For three years in a row, the Arizona legislature has enacted significant changes to the Arizona state and local tax on construction activity, known as the “prime contracting” transaction privilege tax (TPT). If anything, this saga is a testament to the complexity of the construction industry and its economic significance at the state and local levels.

The intent throughout all three legislative sessions has been to simplify the industry’s TPT compliance burdens, but true simplification – repeal of the prime contracting TPT altogether – has not yet been politically viable. In 2013, as part of a larger effort to streamline the TPT structure generally, then-Governor Brewer sought to repeal the prime contracting TPT altogether. If successful, TPT revenues relating to construction activity would have been generated at the retail level as contractors would purchase their materials. But the municipalities were very concerned about the shift in revenues from growing jurisdictions where the construction activities are relatively significant, to the more established jurisdictions where the materials suppliers are located. The result was a last-minute political compromise (enacted as part of House Bill 2111) that created a hybrid industry by splitting it into two categories of projects: (1) maintenance, repair and replacement (MRR) projects, with retail TPT on the cost of materials at the point of sale, and (2) all remaining projects affecting real property, with prime contracting TPT on the contract price paid to the contractor by the owner.

Recognizing some of the challenges created by the rushed compromise in 2013, House Bill 2389 was enacted in 2014 as a clean-up measure. In reality, it was a complete re-do, as it entirely repealed the changes made to the prime contracting TPT laws enacted in 2013. Notably, the term “alteration” was added to the treatment of MRR projects, thereby expanding the scope of materials-tax projects to “MRRA” even though the legislative effort had been billed merely as a technical fix to the 2013 legislation. Thus, while the 2014 legislation did include some clean-up items, it added to the controversy without providing answers to significant open issues directly impeding the industry’s ability to comply with the tax laws directly impacting it. The industry also attempted to convince Governor Brewer to call a special legislative session last fall to postpone the effective date of the prime contracting TPT changes, but that effort was flatly rejected by the Governor’s office.

With the January 1, 2015 effective date for the 2014 legislative changes looming over the industry and attempts to postpone implementation of House Bill 2389, a comprehensive group of stakeholders started working to craft the many missing pieces to the new hybrid prime contracting TPT framework. The result of these efforts is Senate Bill 1446, which was signed by Governor Ducey on February 24, 2015 with an emergency clause and retroactive application to January 1, 2015. This third consecutive legislative effort brings about much-needed clarification for the industry.^[1] That said, while this new legislation has filled in many of the gaps created by the prior legislative efforts, it is really just a stop-gap measure to prevent total anarchy within the industry until the complete repeal of prime contracting TPT can become a political reality. To be sure, Senate Bill 1446 includes the following statement of intent: “to clarify and simplify the transaction privilege tax reform measures enacted [by House Bill 2389] until such time as the prime contracting transaction privilege tax classification can be repealed.”

Don’t forget to contact your legislators about the need to complete this reform effort as soon as possible – the intended repeal of prime contracting TPT may not happen without your input.

A summary of Senate Bill 1446’s key provisions is provided below, along with insights about some forthcoming changes to administrative procedures necessary to fully implement these recent changes to the law.

1. Contractors Maintaining TPT License Can Once Again Purchase All Project Materials Tax-Exempt with Blanket Form 5000
   • Contractors maintaining their TPT license can purchase all materials tax-exempt, as they always did before 2015, for both:
     • Prime contracting TPT projects
     • MRRA projects
   • Vendors can once again rely on these contractors’ blanket Form 5000 without concern about the type of project
   • Avoids impractical “dual inventory” problem for contractors and uncertainty for vendors created by previously enacted bills
   • Exception: Contractors that have canceled their TPT license must pay tax on materials when purchased, unless hired by GC that has issued a Form 5009L for a prime contracting project
   • Note: Until Form 5000 is updated by the Arizona Department of Revenue (ADOR) to specifically cover the purchase of MRRA materials, contractors may wish to check box 19 and write “42-5061(A)(27)(a)” in the space provided – this refers to the provision in Arizona Revised Statutes authorizing these purchases to be tax-free
   • Reporting and Payment for MRRA Materials: For all MRRA materials purchased tax-exempt with a Form 5000, the contractor must pay an amount equal to retail TPT based on:
     • The cost of materials
     • The date the materials are incorporated into the project and
     • The location of the project
2. GCs Can Once Again Issue Blanket Form 5005 to All Subs for All Projects
   • GC can once again issue a blanket Form 5005 to subs, as they always did before 2015, for both:
     • Prime contracting TPT projects
     • MRRA projects
   • Allows subs to issue blanket Form 5000 for tax-exempt purchase of materials without concern for:
     • Risk of paying tax on materials without reimbursement from GC
     • Uncertainty whether it’s reasonable to rely on GC’s determination of MRRA vs. prime contracting
     • Note: Without receiving a Form 5005, the sub will owe tax on MRRA materials purchased tax-exempt by the sub as the sub uses the materials, based on the project location, as noted in the last item in Section 1 above
   • Incentivizes GC to issue Form 5005 to assume tax liability for materials used by subs in an MRRA project by providing an offset opportunity to GC
     • If GC reports and pays the MRRA materials tax liability for the subs, then…
     • GC gets to use the amount of tax liability paid as an offset against prime contracting TPT, if the GC is audited and is found to have mis-classified the project as MRRA
   • Exception/Limitation: Form 5005 is effective only in limited circumstances for a sub that has canceled its TPT license, as follows:
     • Projects for which the sub receives a Form 5009L for tax-exempt materials purchases – the Form 5005 protects the sub from tax on materials if ADOR later determines that the project was an MRRA project and not prime contracting
     • Projects that are prime contracting, though the sub will pay tax on any materials purchased for the project without obtaining and using a Form 5009L, and the GC will not get an offset for tax
     • Form 5005 can relieve sub from tax burden for materials purchased tax-exempt before canceling TPT license, though the sub will need to provide the GC with the sub’s cost of materials
   • Note: ADOR has not finalized a revised version of the Form 5005 – GCs wishing to issue Form 5005 to apply to MRRA projects before the revised Form 5005 is updated should consult their tax advisor
3. Change Orders
   • If the scope of work of a change order directly relates to the scope of work of the original contract, then the tax treatment of the change order follows the original contract
   • If the scope of work of a change order does not directly relate to the original contract, the tax treatment of the change order will depend solely on the scope of work of the change order
4. Definition of Alteration
   • The scope of alteration projects has been narrowed by creating thresholds for determining the upper limit of an alteration project:
   • Residential Property: Tax on cost of materials, if the contract price for the work is 25 percent or less of the property’s full cash value for property tax purposes (31.25 percent, with 25 percent cushion described below)
   • Commercial Property: Tax on cost of materials, if all of the following are true:
     • Contract amount is $750,000 or less ($937,500, with 25 percent cushion) AND
     • Scope of work directly relates to 40 percent or less of existing square footage (50 percent, with 25 percent cushion) AND
     • Scope of work includes an expansion of existing square footage that is 10 percent or less of pre-existing square footage (12.5 percent, with 25 percent cushion)
   • 25 Percent Cushion for All Property: If project qualifies for alteration treatment at time of contract, it will continue to qualify even if the threshold is blown by no more than 25 percent (cost overruns, change orders, etc.)
   • Specifically excludes maintenance, repair and replacement, which have no thresholds (no cost limits or scope of work limits)
   • The residential property valuation should be determinable very quickly by using the County Assessors’ websites to pull the relevant data
5. Clarifies Definition of Prime Contracting Taxable “Modification”
   • Deletes terms within the definition that caused confusion (“improvement” and “movement”)
   • Specifically excludes MRRA activities (MRRA trumps prime contracting)
   • Specifically excludes mobilization and demobilization (erection of temporary facilities, fencing, etc.)
6. Provides Consistent Treatment for MRRA Projects with Tax-Exempt Parties or for Tax-Exempt Property
   • Materials purchased by any person (whether holding a TPT license or not) for their use in an MRRA project for certain nonprofit organizations, such as qualifying hospitals and qualifying health care organizations
   • Materials purchased by any person (whether holding a TPT license or not) for their use in on-reservation MRRA projects for tribal government or enrolled members of the tribe
   • Certain machinery, equipment and other tangible personal property purchased by any person (whether TPT licensed or not) that their owner will use in certain business activities, such as manufacturing, mining and electric generation
   • Note: ADOR is currently considering the form of exemption certificate for tax-free purchases of these items by a non-TPT licensed person
7. Excludes Roadway and other Surface/Subsurface Projects from MRRA Treatment
   • Maintains prime contracting tax treatment for public works projects without vertical construction for:
     • Arizona Department of Transportation (ADOT)
     • Cities
     • Counties
     • Certain special taxing districts addressing surface/subsurface needs
   • Does not apply to state projects other than ADOT
   • Does not apply to most special taxing districts – those not created to address surface/subsurface needs
   • Does not apply to contracts with the Feds
8. Persons Canceling Prime Contracting TPT License Are Protected
   • Issuance of building permit no longer conditioned on holding TPT license
   • Materials purchased tax-exempt that are on hand when TPT license canceled will be taxed as used, sold or discarded
     • Alternative: If TPT license canceled before May 1, 2015, the value of materials on hand can be calculated when TPT license canceled and associated tax spread equally over 12 months based on business location
     • First $10,000 Exempt: If TPT license canceled before May 1, 2015, no tax due on the first $10,000 of materials on hand
   • Reasonable estimation of value of materials on hand is acceptable if TPT license is canceled before May 1, 2015
9. Safe Harbor to Protect Industry During Transition Period
   • Protection provided for good-faith bids/contracts entered into before May 1, 2015, throughout the entire term of the contract
   • Prime contracting treatment permitted for all projects started before May 1, 2015, regardless of when completed

Notes:

^[1] A big “thank you” is owed to Mark Minter and the Board of Directors of the Arizona Builders’ Alliance for taking the lead with drafting, negotiating and seeking legislative approval of Senate Bill 1446, which ABA pursued for the benefit of the construction industry as a whole.