When it comes to jurisdiction over sales taxes, most of us think in terms of state taxes, rather than federal taxes. Yet, as enforcement by the Securities and Exchange Commission earlier this year and the recent debate over the collection of state sales taxes from Internet retailers have shown, these taxes can quickly become a federal issue for public companies.
With states operating at sizable budget shortfalls and e-commerce playing a more important role in the U.S. economy, the stakes are high. According to the National Governors Association, states fail to collect more than $22 billion annually in sales taxes related to products sold online. This number is expected to rise, with the online retail industry poised to grow to nearly $200 billion by the end of 2011, based on projections by Forrester Research.
The issue is not limited to Internet retailing, nor is it relegated to whether a company has a physical presence in a state, the key criteria used to determine whether it is required to pay state sales taxes. Cases that have surfaced in 2011 involve tax compliance policy and internal controls issues.
SPOTLIGHT ON SALES TAXES
In January, the SEC issued an Accounting and Auditing Enforcement Release to Hudson Highland, a $700 million executive search firm, for failing to have adequate controls to manage compliance with state sales taxes and, consequently, maintaining books and records that failed to accurately reflect the company’s tax liabilities.
From the time the company discovered the problem in 2006 through the first quarter of 2009, it paid approximately $3.9 million to various jurisdictions to settle its sales tax liabilities incurred between 2001 and 2007. The company’s accounting issues stemmed from a failure to maintain “appropriate internal controls and books and records relating to tax liabilities.” The SEC contended that its failure to maintain an accounting system resulted in non-compliance with section 13(b)(2)(B) of the Securities and Exchange Act of 1934. The company attributed this to inadequate accounting software, which was unable to automate the calculation of sales taxes to various states. As early as 2003, the company’s in-house tax staff expressed concerns over the potential failure to adequately collect and remit sales taxes. The company’s efforts fell short and it failed to remedy the problem. As a result, it faced a cease-and-desist proceeding by the SEC and was handed a $200,000 penalty.
In today’s heightened regulatory environment, publicly-held companies must demonstrate that they have proper controls in place, whether it relates to potential violations of the United States Foreign Corrupt Practices Act, or in this case, the collection and remittance of sales taxes. If a problem or issue is identified, management teams should take appropriate steps to correct the problem and allocate necessary resources to address it. Companies may also need to consider whether the issue should be disclosed – either via public filing or self-reporting to a government regulator. Complicating matters are the whistleblower provisions contained in the Dodd-Frank Act. Companies that fail to address and remediate an issue on a timely and thorough basis are vulnerable to action taken by the SEC or Department of Justice, or fines that could escalate into the millions.
Until now, the state sales tax issue has fallen outside the purview of corporate boardrooms. Yet, if recent cases are any indication, it is becoming increasingly important for audit committees and boards to become actively engaged in these matters – before they draw scrutiny from regulators.
SENDING A MESSAGE
If sales taxes are primarily a state issue, why does the SEC care? Accounting and auditing enforcement releases serve as an educational tool to public companies and their auditors. Sometimes the agency initiates action for the purpose of delivering “message” cases. The SEC can’t bring actions on all accounting or internal control problems – not all restatements are charged with 13(a) and 13(b) – but the potential remains that it can and will.
The fact is that the SEC may initiate a case based on several factors, whether it be via self-reporting, a whistleblower tip, a referral from another division within the Commission such as the Division of Corporation Finance or the Office of the Chief Accountant, news reports, auditor reports – 10A or Item 4 8-K, restatements, or by comparing disclosures found in the company’s filings. In the past, the agency has cracked down on these issues in areas such as the reconciliation of accounts payable and key balance sheet accounts. It has paid particular attention to companies when they fail to correct these errors, subsequently resulting in restatements. Companies that have these problems or fail to maintain sufficient internal accounting controls may face 13(a) and 13(b) actions.
The SEC has a range of options at its disposal to deter a company from failing to address and resolve an identified accounting issue. Similarly, it can take action if a company cannot demonstrate that its internal controls were sufficient to prevent them from occurring. As a result, it’s important for companies and their boards of directors and audit committees to take these issues seriously. To do so, requires action to remedy a problem once it has been identified.
LINKING TAXES TO INTERNAL CONTROLS
Facing historic budget deficits, state officials have strong motivation to recoup lost tax revenues. States such as California, Florida, and Connecticut have already begun to take measures aimed at collecting taxes from online retailers. On a federal level, the era of whistleblowing has raised the stakes for companies that fail to address internal controls and risks. Consequently, public companies and their boards should take necessary steps to maintain an awareness of and monitor their sales tax obligations and exposure be it directly or as a result of sales made through an affiliate. It’s important to determine which states the company has a physical presence in and whether there are states in which the company is required to collect state taxes but is currently not doing so. The case of sales taxes illustrates the notion that the benefits of addressing potential internal control issues far outweigh the risks and costs associated with failing to take action.