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A common indemnification claim that SRS Acquiom sees relates to sales tax exposure of the target company. These claims tend to be complicated because they often involve an assessment of the target company’s interactions with customers in multiple states and the application of these states’ tax laws.
Additionally, the exposure on these claims can be significant because tax issues, including sales tax, generally fall outside of the standard limitations of time or amount provided for in the indemnification sections of the merger agreement. That means that the indemnification obligations of the shareholders may extend well beyond any escrow period, may not be subject to a basket or caps generally applicable to other kinds of claims.
Because the analysis is so difficult, buyers often are uncertain what the exposure might be after closing. After taking over the company, they may learn that the target company was selling their products or services in many states and that sales taxes were not collected. Often, the buyer may know nothing further and might assert an indemnification claim for estimated or uncertain damages. In most cases, the buyer just wants to ensure that they will not suffer penalties or losses should there be noncompliance with any tax laws. If the representative is able to demonstrate that less is owed in taxes, the buyer is usually happy to reduce the amount of the indemnification claim. The problem is that many representatives have no idea where to start in trying to navigate this mess. Below is an outline of the issues to consider in attempting to reduce this sales tax exposure.
Whose Tax Is It?
The first question to ask is whether any tax that may be due was or is the responsibility of the target company. Under most state laws, and as stated in most sales contracts, taxes on the purchase of goods (and, in some cases, services) are the responsibility of the purchaser. Failure to collect sales taxes may result in penalties and interest assessed against the vendor, but, in the end, the purchaser generally is responsible for the payment of the applicable taxes.
Has the Statute of Limitations Period Expired?
The shareholder representative should get a detailed account on a state-by-state basis to determine where the buyer believes they have potential exposure and for what tax years the buyer believes such exposure exists. In some cases, the statute of limitations for sales tax collection may have already expired, and no further action is required for those tax periods. This can quickly narrow the scope of the exposure and open issues.
Does Nexus Exist?
In other cases, the target company may have had no sales tax nexus. In states where the vendor has nexus (typically where (i) they have a physical location; (ii) there are resident employees working in the state; (iii) the business has real or personal property in the state or (iv), there are employees who regularly solicit business in the state), the vendor may have the responsibility to collect sales tax as an agent of the state. Simply selling a product or service in a state does not itself mean there was a collection obligation.
In states where the vendor does not have nexus and, therefore, typically has no obligation to collect sales tax, the purchaser might still have the obligation to pay taxes on their taxable purchases. The obligation to report those purchases and pay use tax falls on the purchaser and not the vendor. Nexus is, however, quite complex, and it is not unusual for an emerging company to inadvertently trip the nexus requirement and not realize that they had an obligation to collect taxes on their sales in other states.
Who was the Purchaser of the Goods or Services?
Even if it is determined that nexus did exist and the statute of limitations has not expired, there still may be no sales tax exposure.
Many sales are exempt from sales tax in specific circumstances. For example, if a customer is a reseller and does not consume the product, the sale might be exempt from the requirement to collect and remand the tax. Certain other customers, such as schools, may be exempt from sales tax in some jurisdictions. Last, certain products and services might also be exempt, such as training or hardware and software maintenance. It is important to perform an analysis of each purchaser and each invoice. Reseller certificates from purchasers exempt from sales tax may be in the target company files or may be obtained from the purchaser as evidence that no sales tax was due.
Did the Purchaser Already Pay the Tax?
Prior to paying sales tax on any particular sale, the parties should contact the customers to see if they have already paid the applicable use tax. Many corporate purchasers will pay this tax even if the seller fails to collect the related sales tax. If the purchaser has done so, no further tax should be owed. If they have not, the target company should first try to collect the sales tax. The easiest way to do this is to re-invoice the customer assessing sales tax against taxable items, but reflecting that the invoice was partially paid. Included with the invoice should be an affidavit for the customer to confirm whether they had separately paid use tax on the purchased items. Any sales tax received can be remitted to the taxing authority, thus, taking advantage of amnesty and other provisions to minimize or abate interest or penalties on late filing and payment.
The bottom line is that the potential tax liability can often be reduced significantly if the related facts are investigated and the proper steps are taken to mitigate the exposure. When going through this process, it is important to note that supporting detail, including exemption and resale certificates, invoices and other records must be available to defend the company in the event of a sales tax audit. Without proper documentation, a vendor can be held liable for tax not collected from a customer.