Sam Brotman, JD, LLM, MBA July 2, 2020 16 min read

Two Main Issues in California Sales Tax Audits

CDTFA Audits of Sales for Resale

A Claimed Sale for Resale is Allowed if Supported by a Valid Resale Certificate

A claimed sale for resale will be allowed in a CDTFA audit if it is supported by a resale certificate that is proper in form and is timely taken in good faith from a person who is engaged in the business of selling tangible personal property and who holds a California seller’s permit. 

If the purchaser is not required to hold a permit because the purchaser sells only property of a kind, the retail sale of which is not taxable, (e.g., food products for human consumption) or because the purchaser makes no sales in California, an appropriate notation to that effect will be entered in lieu of a seller’s permit number on the resale certificate under Regulation 1667 governing exemption certificate requirements. 

A certificate will be considered timely if it is taken at any time before the seller bills the purchaser for the property, or any time within the seller’s normal billing and payment cycle, or any time at or prior to delivery of the property to the purchaser. CDTFA auditors can be stringent when enforcing the resale certificate requirement.

In an CDTFA audit, any document, such as a letter or purchase order, timely provided by the purchaser to the seller will be regarded as a resale certificate with respect to the sale of the property described in the document if it contains all of the essential elements in Regulation 1668. 

A signed resale certificate that has been scanned and transmitted electronically or via a facsimile machine (faxed) is acceptable provided that it contains all of the information required by Regulation 1668, is timely and accepted in good faith, and contains the date and time of transmission and telephone number of the sender either on the document itself, or on the proof of transmission such as a copy of the email, or on the standard fax cover sheet.

What can be Considered a Resale Certificate in a CDTFA Audit

The California Department of Tax and Fee Administration provides detailed guidelines for CDTFA audits about what can be considered as a resale certificate (http://www.CDTFA.ca.gov/sutax/manuals/am-04.pdf). CDTFA provides following examples:

  1. A purchase order that contains all the elements of a valid resale certificate, containing words “for resale”
  2. A valid qualified resale certificate taken timely and in good faith, combined with a purchase order that contains any of the following phrases or similar terminology to indicate that tax or tax reimbursement should not be added to the sales invoice.
  3. • “for resale”
  4. • “resale = yes”
  5. • “taxable = no”
  6. • “nontaxable”
  7. • “exempt”
  8. If the purchase order includes both items to be resold and items to be used, the purchase order must specify which items are purchased for resale and which items are purchased for use. A seller must retain copies of the purchase orders along with the qualified resale certificates in order to support sales for resale.
  9. A letter covering a specific purchase from an out-of-state retailer or from a California purchaser if all the elements of a resale certificate are shown.
  10. Contracts of sale where all the essential elements of a resale certificate are included.

Other evidence of the validity of a claimed sale for resale may be accepted by the California Department of Tax and Fee Administration too in a CDTFA audit.

California Department of Tax and Fee Administration Resale Audits

Use of Form CDTFA-504 – Proving That a Sale was Not a Resale

In a California Department of Tax and Fee Administration audit, taxpayers should keep in mind that any of the evidence other than the actual resale certificate, by itself, is not the equivalent of a resale certificate timely taken in good faith and may not relieve the seller of the liability for the tax.

In absence of any valid resale documentation, in a California Department of Tax and Fee Administration audit, the auditor may determine that it is appropriate for a seller to use the Form CDTFA–504 series of forms (called “XYZ” Letters) procedure to help satisfy burden of proving that a sale was not at retail even though a valid resale certificate was not obtained or to substantiate a claim that taxpayer’s customer paid the tax directly to the state.

When it is appropriate to use the “XYZ” Letter process, the auditor will provide the taxpayer with a copy of forms CDTFA–504–A, B and C, or other type, if applicable. Various types of this letter are described on CDTFA’s website. 

A response to an “XYZ” Letter inquiry alone is not necessarily enough to support a sale for resale. Generally, the “XYZ” Letter is not a substitute for a timely resale certificate, additional documentation or information may be required by the auditor.

CDTFA Audit – XYZ Letter Procedure

A period of four weeks will be allowed by the CDTFA for the taxpayer to prepare and send the “XYZ” statements and for the customer to reply. It is recommended that the “XYZ” statements be returned directly to the CDTFA.

Auditor will provide the taxpayer with appropriate forms and return envelopes. If the taxpayer elects to have the “XYZ” statements returned to them instead of the CDTFA, then the likelihood of having CDTFA staff contact the customer or sending an additional mailing is greater. Generally, in a CDTFA audit, you would not want the auditor contacting the taxpayer’s customers.

The taxpayer may customize the “XYZ” cover letter. However, the use of a standardized “XYZ” statement will reduce any possible controversy over whether the proof provided is satisfactory. 

The taxpayer may ask their customers to forward payment of tax reimbursement if the transaction is identified as taxable. The statement should clearly state that the payment of tax be forwarded to the taxpayer and not the CDTFA.

All modifications to the cover letter must be approved by the auditor’s supervisor. The “XYZ” statement must be used as provided by the auditor. The taxpayer’s customer is requested to return the completed “XYZ” statement within 10 days. The CDTFA auditor may request a second XYZ letter to be sent, depending on circumstances. All customers’ responses are part of the audit working papers and will be used in the audit.

When XYZ responses are not returned, the California Department of Tax and Fee Administration audit staff will make every effort, if not already done, to determine the taxability of the questioned sale by alternative methods.

The auditor can examine the customer’s seller’s permit registration to determine whether or not the purchaser had a permit at the time of purchase, can review the quantity and type of items sold, review a subsequent resale certificate and can contact the customer over the phone. 

Please note that the CDTFA auditor is allowed to accept or deny support contained in documents based on personal knowledge the auditor gained from prior audits or other sources.

There are occasions when the taxpayer is unable to obtain an XYZ letter response because the customer is no longer in business due to a bankruptcy or another reason. In this situation only (but not in cases of corporate changes or reorganizations of customers) the sale will be considered a sale for resale if the property purchased by the customer is consistent with the type of sales the business makes.

If the sale appears to be of a type that could be consumed, the taxpayer is unable to obtain a proper XYZ letter response, and the auditor is unable to determine the exempt status of the sale by alternative means, the non-response will be treated by the California Department of Tax and Fee Administration auditor as an error.

 

California Department of Tax and Fee Administration – Out-of-State Retailers

An out-of-state retailer “engaged in business in this state” (California) is required to register, collect use tax on taxable sales made to consumers in California, and remit this tax to the California Department of Tax and Fee Administration. Revenue and Taxation Code section 6203 provides that “retailer engaged in business in this state” specifically includes, but is not limited to, any of the following:

  • Any retailer maintaining, occupying, or using, permanently or temporarily, directly or indirectly, or through a subsidiary, or agent, by whatever name called, an office, place of distribution, sales or sample floor or place, warehouse or storage place, or other place of business.
  • Any retailer having any representative, agent, salesperson, canvasser, independent contractor, or solicitor operating in this state under the authority of the retailer or its subsidiary for the purpose of selling, delivering, installing, assembling, or the taking of orders for any tangible personal property.
  • As respects a lease, any retailer deriving rentals from a lease of tangible personal property situated in this state.

Clearly, maintaining an office space or having an agent in California can lead to tax liability to the California Department of Tax and Fee Administration for an out-of-state retailer. Section 6203 does not stop here, and mandates the following: “Any retailer entering into an agreement or agreements under which a person or persons in this state, for a commission or other consideration, directly or indirectly refer potential purchasers of tangible personal property to the retailer, whether by an internet-based link or an internet website, or otherwise, provided that certain conditions are met.” 

Consequently, if an out-of-state retailer, including an online retailer/store, has an agreement with a California agent/contractor/marketer/advertising agent/affiliate or anyone else who refers clients to retailer’s website, then the out-of-state retailer also must register with the CDTFA and collect use tax on taxable sales made to consumers in California.

Section 6203 also imposes such liability to the California Department of Tax and Fee Administration in cases when the out-of-state retailer is simply a part of a larger corporate or holding group, where another member of that group is located in California and in agreement with retailer performs services in California to design and develop tangible personal property sold by retailer, or makes solicitation of sales of tangible personal property on behalf of retailer, or provides other services regarding tangible personal property to be sold by retailer.

Form CDTFA–1164 is usually used by the auditor in the proper registration of out-of-state vendors who are engaged in business in California. A separate Form CDTFA–1164 is prepared for each vendor. 

The California Department of Tax and Fee Administration auditor will pay attention to purchases of both small and large items. The auditor will also pay attention to sales made by sellers located in contiguous states, as the CDTFA thinks that such sellers are likely to have significant sales volume in California.

The auditor will pay special attention to sales made to businesses in the food processing, entertainment and service industries which merit special attention since these types of business may not be required to hold a seller’s permit and use tax due from such businesses may not come to the CDTFA’s attention.

Information required to be obtained and supplied by to auditor on Form CDTFA–1164 for out-of-state retailers includes:

  1. Name and address of the out-of-state retailer
  2. Name and address of sales representative
  3. Name and address of customer
  4. Invoice number
  5. Date of invoice
  6. Amount of invoice
  7. Description of property sold
  8. How the sale was solicited
  9. Any other relevant information concerning seller, sales representative, scope of sales, etc.

During audits of California taxpayers, it has occasionally been noted that California use tax is being remitted to out-of-state vendors who are not billing the purchasers for the use tax. 

If the CDTFA auditor discovers that a taxpayer is erroneously paying use tax to an unregistered out-of-state vendor, then the auditor contacts the California Department of Tax and Fee Administration- Out-of-State District Compliance Office, which then is responsible for further clearing of this situation.

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Sam Brotman, JD, LLM, MBA

Owner and Director of Legal
Brotman Law

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