After more than a year in the making, the five-member board of the California State Board of Equalization (the “Board”) adopted California Sales and Use Tax Regulation (“Regulation”) 1698.5 by a 3-2 vote on May 25, 2010.1 The new regulation, which went into effect on August 18, 2010, is the first attempt by the Board to formalize its sales and use tax audit procedures.

Regulation 1698.5 implements and interprets California Revenue and Taxation Code (“Code”) section 7053, which requires sellers, retailers, and consumers to maintain sales and use tax records, and Code section 7054, which authorizes the Board to examine records, property, and persons and conduct investigations to accurately ascertain sales and use tax liability. Previously, the Board relied on the Sales and Use Tax Department Audit Manual (“Audit Manual”), which incorporates procedures and techniques that have evolved over the years, as a guide in conducting sales and use tax audits. In 2009, the Board expressed a need for a formalized regulation to act as a clear guide for the Board staff and taxpayers alike because the Audit Manual, while available to the public, was primarily an advisory guide for the Board staff, not taxpayers.2 The Board intended that the regulation would provide consistent definitions and procedures, allowing the Board staff to facilitate efficient and timely completion of an audit, help taxpayers navigate through the complex audit process, and ensure fair and consistent application of the Sales and Use Tax Laws.3 In January 2011, the Board issued a Special Notice reminding taxpayers about the formal audit procedures and highlighting the key provisions in the new regulation.4

Provisions of Regulation 1698.5

Regulation 1698.5 is organized according to the following subsections: (a) definitions; (b) general provisions; and (c) audits. Each subsection of the regulation is discussed below.


Subsection (a) sets forth the definition of the common terms found in the sales and use audit process, such as “Board,” “Audit Engagement Letter,” “Pre-Audit Conference,” “Opening Conference,” “Status Conferences,” “Exit Conference,” “Information/Document Request (IDR),” “Audit Findings Presentation Sheet (AFPS),” “Records,” and “Day.”5

General Provisions

Subsection (b) provides that the “purpose of an audit is to efficiently determine whether or not the amount of tax has been reported correctly” and proclaims it is the “duty and... obligation” of the Board to “utilize its audit resources in the most effective and efficient manner possible.”6 Subsection (b) explains the timeframes for an audit, as well as the duties of the Board staff and taxpayers during the audit process. Each element is discussed below.

Timeframes for an Audit

Consistent with the Board’s duty and purpose, subsection (b) explains that an audit of a taxpayer’s records “shall be completed in sufficient time” for the Board to issue a Notice of Determination or Notice of Refund within “the applicable statute of limitations.”7 However, an auditor is required to request a waiver of the statute of limitations when there is “sufficient information to indicate that an understatement or overstatement exists, but there is insufficient time to complete the audit before the expiration of the statute of limitations.”8 Notably, the regulation does not explain what constitutes “sufficient information” or how much time is “insufficient.” “If the taxpayer declines to sign a waiver, the Board may issue a determination for the expiring period(s).”9

However, Regulation 1698.5 provides some protections for the taxpayer. While subsection (c) establishes the standard response times for document requests, discussed below, subsection (b) makes clear the timeframes provided in the regulation are only “intended to provide for an orderly process [for]...a timely conclusion of an audit and are not to be used to prevent or limit a taxpayer’s right to provide information.”10 Accordingly, the regulation requires the auditor to consider late responses to IDRs and AFPSs, subject to certain limitations, and gives the auditor discretion to adjust the timeframes as warranted.11

Duties of the Board Staff

Subsection (b) enumerates a list of duties of the Board staff. Specifically, the staff is required to (1) “[a]pply and administer the relevant statutes and regulations fairly and consistently regardless of whether the audit results in a deficiency or refund of tax”; (2) “[c]onsider the materiality of an area being audited”; (3) “[m]ake information requests for the areas under audit as provided in Regulation 1698”; (4) “not directly access the taxpayer’s computer system if the taxpayer objects to such access”; (5) “[p]rovide an audit plan to the taxpayer”; (6) “[a]dhere to the timelines set forth in the original [or amended audit plan]”; (7) “[k]eep the taxpayer apprised of the status of the audit through status conferences and AFPSs”; (8) “[i]nform the taxpayer of the audit findings at the exit conference”; (9) “[c]opy taxpayers... on all Board correspondence related to the audit when the taxpayer has authorized another party to represent them”; (10) “[s]afeguard taxpayer’s records while examining them”; and (11) “[i]nform the taxpayer of the audit process, the taxpayer’s rights, and appeal rights at the beginning of the audit.”12

Notably, the materiality element attempts to place a needed restraint on an auditor. Previously, the auditors had the authority to decide on the materiality of an audit area.13 Regulation 1698.5 now instructs the auditor to assess the materiality of an audit area by balancing the “potential adjustment...against the time required to audit the area and the duty to determine whether the correct amount of tax has been reported.”14

Duties of the Taxpayers

Regulation 1698.5 also provides rules pertaining to the taxpayer’s duty to maintain records. In general, taxpayers have a duty to maintain records and documents, provide the records requested by the Board, and make records available for photocopying or scanning.15


Subsection (c) establishes guidelines for audit procedures, including: (1) location and time of the audit; (2) pre-audit conference, opening conference, audit plan, and status conferences; (3) record requests; and (4) AFPSs and exit conferences. Each element is discussed below.  

Location and Time of the Audit

Subsection (c) provides that “[a]udits [will] generally take place at the location where the taxpayer’s original books, records, and source documents relevant to the audit are maintained, which is usually the taxpayer’s principal place of business.”16 However, a taxpayer can request a change in the audit location and such request “will be granted unless...[the] staff determines the move will significantly delay the start or completion of the audit, or the Board does not have adequate resources to conduct the audit at the requested location.”17 Any subsequent requests for location changes in the same audit period will be considered on a “case-by-case basis.”18 Notably, “[i]f the taxpayer operates out of a private residence, or has a small office or work environment that will not accommodate the auditor(s), Board staff may require that the records be brought to a Board office or taxpayer’s representative’s office.”19 “Some interested parties expressed concern that the provisions are a step backward from the [prior] practice which allow[ed] taxpayers to determine the location of an audit if adequate books and records are provided to Board staff at that location.”20 They argued that “[these] provisions give too much discretion to Board staff to deny taxpayers the ability to undergo an audit at the taxpayer’s most convenient location.”21

Further, subsection (c) also provides that the Board will not hold an audit in abeyance pending conclusion of a prior audit or an appeal of a prior audit.22 If a prior audit is under appeal, the Board will “begin the current audit by examining areas that are not affected by the outcome of the appeal.”23 On this issue, some interested parties noted that “it is unreasonable to conduct an audit when a significant amount of time and effort might be saved [by] the outcome of an appeal or an audit in progress.”24 They raised the issue that many times, “when an older audit is concluded, the taxpayer and the auditor will agree to apply the results of the audit to future periods,” saving resources for both the taxpayer and the state.25

Pre-audit Conference, Opening Conference, Audit Plan, and Status Conferences

A pre-audit conference is a meeting between the taxpayer and the Board staff to discuss the availability and production of records.26 An opening conference is the first meeting between the taxpayer and the Board staff to discuss, among other things, the audit plan.27 “The audit plan documents the areas under audit, the audit procedures, and the estimated timeframes to complete the audit.”28

While the audit plan may be amended throughout the audit process, the regulation encourages the taxpayer and the auditor to sign the audit plan as an indication of their “commitment” to the plan.29 Interested parties have argued that it should be “clear that the audit plan is not binding and the taxpayer is not compelled to agree with it”; signatures should indicate only that the taxpayer has read and understood the plan.30 Notably, the interested parties argued the “use of the word ‘commitment’ causes concern that the audit plan may be used to force a taxpayer into an unfavorable audit methodology.”31 Further, under subsection (c), the Board announced its goal to complete an audit within a two-year timeframe.32 Accordingly, Regulation 1698.5 directs the Board staff to “develop an audit plan that strives for the completion of the audit within a two-year timeframe commencing with the date of the opening conference.”33 While Regulation 1698.5 provides that the audit is not limited to two years “when a longer timeframe is warranted,” it does not clarify what circumstances would warrant a longer audit.34 Some interested parties have noted that “it is unreasonable to expect large audits to be completed in two years” because it would require an “exorbitant amount of state and taxpayer resources.”35 They argued that these “costs would outweigh any benefit from an expedited audit.”36 Further, they raised concerns that “auditors trying to meet the two-year timeframe probably would not allow taxpayers additional time to provide records to resolve audit issues in the field and as a result, there will likely be an increase in audit appeals.”37

Subsection (c) also outlines status conferences, which are meetings held between the taxpayer and the Board staff throughout the audit to discuss audit issues and the progress of the audit.38 According to the regulation, status conferences are necessary to ensure the audit is on track for completion within the estimated timeframes.

Record Requests

Regulation 1698.5 also sets forth a standard procedure for requesting records, including verbal requests, IDRs, and Formal Notice and Demand Letters, and establishes standard response times for such requests. While the auditor must initially make a verbal request for records, if the taxpayer fails to respond or the auditor cannot establish verbal contact with a taxpayer, the auditor may utilize the IDR process to obtain the necessary information.39 Taxpayers are generally allowed 30 days to respond to an initial IDR and 15 days to respond to a follow-up IDR requesting the same records as the initial IDR.40 If the taxpayer fails to furnish the requested records in response to the followup IDR, the auditor will issue a formal notice and demand to furnish information.41 If the taxpayer fails to provide records in response to the notice and demand within 15 days, the auditor may “issue a subpoena for those records or issue a determination based on an estimate.”42

Some interested parties have noted that the “30-day response time for an IDR is not reasonable” because “much of the audit fieldwork is centered on reviewing thousands of transactions.”43 They argued that the IDR process “ignores the detailed nature of a sales and use tax audit.”44 While Regulation 1698.5 provides that timeframes cannot be used to prevent or limit a taxpayer’s right to provide information and requires the auditor to consider late responses,45 unless facing an expiring statute, it remains to be seen whether this provision will facilitate a cooperative environment between the auditor and the taxpayer to allow the taxpayer sufficient time to provide the requested records.

AFPSs and Exit Conferences

Subsection (c) also explains that an AFPS should be “used during the course of an audit as soon as each area of the audit is completed.”46 Taxpayers do not know what the final determination by the auditor will be prior to the issuance and receipt of the Notice of Determination or Notice of Refund, and AFPSs may remedy this problem and encourage resolution of more issues at the audit level. Generally, “[t]axpayers will be asked to indicate whether they agree or disagree with the proposed findings...[and] will be given an opportunity to...rebut the audit findings.”47 “Agreement to the audit findings does not preclude the taxpayer from appealing the issue(s) at a later date.”48 However, some interested parties have noted that the “AFPS provision seems to require the taxpayer to formulate a defense during the course of the audit” and does not provide sufficient time for taxpayers to “consult with legal counsel and gather necessary information before formulating a position on certain portions of the audit.”49

Finally, at the conclusion of an audit, an exit conference is held between the taxpayer and the Board staff to discuss the audit findings.50 If the taxpayer disagrees with the audit findings, the taxpayer has an opportunity to provide additional information within 30 days following the exit conference. The auditor then has the discretion to adjust the findings, if warranted.51

Franchise Tax Board Regulation 19032

The Board’s new audit regulation closely mirrors the Franchise Tax Board’s (the “FTB”) audit procedures outlined under FTB Regulation 19032.52 Like the Board, the FTB uses the audit plan, conferences, IDRs, and Audit Issue Presentation Sheets throughout the audit and similarly instructs its auditors to take into account the materiality of an issue being audited.53 With the exception of limited circumstances, the FTB also seeks to complete an audit within a two-year timeframe.54 However, there are notable differences. For example, an FTB auditor has the option to determine whether to conduct a “desk audit” in lieu of a “field audit.”55 “A ‘desk audit’ is an audit conducted primarily through mailed correspondence,” while a “‘field audit’ is an audit that takes place at the taxpayer’s residence, place of business or some other location that is not an office of the Franchise Tax Board.”56 FTB auditors can also impose a failure-to-furnish- information penalty if a taxpayer fails to comply with an initial request and second request for any item of information.57 Just as the Board faced staunch criticisms from various interested parties on its proposed regulation, the FTB faced similar criticisms more than 10 years ago when it proposed and ultimately promulgated its audit procedures regulation.58  


Through Regulation 1698.5, the Board hopes to improve transparency of the sales and use audit process, promote communication between the Board staff and taxpayers, and facilitate a timelier resolution of audits. While some taxpayers may welcome the guidance and transparency, critics abound. As discussed above, interested parties raised various objections to Regulation 1698.5 throughout the interested-parties meetings held in 2009. Notably, they disapproved of what they viewed as vague language, voicing concerns that an imprecise regulation will only lead to disputes with taxpayers over interpretation, ultimately resulting in litigation. While taxpayers undergoing a sales and use tax audit with the Board have reason to be cautiously optimistic, it still remains to be seen whether the concerns raised by some will impede the successful administration of the new regulation.