Tax Type
Retail Sales and Use Tax
Description
Assessment; excessive bad debt deductions denied
Topic
Accounting Periods and Methods
Appropriateness of Audit Methodology
Penalties and Interest
Date Issued
05-29-2002
May 29, 2002
Re: § 58.1-1821 Application: Retail Sales and Use Tax
Dear *****:
This is in response to your correspondence requesting correction of the retail sales and use tax assessment issued to your client, ***** (the "Taxpayer") as a result of an audit. I apologize for the delay in the department's response.
FACTS
The Taxpayer is a national retailer. An audit for the period September 1994 through August 1997 resulted in the assessment of sales tax on bad debt deductions that were denied for being excessive.
Specifically, the Taxpayer credits payments received from customers first to post-sale debt charges, such as finance and interest charges, late charges, returned check fees, insurance, and other post-sale fees (hereinafter, "post-sale charges") and then lastly to the principal (i.e., the original sales price of the transaction). The Taxpayer takes exception to the denied bad debt deductions and maintains that Code of Virginia§ 58.1-621 does not prohibit the Taxpayer's method of payment application in computing its bad debt deductions.
DETERMINATION
Bad Debt Deductions
I understand that you recently met with members of my Policy Development staff and Appeals and Rulings staff to discuss the bad debt deductions denied by the department. I understand that the main issue is about the correct interpretation of Code of Virginia § 58.1-621 that sets out the following provisions:
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- In any return filed under the provisions of this chapter, the dealer may credit, against the tax shown to be due on the return, the amount of sales or use tax previously returned and paid on accounts which are owed to the dealer and which have been found to be worthless within the period covered by the return. The credit, however, shall not exceed the amount of the uncollected sales price determined by treating prior payments on each debt as consisting of the same proportion of sales price, sales tax and other nontaxable charges as in the total debt originally owed to the dealer. The amount of accounts for which a credit has been taken that are thereafter in whole or in part paid to the dealer shall be included in the first return filed after such collection. (Emphasis added.)
This statute mandates that for purposes of the bad debt deductions, payments from customers must be credited first to the original debt. The statute makes no mention of applying payments to post-sale charges. The department's policy is also consistent with this statute. For example, Title 23 of the Virginia Administrative Code (VAC) 10-210-160(B) establishes that:
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- Prior payments made to the dealer on a debt which is subsequently determined to be uncollectible must be allocated to the sales price, sales tax and other nontaxable charges based on the percentage that those charges represent to the total debt originally owed. (Emphasis added.)
Furthermore, the department has not changed this policy. In Public Document 94-153 (5/12/94), the Tax Commissioner's ruling references the bad debt regulation and indicates that the regulation:
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- sets forth the computation that should be used to determine the correct bad debt deduction for those transactions where a portion of the debt has been paid. In cases where none of the debt has been paid, the Taxpayer must determine the deduction amount with reference to the specific amount of each bad debt actually related to the taxable sales price.
The consumer's debt to the taxpayer dealer is a liquidated sum that is fixed and determined at the time of sale. It may consist of taxable and nontaxable components plus the sales tax on the taxable components. Thereafter, any additional charges that may accrue on the consumer's account for such elements as late charges, interest, carrying charges, returned check charges, insurance on the item purchased or other fees are not part of "the total debt originally owed to the dealer" as that phrase is used in § 58.1-621. Notwithstanding any credit agreement between the dealer and the consumer that may require payments by the consumer to be applied first to such later applied charges, when calculating the amount of bad debt credit that may be claimed, § 58.1-621 requires prior payments to be applied first to the original debt in "the same proportion of sales price, sales tax and other nontaxable charges as in the total debt originally owed to the dealer." This result, required by statute, cannot be varied by a contractual arrangement between the dealer and the consumer regarding later-applied charges.
Therefore, in computing the bad debt deduction for Virginia retail sales and use tax purposes, I must conclude that the Taxpayer's payment application for bad debt claims does not comply with the statutory authority and regulation cited above. Clearly, for purposes of the bad debt deduction, none of the prior payments from customers should have been applied to the post-sale charges.
Unfortunately, a review of the audit findings reveals that some of the post-sale charges were erroneously included as nontaxable charges in the computation of the bad debt deduction. As stated above, the inclusion of post-sale charges in the computation of the bad debt deduction is not permitted. However, because of this erroneous treatment and for this audit only, the department will not increase the audit tax assessment based on the removal of post-sale charges from the bad debt calculation.
Taxpayer's Proposed Sampling
I understand that you claim that the ten-customer sample used in this audit is not sufficient. You propose that the department use a different methodology.
1st Proposal. Your first proposal would use company-wide data showing total nontaxable components of the original customer invoices. Using data for a four-year period, you indicate that these nontaxable charges account for 1.566% to 1.966% of the Taxpayer's total sales revenue for an overall average of 1.7% for all of the years. Thus, this proposal would reduce the Taxpayer's bad debt claims by 1.7%.
Regardless of whether the Virginia or national data is used, I do not find this proposal to be in accordance with the bad debt statute cited above. This proposal would essentially treat virtually the entire sales price as being uncollectible although the Taxpayer's records demonstrate that payments from customers were in fact received on these accounts. Moreover, company-wide data, which appears to include transactions paid by cash and with other credit cards not subject to the company's payment rules, is unlikely to be an accurate reflection of purchases made with the company's credit card. As noted above, payments from customers must be applied to the original debt in order to claim the bad debt deduction.
2nd Proposal. Your second proposal applies payments first to the post-sale charges and then to the sales price. In this manner, you hope to reduce the taxable portion from 26.2% to 5.8% of the sales price. I also find that this proposal is not in accordance with the bad debt statute cited above because it does not apply prior payments in the manner required by the statute.
3rd Proposal. Your final proposal is a combination of the first and second proposals to produce an average of 3.75% [(5.8% + 1.7%)/2] as the reduction in the bad debts claimed. However, this proposal is not acceptable for the same reasons cited for the other two proposals.
Audit Sample
In the original assessment, I understand that all of the bad debt deductions claimed by the Taxpayer were disallowed. I understand that the audit staff subsequently agreed to re-examine the bad debt claims of the Taxpayer using a three-month sample period. However, the Taxpayer was unable to provide all of the required documentation and requested the examination be limited to only ten customers selected by the Taxpayer from August 1996. Thereafter, the Taxpayer was unable to produce the required information. I understand that the Taxpayer then requested the use of another ten customers selected by the Taxpayer from another period (August 1997, the last month of the audit) for which it produced the documentation. This final selection represents the sample of the disallowed bad debts.
From the foregoing, it is clear that the department has allowed the Taxpayer several opportunities to furnish documentation to substantiate its bad debt claims. Although a more extensive sample was initially chosen, the Taxpayer lacked the evidence for that period. Consequently, at the request of the Taxpayer, the department agreed to substantially reduce the sample to ten customers.
Although a small sample was chosen, this choice was requested by the Taxpayer. Furthermore, the Taxpayer not only selected and reselected the sample periods but also selected and reselected the particular customers used in the sample. Clearly, the Taxpayer played the principal role in choosing the scope and content of the sample.
Although the scope of the sample is small, the sample includes specific claims for bad debts and is supported by documentation related to the specific customers selected for the sample. As such, the sample uses the best information available to test certain bad debt claims to determine whether they conform to the requirements of the bad debt statute.
The Taxpayer has not furnished any convincing evidence to establish that the sample overstates the Taxpayer's bad debt claims. Therefore, I find no basis for revising the sample.
Conclusion
Based on all of the foregoing, the assessment is deemed correct, and a consolidated bill with interest accrued to date will shortly be mailed to the Taxpayer. No additional interest will accrue provided the outstanding liability is paid within 30 days of the date of this letter.
Copies of the Code of Virginia, regulations and public documents cited are available online in the Tax Policy Library section of the Department of Taxation's web site, located at www.tax.state.va.us. If you have any questions about this determination, you may contact ***** in the department's Office of Policy and Administration, Appeals and Rulings, at *****.
Sincerely,
Kenneth W. Thorson
Tax Commissioner
AR/37141R
Rulings of the Tax Commissioner