The Ohio Department of Taxation (the “Department”) is focused on increasing registration and compliance with the commercial activity tax (the “CAT”), which replaced Ohio’s corporate franchise, personal property and personal income taxes (although the final phase-out of the personal income tax has been delayed). As part of the Department’s addition of 100 revenue generating employees, a nine person Nexus Unit in the Department’s CAT Division was created with the primary purpose of registering taxpayers for the CAT. 

The Nexus Unit, started in November, 2009, identifies and contacts businesses believed to have greater than $500,000 of annual Ohio gross receipts, thereby meeting the definition of “bright-line” nexus. One way the Nexus Unit is identifying such businesses, making sales into Ohio but not necessarily with a physical presence in the state, is by creating a database of accounts payable from taxpayers audited for Ohio sales and use taxes.  This allows the Department to identify taxpayers with “bright-line” nexus merely through audits of the business’ Ohio customers. In addition, the Nexus Unit is using several types of information publicly available, such as SEC filings and Forbes lists, to identify businesses skirting their CAT obligations. 

A penalty of up to 60% of the delinquent liability may be imposed upon those who receive notice from the Department instructing them to register for the CAT, but fail to do so. This steep penalty can be avoided by participating in the CAT’s Voluntary Disclosure Program. This program requires the business to register for the CAT and pay its delinquency, while avoiding applicable penalties.  However, the Voluntary Disclosure Program is not available after having been contacted by the Department. 

As explained in a previous post, Ohio changed its sourcing rules effective January 1. Now, intrastate sales of tangible personal property (“TPP”) are generally sourced by origin (vendor’s location where order is received), and interstate sales are sourced generally by destination (consumer’s location).  More importantly, incremental use tax is not owed to the Ohio County of storage, use or consumption when the sourcing rules are followed.  The following two examples illustrate the potential for a sales tax savings based upon these new sourcing rules. Both examples use Cuyahoga County as the business’s location, which has a combined sales tax rate of 7.75% - the highest in Ohio. 

1) An Ohio business located in a high tax rate county can obtain an advantage by purchasing taxable TPP from an in-state vendor instead of an out-of-state vendor.  Lets assume a Cleveland based company is purchasing $500,000 of taxable TPP.  If the business purchases the TPP from a vendor located outside Ohio, the Cuyahoga County rate of 7.75% will apply, resulting in sales tax of $38,750.  However, if the same business purchases from a Lake County vendor and the order is received by said vendor in Lake County, the transaction is taxed at 6.25%, resulting in sales tax of $31,250 – a savings of $7,500. 

2) An Ohio business located in a high tax rate county could reduce the effective tax rate borne by its Ohio customers by receiving orders in a lower rate county.  Lets assume a Cleveland based business is concerned that it may lose purchases from Ohio customers due to the higher tax rate in Cuyahoga County.  Instead of having the 7.75% Cuyahoga County rate apply, the business could receive orders at a different location in Lake County, where the lower 6.25% rate would apply – effectively giving its customer a 1.5% savings.  Further, since the determining factor for origin based sourcing is where the order is received, the product could still be shipped from the vendor’s Cleveland location. 

As you can see, the new sourcing rules for Ohio sales tax have created a situation where a consumer can gain an advantage (or disadvantage) by choosing to purchase TPP from an Ohio vendor over a non-Ohio vendor (or even amongst different Ohio vendor).  This result could be the basis for a claim that Ohio’s sourcing rules discriminate against interstate commerce and, therefore, are unconstitutional.  Nonetheless, until such a determination is made, planning opportunities exist for Ohio based businesses, especially those located in Cuyahoga County, to minimize Ohio sales tax owed on its purchases or sales to Ohio customers. 

With the addition of 85 agents to the Ohio Department of Taxation’s (the “Department”) Audit Division (representing a 32% increase), half of which are assigned to sales and use tax, audits in this area are certain to substantially increase in the coming years. As Ohio attempts to capture revenue, you should understand the process and expectations of a sales and use tax auditor. 

The first contact by the Department informing of an audit is generally an Audit Commencement Letter (ACL) requesting numerous documents from the taxpayer. Oftentimes, taxpayers respond to the ACL themselves hoping they can quickly resolve the matter. This is not likely. Prior to even sending the ACL, the auditor has compiled substantial information about the taxpayer by reviewing prior Ohio tax history and returns, federal tax returns, Security and Exchange Commission filings, and information available through Harris InfoSource and other databases, as well as the taxpayer’s website and searching Google, Yahoo and other search engines. Moreover, the taxpayer’s response to the ACL, and any information or documentation provided therewith, will be used by the auditor during the audit. Thus, it is imperative to respond to the ACL in a manner that preserves the taxpayer’s rights and presents the information/documentation in a light most favorable to the taxpayer. 

After the initial contact is made, the auditor will likely attempt to schedule a meeting at the taxpayer’s facility to discuss the method and timeline for conducting the audit, and perhaps request a plant tour. The timeline is helpful in that it gives the taxpayer an expectation as to the depth and procedure of a sales and use tax audit. Furthermore, if a test check will be conducted, where only a representative portion of the taxpayer’s purchases or sales will be examined, the auditor will attempt to enter into a sample agreement with the taxpayer setting forth the method for conducting the test check. Beware this sample agreement is binding and will foreclose any challenge on appeal to the methodology of the test check, except to the extent the agreement itself is unreasonable or unreliable.

Many taxpayers dig themselves into a hole by attempting to head off an audit at the initial stages by responding to the Department’s inquiries themselves. Unfortunately, if one waits too long to retain a professional to assist with the audit, after crucial information has been disclosed, the taxpayer may unnecessarily waive some of its rights. By contacting a sales and use tax attorney immediately upon receipt of the ACL, you enhance the ability to present the required information and documentation in a favorable light, while preserving all of your rights as a taxpayer.

Much attention is given to the presence of an employee or agent in a state when analyzing whether a business has nexus for sales and use tax collection purposes on its sales. This generally causes other nexus creating activities to be overlooked. One such activity is renting a warehouse or other storage space in a state where the business otherwise does not have a physical presence. Often, a business will rent a warehouse to store its inventory without realizing that this presence, even without any employees or agents in the state, likely creates nexus for sales and use tax collection purposes.

This includes when a common carrier, such as UPS or FedEx, receives an inventory of goods on behalf of a retailer, stores those goods, and later processes shipments to the retailer’s customers. While delivery to the common carrier does not create nexus, activities beyond those customarily performed by a common carrier can create sales tax nexus. It is not always clear when the “customary common carrier” line is crossed, but it is likely that storing one’s inventory and processing shipments on its behalf crosses that line.

 Therefore, businesses should be aware that renting space in a  public warehouses located in a state where they otherwise do not have a physical presence, or engaging a common carrier to store and process shipments in such a state, will generally create sufficient nexus for purposes of imposing a sales and use tax collection obligation on its sales.  This can lead to sufficient nexus for purposes of other taxes as well. However, at least one state, Oregon, has an exemption for inventory stored in a public warehouse which is shipped directly to customers outside the state. Please contact us if you would like us to review whether any other states have such an exemption.

Like other states, Ohio’s use tax is complementary to its sales tax, with tax being imposed upon the storage, use, or consumption of tangible personal property in Ohio and the receipt of the benefit of a taxable service, to the extent sales tax has not been paid.  The reality is that every Ohio resident and business operating in Ohio likely has a use tax liability arising from out-of-state purchases when the vendor did not collect Ohio tax (and, through December 31, 2009, also arising from purchases made from vendors in an Ohio county with a lower tax rate than the county of the consumer’s storage, use or consumption of the property).  The failure to file an Ohio use tax return enhances the likelihood: 

1. You will be audited, as the Tax Commissioner will be concerned there is no means by which your use tax obligations are being met (and those not audited are simply lucky due to the limited resources of the Tax Commissioner). 
2. The penalty resulting from an audit will be the maximum 15%. 
3. An audit will encompass a substantial period since there is no statute of limitation if returns are not filed.