signed by the appropriate corporate officer). A properly completed and executed resale certificate provides the vendor assurance that the items purchased are for resale and, as such, no sales tax need be collected.
When non-inventory items are purchased, (e.g. fixed assets, operational software, supplies) tax must either be paid to the vendor at time of purchase or use tax must be self-accrued and remitted by the purchaser. If the vendor charges tax, it must make certain assumptions about which state and localities the purchased assets will be used in and, accordingly, charge tax based on its assumptions regarding the locale of usage.
If a vendor makes a mistake as to the location of usage, the proper tax rate or even the taxability of the purchase, for most jurisdictions, a refund claim for incorrect tax amounts must be made through the vendor (not directly by the company to the taxing jurisdiction).
Almost all states have a corollary to "sales" tax: "use" tax. In general, use taxes apply in situations where the vendor either was not obligated to, or did not collect sales tax on, an otherwise taxable purchase of goods, services or taxable intangible licenses. Use tax has several nuances. Use tax can (although not often) be imposed at a different rate than sales taxes. Further, use tax is typically "self accrued" by the purchaser, and as such, the determination of the proper taxing jurisdiction(s) and rate(s) is left to the purchaser.
So why does this matter? If wrong tax determinations are made by a company's vendors, inefficiencies occur because the tax (cash) paid will remain in hands of third parties unless or until it can be proved to the satisfaction of the vendor that an error was made. This is a time-consuming process during the pendency of which a company's cash remains in limbo.
What are the Dollar Benefits of Tax-efficient Procurement?
Depending on the nature, amount and the jurisdiction of deployment of non-inventory spend, tax savings can be significant.
How can savings be obtained? Saving can be obtained in a variety of ways, including:
- Prevention of incorrect or duplicative taxation (who knows better what is taxable, where its is taxable and when it has been placed in service then the company's tax department);
- Matching the incidence of taxation to when items are actually placed in service (for example, the time period during which a point of sale equipment is purchased and "imaged" (loaded with software) and the time the equipment is actually shipped to, and placed in service by, a store);
- Matching subsequent rebate or discounts with original purchase price (thereby reducing the overall taxable purchase price);
- Facilitating the structuring of the transaction to fit within a statutory or regulatory exemption (particularly applicable with software purchases);
- Unbundling taxable items from non-taxable items (typically services from the purchase of tangible personal property) thereby reducing the taxable base of the transaction; and
- Ensuring duplicative taxation does not occur (where the vendor believes your company will place the asset in use and where the asset is actually placed in service).
Are the dollar benefits the same for all companies? The short answer is no. Why? Because the location of procurement functions, the type of assets purchased and the amount of certain assets purchased all differ from company to company, thus impacting the achievable benefit. Nonetheless these savings can be substantial, permanent and ongoing.
What Are the Practical Advantages of Tax-efficient Procurement?
From a tax perspective, ownership of the transaction (i.e. the ability to determine the amount, subject matter and jurisdiction) of taxation is the single most crucial function to own. Are there non-tax operational and financial reporting benefits from "owning" taxing decisions? Yes, specifically:
- Improving the sales tax audit trail, thereby reducing the time required to respond to state sales tax audits;
- More efficient processing of refund claims when tax errors have been made (this efficiency occurs because the company, as the collecting agent, can apply directly to the taxing jurisdiction, instead of going through its vendors, to obtain refunds);
- Greater certainty regarding tax decisions frees up financial accounting reserves (contingent reserves for non-income taxes are required under FASB Statement No. 5, Accounting for Contingencies.) created for miss-compliance, thereby producing financial statement benefits; and
- Reduction of audit assessments, including related interest and penalty costs, is a risk management goal.
The end result: labor is engineered out of an often over-stretched tax department, tax efforts are better aligned with supply chain objectives and risk is minimized.
What is Required to Achieve Savings?
Typically, in order to achieve tax self-determination, a company must create a captive legal entity for procurement in order to purchase assets tax free for resale to a related entity (under a sales tax resale certificate). The legal entity structure can be quite flexible. The procurement entity can take many forms, (corporation or limited liability company (LLC)) and can be either regarded or disregarded for federal and state income tax purposes. The following is a basic list of minimum requirements:
- A separate legal entity housing certain procurement functions;
- Registration of the entity to collect sale tax in the jurisdictions in which it is required to collect tax;
- Tax systems sufficient to generate internal invoices (between the procurement entity and its related operating entities); and
- A tax decision matrix capable of making taxability and rate determinations for the types of assets purchased in the jurisdictions in which they will be deployed (this functionality is typically contained in most sales tax software).
For many companies, the information technology (IT) systems/investment required for implementing a tax-efficient procurement platform is modest, particularly when compared with the massive dollar amounts spent acquiring, customizing, installing and testing complex supply chain software platforms.
Key Factors in Creating a Competitive Advantage
A competitive advantage exists for those companies that look beyond tax compliance and toward tax self determination. However, in evaluating this objective, perspective is key. If tax determination is viewed either as simply a cost-center necessity or, alternatively, as "too complex" to be understood by key operational decision makers, then meaningful tax efficiencies cannot be achieved.
Instead, a holistic approach is required to properly envision the desired efficiencies, create an actionable plan to achieve those efficiencies and put together a coordinated effort to execute the plan. In order to achieve sustainable supply chain, procurement-based tax savings there needs to be functional coordination between procurement professionals, the tax department and the IT department. Further, there needs to be an understanding of the issue, an appreciation for the importance to the organization of the effort and the buy-in of every department impacted. This perspective is essential in order to ensure shared ownership of the effort and shared credit for the results.
Why Isn't This Type of Thinking Common?
Unlike many of the complex issues in business, which take mounds of data and hours of intense analysis of which to make any sense, the reason that this type of thinking is not common in most businesses is quite simple: tax departments and supply chain executives seldom, if ever, talk to each other. Further, the two groups view operations from widely different perspectives. Supply chain and procurement executives are viewed as, if not profit centers, certainly profit drivers within organizations. The savings they are deemed to create are seen as contributing directly to the bottom line of profit-hungry consumer and industrial products companies. In contrast, tax departments are considered cost centers. Tax departments are viewed, often unfairly, as the source of issues that hamper operations and cost the organization money.
Corporate perspectives toward resource allocation also come into play. Systems or processes that reduce the cost of acquiring goods are deemed mission critical. As such, when requests are made to spend millions of dollars on sophisticated supply chain, point of sale, inventory management or electronic data interchange projects, such projects often receive swift approval, frequently based on similar expenditures by competitors.
It is also important to note that most of the planning talent and effort within the tax departments of most large corporations is devoted primarily to corporate income tax issues, not sales and use taxes. In addition, when the proposed prospective sales and use tax savings are dependent, in part, on the tax department's understanding of, or willingness to modify, existing information systems supporting tax reporting, such ideas seldom attract enthusiasm from the tax department. Why? Many tax "technicians," those who understand, in detail, the tax laws with which a corporation must comply, are not technologically proficient, nor do they care to be. As such, people migrate to activities in which they have a high level of comfort. Moreover, traditionally, when tax departments have made IT resource requests within organizations, such requests tend to be put on the back burner. Finally, tax departments are often required to make extraordinary justifications for any proposed additional resource expenditures for a "cost center" function. Such exercises have put a bad taste in the mouths of most corporate tax professionals.
Anyone who goes to business process improvement seminars will frequently hear the often-repeated phrase "thinking outside the box." The application of that phrase is commonly understood to mean that if you want to succeed in a highly competitive economy you have to think about that which others are not. The concept of "thinking outside the box" is easy to understand but difficult to execute. Why? Because people don't tend to think about things they don't know about. It is the cross-pollination of ideas from discipline to discipline that separates the players from the pretenders.
Companies that want to create superior supply chain efficiencies have to do what their competitors are not doing: effectively integrate tax planning with procurement.