Can I get a Virginia use tax refund by recalculating my own error factor under a direct pay permit, without a Department-approved front-end agreement?

Plain-English summary

A Virginia-based coal-products manufacturer used a direct pay permit, which lets a business buy goods tax-free and self-accrue use tax later based on how items are actually used. Instead of tracking each taxable item, the taxpayer's predecessor entity had, decades earlier, adopted an "error factor" -- a percentage-based shortcut developed after a 1990s Department audit -- to estimate its use tax liability. The taxpayer (formed in 2016 after a reorganization) later decided that error factor was overstated, recalculated a lower one, and filed for a refund of the difference for 2016-2017.

The Department granted part of the refund but denied most of it, because that kind of percentage-based estimating is only allowed under a front-end agreement -- a negotiated arrangement with the Department, not defined by statute but recognized by Virginia courts, that lets certain direct-pay/manufacturer taxpayers report tax using an agreed error factor instead of item-by-item accrual. The taxpayer, formed in 2016, was never itself party to any such agreement (any 1990s agreement would have been between the Department and the now-dissolved predecessor). Neither Virginia law nor regulations allow a use tax refund based on an estimate you calculated yourself.

But the story doesn't end with a flat denial: because the Department had never actually audited this taxpayer to confirm whether its estimated remittances were accurate, the Tax Commissioner remanded the case for a full audit of 2016-2017, which could produce either a refund (if the audit shows overpayment) or a new assessment (if it shows underpayment, subject to the normal statute of limitations).

What this means for you

Businesses using a direct pay permit

A direct pay permit lets you buy tax-free and accrue use tax later, but the default method is tracking the cost price of each taxable item as it's put to taxable use -- not an estimated percentage. If you want to use a shortcut error-factor method, you need your own written front-end agreement with the Department; inheriting or reusing a predecessor company's old agreement or audit-derived factor won't work once a new legal entity is formed.

Manufacturers going through a reorganization or entity change

If your company was reorganized, merged, or dissolved and re-formed, any front-end agreement your predecessor had with the Department does not automatically carry over to the new entity. Treat a corporate restructuring as a trigger to revisit your sales/use tax compliance methodology, not just your ownership structure.

Accountants and tax professionals

This ruling draws a sharp line: a refund claim under Va. Code § 58.1-1823 must be based either on tax actually accrued and paid on identifiable exempt transactions, or on a Department audit under an existing front-end agreement showing an overpayment -- not on the taxpayer's own recalculated estimate. It's also a useful example of the Department using its remand authority: rather than simply denying an unsupported refund claim, it ordered the audit that should have been happening on a recurring cycle in the first place.

Common questions

Q: What is a "front-end agreement"?
A: It's a written agreement, not defined in the Code of Virginia or regulations but recognized by Virginia courts, that lets certain manufacturers and direct pay permit holders report use tax using a negotiated error percentage on specified categories of purchases, instead of tracking each item.

Q: Can I use my predecessor company's old error factor after a reorganization?
A: Not according to this ruling. A front-end agreement runs between the Department and the specific entity that entered it; a successor entity formed after a reorganization is not a party to it and cannot rely on it to compute its own liability.

Q: What happens if the Department never audited me?
A: In this case, the lack of recurring audits to verify the error factor was itself a problem -- the Department ordered a full audit of the period at issue rather than simply denying the refund outright, since it couldn't confirm whether the taxpayer had actually over- or under-remitted.

Q: Does this ruling apply to my company?
A: Not automatically. This is a published ruling based on this taxpayer's specific facts and the law as it stood in 2023; another taxpayer's front-end agreement history, entity structure, or audit history may differ.

Citations and references

• Va. Code § 58.1-624; 23 VAC 10-210-920 F (direct pay permits)
• Va. Code § 58.1-1823 (three-year deadline for refund claims)
• 23 VAC 10-210-3040 (refund limited to net tax remitted on exempt transactions)
• Va. Code § 58.1-634 (assessment statute of limitations)
• Va. Code § 58.1-1821; 23 VAC 10-20-165 (appeal procedure)
• Reynolds Metals Co. v. Commonwealth of Virginia, Dep't of Taxation (Augusta Cir. Ct. 2000), published as P.D. 01-11 (front-end agreements recognized)
• P.D. 17-98 (Guidelines for Retail Sales and Use Tax Refund Claim Procedures)

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 23-108

Original ruling text

October 5, 2023

Re: § 58.1-1821 Refund Application: Retail Sales and Use Tax

Dear *:

This is in response to your letter submitted on behalf of * (the “Taxpayer”) in which you request a refund of the Virginia retail sales and use tax paid for the period January 2016 through December 2017. I apologize for the delay in responding to your refund appeal.

FACTS

The Taxpayer, a Virginia based subsidiary of a coal company that manufactures products derived from coal, filed amended returns for the periods at issue. The Taxpayer claims it overpaid its use tax under its direct pay permit on purchases of tangible personal property that were eligible for the manufacturing exemption. Since its inception, the Taxpayer had been accruing use tax based on an error factor developed by its predecessor entity in conjunction with an earlier audit performed by the Department. Based on a more recent review of its purchasing, the Taxpayer believed the error percentage was overstated, resulting in the refund claim.

The Department granted a portion of the refund, but denied the majority of the claim because it was based on a revised error factor that was not supported by a “front-end-agreement.” The Taxpayer filed an appeal contending that the absence of a front-end-agreement is not supported by the Code of Virginia and is not relevant to the determination of the tangible personal property’s qualification for a refund.

DETERMINATION

Direct Pay Permits

The Taxpayer was authorized to use a direct pay permit by the Department in 2016. Virginia Code § 58.1-624 and Title 23 of the Virginia Administrative Code (VAC) 10-210-920 F allow certain taxpayers to apply for and use a direct pay permit to pay the Virginia retail sales and use tax directly to the Department when it is not possible at the time tangible personal property is purchased to know how it will be used. When a direct pay permit is granted, the taxpayer must file copies of the permit with dealers in order to make purchases without paying retail sales and use tax. The validity of such a permit is perpetual unless surrendered by the taxpayer or cancelled for cause by the Department.

Under a direct pay permit, a taxpayer usually makes purchases exempt from the tax and then accrues tax on taxable items when they are put into use or consumed. The accrual is based on the cost price of the specific item used in a manner that is taxable under Virginia’s sales and use tax statutes.

In this instance, instead of accruing tax based on the use of taxable items, the Taxpayer used an error factor to estimate the amount of tax remitted to Virginia. As indicated above, no basis for such a computation is permitted under the statutory framework for direct pay permits. The only taxpayers permitted to use such a method are those that have executed front-end agreements with the Department.

Front-End Agreements

Front-end agreements have been used for taxpayers that are manufacturers or holders of direct pay permits. The agreement usually covers the expense purchase portion of the audit. Under a written agreement with the Department, a direct pay permit holder may agree to remit tax based on an error factor on certain accounts payable data for which taxability cannot be determined at the time of purchase, and for amounts in certain accounts in which all the activity is deemed taxable.

The initial agreement is based on audit findings by the Department. In subsequent audits, limited procedures are performed to verify if the agreement is being followed and determine whether or not the error factor or accounts need to be adjusted. Negotiations with the direct pay permit holder would fix the agreement for the subsequent audit cycle.

In this case, the Taxpayer was formed in 2016 as the result of a reorganization and dissolution of its predecessor entity. Since then, the Taxpayer had been computing its use tax liability based on an error factor used by its predecessor entity that resulted from an audit completed in the late 1990s. Based on a more recent review of its purchasing, the Taxpayer concluded the error factor was overstated. It recalculated its error factor for the period at issue and applied for the refund based on its internally calculated overpayments using the recalculated error factor.

The Taxpayer argues that the auditor’s denial based on the lack of a front-end agreement is not supported by Virginia statute. It is true that front-end agreements are not defined in the Code of Virginia or the Virginia Administrative Code. However, in Reynolds Metals Company v. Commonwealth of Virginia, Department of Taxation , (Augusta Cir. Ct., March 21, 2000), published as Public Document (P.D.) 01-11 (10/19/2001), the Circuit Court concluded that front-end agreements can be a simplified method for certain taxpayers to report sales and use tax liability. Under such an agreement, a taxpayer is allowed to assume a certain percentage of its transactions will be taxable and to calculate and pay its liability using an error percentage or factor. Thus, while not specifically supported by statute, the court recognized their value to taxpayers and the Commonwealth.

While neither the Department nor the Taxpayer have been able to produce a copy of a front-end agreement executed in the 1990s, the fact that the Taxpayer has been remitting tax based on an error factor determined by a Virginia audit is a strong indication that an agreement of some nature was implemented. In addition, because any such agreement would have been between the Department and the predecessor entity, the Taxpayer would not be a party to such an agreement and, therefore, ineligible to use the agreement’s error factor to compute its liability.

According to the “Sampling & Front-End Agreements” section of the Department’s Sales & Use Tax Audit Procedures (the “Procedures”), front-end agreements have traditionally been used for recurring three-year cycle audit candidates that hold direct pay permits. When an audit is conducted, the auditor can determine if the agreement is being followed, resulting in either an assessment or refund, and determine whether the error percentage or factor needs to be adjusted for the next audit cycle. Here, the Department has never audited the Taxpayer. As confirmed by the Taxpayer, a business’s spending habits will change in accordance with economic and operational changes, business reorganizations, and amendments to the statutes enacted by the General Assembly. Under such circumstances, recurring audits ensure accurate compliance with the Virginia’s retail sales and used tax statutes.

Refund Claim

Based on its estimated accrual method, the Taxpayer timely filed a refund request with the Department. Under Virginia Code § 58.1-1823, a refund request must be made by a taxpayer within “three years from the last day prescribed by law for the timely filing of a return….” Pursuant to Title 23 VAC 10-210-3040, a refund of retail sales and use tax is limited to the net amount of tax remitted to the state on an exempt transaction. Neither the Code of Virginia nor Virginia regulations permit use tax refund requests based on estimated accruals. Thus, in order to be eligible for a refund, a taxpayer must be able to show that either tax was accrued and paid on specific exempt transactions or, in the case of a front-end agreement, an audit by the Department reveals that the amount of tax remitted exceeds the amount of tax that should have been accrued on taxable transactions.

CONCLUSION

As indicated above, the Taxpayer timely filed a refund claim for the period at issue. However, because the claim was based on an error factor estimate, the refund was appropriately denied by the Department.

Because the Department did not regularly perform audits to determine if the error factor used by the Taxpayer accurately estimated its sales and use tax liability, however, the sales and use tax paid by the Taxpayer for the period January 2016 through December 2017 is likely not in compliance with Virginia’s existing sales and use tax statutes and must be audited to determine the extent to which the tax, if any, may have been overpaid.

In accordance with this determination, the refund request will be returned to the audit staff to conduct a complete audit of the Taxpayer’s sales and use tax accruals and remittances for the period at issue. The audit staff will contact the Taxpayer to schedule the audit and request specific records for review. The Taxpayer will have 30 days from the date of contact to respond to the auditor’s request and be ready to give the auditor access to requested records.

Audit staff will review the Taxpayer’s records, make adjustments as appropriate, and issue an updated audit report. If the audit results in an overpayment, a refund will be issued along with any refund interest in accordance with the Guidelines for Retail Sales and Use Tax Refund Claim Procedures , published as P.D. 17-98 (6/12/2017). If the audit results in an underpayment, the Department will only be permitted to issue assessments within the statute of limitations provided under Virginia Code § 58.1-634. If the Taxpayer disagrees with the audit, it may submit an appeal within 90 days of the updated audit report in accordance with Virginia Code § 58.1-1821 and Title 23 VAC 10-20-165.

The Code of Virginia sections, regulations, and public documents cited are available on-line at www.tax.virginia.gov in the Laws, Rules and Decisions and Guidance Documents sections of the Department’s web site. If you have any questions about this response, you may contact * in the Department’s Office of Tax Policy, Appeals and Rulings, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/4229.W

Related Documents

01-11

17-98

23-89

23-90

23-91