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CA Sales Tax Audit Notes: Government Contractors’ (3 Ply) Exemptions

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You’re really reselling that toilet paper? That’s the question retailers have been asking government supply contractors operating in states such as Arizona, California, Missouri and Texas. And it is certainly understandable when the purchaser is a company that builds fighter jets for the U.S. Government.

Who knew you got a case of Charmin with every F18?

Of course, the reality of the situation isn't quite that simple or it wouldn't involve sales tax. To illustrate the odd linkage of toilet paper and government contracting taxability rules, let’s look at California.

During the 1970’s, the California Board of Equalization (BOE) performed a series of sales tax audits on Aerospace Corporation, a research and development company doing work for the U.S. Government. As a result of those audits, the BOE assessed tax on purchases of supplies and other overhead material (indirect goods and services such as toilet paper) on which sales tax had not been paid. Aerospace paid the assessments and then filed Claims for Refund. The case eventually ended up before the California Court of Appeals which found in favor of Aerospace. (Aerospace Corp v. CA BOE)

The material issue raised in Aerospace Corp v. CA BOE, centered on whether Aerospace owed sales tax on purchases of supplies and other overhead materials. The BOE argued that (as was commonly held) that federal government contracts contained clauses that passed title only to direct purchases (goods and services charged directly to specific contract(s)) to the U.S. Government, and these were therefore exempt from tax. It was on this basis that the BOE assessed tax on Aerospace Corp. The California Court of Appeals disagreed, and interpreted the passage of title (and by extension the tax exemption) as applicable to all goods and services at time of purchase, including those considered indirect.

Obviously the BOE didn't like the Court of Appeals ruling that indirect purchases (costs charged to contracts purely on some allocation method with no specific identification of the item or contract) also passed to the government and were therefore exempt. It just didn't seem logical that toilet paper and other overhead items like pencils and pens, mops, employee parties (excluding booze), landscaping, et. al. became the property of the government.

Aerospace Corp. was just the beginning; most companies in California who did any work for the US government immediately filed their own refund claims.

While the courts had stated the grounds for their findings, there were little to no guidelines governing how to  audit the refunds or to apply the new ruling going forward. Questions arose such as:

  • Who really qualified for the exemption?
  • What about companies who also did commercial work or had government contracts lacking the proper title clauses?
    • How was the exempt portion calculated?
    • Should the companies buy everything without tax and report the non-qualifying costs later?
    • Or pay tax on everything and take credit on their tax returns?
    • What if the credit was greater than the tax liability?
    •  Where did this put the vendors?
      • Could they safely accept a resale certificate from any company for every purchase?
      • Was only the qualifying percentage exempt?
      • How did a vendor know what the percentage was?
      • Where was the “good faith” line?

These were just some of the questions and issues California faced. There was also the monetary impact. Initially the state took a three pronged hit (on the 3 ply issue): Not only were these purchases no longer subject to tax, which resulted in a wholesale reduction in revenue going forward; the state also had to refund an unknown financial amount, which would likely drain coffers of previously collected tax. In addition, auditors who would normally be working to bring in tax dollars were now spending their time working on those refunds.

Eventually, through trial and error, court cases, internal rulings and a bit of good old common sense, tax regulations and audit procedures were established. But just because the guidelines now exist doesn't mean applying them is simple and easy. Since the required title clauses vary by type of contract, each contract must be reviewed to determine type and then establish the presence of the clause(s). Even these seemingly basic steps can be difficult - some contracts require security clearances so special procedures must be applied and other contracts fill entire filing cabinets.

Depending on the specific government agency involved, the title clauses have slightly different nomenclature. And then there are the companies who use different allocation methods (head count, square footage, etc) for different cost centers so different qualifying percentages must be computed and applied to different sets of purchases.

So there you have (part) of the story why all U.S. Government jets and ships come with their own toilet paper. On the other hand, just imagine how much the darn things would cost if the price included sales tax on that paper.

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