As noted in my last blog, Arizona’s sales tax law (officially, transaction privilege tax, or TPT) changed significantly with respect to construction contractors as of January 1, 2015.
Activities within the “prime contracting” classification are still taxed upon 65 percent of the gross proceeds derived from each job, and contractors working within that classification are still considered retailers rather than consumers of materials or fixtures that they install. However, the new law removes a substantial number of activities from the “prime contracting” classification and reclassifies them as exempt services.
The reclassified activities are maintenance, repairs, replacements, and alterations to real property. Contractors performing these functions are regarded as consumers of any materials they install and must either pay sales tax when they buy the materials or report use tax on the materials costs for the period of purchase. Once the contractors have paid sales or use tax on their materials costs, no further tax will be due, and they should not bill tax to their customers.
The activity that remains within the prime contracting classification is called “modification,” which encompasses real property construction, improvement, movement (including removal), wreckage or demolition. Modification does not include the replacement of an existing unit with a new unit, even if the new unit is an upgraded version. It also excludes activities that cause physical changes to real property that do not result in a change in the identity of the real property.
Under the new criteria, many jobs will include a mixture of modifications (subject to tax on 65% of the gross proceeds) and maintenance, repairs, replacements, and/or alterations (exempt services, where the contractor only pays tax on the costs of installed materials). When a project includes such a mixture, a “de minimis” test will apply: if the amount attributable to modification is less than 15% of receipts from the total contract, the entire contract will be treated as an exempt service. If the modifications comprise more than 15% of the contract, the entire contract will fall within the prime contracting classification and thus be taxable on 65% of the proceeds.
In determining the appropriate tax status, each change order is treated as a separate contract rather than being aggregated with the original contract. Thus, change orders have no effect on the taxability of the original contract, and vice versa.
Nontaxable maintenance and repair activities are relatively easy to identify: maintenance is simply upkeep (such as re-staining a wood deck or repainting a building), and a repair is the restoration of partly or totally nonfunctional real property to fully operational status. Distinguishing replacements and alterations from modifications can be much more difficult, so here are a few examples.
- Existing construction is demolished and some earth is removed as part of a nontaxable alteration. The demolition and earth removal are taxable modifications, and if they represent more than 15% of the total contract proceeds, 65% of the entire contract is subject to sales tax (TPT). If the demolition and removal are less than 15% of the total contract proceeds, the entire contract will be regarded as an exempt service. The contractor then will pay tax on the costs of the installed materials, and none of the contract proceeds will be taxable.
- A contractor performs a kitchen remodel that includes replacement of the existing appliances and flooring as well as construction of a new island that did not exist previously. The appliances and flooring are nontaxable replacements, and the construction of the island is a nontaxable alteration (because it does not change the identity of the realty). The contractor pays tax on the costs of the installed materials, and no part of the contract proceeds will be taxable.
- A business hires a contractor to install a pump system in a building where there was no previous system. Since the identity of the realty was not changed by the addition of the pump system, the contract is a nontaxable alteration.
- A contractor builds new concrete ramps and sidewalks where none existed before. The contractor also removes and replaces existing concrete sidewalks, as part of the same contract. The construction of new ramps and sidewalks and the demolition and removal of the existing concrete are taxable modifications. The replacement of the existing sidewalks, however, is a nontaxable replacement activity. Since all of these activities occurred as part of the same contract, the 15% de minimis test must be applied to determine whether the entire contract will be subject to TPT on the contract proceeds (as a modification) or the entire contract will treated as an exempt replacement (taxable only on the contractor’s materials costs).
- A homeowner hires a contractor to build a free-standing outdoor kitchen in her back yard. The kitchen will not be attached to an existing structure (such as a patio or existing concrete slab) and will be installed in a spot where only grass currently exists. This contract will be regarded as a modification subject to TPT on the contract proceeds.
- A contractor is hired to convert a 20,000 square foot warehouse into an indoor go-cart racing facility. In addition to reconfiguring the building’s interior to accommodate a racetrack and other amenities, the conversion will enlarge the building to 30,000 feet, which will expand it to cover adjacent raw land and a portion of an existing parking lot. Because all activities are performed on existing improved realty, the conversion will generally consist of exempt alteration activities that are exempt from prime contracting TPT. Any demolition and removal activities will be regarded as modification, however, so the contract will be subject to the 15% de minimis test.
The latter example particularly illustrates the confusion created by the Arizona legislature through its use of misleading terminology. In ordinary (and correct) English usage, the words “alteration” and “modification” are pretty much synonymous; in the new state sales tax legalese, the terms have completely different meanings. Therefore, when attempting to determination whether you’ll be creating an Arizona construction “modification,” you cannot rely on your understanding of the English language. Instead, you’ll need to compare the components of your project to the specific activities included within the legislature’s new definition.
Arizona’s Transaction Privilege Tax Notice TPN 14-1 (referenced in my previous blog) provides several additional examples. If you’re still in doubt about a specific project, your safest solution is to contact the Arizona Department of Revenue for a written opinion.
Other recent “Construction / Contractor Tax” posts by Dan Davis:
- Arizona's New Contractor Tax Rules: Watch for Misleading Terminology!
- Contractors: Watch Out for Arizona Tax Changes
- Construction Contracts with Exempt Entities (State Breakdown)
- Supporting Your Exemptions: Acceptable Documentation
- Common Construction Exclusions and Exemptions