What is Tax Calculation in CPQ?

Tax calculation is the process of determining applicable taxes (e.g., sales tax, VAT, GST, or other regulatory taxes) on a product or service during a transaction. It involves identifying the tax rates and rules based on various factors such as location, product type, and tax exemptions.

In CPQ (configure, price, quote) and billing systems, tax calculations happen automatically in real time, as you select products and choose the customer’s region. This streamlines the quoting and invoicing processes, as your sales and billing teams no longer have to calculate and apply taxes for each transaction manually.

Synonyms

• Sales tax calculation
• Tax rate calculation

Understanding Sales Tax in Quotes

Calculating taxes accurately is a critical part of compliance, pricing accuracy, and building trustworthy relationships with your customers. In quotes, they’re particularly relevant, as they directly impact the final price that your customer will pay. If you close them on a price without taxes included, you may face chargebacks and disputes when the final invoice is generated.

Accurate pricing and quoting

When you use CPQ software, sales tax calculations are based on the product’s ship-from and ship-to addresses. This means that if you’re selling tangible goods, the taxes applied will be based on the customer’s location. If you’re selling services, the tax applied will depend on where your company and theirs are located.

Tax rules and regulatory compliance

Automated tax calculations in CPQ and billing software ensure you’re adhering to regional and international tax laws. They validate customer addresses and map them to specific tax jurisdictions, ensuring the correct taxes are applied down to the local level.

On top of that, they can manage tax exemptions by storing exemption certificates and applying them where appropriate. They also handle special tax cases, such as tax holidays or customer-specific exemptions, ensuring that these are correctly applied during transactions.

Sometimes, automated systems integrate with third-party tax engines like Avalara AvaTax, Vertex O Series, or Thomson Reuters ONESOURCE, which provide real-time tax rate determination and compliance updates by pulling from hundreds of millions of data-driven tax rules.

Tailored quoting, bundling, and product customization

Different products and services may be taxed differently across the regions you’re selling into. Quoting and billing systems maintain detailed taxability matrices that define how various items are taxed in different jurisdictions.

As for product bundling, a bundle comprises a parent product and associated options, organized into features for categorization. The hierarchical structure is what allows for complex configurations and ensures that all components are appropriately accounted for during tax calculations.

For custom products, the system can track and apply unique tax rates based on specific attributes, such as material costs or labor. And during invoice generation, each product within the bundle is listed on separate quote lines with its corresponding tax amount.

Within quoting software, all these features come together to make it easy for sales reps to create custom quotes for each buyer, complete with accurate tax info.

Approval workflows

An approval workflow is a set of steps your CPQ or quoting software will execute once a quote has been submitted for approval, provided it reaches certain parameters (e.g., a specific type of discount or a quote over a certain dollar value).

By automating your approval workflows within the system, you can ensure each quote is routed to the correct place, depending on pre-defined criteria. For quotes with complicated tax considerations, this could mean triggering a review by your tax department before getting routed to a sales or finance team member for final approval.

Tax filing and reporting

Through integration with tax engines, your bookkeeping software, or your enterprise resource planning (ERP) system, CPQ software can also support tax filing and reporting. Since it consolidates all transaction data, including calculated taxes, into a centralized database, it facilitates efficient tax reporting and filing.

Calculating Tax on Quotes

When you (or, rather, your software) determine the final tax amount for a product or on a quote, there are several factors that can influence the calculations, including:

• The product or service being sold
• The location of the buyer
• Exemptions that apply
• The method you use to calculate taxes
• Whether your company has nexus (i.e., a significant presence) in that buyer’s state

Let’s dive into each, and what considerations you need to make:

Product type

What exactly you’re selling can have a significant impact on how taxes are calculated. This is especially important to think about if you’re a manufacturer, wholesaler, distributor, or retailer for one of the following types of products:

• Grocery items
• Clothing
• Feminine products
• Alcoholic beverages
• Medical devices
• Luxury goods

Some of these items, like groceries, basic clothing, and medical devices are normally (but not always) exempted from sales tax because they’re classified as “essential items.” Others, like luxury goods and alcoholic beverages, are frequently subject to higher tax rates.

The taxation of digital goods, such as e-books, music downloads, or software, varies by jurisdiction. Some states have enacted laws to tax digital goods similarly to their physical counterparts, while others may exempt them. For example, in U.S. states where services aren’t taxable, SaaS products also aren’t taxable.

Tax rates and location

That brings us to our next point: Taxes are charged based on the location of where the good or service is being sold, not where it was shipped from. If you’re selling to a European customer, you’ll need to know the tax rate for the country they live in, plus which regulations apply to their jurisdiction (e.g., the EU).

If you’re selling goods or services in the U.S., sales tax rates and regulations vary wildly at the state and local level. For example, Colorado’s state sales tax is 2.9%, but local taxes can increase the rate up to 11.2%. And, like we said, states differ on what they consider taxable and non-taxable.

Exemptions

We’ve already talked about how there are product-based exemptions for essential items. But there are also:

• Use-based exemptions for resale items, machinery and equipment used directly in the manufacturing process, and items used in farming, such as seeds, fertilizers, and certain equipment
• Entity-based exemptions for charitable, religious, and educational nonprofits and federal, state, and local government agencies

To claim these exemptions, buyers usually have to provide appropriate documentation, such as exemption certificates, to the seller. Sellers are responsible for collecting and maintaining these certificates to substantiate the exempt status of transactions.

Tax calculation method

There are several ways to calculate the final tax amount on a quote:

• Per-item tax calculation calculates tax individually for each line item based on its specific price, quantity, and applicable tax rate.
• Per-total tax calculation applies the tax rate to the aggregate total of all taxable items.
• Origin-based taxation is calculated based on the seller’s location.
• Destination-based taxation is determined based on the buyer’s location.
• Tax-inclusive pricing is when prices presented include tax.
• Tax-exclusive pricing is when tax is shown on top of the price.

The correct method depends on where the goods are sold and shipped, the buyer’s tax-exempt status, and other factors. For example, in Europe, VAT is generally added into the list price, whereas in the United States, sales tax is typically added at checkout.

And, if you’re selling into one state’s market, origin-based taxation makes everything less complicated. But it complicates things when you’re all over the U.S. and will need to apply different rates.

Economic Nexus Responsibilities

Economic nexus is a legal term that refers to the extent of physical or economic presence a business has in a state that requires them to collect and pay sales tax.

• Physical presence is simple: if you have offices, employees, or inventory in a state, you will owe tax.
• Economic presence is a bit more complicated. If you exceed sales thresholds in a state, even without physical presence, the South Dakota v. Wayfair, Inc. decision allows states to enforce sales tax collection based on economic nexus. This varies from state to state, so you have to know the rules in each jurisdiction you conduct business.

The solution here is to continuously track your sales in all states to determine if you meet the economic requirements. Once you reach the threshold, you’ll need to register with each state, collect and file taxes accordingly.

Quoting and billing tools make this easy because they include each customer’s address on invoices. It aggregates this data and can tell you automatically when you’ve crossed a state’s threshold.

Complexity of Manual Tax Management

The biggest issue with manual tax management is that the tax code is incredibly complicated. And chances are, you aren’t selling into just one market — even if you’re only selling to U.S. companies, for example, you’re already looking at 50 different jurisdictions. Knowing the tax code makes it easier, but it’s fundamentally impossible to manage all those rules at once.

Not to mention, sales reps are not tax professionals. If you leave it to them to calculate tax on every quote, you’re going to create a heap of back office work and run into tons of tax compliance issues. And setting up an approval workflow to a tax professional just creates unnecessary steps and friction in the sales process where it could otherwise be automated.

Even if they were all tax experts, tax codes are always changing. Your salespeoeple would have to be constantly updating their knowledge and keeping track of any new changes in tax laws for each state in which they are selling, just to calculate the price on a quote.

So, it’s complex, error-prone, and time-consuming. And, most importantly, there’s no reason to manage taxes manually because software can already do it automatically.

Controlling Tax Calculations with CPQ

One of the best features of CPQ software is it calculates taxes based on customer information. For different products, it can apply different rules. And as for billing software features, it processes those payments and automatically applies the right tax rate.

There are also features for more granular tax control:

• Creation and association of tax exemption certificates with specific accounts
• Sales tax rate lookup functionality
• Integrations with external tax engines
• Custom tax settings tailored to the country of supply and purchase (for multinational companies)
• Estimated tax during quoting, then actual tax during billing
• Assigning specific tax codes to products
• Default tax calculation overrides at the order product level
• Pricing rules with taxable and tax-exempt product codes

With these additional features, you have an entirely customizable tax configuration tailored to your customers’ specific needs. And you can provide a seamless buying experience.

Integrate CPQ with CRM and ERP Systems for Seamless Workflows

CRM and ERP are the two most important integrations for CPQ software. CPQ complements CRM by allowing sales teams to access customer data, manage opportunities, and generate accurate quotes within a unified platform. ERP integration facilitates the transfer of finalized quotes and orders to backend processes like manufacturing, inventory management, and billing.

Normally, this is done through APIs provided by your software vendors, which create direct connections between systems. But, when you’re comparing CPQ vendors, you need to look at whether the platform integrates seamlessly with your CRM and ERP — not all do. This can create gaps in data, processes, and workflows, which ultimately impact your customer experience.

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