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Balancing retail taxation benefits and risks

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Woman in retail shop As the retail industry revives in the post-pandemic recovery, businesses should be seeking ways to use new opportunities for growth. A retail company’s tax compliance responsibilities are typically viewed as a part of a company’s risk mitigation strategy – and rightfully so.

But a retailer’s approach to tax compliance can be used to boost growth and share value. A company would be well-advised to look at tax compliance not as a necessary burden, but more holistically -- as a way to address and advance many company goals. As Frank Russo, a tax reporting and advisory partner at Grant Thornton, observes, managing taxes can be just as much about realizing opportunities as it is managing risks.

In this article, we take a look at two particular tax compliance issues that offer different opportunities to advance the goals of almost any retail businesses: the research and development (R&D) credit and sales and use taxes.

R&D tax credit Rob Levin, a strategic federal tax services partner at Grant Thornton, said when he introduces the idea to retailers of using an R&D credit to reduce tax obligations, most company executives are surprised it would even apply. The term “research and development” can conjure up images of employees in lab coats holding beakers full of bubbling liquids. But the truth, Levin said, is that many types of initiatives and infrastructure changes commonly performed by retail businesses can qualify for this tax credit.

For instance, when the pandemic sent everyone scrambling to buy online, many retailers were forced to greatly enhance or even completely create an online sales environment. Omnichannel purchasing methods were increasingly preferred by customers, where one could “mix and match” different shopping experiences based on comfort level, availability and personal preferences — curbside pickups from phone-in orders, in-store pickups from online delivery, package deliveries resulting from in-store purchases, and other pathways.

All these new types of purchasing capabilities likely required significant revision and expansion of a retailer’s sales operations through new technology channels, and the creation of those types of systems should be considered for an R&D credit.

The R&D tax credit is available both from the federal government and more than half the states. The credit can be calculated under two methods, both of which entail calculating the current year qualified expenses and comparing them to a company’s historical R&D. The incremental increase in spending is then claimed at either a 14% or a 20% rate, depending on a company’s situation.

The R&D tax credit is important, Levin said, because it is permanent and, unlike other tax deductions, it acts as a value driver. A business can also elect to carry it back one year or carry it forward as much as 20 years, depending on how it best impacts other factor’s in a company’s tax obligations.

“What that means is that it is one of the few tax opportunities that is a not only a cash savings, which is great, but it’s also good for a company’s earnings-per-share and stock price. It impacts the financial statement,” Levin said.

So to begin, a company needs to establish just what the research and development costs are for a company. For the types of R&D typically done by a retailer, one would usually start in the IT department, Levin said. The department would typically have software developers either performing development or maintenance and support functions. It would be a matter of properly categorizing those costs, whether coding, construction, testing, design or other applications.

What’s important is that you document the technical issues and the process of experimentation. This type of documentation already should exist as part of the software development lifecycle, so it’s not a matter of recreating a set of records to apply for the credit, Levin said. Those documents often will show a process of trial-and-error testing, all of which establishes the completed work as research. This is important because businesses can often be wary of applying for this credit assuming it requires a daunting amount of paperwork that doesn’t exist.

And the systems developed that apply for the credit don’t have to be wholly original, Levin said, but they do need to show “newness” which can be demonstrated through documenting a system’s adaptability and integration into a particular business’s operations. Just copying the system of a competitor won’t qualify. Even work done by hired third parties can qualify to the extent that the work, pending whatever obligations are in that contract.

Sales and use taxes Sales and use taxes are familiar enough to retailers, but the ability to tax online sales regardless of where the seller is located, a consequence of the Supreme Court Wayfair decision, has made this more complex. Nicole Bryant, a state and local tax principal at Grant Thornton, said retailers that don’t monitor the application of these law changes to operations run the risk of compliance complications and future penalties, which typically add from 20% to 25% more to a company’s tax burden but could, in some cases, rise to 40%. Further, sales tax is a tax imposed on a consumer, collected in trust by the retailer, but delays in sales tax collection procedures causes this to be a direct tax expense of the company.

One consequence of the growth of the online marketplace is that wholesalers conditioned to selling to brick-and-mortar retailers have decided to go direct-to-customer themselves, with only their website as their “storefront.” However, these wholesalers, instead of filing returns and collecting exemptions certificates in four or five states, are now having to collect tax and file in nearly all.

“And they’re not set up for that,” Bryant said. “They don’t have the software or systems in place.”

And that increase is typical for one legal entity selling one brand of goods. Multiply that complexity for retailers owning many subsidiary companies each with an array of different products and it is easy to see how sales and use tax compliance can become overwhelming. Russo said it’s important to keep in mind that many sales and use laws are triggered by surpassing certain sales thresholds and close monitoring of online and brick-and-mortar sales is needed for compliance.

And that complexity is not only at the state level. Many larger cities and counties have separate sales and use tax laws, with some states like Colorado permitting smaller cities to impose sales taxes at a local level. Further complications arise when retailers are selling digital products or other complex products and services, where it is not immediately obvious whether the sales are taxable in each jurisdiction, Bryant said.

With Wayfair allowing states to collect online sales taxes, states were fortunate to still gain revenue when the pandemic directly led to a massive shift towards buying online and away from brick-and-mortar locations. However, Bryant said all but approximately six states are running a deficit as they emerge from the economic downturn, which has led many of them to aggressively enforce tax collection rules. Companies must be more diligent about documentation because they can’t assume, as they may have before, that state auditors will allow a reasonable approach to document tax exempt sales, such as to distributors, nonprofits, and the government.

“Auditors are going to want to see every form in place, every box checked, every line filled out in order to allow those exemptions,” Bryant said. Controversy and audit defenses are likely to become an increasing concern as the pandemic eases and the increase in store build-outs generates more questions on the proper payment of use tax, Bryant said. With a high volume of states potentially involved, just maintaining contact and communications with various auditors can be a difficult task. The implementation of process improvements and more technology to manage sales and use tax is crucial.

To monitor and comply with these requirements, accurate accounting of operations, sales and supply chain costs is crucial, and often, consultation with outside advisors with experience in these compliance matters can be a helpful step.

Contacts:

Nicole Bryant
Principal
State and Local Tax
T +1 206 418 6042

Rob Levin
Partner
Strategic Federal Tax
T +1 404 475 0190

Frank Russo
Partner
Tax Reporting and Advisory
T +1 212 542 9605