When a city raises its local sales tax rate mid-project, does a construction contract signed before the increase still shield materials and subcontracts from the higher rate?

Subject

Local Tax — Prior Contract Exemption — Increased Local Tax Rate

Plain-English summary

A taxpayer's client signed a separated new-construction contract with a general contractor in October 1995 to build a building in Sherman, Texas. The contract laid out all aspects of the construction and defined specifically the work to be performed. As the project moved forward, the general contractor entered into various contracts with subcontractors for different phases, and purchased materials as needed throughout the project.

After the contract was signed, the city of Sherman raised its local sales tax rate twice -- once effective April 1, 1996, and again effective October 1, 1996 -- bringing the total local rate to 1 3/4%. The taxpayer asked whether the "prior contract exemption" would shield the general contractor's material purchases, and the subcontracts, from these rate increases, and whether a change order would also qualify.

The Comptroller answered by pointing to Tax Code Sec. 321.2091, the transition exemption for additional municipal sales and use tax. That statute exempts purchases used to perform a written contract entered into before a municipal tax adoption or increase takes effect, as long as the contract is not subject to change or modification because of the tax (or, alternatively, purchases made under a bid submitted before the increase that can't be withdrawn or modified because of the tax). The exemption only lasts for three years from the date the tax increase takes effect.

Applying that rule: the general contractor's material purchases qualify for the exemption if the contract meets those requirements and doesn't contain a tax pass-through clause. The subcontracts between the general contractor and its subcontractors also qualify if they meet the same criteria. However, change orders that add to the contract -- more coverage, taxable items, labor, or services -- are not covered by the prior contract exemption, though the original contract can keep its own exemption if the change order can be separately identified from it.

The letter notes this opinion is based on the facts presented, and that other, similar facts could produce a different result.

What this means for you

General contractors on projects spanning a local tax rate increase

If you signed a written construction contract before a city raised (or adopted) its local sales tax, your material purchases for that project may be exempt from the increase -- but only if the contract can't be changed because of the tax and has no tax pass-through clause. The exemption is time-limited: it stops applying three years after the rate increase takes effect.

Subcontractors working under a general contractor's prior contract

Subcontracts entered into under the umbrella of a qualifying prior contract can also get the exemption, if they meet the same no-tax-modification and no-pass-through criteria as the general contract.

Anyone issuing or receiving change orders on an exempt contract

Don't assume a change order rides along on the original contract's prior-contract exemption. Under this ruling, change orders that add coverage, items, labor, or services generally do not qualify for the exemption -- though the original contract can retain its own exemption if the change order is kept separately identifiable from it.

Common questions

Q: Does a contract signed before a local tax rate increase protect a contractor from the higher rate?
A: Yes, according to this ruling, if the contract was entered into before the tax increase took effect, is not subject to change or modification because of the tax, and has no tax pass-through clause.

Q: Do subcontracts under the general contract also qualify?
A: Yes -- the ruling states the contracts between the general contractor and the subcontractors will qualify for the prior contract exemption if they meet the same criteria noted for the general contract.

Q: Does a change order qualify for the prior contract exemption?
A: Generally no. Change orders that add to the contract -- increases in coverage, taxable items, labor, or services -- are not included in the prior contract exemption, though the original (unchanged) part of the contract may keep its exemption if the change order can be separately identified.

Q: How long does the prior contract exemption last?
A: Per Sec. 321.2091(b), the exemption has no effect after three years from the date the tax adoption or increase takes effect in the municipality.

Q: What tax rate was involved in this ruling?
A: The city of Sherman, Texas enacted two incremental local tax rate increases, effective April 1, 1996 and October 1, 1996, bringing the total local tax rate to 1 3/4%.

Citations and references

Statutes and rules:

• Tex. Tax Code, Chapter 321 (Municipal Sales and Use Tax Act), Sec. 321.2091, Transition Exemption: Additional Municipal Sales and Use Tax
• 34 Tex. Admin. Code Rule 3.319, Prior Contracts
• 34 Tex. Admin. Code Rule 3.372, Prior contract exemptions (local)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9610049L

Original ruling text

October 29, 1996

**Via FAX **
Dear **:
This is in response to your request for a ruling concerning prior contract
exemptions. The following facts pertain to your question:
Your client entered into a separated new construction contract with a general
contractor to construct a building. This contract laid out all aspects of the
construction and defined specifically the work to be performed.
The contract was signed in October 1995.
As the project progressed, the general contractor entered into various
contracts with the subcontractors to perform the various phases of the
construction as the work was needed.
The general contract purchased materials as needed during the project.
The property is located in Sherman, Texas.
The city of Sherman has enacted two incremental tax rate increase, one
effective April 1, 1996, and the other effective October 1, 1996 (total
current local tax rate 1 3/4%).
Questions: Considering the above facts, will the prior contract exemption
apply to the local tax increases for the general contractor's purchase of
materials? In addition will the prior contract exempt apply to the local tax
increases of the contracts between the general contractor and the
subcontractors? Will a change order also qualify for the prior contract
exemption?
Response: Chapter 321. Municipal Sales and Use Tax Act Sec. 321.2091,
Transition Exemption: Additional Municipal Sales and Use Tax, provides:
(a) The receipts from the sale, use, or rental of and the storage, use or
consumption of taxable items in this state are exempt from the adoption or
increase of the additional municipal sales and use tax if the items are used:
(1) for the performance of a written contract entered into before the date
the adoption or increase of the additional tax takes effect in the
municipality, if the contract is not subject to change or modification by
reason of the tax; or
(2) pursuant to an obligation of a bid or bids submitted prior to the date
the adoption or increase of the additional tax takes effect in the
municipality, if the bid or bids may not be withdrawn, modified, or changed by
reason of the tax.
(b) The exemptions provided by this section have no effect after three
years from the date the adoption or increase of the additional tax takes effect
in the municipality.
In order for general contractor's purchases of materials to be exempted from
the rate increases the contract must meet the above requirements and not
contain a tax pass-through clause. See also Rule 3.319, Prior Contracts and
Local Rule 3.372 - Prior contract exemptions, sent under separate cover.
The contracts between the general contractor and the subcontractors will
qualify for the prior contract exemption if they meet the criteria noted above.
Change orders that constitute additions to the contract or increases in
coverage or taxable items, labor or services added to the contract are not
included in the prior contract exemption. The original part of the contract
may still retain its prior contract exemption if the change orders can be
separately identified. See 3.319(c)(2).
This opinion is based on the facts presented. Other facts though similar may
provide a different result.
You may call me toll-free at 1-800-531-5441, extension 3-4502. The direct line
is 512/463-4502. You may also write to Tax Policy Division, Comptroller of
Public Accounts. My Internet address is: [email protected].
Sincerely,Gilbert Zamora
Tax Policy Division