When a building owner leases space to a tax-exempt governmental entity and has remodel work done on that space, who is responsible for sales tax — the building owner (lessor) or the government tenant (lessee)?

Subject

Governmental Entities/Exempt Org — Leases Realty To Non-Exempt Lessor Who Makes Improvements To Realty Prior To Occupancy — Two Prong Test To Determine Primary Use And Benefit

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9312L1283D02

Plain-English Summary

A building owner (the letter refers to the contractor as "ABC Company") had cabinets and plumbing remodeled in leased space occupied by the Comptroller of the Currency, a federal government tenant. Sales tax was charged on the remodel invoice, collected, and paid to the state. The Comptroller of the Currency then told the building owner it was tax-exempt and shouldn't have paid sales tax, so the building owner asked ABC Company for a refund of the tax — which ABC Company gave. The building owner then asked the Comptroller's office to clarify how this should work for future jobs.

The Comptroller's response set out a two-prong test to figure out who actually gets the "primary use and benefit" of real property improvements when a taxable-status lessor leases to a tax-exempt lessee:

1. The lessee must qualify for exempt status under Section 151.309 or Section 151.310, and
2. The lease must be long-term, in reasonable relationship to the useful life of the improvements themselves.

If both prongs point to the lessee as the primary beneficiary, the remodel work is exempt from sales tax. If instead the lessor (the building owner) is found to be the primary beneficiary of the improvements, the work is taxable — regardless of who occupies the space day to day. The letter closes by noting this opinion is based on the specific facts presented, and that different facts, though similar, could lead to a different answer.

What This Means For You

If you're a building owner leasing to a tax-exempt government or nonprofit tenant: Don't assume that remodel or improvement work automatically becomes tax-exempt just because your tenant is exempt. The tenant's exempt status (prong one) is necessary but not sufficient — you also need a long-term lease that reasonably matches the useful life of the improvements (prong two) before the work can be treated as exempt.

If you're a contractor billing for remodel work on leased space: Charging sales tax to be safe, as ABC Company did here, is a defensible default. Whether tax should have been charged at all turns on facts the contractor may not have (lease length, exempt status documentation) — those are the building owner's and tenant's facts to establish, not just an assumption based on who occupies the space.

If you're relying on a tenant's verbal claim of exemption: This letter shows that a tenant telling the landlord "we're tax exempt and don't pay sales tax" isn't, by itself, the end of the analysis. Exempt status under Section 151.309 or 151.310 is only prong one; the improvements must also primarily benefit that exempt tenant under a long-term lease before the work escapes tax.

Scope note: This letter does not state which party — lessor or lessee — actually came out as the primary beneficiary in the specific ABC Company/Comptroller of the Currency facts described; it only supplies the test to apply. It also does not specify what "long-term" means in years, only that the lease term should be "in reasonable relationship to the life of the improvements themselves."

Q&A

Q: Does a government tenant's tax-exempt status automatically make remodel work on its leased space exempt from sales tax?
A: No. The letter's two-prong test requires that the lessee qualify for exempt status under Section 151.309 or 151.310 (prong one), and that the lease be long-term relative to the life of the improvements (prong two). Exempt status alone is not enough.

Q: Who is responsible for sales tax on improvements to leased space — the lessor or the lessee?
A: It depends on who has the primary use and benefit of the improvements under the two-prong test. If the lessee is the primary beneficiary, the work is exempt; if the lessor is, the work is taxable.

Q: In the facts described in this letter, was the remodel work ultimately taxable or exempt?
A: The letter does not say. It sets out the two-prong test to be applied but does not state the outcome for the specific cabinet and plumbing remodel work described in the facts.

Q: What does "long-term" mean for the second prong of the test?
A: The letter doesn't give a specific number of years. It only says the lease "should be long-term (in reasonable relationship to the life of the improvements themselves)."

Original ruling text

December 29, 1993

Dear *****:

This is in response to your letter dated December 20, 1993, regarding
sales tax as it applies to remodel work to a nonresidential property that is
leased to a governmental entity.

FACTS: ABC Company recently modified cabinets and plumbing in lease space
that is occupied by the Comptroller of the Currency. Sales tax was charged on
the invoice to the building owner. The tax was collected and paid to the
state.

Evidently this cost is passed on to the Comptroller of the Currency by
the building owner. The Comptroller of the Currency has told the building
owner they are tax exempt and do not pay sales tax. In turn, building owner
has requested sales tax be refunded to them from ABC Company (and - we have
done so).

QUESTION: Would you clarify this issue for future work?

RESPONSE: It must first be determined which party is the benefactor of
the improvements (lessor or lessee). A two prong test has been devised in
order to determine primary use and benefit to be used in the fact situation
presented in your letter. The test is as follows:

1. The lessee must qualify for exempt status under either Section 151.309
   or Section 151.310; and

2. The lease should be long-term (in reasonable relationship to the life
   of the improvements themselves).

If it is determined that the lessee derives the primary use and benefit
(under the two prong test), the work will be exempt. If the lessor receives the
primary use and benefit, the work is taxable.

This opinion is based on the facts presented. Different facts, though
similar, might lead to different answers. If you have any questions or need
moreinformation, please write or call me toll free at 1-800-531-5441, extension
5-0330, or 512-475-0330.

Sincerely,

Bettie Peterson
Tax Administration Division

NOTE: Previous Accession Number 9402005L.2 and/or 9402005L