OVERVIEW OF ARIZONA’S SALES TAXATION OF CONTRACTING By: Pat Derdenger Partner, Steptoe & Johnson LLP
Building Materials Vendors Owner GeneralContractor Sub Sub Sub Sub Sub-Sub Sub-Sub
STRUCTURE OF THE ARIZONA CONTRACTING TAX The “Prime Contractor”is Taxable.
DEFINITION OF “CONTRACTOR” • A.R.S. § 42-5075.G.2 defines “contractor” as being “synonymous with the term ‘builder’ and means a person, firm, partnership, corporation, association or other organization, or a combination of any of them, that undertakes to or offers to undertake to, or purports to have the capacity to undertake to, or submits a bid to, or does himself or by or through others, construct, alter, repair, add to , subtract from . . .
DEFINITION OF “CONTRACTOR” … improve, move, wreck or demolish any building, highway, road, railroad, excavation or other structure, project, development or improvement, or to do any part thereof, including the erection of scaffolding or other structure or works in connection therewith, and includes subcontractors and specialty contractors." This Section also provides that the definition will govern "without regard to whether or not the contractor is acting in fulfillment of a contract."
DEFINITION OF “PRIME CONTRACTOR” A.R.S. § 42-5075.G.6 defines "prime contractor" to mean "the contractor who supervises, performs or coordinates the construction, alteration, repair, addition, subtraction, improvement, movement, wreckage or demolition of any building, highway, road, railroad, excavation or other structure, project, development or improvement including the contracting, if any, with any subcontractors or specialty contractors and is responsible for the completion of the contract."
THE SUBCONTRACTOR EXEMPTION A.R.S. § 42-5075.D provides that a subcontractor is not liable for the Sales Tax "if the job was within the control of a prime contractor . . . and that the prime contractor . . . is liable for the tax on (its) gross income . . . attributable to the job and from which the subcontractors . . . were paid."
R15-5-602.C.1 Subcontractors are exempt provided that such persons are not acting in the capacity of prime contractors. A subcontractor is considered to be a prime contractor, and therefore liable for the tax, if: a. Work is performed for and payments are received from an owner-builder. b. Work is performed for and payments are received from an owner or lessee of real property.
PERSONS ACTING AS “AGENTS” OF THE OWNER ARE NOT TAXABLE AS “PRIME CONTRACTORS” • Mackey Plumbing Co. v. Arizona Department of Revenue • Jerry's Plumbing v. Arizona Department of Revenue • Mountain View Development Co. v. Arizona Department of Revenue BUT SEE: • Camden Development • Ormond Builders
NO TAX ON PURCHASE OF MATERIALS Tangible personal property sold to a person that is subject to tax under this article by reason of being engaged in business classified under the prime contracting classification under § 42-5075, or to a subcontractor working under the control of a prime contractor that is subject to tax under article 1 of this chapter, if the property so sold is any of the following:
NO TAX ON PURCHASE OF MATERIALS (a) Incorporated or fabricated by the person into any real property, structure, project, development or improvement as part of the business. (b) Used in environmental response or remediation activities under § 42-5075, subsection B, paragraph 6.
NO TAX ON PURCHASE OF MATERIALS (c) Incorporated or fabricated by the person into any lake facility development in a commercial enhancement reuse district under conditions prescribed for the deduction allowed by § 42-5075, subsection B, paragraph 8. NOTE: • Consumable items not incorporated into structure are taxable • Equipment rented to contractors is taxable under the rental classification
PRIMARY DEDUCTIONS • Land Deduction (20% audit “safe harbor”) • 35% Labor Deduction or 65% Inclusion. • Contractor’s Deduction for State and Municipal Sales Taxes - Factoring: gross amount ÷ .65 x(1 + tax rate) or taxable amount ÷ (1+ tax rate). Example: $1000 ÷ (1.081) = $925 (combined tax rate is 8.1%) • DOR Automatic Factoring Worksheet!
OTHER DEDUCTIONS • Groundwater Measuring Devices. • Furniture, Furnishings, Fixtures and Appliances not attached to manufactured buildings (separately taxed under retail classification). • Military Re-Use Zone (Williams Air Force Base).
OTHER DEDUCTIONS • Qualified Environmental Technology Manufacturing Facility (must have been certified by Dept. of Commerce by June 30, 1996). • Remediation Work. • Installation of Exempt M&E - “Not Permanently Attached.”
OTHER DEDUCTIONS • Lake Facility Development (Tempe Town Lake). • Exempt machinery and equipment and tangible personal property sold to “qualifying hospital” and 501(c)(3) organization engaging in job training, placement, etc. (Added effective January1, 1999 and Repeals Purchase Agency Requirement) • Construction of egg production facilities.
OTHER DEDUCTIONS • Construction of Agricultural pollution control facilities. • Installation of clean rooms (NOTE: equipment is also exempt). • Construction of non-profit residential apartments for low income/over age 62 (beginning July 1, 2001). See ARS § 42-5075
DESIGN & ENGINEERING FEES EXCLUDED FROM TAX • Direct Fees Are Excluded • Indirect Are Not See Senate Bill 1293 (2004)
FOUR VARIANTS OF THE CONTRACTING CLASSIFICATION TAXING SCHEME • The Normal General Contractor • The Speculative Builder • The Owner Builder • The Construction Manager
NORMAL “GENERAL CONTRACTOR” SITUATION Chart No. 1 Normal Prime Contractor Situation Building Materials Vendors Taxed Owner Exempt Taxed PrimeContractor Exempt Sub Sub Sub Sub
TAX COMPUTATION Construction Contract - $1 Million Gross income from contracting 35% Labor Deduction Taxable Amount (65% Tax Base) Factored Tax Deduction ($650,000 1.081) Tax Rate (State, County & City) Tax $1,000,000 - 350,000 650,000 601,295 x 8.1% $ 48,705
SPECULATIVE BUILDER Chart No. 2 Speculative Builder (Builds with Intent to Sell) Sells $ Building Materials Vendors Speculative Builder Owner & Prime Contractor Buyer Exempt Taxed Exempt No Tax Sub Sub Sub Sub
TAX COMPUTATION Land Value - $400,000Construction Cost - $1 Million (paid to subs) $ 2,000,000 - 400,000 $ 1,600,000 - 560,000 $ 1,040,000 962,072 x 8.1% $ 77,928 Gross Sales Proceeds Land Value (20% “safe harbor”) 35% Labor Deduction Taxable Amount (65% Tax Base) Factored Tax Deduction ($1,040,000 1.081) Tax Rate (State, County & City*) Tax Compare to $48,705 (Prime Contractor) * Assume City has land deduction.
SPECULATIVE BUILDERChart No. 2ADepartment of Revenue’s Unwritten Audit Position Speculative Builder Constructs House Without Contract In Place Before Completion DOR’s position is that state statute does not have a speculative builder classification as does Model City Tax Code Ignore definition of contractor: “without regard to whether or not the contractor is acting in fulfillment of a contract Sells $ Building Materials Vendors Buyer Taxed Speculative Builder (Owner & Prime Contractor) No Tax Exempt Taxed Sub Sub Sub Sub
SPECULATIVE BUILDERChart No. 2BDepartment of Revenue’s Unwritten Audit Position Speculative Builder Constructs House Without Contract In Place Before Completion Gives Forms 5005 to subcontractors Buyer Sells $ Speculative Builder (Owner & Prime Contractor) Building Materials Vendors Taxed Speculative Builder Taxed on Amounts Paid to Subs No Tax Taxed Exempt Exempt Sub Sub Sub Sub
SPECULATIVE BUILDERChart No. 2CDepartment of Revenue’s Unwritten Audit Position Speculative Builder Constructs House With Contract To Sell In Place Before Completion Building Materials Vendors Exempt Sells $ Speculative Builder(Owner & Prime Contractor) Buyer Taxed Exempt Exempt Sub Sub Sub Sub
SPECULATIVE BUILDER • So, Under DOR’s Position: • A homebuilder (no “dual structure”) would not be taxed on sale of home if the house was not “presold” • Subs would be taxable
OWNER-BUILDERChart No. 3Owner-Builder (Builds with Intent to Hold) Owner-Builder (Acts as OwnPrime Contractor) Building Materials Vendors Taxed Taxed Exempt Sub Sub Sub Sub
TAX COMPUTATION Land Value - $400,000 Construction Cost - $1 Million (paid to subs) Subs are taxed on $1 Million. $ 1,000,000 - 350,000 650,000 601,295 x 8.1% $ 48,705 Labor Deduction (65% Tax Base) Taxable Amount Factored Tax Deduction ($650,000 1.081) Tax Rate (State, County & Phoenix) Tax Compare to $48,705 (Normal Prime Contractor Situation) • Note: If Owner-Builder uses a prime contractor that pays the tax on initial construction, Owner Builder is liable for tax on value of improvements made after substantial completion if sold within 24 months of substantial completion.
CONSTRUCTION MANAGER *Is Fee taxed? Building Materials Vendors Taxed Construction Manager Owner Who is taxed on $ paid to Subs? CM or Subs. Exempt Sub Sub Sub Sub Taxed * Under the Model City Tax Code, the cities’ position is that the fee is taxable.
CITY SALES TAXATION: CITIES DO NOT FOLLOW THE STATE STRUCTURE By Pat Derdenger
City Sales Taxation: Cities Do Not Follow the State Structure • Model City Tax Code • Adopted by All Cities that Impose a Sales Tax • Program Cities vs. Non-Program Cities • Program Cities and Supplemental Audits
City Sales Taxation: Cities Do Not Follow the State Structure • All “Construction Contractors” are Taxable • Subcontractors are Exempt Only if it Receives “Written Declaration” from Another Construction Contractor (i.e., the “general”)
City Sales Taxation: Cities Do Not Follow the State Structure • Speculative Builders Who Sell Improved Real Property Are Taxable • Commercial Property – Within 24 months of Substantial Completion • Residential Property – No Limit • Credit for Taxes Paid by Construction Contractors
City Sales Taxation: Cities Do Not Follow the State Structure • Owner Builders Are Taxable • Upon Expiration of 24 Months of Substantial Completion • If They Gave the Construction Contractors Owner-Builder Certificates • Tax Based on Amounts Paid to Construction Contractors
City Sales Taxation: Cities Do Not Follow the State Structure • Construction Managers • MCTC Purports to Tax CM Fees • “Construction Contractor includes anyone receiving fees for supervision or coordination of the project”
Land Deduction • Most Cities Do Not Provide Land Deduction • Cities That Do – Mostly Smaller Cities – 2 Methods • Cost of Land, or • Fair Market Value of Land • Documented by appraisal, or • 20% safe harbor
THANK YOU Patrick Derdenger Partner, Steptoe & Johnson LLP 201 E. Washington Street, 16th Floor Phoenix, Arizona (602) 257-5209
SIGNIFICANT CASE LAW RELATED TO THE TAXATION OF CONSTRUCTION ACTIVITIES By Pat Derdenger
Duhame v. State Tax Commission, 65 Ariz. 268, 179 P.2d 252 (1947). • Construction contracting income is distinct from retail sales, and taxation of contractors as a separate class is not discriminatory.
Moore v. Smotkin, 79 Ariz. 77, 283 P.2d 1029 (1955). • Landowners subdividing and developing tracts of land are not taxable contractors.
Arizona State Tax Commission v. Staggs Realty Corp., 85 Ariz. 294, 337 P.2d 281 (1959). • Speculative builder was not engaged in taxable contracting. • Definition of a contractor changed. • “This definition shall govern without regard to whether or not such contractor is acting in fulfillment of a contract.”
Combustion Engineering, Inc. v. Arizona State Tax Commission, 91 Ariz. 253, 371 P.2d 879 (1962). • Comparatively insignificant local supervision and labor required to install boiler for APS where boiler was constructed outside the state constitutes interstate commerce and thus not taxable in Arizona.
State Tax Commission v. Parsons-Jurden Corp., 9 Ariz. App. 92, 449 P.2d 626 (1969). • Procurement, consulting, and design and engineering fees are not taxable under the contracting classification.
Ebasco Services Inc. v. Arizona State Tax Commission, 105 Ariz. 94, 459 P.2d 719 (1969). • Design and engineering fees received by a contractor and funds a contractor spends as a purchasing agent are not taxable contracting.
State Tax Commission v. Howard P. Foley Co., 13 Ariz. App. 85, 474 P.2d 444 (1970). • Interstate commerce exemption did not apply to foreign corporation’s’ joint venture to perform one construction contract in the state using materials procured outside the state.
Lusk Corp. v. Arizona State Tax Commission, 462 F.2d 187 (9th Cir. 1972). • Construction of “off-site” improvements to residential lots is taxable contracting.
State Tax Commission v. Holmes & Narver, Inc., 113 Ariz. 165, 548 P.2d 1162 (1976). • As in Ebasco, design and engineering services are not taxable even where those services were not separately stated in the contract; a three part test was used to determine whether otherwise nontaxable services must be included in a construction contract.