When a landlord renovates a former retail building (a furniture store) into a charter-school campus and leases it back for 30 years, does that renovation contract qualify as exempt under Tax Code § 151.311 -- the same as new ground-up construction?

Plain-English summary

This appears to be the origin ruling for a large recurring cluster of Texas charter-school build-to-suit lease rulings found throughout this corpus — the Comptroller expressly notes "it does not appear that the agency previously addressed the precise facts presented by this inquiry," and at least three other same-year rulings for the same charter-school operator's additional campuses cite this ruling by document number as their most recent precedent.

A Texas nonprofit charter-school operator was relocating a campus from one city to another, opening in fall 2014. Unlike most of the later rulings in this cluster (which involve ground-up new construction), this one involves renovating an existing building — specifically, converting a former furniture store into an educational facility. The landlord agreed to renovate the property to the school's specifications and lease it back for a 30-year term, with the parties' stated intent that the school would exercise its purchase option during years three, four, or five of the lease.

The Comptroller applied the two-prong test from Comptroller's Decision No. 28,391 (1993) — apparently for the first time to this specific renovation/relocation fact pattern:

1. Is the lessee a qualified exempt entity? Yes — the school is exempt under § 151.310.
2. Is the lease term long enough relative to the improvement's useful life? The 30-year lease term exceeds the school's own asserted 22-year useful-life figure (from the state's capital-asset depreciation schedule for buildings), so yes.

Because both prongs are met, the renovation contract is an exempt § 151.311 contract — confirming that the doctrine applies equally to renovating an existing building as to new ground-up construction, as long as the lease-term-vs-useful-life math works out.

What this means for you

Charter schools relocating into renovated (not newly built) facilities

This ruling establishes that converting an existing commercial building (here, a former furniture store) into a school campus gets the same § 151.311 treatment as new construction — the two-prong test doesn't require ground-up building.

Anyone researching the charter-school build-to-suit lease doctrine cluster

This is the earliest-dated ruling in this corpus applying the doctrine to a build-to-suit charter-school lease and is the ruling several later 2014-2015 rulings for the same operator's other campuses cite as their most recent precedent — treat it as the anchor point for this recurring fact pattern.

Common questions

Q: Does renovating an existing building into a school campus qualify for the § 151.311 exemption the same way new construction does?
A: Yes, per this ruling — the Comptroller applied the identical two-prong test to a renovation/conversion project as it does to ground-up new construction.

Q: What lease term is long enough to satisfy the "primary use and benefit" test?
A: There's no fixed bright line — per this ruling, a 30-year lease against a 22-year useful life was sufficient.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.311 (Taxable Items Incorporated Into or Used for Improvement of Realty of an Exempt Entity)
• Tex. Tax Code § 151.310 (Religious, Educational, and Public Service Organizations)
• 34 Tex. Admin. Code Rule 3.291(a)(5) (Contractors — exempt-contract definition)
• 34 Tex. Admin. Code Rule 3.1; Rule 3.10 (Taxpayer Bill of Rights — detrimental reliance)

Cited prior guidance:

• Comptroller's Decision No. 28,391 (1993) — source of the two-prong "primary use and benefit" test
• Comptroller's Decision No. 31,505 (1994) — contrasting failure: 5-year lease term too short relative to improvements' useful life

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201409958L

Original ruling text

September 19, 2014

RE: Private Letter Ruling # 141600834

Dear *****:

We issue this private letter ruling in accordance with Rule 3.1 in response to
your request dated June 5, 2014. Detrimental reliance is provided in
accordance with Rule 3.10, the Taxpayer Bill of Rights.

You requested guidance on the comptroller’s interpretation of the exemption in
Tax Code Section 151.311 for tangible personal property and taxable services
purchased for use in the performance of a contract to improve realty for an
organization exempt under Tax Code Section 151.310. It does not appear that the
agency previously addressed the precise facts presented by this inquiry, though
it has addressed similar situations.

FACTS PRESENTED

COMPANY A is a Texas non-profit corporation granted tax-exempt status by the
Internal Revenue Service (“IRS”) pursuant to Section 501(c)(3) of the Internal
Revenue Code. On June 11, 2004, COMPANY A met the qualifications for exemption
from Texas Sales or Use tax outlined in Rule 3.322 relating to exempt entities.

COMPANY A received a charter from the Texas Education Agency (“TEA”) to operate
an open-enrollment charter school. One of its campuses is relocating from CITY
A, Texas to CITY B, Texas and is scheduled to open in the fall of 2014.
COMPANY A entered into a build-to-suit lease and purchase option (“Lease”)
[ENDNOTE 1] with COMPANY B (“Landlord”), where Landlord agreed to renovate the
property per COMPANY A’s specifications and to lease the CITY B campus to
COMPANY A for an initial term of thirty (30) years. Under the Lease, COMPANY A
has the option to purchase the campus during the third, fourth, and fifth year
of the Lease. Per the Lease, it is the intent of the parties that COMPANY A
will exercise its option.

The Lease specifies that all structural and equipment specifications are
subject to governmental review and approval. As set out in Article 5 of the
Lease, all plans are subject to COMPANY A’s approval and any changes to the
plans shall be adopted by the Landlord unless the changes will not be approved
by the applicable governmental agencies.

The site of the new campus will require extensive renovation and improvement to
convert a former furniture store into an educational facility. The Lease
requires Landlord to do the renovation and improvement to the CITY B campus
with the cost incorporated into the Lease and paid for by COMPANY A either in
monthly payments or by exercising its option to purchase. The campus is being
improved for, leased by, and used exclusively by COMPANY A as an
open-enrollment center, which, under Texas Education Code Section 12.105 is a
part of the Texas public school system.

COMPANY A receives its funding from the State of Texas (“State) through a
funding system known as the Foundation School Program as authorized by Texas
Education Code Section 12.106. COMPANY A used state funds to lease the campus
and its leasehold is pursuant to Texas Education Code Section 12.128, which
states that property, whether purchased or leased, is considered public
property for all purposes allowed by state law and is deemed to be state
property held in trust by the charter holder for the benefit of the students
and may be used only for a purpose for which a school district may use school
district property.

The charter holder—in this case COMPANY A—holds the state-owned property in
trust for the benefit of the attending students. If COMPANY A closes or ceases
to exist, the Texas Commissioner of Education (on behalf of the State) takes
immediate possession and assumes control over the property, including leasehold
rights under Texas Education Code Section 12.128(c)(1). The commissioner then
is charged with disposition of the property under Texas Education Code Section
12.128(c)(2).

RULING AND ANALYSIS

Our restatement of the ruling you requested is shown below, followed by our
response and analysis.

Is the build-to-suit lease at issue an exempt contract as contemplated by Texas
Tax Code Section 151.311, thereby allowing the tax-free purchase of taxable
items by the taxable entity for incorporation into property leased by the
tax-exempt entity?

RESPONSE: This question is not addressed by statute or rule and the response
provided will be memorialized in a future amendment to Rule 3.291
(Contractors). The build-to-suit lease at issue is an exempt contract as
contemplated by Texas Tax Code Section 151.311 because it is a contract to
improve real property for the primary use and benefit of an exempt entity.
Tangible personal property or taxable services meeting the requirements
expressed in Texas Tax Code Section 151.311 are exempt from Texas sales or use
tax.

Texas Tax Code Section 151.311 provides, in part, that the purchase of tangible
personal property for use in the performance of a contract for an improvement
to realty for an organization exempted under Sections 151.309 or 151.310 is
exempt if the tangible personal property is incorporated into realty in the
performance of the contract. Tax Code Section 151.311 further provides that the
purchase of a taxable service for use in the performance of a contract for an
improvement to realty performed for such an organization is exempt if the
service is performed at the job site and if the contract expressly requires the
specific service to be provided or purchased by the person performing the
contract or the service is integral to the performance of the contract.

Rule 3.291(a)(5) defines an exempt contract to include a contract for the
improvement of real property with an entity that is exempt under Section
151.309 or 151.310. An example of an exempt contract is a contract with a
non-exempt entity to improve real property for the primary use and benefit of
an organization exempted under Section 151.309 or 151.310. See Rule
3.291(a)(5).

Tax Code Section 151.311 does not require that the real property be owned by
the exempt organization. For situations involving an exempt lessee and a
non-exempt lessor, the agency developed a two-prong test to determine whether
improvements to real property are for the primary use and benefit of the exempt
entity. The test was first set forth in COMPTROLLER DECISION NO. 28,391
(1993).

First, the lessee must qualify for exempt status under Section 151.309 or
151.310. Based on the facts presented, COMPANY A is a qualified tax-exempt
entity under Section 151.310; therefore, it meets the first prong of the test.

Second, the term of the lease must be sufficiently long in relationship to the
life of the improvements themselves. This test has been consistently applied
by the comptroller. See for example, COMPTROLLER DECISION NO. 31,505 (1994),
which found extensive renovations and improvements failed to meet the second
prong of the test because the life of the improvements exceeded the term of the
lease which was only five (5) years.

Determining the life of the real property improvements for the second prong of
the test is a fact issue, and the agency has not developed any standard for
when the test is met. COMPANY A references Appendix A “Class Codes” of the
State Property Accounting Process User’s Guide for depreciation of state
capital assets that sets 264 months (22 years) as the useful life for buildings
and building improvements. The thirty (30) year term of the Lease is
sufficiently long to ensure that COMPANY A will have the primary use and
benefit of the improvements under the Lease; therefore, the second part of the
test is met and the Lease is exempt under Section 151.311.

If you have questions about this private letter ruling, please email us at
https://www.window.state.tx.us/taxhelp/ and reference Private Letter Ruling

141600834.

Sincerely,

Tax Policy Division

ENDNOTES

1. The Association of Corporate Counsel defines a build-to-suit (or
   design-build) lease to be “essentially a landlord/developer’s agreement to
   construct a purpose built building, usually for a single tenant. The landlord
   will typically own or ground lease the lands (and once constructed, the
   building) and has the option of re-letting the building to a new tenant upon
   the expiry of the term of the build-to-suit lease to the original tenant.
   Build-to-suit leases typically are for a longer term than a normal lease in
   order to permit the landlord to recoup its investment over the duration of the
   lease term.”