What is a tax engine?

Consumption taxes are a fundamental part of the business landscape, and managing them can be complex, especially with over 12,000 local and state tax jurisdictions in the United States alone. Navigating these complexities can be a significant operational challenge for businesses, especially when selling online and serving customers abroad.

Fortunately, tax engine software provides a powerful solution. In this article, we will delve into:

• What a tax engine is
• How a tax engine works
• How using a sales tax engine can help your business stay compliant with tax laws both in the US and internationally, while also boosting operational efficiency.

Let's get started.

What is a tax engine?

A tax engine is a specialized cloud-based software tool that automates key processes of sales tax compliance, so that companies remain compliant with all tax laws wherever they operate. Subscribing to a third-party tax engine is a primary way for SaaS companies and other startups to outsource tax compliance for consumption taxes such as US sales tax, VAT, and GST.

If you need a refresher, check out how different consumption taxes work.

Why a sales tax engine is necessary

Maintaining your tax compliance processes requires a lot of time and resources thanks to complex US sales tax rules. There are a total of 45 US states that levy sales and use taxes, with rates ranging from 2.9% to 7.25%.

For small suppliers who mostly do business locally, this may not pose too much of a problem. But the minute you begin to scale up, complications arise.

For instance, if you run an ecommerce company that ships nationwide, calculating and applying sales tax can be fraught with difficulty. For one thing, how do you determine which state’s rules apply?

Is it the company’s home state or the customer’s? And what if the goods are shipped from a third location rather than the company’s office? Are you on the hook for sales tax at all, or can you ignore it?

There are also other nuances to consider, such as:

• Unique tax treatment for different types of products or services
• Customer exemptions
• Occasional sales tax holidays

If you do business internationally, of course, this patchwork of rules becomes even more elaborate and complex. Businesses operating in the SaaS space, for instance, quite often have global reach because they’re selling a cloud-based product.

The great advantage of using a tax engine is that it cuts through all this complexity. You can integrate it with your existing business tools to calculate the tax owed in real time. Your tax engine provider keeps all the tax data up to date so you don’t have to spend time and resources doing this in-house.

Core functions of a tax engine software

Tax engines are designed with a number of key features to meet core compliance needs. These include:

• Automated tax calculation: The engine performs automatic tax calculations thanks to an accurate database of tax rates around the world. The system adds the correct sales tax amount for each transaction by considering where the customer is located and what they're buying.
• Tax jurisdiction management: It keeps track of all the different tax regions and their respective rates, so you don't have to. You can store your tax registration information and also monitor when you’ll become liable for consumption tax in a new place.
• Exemption management: If a customer qualifies for a tax exemption, the system handles all the details, from tracking the certificates to processing the exemptions.
• Filing and remittance: It takes care of preparing and submitting tax returns, making sure payments are sent to the right places without a hitch.
• Reporting and analytics: You'll get access to detailed reports and insights on your sales tax obligations and transaction history.
• Compliance updates: The engine stays up-to-date with any changes in tax laws, so your compliance is always current.
• Integration capabilities: It connects smoothly with your existing payment gateways, sales channels, and e-commerce systems, making the whole process more efficient. Plus, all of your business data is streamlined into one dashboard.
• Audit support: When it's time for an audit, all the necessary documentation is organized. This feature can also be useful for analytical purposes, such as when you’re instituting a fraud risk assessment process.
• Multi-currency support: No matter the currency, the engine applies the correct tax rules to each transaction. The app can reconcile currency differences in its reporting.
• User access and security: It ensures that only authorized users have access, with strong measures in place to keep your data safe and secure.

Why do online businesses need a tax engine?

After 15 years in the industry, we’ve experienced most of the tax challenges faced by many of our customers. When selling online, tax compliance is too complex to manage manually. Business owners everywhere are seeking tax automation for ecommerce or a tax solution for SaaS.

Let’s look at how the core functions of a tax engine translate into real-world benefits for your business. Here are some of the main advantages:

• Reduces the rise of tax calculation errors and costly audits
• Ensures compliance with all applicable local tax laws
• Saves time and increases the efficiency of your finance team
• Enables you to process high volumes of transactions

Reduces the risk of tax calculation errors and costly audits

When it comes to tax, making mistakes can get very expensive. If you’re consistently overcharging for tax because you’re not taking into account the applicable tax deductions, for example, you’re essentially cutting into your profits.

Worse, you could be overcharging your customers. That makes you less competitive and could hurt your brand reputation in the long term.

But the biggest hit to your reputation will come if an audit discovers your company has been non-compliant with tax. As well as having to make up the amount due, you’re likely to be hit with fines.

Ensures compliance with all applicable local tax laws

Keeping up with changes in local, state, or international tax laws can be an intimidating challenge if you try to do it yourself. After all, changes happen regularly, and you need to be able to move quickly to comply. And some of those changes can be pretty transformative.

Take the South Dakota v. Wayfair Inc ruling, for instance. This was a Supreme Court decision back in 2018 that revolutionized the tax rules for online businesses.

Prior to this ruling, businesses without a physical presence in a state (like a factory or an office) were not liable to pay sales tax in that state. The ruling had an immediate impact on many online platforms and marketplaces because it said that remote sellers could be held liable for US sales tax even if they were located elsewhere.

With a tax engine, you never need to worry about this. Your software provider keeps all tax-related information up to date so you’ll always remain compliant.

Saves time and increases the efficiency of your finance team

On a more positive note, using a tax engine can be a terrific way of maximizing efficiency. That’s because it saves you time and resources that you can then deploy in other areas of your business.

In fact, you could almost say it acts like an automated employee, a bit like a virtual agent (If you’re wondering “What is a virtual agent?”, it’s one of those automated chat tools that help take the load off contact center agents during peak times).

If you’ve been skeptical about whether a tax engine is really necessary because you already have an excellent ERP system up and running, this is one of the main reasons it is.

Yes, you absolutely can use your ERP to calculate taxes, but because those systems are general tools not specifically designed with tax in mind, you’ll need to put a lot more effort in to make it work.

For instance, keeping all your tax rate information up to date is a major task. To accomplish this, you’ll either have to employ people on your team to research and update the database or else pay a third party for the service.

A tax engine removes this problem and frees up your finance team to focus on other things.

Enables processing of high volumes of transactions

As your company grows, you need all your business tools to be easily scalable. This is one reason why we’re seeing an increase in the popularity of automating standard processes, such as with e-invoicing, for example.

Tax engines use real-time processing, which means they calculate and apply the tax due as each transaction happens. Instead of having to use a separate process and then consolidate the calculation with the rest of the transaction procedure, the system does everything automatically.

This means transactions go through much more quickly than they otherwise would. It also means you need less computing power to support a higher number of transactions, so it’s an excellent route to efficiency.

How does tax engine software work?

We’ll now examine how tax engine software works in a little more detail. We’ll dig into some of the features previously mentioned and explore them further.

Integrates easily with your core business systems

Your tax engine’s integration capability is the key to unlocking better efficiency in your business transactions. It slots into your existing setup seamlessly, working with a wide range of different tools, such as your ERP, CRM, or payment processing platform.

If you’re using an API-based solution like Quaderno’s sales tax API, your developers will be able to create customized solutions specific to your company’s unique circumstances.

ERP, CRM, and other business software

When you decide to implement a tax engine in your systems, there’s an initial configuration phase. This aligns tax engine software with your existing tech stack so that, say, the shipping address data held in your CRM can be used to calculate sales tax automatically and report all relevant information to your ERP, payment processing gateway, or finance analytics platform.

Identifies the tax rules applicable to the transaction

The tax engine takes all relevant data about where the relevant parties are located and what kind of goods or services are involved in the transactions and then determines which tax rules should apply.

For example, if you’re a French business selling to a company in Germany, a tax engine will recognize that the sale is B2B and perform the following compliance tasks:

• Automatically verify the German company’s VAT number using the EU’s VIES tool
• Apply the reverse charge mechanism to the transaction, so you don’t collect any VAT from the customer.

No matter how complicated the tax rules, a top-quality tax engine is designed to follow them.

Calculates appropriate tax rate in real time

Having identified which tax rules apply, the tax engine then makes the calculation in real time. On an ecommerce platform, this could mean displaying a separate line for the sales tax amount on the checkout page.

Since the amount is known in advance of the payment going through, there’s no need for consolidation reviews after the fact. This makes life much easier for your accounts receivable department and finance team.

Automatically generates tax reports and records

Accurate record-keeping is an integral part of filing business taxes. Tax engine software guarantees that every single cent is accounted for through its comprehensive reporting functionality.

You’ll be able to track the sales tax due or paid down to the last penny in every single one of the numerous jurisdictions in which you do business.

Assists in accurate tax filing and compliance processes

When the time comes to report and file consumption taxes, all you have to do is generate a report from your tax engine software. This is an enormous time-saver, but it also provides valuable peace of mind.

In short, you know that no matter how complex the tax environment is, you’re remaining fully compliant with taxes at all times. No more worrying about the possibility of overpaying or underpaying or just overlooking some crucial change in the rules. Your tax engine takes care of all of that for you.

Final thoughts

The complexity of modern sales tax and VAT rules can pose serious challenges, not to mention take up a lot of your time. Keeping abreast of all the different rates that apply in multiple jurisdictions, as well as any exemption or deduction rules, is a huge job.

Luckily, top-end tax engines like Quaderno Connect can give you all that time back. The best solutions not only automate the tax calculation itself but also provide a broad range of extra features to make your life easier, such as automatic invoicing, advanced reporting tools, and a wide array of integrations to ensure they work well with your existing business software.

In the end, it’s all about increasing efficiency in your everyday operations and scaling with confidence. A bonus is the peace of mind that comes from knowing your company is meeting all its tax obligations on an ongoing basis.

If you’re curious how a tax engine like Quaderno can work for your business, book a free call with one of our product experts today.