Divergent use occurs when companies issue resale or exemption certificates instead of paying tax and make use of the item in a taxable manner. It is most common to see this in the context of items purchased tax-free because the purchaser says they are going to resale or rent the items to third parties. Remember, when you use a taxable item or service, you owe tax. For more on the concept of Taxable Purchases, visit Don’t Forget Use Tax! and Taxable Purchases Made Easy!
For an online class on how to complete a Texas sales and use tax return, including the report of Taxable Purchases, visit Understanding Your Texas Sales and Use Tax Return.
Divergent Use: Example One
Imagine that a company purchases heavy construction equipment to rent to third parties. The equipment is purchased tax-free due to the issuance of a resale certificate. Business is so great that the company expands its service offerings. Instead of just renting the equipment to third parties, operators actually complete projects for clients. When the operator uses the equipment to provide the service, divergent use of the equipment has occurred.
Divergent Use: Example Two
A store owner has purchased beautiful clothing to sell on her online store. Your sister loves an item so much that she gives it to her or she decides to gift the item to an influencer. If a resale certificate was issued instead of paying sales or use tax on the item, a divergent use has occurred. The item was not resold. Use tax is due on this taxable purchase.
Why divergent use matters
This issue results in the under-reporting of use tax, i.e. an important area of review during an excise, sales, and use tax compliance audit. The tax may not be material (at first). However, depending on the value of the item that is being used and the frequency with which you engage in divergent use, the item may become very material. Resale certificates and exemption certificates are agreements with state tax authorities. You sign a legal document that you are not paying tax because you are using taxable items in the manner described on the certificate.
If you violate the terms of the agreement with the state tax authority, tax is due. You should refer to the rules and policy that govern divergent use in the jurisdictions in which you operate. Divergent use is almost always a nasty surprise that is discovered during an audit. Very few people read the fine print on the resale certificate. It’s there!
Divergent Use Take-Aways
A few years ago, a client was surprised by a nasty bill due to a finding that he violated the terms of the resale certificate and used expensive equipment for internal purposes. After discussing the governing laws and policies together, we all drew the following conclusions:
Planning: You must carefully evaluate the issuance of resale and exemption certificates. Exemptions are narrowly construed. Have a system in place to make sure that you remit use tax if you ever use items purchased tax-free in a way that does not reflect the assertions made on related certificates.
Documentation: You must fully document when you remit use tax. Keep documentation that supports the value of the taxable item and when you remitted use tax for the statute of limitations.
Business Expansion: When you decide to change business offerings, review the use of resale and exemptions certificates. Make sure that the issuance of all certificates is valid. If you are using tax-free items to provide a service, revisit issuance of all certificates.
The following items vary by jurisdiction:
Situations in which you are eligible to issue the certificate.
Circumstances under which you can issue the certificate.
Forms that are acceptable to the tax authority.
When you make a tax-free purchase, you make representations to the state that otherwise taxable purchases are exempt for specific reasons. It is a contract between you and the taxing authority. Make sure you honor the terms of the deal. There are mechanisms to capture the tax when you step outside the terms of the deal.
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