When a 17-campus charter-school network has three out-of-state LLCs jointly acquire land and build a new campus, then lease it back for 25 years with a purchase option in years 2-5, does the construction qualify as exempt under § 151.311?

Plain-English summary

A Texas nonprofit charter-school operator running seventeen campuses across central and south central Texas had a new facility built for one campus. Financing was structured through three Idaho limited liability companies acting jointly as "Landlord": they acquired the previously unimproved land and constructed the new facility to the school's specifications under a build-to-suit lease, with the school's plans requiring governmental review and Landlord approval of any changes. The lease ran for a 25-year primary term, with the school able to buy the campus during years two through five.

Applying the two-prong test under § 151.311 — citing this same operator's own recent ruling (STAR Document 201409958L, issued about seven weeks earlier) as the most similar precedent:

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 25-year lease term exceeds the campus's 22-year expected useful life (the school's own figure), so yes.

Both prongs being met, the build-to-suit lease is an exempt § 151.311 contract, letting the landlord group buy construction materials and qualifying services tax-free.

What this means for you

Charter-school networks financing campus construction through multiple co-landlord entities

Multiple entities jointly serving as "Landlord" (here, three Idaho LLCs acquiring the land and building together) doesn't complicate the exemption analysis — the Comptroller applies the same two-prong test regardless of how many entities sit on the landlord side.

Related rulings

This is one of a same-day (November 6, 2014) trio of rulings for the same 17-campus charter-school operator, each covering a different campus. It's distinguished from its two companions by involving Landlord's ACQUISITION of previously unimproved land (rather than a sale-leaseback of land the school already owned) and by having three co-landlord entities rather than one or two.

Common questions

Q: Does having multiple co-landlord entities change the § 151.311 exemption analysis?
A: Not per this ruling — the Comptroller's two-prong test looks at the exempt lessee's status and the lease term, not at how many entities make up the landlord side.

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 25-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
• STAR Document 201409958L (September 19, 2014) — this operator's own prior ruling for a different (renovated) campus, cited as the most recent similar precedent

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201411980L

Original ruling text

November 6, 2014

RE: Private Letter Ruling # 142750488

Dear *****:

We issue this private letter ruling in accordance with Rule 3.1 in response to
your request dated September 23, 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. The agency has addressed
similar facts presented by this inquiry; most recently in another private
letter ruling, STAR Document No. 201409958L issued on September 19, 2014.
However, because guidance on this issue is not expressly provided for in
statute or agency rule, we also issue this private letter ruling.

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 February 12, 2010, 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. COMPANY A presently operates seventeen
campuses in central and south central Texas. One Texas campus, CAMPUS 1, has
had a new facility constructed at *****. In order to finance the
acquisition of the premises and construction of the facility, COMPANY A entered
into a build-to-suit lease [ENDNOTE 1] and option (“Lease”) on March 7, 2014,
between itself and COMPANY B, an Idaho limited liability company, COMPANY C, an
Idaho limited liability company, and COMPANY D, an Idaho limited liability
company, collectively referred to as “Landlord.” Landlord agreed to acquire the
premises and construct the new facility per COMPANY A’s specifications and to
lease CAMPUS 1 to COMPANY A for an initial term of twenty-five (25) years.
Under the Lease, COMPANY A has the option to purchase the campus during the
second through fifth years of the lease.

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 the construction of a new facility on
previously unimproved real property. The Lease requires Landlord to implement
the construction project and make all of the improvements to CAMPUS 1 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 CAMPUS 1
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 twenty-five (25) 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 the
following link, https://www.window.state.tx.us/taxhelp/ and reference Private
Letter Ruling #142750488.

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.”