The allure of sales tax automation is undeniable. Many companies, particularly large enterprises, embrace automation with the belief that it will solve all their sales tax challenges, accurately classifying taxable and nontaxable transactions without the need for human intervention. The buzz phrase “automating everything” often leads to a perception that once systems are automated, the complex world of sales tax compliance will simply manage itself.
However, this reliance on automation alone, while certainly improving efficiency and productivity, can pose a significant risk. Our own experience shows that even the largest, most automated clients still face substantial recovery opportunities and challenges with their automated systems. Automation can drastically improve systems and reduce the time spent reviewing transactions, but, without a human in the loop, it is not the ultimate answer.
The Automation Paradox: When Hands-Off Leads to Higher Risk
The core benefit of sales tax automation lies in its ability to manage the sheer volume of transactions. Approximately sixty percent of transactions can often be automated using product, inventory, or general ledger codes to consistently identify items as taxable or nontaxable. For instance, certain vendors from which a company consistently purchases exempt items like inventory for resale or raw materials for processing can be automatically flagged as nontaxable transactions, saving significant manual review time. Some automation is even set up at the purchase order stage to prevent incorrect taxation up front.
Yet, the complexity of sales tax, especially for companies dealing with thousands of vendors and diverse item categories, quickly surpasses the capabilities of basic automation. This point is where the automation paradox emerges: the more you rely on a completely hands-off system, the higher your exposure to audit risk, financial penalties, and reputational harm. Consider the nuances:
- An item’s taxability can depend entirely on its use within a process, not just its product code; and
- The exact same item might be taxable or exempt depending on its specific application.
For example, a forklift used in the manufacturing process is often tax-exempt. However, if that same forklift is used for loading and delivery, it is typically taxable. Even repair costs for the forklift can be taxed differently depending on its specific use. Pinpointing where and how an item is used is therefore critical for accurate tax calculation, but this information is frequently missing at the individual item level, which complicates automated tax determination. For this reason, human intervention is essential to document how and where the relevant resource is used.
Industries Most Susceptible to Automation Pitfalls
Certain industries, due to their intricate operations and high infrastructure expenditures, are particularly prone to these sales tax complexities, where overreliance on automation without proper oversight can be detrimental.
- Manufacturing. This industry is inherently complex due to the many facets of its operations, significant asset purchases, and constant repairs and maintenance. The taxability of these repairs and maintenance items often hinges on their specific use within the manufacturing process;
- Oil and gas. With upstream, midstream, and downstream functions and complex refinery plants, using items across various business functions adds layers of taxability challenges;
- Mining. Similar to manufacturing and oil and gas, mining involves high infrastructure spending and numerous business facets, making sales tax determinations highly complex;
- Retail (especially multilocation and e-commerce). Destination-based sales tax has complexities due to varying jurisdictional rules and multiple physical locations. E-commerce introduces economic nexus, requiring tax collection in states exceeding sales/transaction thresholds. Retailers face challenges with food taxation (groceries versus prepared meals), sales tax holidays, and categories of diverse products with differing taxability across jurisdictions;
- Construction. Construction contractors navigate sales tax complexities across states, especially distinguishing between real property improvements and tangible personal property. Working with tax-exempt entities adds challenges due to varied state rules on pass-through exemptions and contractor use tax obligations; and
- Health care. Delivering health care depends on many variables, and legislatures often create broad sets of exemptions for medically necessary items, which are tangible personal property but often exempt by need. This inconsistency creates unique taxability challenges.
The common thread among these industries and many others is that automation systems often rely on too few qualifiers to determine taxability. The danger lies in not using enough criteria to accurately classify items as taxable or nontaxable. Basing decisions on only one or two qualifiers, assuming they are the only necessary factors, is a significant risk. Many mistakenly try to rely on a single qualifier, often because their systems have this limitation.
The Human Element: Why Communication Breaks Down (and How to Fix It)
Significant breakdowns that occur when a company relies solely on automation arise from communication gaps within the organization. For instance, a client recently alerted us to the assumption in some companies that someone else is always monitoring automated processes. This supposition might result in unclear accountability for reviewing and updating the underlying code and ensuring that it works correctly. Two main factors can compound communication breakdowns:
- Employee turnover. Tribal knowledge is lost when experienced buyers leave, and new employees, following their understanding of rules, may not accurately communicate nuances down the chain; and
- Vendor turnover. Companies can see anywhere from twenty percent to thirty percent vendor turnover annually. If new vendors’ specific taxability criteria aren’t correctly entered—often by nontax personnel—the “garbage in, garbage out” principle applies, leading to significant errors.
The tax department, often far removed from day-to-day data entry, sets the rules, but the coding is done by nontax personnel who may not understand the “why” behind their actions. Moreover, some systems may not be equipped with enough parameters to account for all scenarios.
Financial Penalties and Reputational Harm: The Cost of Overreliance
The financial repercussions of incorrect sales tax payments due to overreliance on automation can be dramatic. Penalties typically start at around ten percent plus interest. Some states impose interest rates as high as fifteen percent, which can compound, leading to accumulated interest reaching up to fifty percent on older liabilities within the statute of limitations.
Beyond the monetary penalties, a critical concern for companies is reputational harm. Companies flagged for underpaying tax are often subjected to more frequent audits, significantly burdening the tax department and consuming valuable resources.
Conversely, engaging expert consultants can drastically reduce audit frequency.
Strategic Integration: A Path Forward
Although full manual review of tens of thousands of monthly transactions for multibillion-dollar companies is impractical, some automation is essential. The key lies in strategic integration and continuous oversight. Here are key considerations for integrating tax technology strategically:
- Foundational tagging. Establish basic nontaxable tags at the accounts payable entry point, with the aim to process ninety percent of transactions correctly;
- Human review for complexity. Recognize that the remaining ten percent of complex transactions are likely to require expert review, either internally or by external consultants. We have yet to see a company entirely eliminate human review for transaction accuracy through automation, primarily due to the inherent possibility of errors, even as automation offers significant gains in efficiency;
- Electronic recordkeeping. Ensure that all automated reports and taxability determinations are kept electronically in case of future audits. This documentation is crucial for demonstrating how products are tagged and how taxable bases are determined;
- The reality of “never 100 percent correct.” No human or automated system achieves 100 percent accuracy. Human error alone accounts for about three percent. Computer error rates can be even higher, because systems cannot foresee every scenario, and laws constantly change; and
- Regular external validation. A review will always produce better results than relying on the system alone. An external firm brings an objective, unbiased perspective and specialized expertise. It can identify breakdowns and leakages of incorrectly taxed items, providing a valuable blueprint for improvement.
In our experience, every review invariably uncovers recoverable funds. Ironically, companies that depend heavily on automated systems, often with reduced human scrutiny, tend to produce more errors. Counterintuitively this scenario results in more substantial recoveries when expert reviews are performed. Although valuable in many ways, total reliance on automation can foster a dangerous false sense of security.
External consultants also stay current with ever-changing laws, educating clients on updates and consistently validating their systems every two to three years. This outside perspective offers invaluable peace of mind and significantly mitigates ongoing risk.
By actively engaging in these practices, tax professionals can lead successful software integrations and avoid common system pitfalls. The key is leveraging the power of automation while maintaining an expert hand on the wheel.
Richard Van Komen is the vice president of sales and use tax recovery at Revenew International.
