For auto repair businesses and dealerships operating in California, navigating the complexities of sales and use tax is crucial. Regulation 1655, a key component of California’s Sales and Use Tax Regulations, specifically addresses how returns, defects, and replacements of merchandise impact taxable sales. Understanding this regulation is essential for accurate tax reporting and compliance. This article breaks down Regulation 1655, providing a clear and concise overview for those in the automotive industry.
Navigating Merchandise Returns Under Regulation 1655
Regulation 1655 clarifies the conditions under which returned merchandise can be excluded from taxable gross receipts. The core principle is that if a sale is genuinely reversed with a full refund, it should not be taxed.
(1) General Rules for Returned Merchandise
Generally, sales tax is not applicable to returned merchandise when the following conditions are met:
- Full Refund: The customer receives a complete refund of the purchase price, including any sales tax initially charged. This refund can be in cash or store credit.
- No Mandatory Repurchase: The customer is not obligated to buy another item at a price exceeding the returned item’s price to receive the refund. This ensures the return is not simply a disguised exchange.
It’s important to note that a “full refund” can include deductions for rehandling and restocking costs. However, these deductions are limited:
- Actual Cost or Average Percentage: Sellers can withhold either the actual cost of rehandling and restocking for each return or a percentage based on the average cost from the previous accounting cycle (typically a year).
- Percentage Election: If a seller chooses to use a percentage, they must apply it consistently for the entire accounting cycle.
- Cost Limitations: Rehandling and restocking costs cannot include general overhead increases, costs to repair customer-caused damage, or pre-sale expenses.
Record Keeping is Key: Businesses must maintain thorough records to support any percentage used for rehandling and restocking costs. These records are subject to audit to verify compliance.
(2) Special Case: Contract Cancellation Options for Used Vehicles
Regulation 1655 includes specific provisions related to the “Car Buyer’s Bill of Rights” in California, particularly concerning contract cancellation options for used vehicles under $40,000, as mandated by Vehicle Code section 11713.21.
(A) Contract Cancellation Option Price: The price charged for the option itself is not considered part of the taxable gross receipts or sales price. The regulation sets maximum prices for these options based on the vehicle’s cash price.
(B) Restocking Fee for Cancellation: Similarly, the restocking fee charged when a buyer exercises their cancellation option is not taxable. Maximum restocking fees are also defined based on the vehicle’s price.
(C) Refunds Under Cancellation Option: When a customer returns a used vehicle and receives a refund under a contract cancellation option, this refunded amount is also excluded from taxable gross receipts and sales price.
These provisions acknowledge the unique nature of these legally required cancellation options and ensure that neither the option price, restocking fee, nor the refunded vehicle price are subject to sales tax.
Handling Defective Merchandise and Tax Implications
Regulation 1655 also addresses how to handle defective merchandise and its impact on sales tax.
(1) General Adjustments for Defects
When a seller provides a credit or refund to a customer due to defective merchandise, this amount can be excluded from the taxable amount. This applies to outright refunds or credits given for faulty goods.
However, if defective merchandise is taken as a trade-in for new merchandise, and an additional allowance is given due to the defect, only this extra defect-related allowance is tax-exempt. The standard trade-in value remains taxable.
(2) California Lemon Law and Restitution/Replacement
California’s Lemon Law (Civil Code section 1793.2) requires manufacturers to offer restitution or replacement for “new motor vehicles” (as defined in Civil Code section 1793.22) that cannot be repaired after a reasonable number of attempts under warranty. Regulation 1655 outlines the sales tax implications of Lemon Law cases.
(A) Lemon Law Overview: If a manufacturer cannot fix a new vehicle under warranty after repeated tries, they must either replace the vehicle or provide a refund (restitution) of the purchase price, at the buyer’s choice. This regulation extends “buyer” to include lessees of new vehicles.
(B) Restitution and Sales Tax Refund: When a manufacturer provides restitution according to Civil Code section 1793.2(d)(2), they are entitled to a refund of the sales or use tax (or sales tax reimbursement) included in the restitution payment.
To claim this refund, manufacturers must file with the California Department of Tax and Fee Administration (CDTFA) and provide detailed documentation, including:
- Original sales or lease agreement.
- Proof of all deductions from the restitution amount.
- “Lemon Law Buyback” title.
- Proof of Lemon Law decal affixed to the vehicle (Vehicle Code section 11713.12).
- Seller’s permit number of the original dealer or lessor.
- Evidence that sales or use tax was paid on the original sale or lease.
(C) Replacement Vehicles and Tax: If a manufacturer replaces a defective vehicle with a “substantially identical” new vehicle under Lemon Law, this replacement is considered under the original warranty terms. No additional sales tax is due unless the customer pays an extra amount to upgrade to a more expensive replacement vehicle. In that case, tax is only due on the additional amount paid. If a refund is given as part of the replacement process, and it meets Lemon Law restitution requirements, the manufacturer can claim a sales tax refund on the tax portion of that refund, as described in section (b)(2)(B).
(D) Use Tax Reimbursement Limits: The CDTFA’s reimbursement to the manufacturer for use tax is capped at the amount of use tax the manufacturer is legally required to pay for the lessee under Civil Code section 1793.2.
Warranties and Replacement Parts: Sales Tax Rules
Regulation 1655 also clarifies sales tax rules related to warranties and replacement parts. It distinguishes between mandatory and optional warranties.
(1) Warranty Definitions:
- Mandatory Warranty: A warranty that the buyer must purchase as a condition of the sale.
- Optional Warranty: A warranty the buyer is not required to buy from the seller and can obtain from any provider.
(2) Mandatory Warranties and Tax: When a product is sold with a mandatory warranty, the sale of the product includes the warranty. If the product sale is taxable, the amount charged for the mandatory warranty is also taxable, even if separately stated. When replacement parts are provided under a mandatory warranty, the sale of these parts to the warranty provider is considered a sale for resale and is not taxable.
(3) Optional Warranties and Tax: With optional warranties, the company providing the warranty service is considered the consumer of the parts and materials used for repairs. Therefore, the sale of these parts to the warranty provider is taxable. If the warranty provider bought the parts without paying California tax (e.g., out-of-state purchase for resale), they must report and pay use tax on the cost of the parts when they are used to fulfill the warranty.
(4) Deductibles and Sales Tax: If a customer pays a deductible under either a mandatory or optional warranty for repairs, a portion of that deductible is taxable if it covers tangible personal property (parts). The taxable portion is based on the proportion of the repair value attributable to parts versus labor. For example, if parts represent 50% of the repair cost, then 50% of the deductible is taxable. Unless the warranty agreement states otherwise, the warranty provider is responsible for collecting and remitting the sales tax on the taxable portion of the deductible.
Conclusion: Compliance and Clarity for Auto Businesses
Regulation 1655 provides essential guidelines for California auto businesses to correctly handle sales and use tax related to returns, defective merchandise, and warranties. By understanding these rules, businesses can ensure accurate tax reporting, avoid penalties, and maintain compliance with California law. Staying informed about regulations like 1655 is a vital part of successful operations in the automotive sector.
