In September 2017, the California Department of Tax and Fee Administration (CDTFA) issued Special Notice L-506 which provides guidance on the application of excise tax on sales from out-of-state licensed tobacco distributors to in-state licensed tobacco distributors. In summary, Special Notice L-506 states that the sale from an out-of-state licensed tobacco distributor to an in-state licensed tobacco distributor is not a distribution and therefore does not constitute a taxable transaction for the out-of-state licensed distributor.
According to discussions we held with representatives from the CDTFA, the special notice was intended to clarify the long-standing interpretation of the California Cigarette and Tobacco Products Tax Law for out-of-state licensed distributors. That claim, however, is inconsistent with our experience dealing with audits of in-state distributors who have historically paid tax on the cost of products purchased from out-of-state licensed distributors. Under the provisions outlined in Special Notice L-506, in-state distributors that purchase from outside the state are required to pay tax on their selling price, as opposed to their purchase. Historically, licensed out-of-state distributors would pay tax on their wholesale cost of tobacco products when making sales to in-state licensed tobacco distributors and would then indicate that the excise tax was paid on the invoice to the in-state distributors. The in-state distributors would then have no further excise tax obligation.
The implications of Special Notice L-506 have particularly negative implications for in-state distributors. Specifically, when in-state distributors are audited by the CDTFA they may be assessed tax on purchases from out-of-state distributors which they believe were acquired tax paid. Because the audit staff will not consider the original purchase a “distribution,” they will assert that the tax was due on the subsequent sale by the in-state distributor. The in-state distributor will then be assessed excise tax on purchases that were acquired tax paid and therefore not reported at the time they were sold. We have managed audits where this issue arose.
We believe that Special Notice L-506 is in conflict not only with the historical treatment of these transactions by the CDTFA and its audit staff, but also with the California Cigarette and Tobacco Products Tax Law. If you are an in-state tobacco products distributor who has recently been audited and is facing an asserted obligation, please feel free to contact us for a free consultation on how we may be able to help you resolve this issue.