Maintaining compliance with sales tax regulations, including collecting and remitting the correct amounts, is one of the most challenging parts of running a business, especially if you operate online and have to comply with varying tax rates across many states (and, perhaps, countries).
That's where a tax engine comes in. A tax engine can be integrated into your business platforms. It calculates the correct amount of taxes due, such as sales tax in the U.S. and value-added tax (VAT) or goods and services tax (GST) for international sales.
With a tax engine, it's easy to collect the right amount of tax for every transaction. You can charge taxes at the point of sale or add them directly to an invoice, record the correct amount of taxes for easy reporting, and be ready to remit the amounts to the appropriate tax authorities — without spending a lot of time on calculations or risking human error.
This guide explains how tax engines work and what the benefits of using a tax engine are.
What does a tax engine do?
A tax engine is software that works with your enterprise management system (ERP), customer relationship management system (CRM), and e-commerce platform to make sure that your business is compliant with all relevant tax regulations. When a transaction is initiated, the system will consider:
- Applicable tax rules: Is the transaction subject to sales tax, VAT, GST, or some other type of tax? And which specific items in the transaction are taxable?
- Exemptions: Is the buyer exempt from having to pay taxes? If so, do you have an exemption certificate on file?
- Tax rates: What tax rate is charged on the specific goods or services?
All of this information will be assessed in real time to determine whether the transaction is taxable and, if so, how much tax is due. The correct amount of tax can then be added to the invoice and, when possible, paid immediately by the customer who’s making the purchase.
Tax engines are extremely helpful because sellers are required to collect sales tax, VAT, or GST when they sell into a location where they have economic or physical nexus.
Tax engines vs. basic accounting software
Basic accounting software allows you to record and manage financial transactions, but it is not specifically geared toward the calculation of sales tax. While some accounting software may be able to apply a set sales tax rate and calculate tax on simple transactions, accounting software is not designed to provide accurate real-time sales tax, VAT, or GST calculation.
The rules that apply to these taxes can be very complex, and they frequently change. For example, in many areas, certain kinds of food are exempt from tax, but not all foods. In fact, tax rules can be so specific that the question of whether candy is taxable can come down to whether it has wheat flour in it or not.
Tax engines can track all of the very specific rules that apply to indirect taxes and make sure that the tax calculation is accurate under current regulatory requirements and with the specific details of the sale.
How does a tax engine work?
Core components
Tax engines typically offer these features:
- A database of tax rates that apply to different kinds of goods and services.
- A database of taxable and nontaxable goods.
- An automated process that determines what specific state or country's tax rules apply to each transaction.
- A method of tracking exemptions and storing exemption certificates so tax isn't charged on exempt sales.
- Reporting tools so you can determine how much tax was collected in order to file your tax forms properly.
- Integration capabilities so the software works seamlessly with your systems and can correctly and instantly calculate and track taxes on appropriate transactions.
Not all tax engines offer all of these features. You'll want to find one that offers as much functionality as possible and that covers all of the locations where you might be responsible for collecting and remitting sales tax, VAT, or GST.
Automation and real-time calculations
Good tax engines automate the process of calculating the amounts of indirect taxes a business owes, so no accounting professional needs to perform this service.
These programs can calculate information in real time, so sales tax, VAT tax, or, for example, GST if you are selling in a country like Canada, can be collected from the customer when the sale takes place or can be added to an invoice.
The software should be able to calculate the amount due in seconds, so there’s no lag time that could reduce the chances of the customer completing the purchase.
Integration with business systems
Your tax engine should also integrate with your business systems. You want it to automatically calculate sales tax when a customer tries to check out on your billing platform or when you enter a purchase order into your system, so an accurate invoice can be created for customers.
Ideally, the reports that your tax engine produces can integrate into your other accounting and financial software, providing you with a detailed record of taxes collected in different transactions.
Key benefits of using a tax engine
Using a tax engine can benefit a company in many ways. Here are some of the most important:
Accuracy in tax calculation
When software can automatically determine what items are taxable and at what rate they should be taxed, you can calculate sales tax, VAT, or GST accurately and instantly.
Since the process of determining how much tax to charge requires detailed knowledge of tax rates, which products are taxable, and which jurisdiction's rules apply, using a software solution that does these calculations accurately is critical.
You can avoid human error with the right tax engine, and ensure that someone doesn't misapply tax rules and end up causing you to undercharge or overcharge customers — which could result in a tax audit, reputational damage, and other serious consequences.
Efficiency and time savings
Tax engines reduce the burden of calculating taxes. Since they can calculate the amount due instantly, there’s no need for a financial professional to do manual calculations.
Compliance with complex tax Laws
If you don’t pay the correct amount of sales tax, VAT, or GST, you can face serious penalties. If you are audited and found to have underpaid, you could owe back taxes, fines, and interest.
By automating the process of calculating, collecting, and recording taxes, you can reduce the chances that an inadvertent failure to follow the law could have costly consequences.
Since tax regulations change often, using a tax engine also allows you to make sure that the most up-to-date rules are being applied for every transaction.
Types of businesses that benefit most from tax engines
Any business that must collect sales tax, VAT, or GST can benefit from a tax engine. However, some businesses may have more to gain, including:
- E-commerce businesses may need to collect sales tax in as many as 50 U.S. states and multiple countries, depending on transaction volume and how many locations they’ve established economic or physical nexus in. When you have so many different tax regulations to comply with, automating the process is essential.
- SaaS (software as a service) companies often generate invoices in one place and serve companies in another, which means that they must determine which jurisdiction's tax rules apply. States and foreign countries are also still establishing regulatory frameworks for how to tax SaaS, so using a tax engine to ensure that the most current rules are being followed is wise.
If you want to do business on a national or an international scale, having a tax engine can make that possible without putting you at risk of violating tax rules.
Selecting the right tax engine
Selecting a tax engine that meets your company's needs is critical. Here are some key capabilities you should look for:
- It’s scalable and can expand with your business as you begin selling in different jurisdictions or begin selling different kinds of products.
- It can integrate with your existing platforms and business tools, including your ERP, CRM, invoicing tools, or e-commerce platform, so you can correctly calculate tax on all transactions and ensure that you're generating the right reports to comply with your tax obligations.
- It provides support for international tax compliance if you do business outside of the U.S.
- It keeps up-to-date on changes in regulatory frameworks for indirect taxes.
- It calculates taxes quickly and in real time.
Numeral offers all of these features and many more; it’s easy to use and makes tax compliance simple.
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The bottom line
Companies may be expected to collect taxes on behalf of many states and countries, so they need to find a way to comply with these complicated requirements. Tax engines make it easy by automating the complex tax collection process.
