H Tax Compliance

The tax and compliance changes likely to affect manufacturers in 2023

Jan. 31, 2023

By Kael Kelly, general manager, compliance documents, Avalara

Over the past few years, manufacturers have endured persistent supply-chain interruptions and major staffing shortages. The challenges have inspired manufacturers to break the mold and embrace creative solutions, including adopting automation and taking B2B businesses online in order to grow.

But these solutions often trigger new tax obligations.

Adding to this tax complexity, manufacturers and other tax-exempt sellers often face higher audit risks than other industries, in part because exemption certificates and consumer-use tax are among the most prevalent issues auditors find.

Many businesses also don't know that sales-tax audits can go back as far as seven years, depending on the jurisdiction and specific audit. Since auditors only audit a sample of a company’s transactions, but apply what they find in that sample to, potentially, 100% of the total transactions over multiple years, the sheer complexity of the process can be even more of a nuisance for manufacturers.

Manually managing sales and use tax is rarely an easy task for manufacturers, and the turbulence of the last few years has made it worse. Breaks in the supply chain, geopolitical upheaval, and inflation can drive manufacturers to find new customers, source alternative suppliers, and develop new processes, all of which can affect their tax obligations. For example, a manufacturer that buys a forklift in Oregon, then moves it to Washington to replace broken equipment, may owe consumer-use tax in Washington against the original or fair-market value.

Confusing, right?

Over the next year, the manufacturing industry will have to keep compliance top of mind, including ongoing updates and challenges with economic nexus, the emergence of digital transformation and how it will affect new tax obligations, and the ever-present compliance risk tied to exemption certificates.

The ongoing challenge of economic nexus

Manufacturers are often subject to state economic nexus laws, which base a sales and use-tax obligation on business activity in a state, rather than physical presence. Economic nexus isn’t new, but in the five years since SCOTUS overturned the physical-presence rule with its decision in South Dakota v. Wayfair, Inc., sales-tax complexity for the manufacturing industry has only grown.

Manufacturers that establish economic nexus with a state must register with the tax department, collect sales tax on any taxable sales made in the state, remit use tax as required, and be able to prove to the state that any transaction not taxed is authorized by virtue of having collected a valid exemption certificate from the buyer.

On top of all that, manufacturers must monitor sales into all states with a sales tax because they all have economic-nexus laws now, too. Some states require businesses to register and comply with all applicable sales and use-tax laws immediately after crossing an economic-nexus threshold. This dynamic and ever-changing threat of economic nexus presents an ongoing challenge to manufacturers as we begin the new year.

Adding new technology adds new tax obligations

Digital transformation is changing industry every day. For example, labor shortages are inspiring manufacturers to adopt new technologies that enable remote collaboration within the sector. But the speed at which manufacturers embrace new technologies and update operations to respond to changing circumstances isn’t always mirrored by the finance departments that handle tax compliance.

Additionally, higher costs may inspire manufacturers to put more into technology-related research and development (R&D) in hopes of streamlining production. While most states offer exemptions, partial exemptions, or reduced rates for machinery and equipment purchased for use in R&D, such exemptions can complicate tax compliance because qualifying R&D activities vary from state to state and can change over time.

For example, Vermont’s sales and use-tax exemption for manufacturing machinery and equipment includes equipment used as part of an integrated process. Florida also recently provided an exemption for machinery and equipment necessary to produce electrical or steam energy that results from burning hydrogen.

The more exemption certificates, the more compliance risk

Managing exemption certificates is by far the most time-consuming part of the compliance process. There are always new certificates to verify, incompletes to follow up on, and expiring ones to replace.

Manufacturers often have to deal with hundreds or even thousands of exemption certificates. With more than 1,500 different tax-exemption forms in use in the US, determining the correct form for each exempt transaction can be a nightmare without automation.

Ensuring each form is properly and accurately completed is the next important step after determining the correct form. Then, exemption certificates need to be stored, easily accessible, and renewed as necessary. It’s an important task, and even more critical to get right because state tax officials tend to keenly focus on exemption certificates during audits.

As we leap into the new year, tax compliance remains more complicated than ever for manufacturers, distributors and wholesalers due to supply-chain problems, shifting sales channels, labor shortages, and more. The manufacturing sector will need to navigate these complex and changing sales and use-tax obligations over the next year, keeping in mind their obligations to meet economic nexus, remembering how digital transformation will affect their business, and how mismanagement of exemption certificates can lead to compliance risk.