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Sales and Use Tax Two Step

Published February 6, 2011 by The Wooten Law Firm

In the recent case of Technocom v. Department of Revenue, 2011 NCBC 1, the North Carolina Business Court addressed the issue of whether a taxpayer may use a sales tax that it previously paid in error as a credit against a use tax liability assessed on the same transaction. In overruling both the North Carolina Office of Administrative Hearings and the North Carolina Department of Revenue, the Business Court held that the Department of Revenue must credit the sales tax previously paid against the use tax liability. In doing so, the Business Court hopefully has ended the inequitable practice of the Department of Revenue of taxing certain transactions that bear indicia of both a taxable sale and a taxable use as both a sale and a use thereby imposing a “double tax” on the transaction.

In this case, our client, Technocom Business Systems, Incorporated, was engaged in the business of selling and leasing office equipment. In connection with its business, Technocom entered into maintenance agreements with its customers under which Technocom serviced the equipment that it sells or leases to its customers (the “Service Agreements”). In fulfilling the Service Agreements, Technocom provided parts and supplies necessary to service the equipment. Historically, Technocom treated the provision of parts and supplies in connection with its Service Agreements (the “Taxable Transaction”) as taxable sales. The Department, however, audited Technocom and concluded that the Taxable Transactions were really taxable uses and not taxable sales. As a result, the Department of Revenue assessed Technocom for use taxes for the taxable use it made of the parts and supplies.

Technocom did not disagree that the Taxable Transactions were really taxable uses, not taxable sales. Instead, Technocom simply asked the Department of Revenue to credit the sales taxes Technocom had previously paid on the Taxable Transactions against the use tax liability created as a result of the Department of Revenue’s recharacterization of the Taxable Transactions as taxable uses. The Department of Revenue refused, claiming that N.C.G.S. § 105-164.11(a) prohibited it from crediting the previously paid sales taxes against Technocom’s use tax liability.

N.C.G.S. § 105-164.11(a) provides that the Department cannot refund taxes collected on “exempt or nontaxable sales . . . unless the purchaser has received credit for or has been refunded the amount of tax erroneously charged.” We argued on behalf of Technocom that the Department’s application of N.C.G.S. § 105-164.11(a) was erroneous. Specifically we argued that N.C.G.S. § 105-164.11(a), by its express terms, only applies to taxes collected on “exempt or non-taxable sales.” In this case, the Department had stipulated that the Taxable Transaction was a taxable use, not a sale, exempt, non-taxable or otherwise. Thus N.C.G.S. § 105-164.11(a) was inapplicable.

We also discussed the policy behind N.C.G.S. § 105-164.11(a). When a tax is collected on a transaction that is not subject to tax, the monies collected (the “windfall”) need to be paid to someone. Basically N.C.G.S. § 105-164.11(a) ensures that if a windfall arises as a result of the collection of sales tax on a non-taxable sale, the windfall is either paid to the customer that paid the sales tax in error or the state. It simply makes no sense for the retailer to keep the windfall and N.C.G.S. § 105-164.11(a) prevents that.

This policy, however, is not furthered where there is no windfall to allocate. In the Technocom case, there was no windfall. Whether Technocom paid a sales tax or a use tax, in either event Technocom would pass the cost of the tax onto the customer. (In the case of a sale the customer pays the sales tax to the retailer directly; in the case of a taxable us, the customer still pays the cost of the tax in the form of an increased cost for service that is charged by the service provider to reflect the additional cost of the use tax paid by the service provider.) Requiring Technocom to pay the use tax without giving it a credit for the sales tax means that the tax is paid twice, first as a sales tax and then as a use tax.

The Business Court agreed with our analysis, and particularly the allocation of the windfall that is created when a non-taxable transaction is taxed. As the Court stated “[t]ransactions that do not generate a windfall and that do not result in the unfair treatment of customers are not included in the meaning of ‘exempt or nontaxable sales’ in Section 105-164.11(a).” The Court also recognized that reading N.C.G.S. § 105-164.11(a) “as requiring Technocom to reimburse its customers before receiving a credit for taxes paid twice on the same transactions when there is no windfall to the company and when its customers did not expect to receive a tax-free service under” its maintenance agreements with Technocom was unwarranted under the statute and inconsistent with basic notions of equity. Because there is no “windfall” to allocate, the Court held that N.C.G.S. § 105-164.11(a) does not apply and Technocom is entitled to a credit of the sales taxes previously paid in error against the use tax liability under N.C.G.S. § 105-164.42, the general refund and credit statute.

The old adage “give them an inch and they will take a mile” applies to the Technocom case. The underlying purpose of N.C.G.S. § 105-164.11(a), to allocate the “windfall” created by the collection of tax on a non-taxable transaction is laudable. The Department, however, has twisted the carefully crafted language used by our General Assembly in N.C.G.S. § 105-164.11(a) to create a construction that is contrary to the express language of the statute, the public policies the statute serves and all notions of equity. Under the Department’s application of N.C.G.S. § 105-164.11(a), the Department seeks to treat the Taxable Transaction as a “use” for tax purposes but a “sale” for refund purposes. Not surprisingly this creates a situation where the same transaction is taxed as both a sale and a use. Clearly this construction is at odds with the sales and use tax regimes which, when “taken and applied together, provide a uniform tax upon either the sale or use of all tangible personal property” and form “complementary and functional parts of one system of taxation.” Secretary of Revenue v. Jefferson-Pilot Life Insurance Company, 161 N.C.App. 558, 561, 589 S.E.2d 179, 181-82 (2003), citing Johnston v. Gill, 224 N.C. 638, 643-644, 32 S.E.2d 30, 33 (1944). It is also at odds with Article V, Section 2(1) of the North Carolina Constitution which provides the “power of taxation shall be exercised in a just and equitable manner . . . .”

Unfortunately the Department has given notice that it plans to appeal the decision of the Business Court. Hopefully the Court of Appeals will agree with the Business Court and end once and for all the double taxation scheme created by the Department of Revenue in its misapplication of N.C.G.S. § 105-164.11(a).


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