By now, many within the construction industry in Arizona are aware that significant effort has been made over the past few years to reform Arizona’s state and local transaction privilege tax (TPT) system, particularly as it relates to the prime contracting TPT.^[1] This reform effort has traveled many roads, having started with the 2012 Governor’s TPT Simplification Task Force, then in the 2013 legislative session with House Bill 2111 (which replaced House Bill 2657), then in the 2014 legislative session with House Bill 2389 and most recently with the Arizona Department of Revenue’s Transaction Privilege Tax Notice, TPN 14-1. Although the changes to prime contracting TPT will take effect on January 1, 2015, this reform project is not yet complete. Below, we highlight a few significant changes to prime contracting TPT that will take effect on January 1, and then we outline key aspects of the industry’s 2015 legislative effort to simplify and streamline the current structure in the 2015 legislative session. For a comprehensive review of the new law as it will take effect on January 1, be sure to check out TPN 14-1.

Current Version of Prime Contracting TPT Reform Taking Effect on January 1, 2015

Big Win for Service Contractors Performing Only MRRA Projects

After the attempted complete repeal of prime contracting TPT failed in early 2013, the Governor’s office wanted to do whatever it took to prevent businesses that focus on making service calls – those that typically perform only maintenance, repair, replacement or alteration (MRRA) activities – from having to comply with tax laws that are difficult for technicians handling high volumes of service calls to administer from their trucks as they work across multiple local taxing jurisdictions with different rules and tax rates. For those who squarely fall within this “service contractor” category, the TPT reform effort is a big win.

Rather than being forced to track the varying tax rates and the varying tax laws from one jurisdiction to another, these service contractors can cancel their state and city prime contracting TPT licenses and avoid reporting and paying tax to multiple jurisdictions each month. This means that these service contractors will need to pay tax on all materials they purchase, including paying use tax on any materials they purchase from retailers located outside of Arizona who don’t collect Arizona tax on the purchases. For those businesses falling into this category that will have materials on hand that were purchased tax-free, you’ll want to review Question and Answer #8 in TPN 14-1.

The Jury is Out for “Hybrid” Contractors Engaging in Both Modification Activities Subject to Prime Contracting TPT and MRRA Activities with Materials Subject to Retail TPT

Businesses that will perform both taxable “modification” activities – those involving “construction, improvement, movement, wreckage or demolition” of real property or improvements to real property – and MRRA activities that will no longer be subject to prime contracting TPT, have come to be known as the “hybrid” contractors. These contractors are faced with the uncertainty of determining whether a particular project will be treated as a prime contracting TPT project or whether it will be treated as an MRRA project for which tax must be paid on the materials at the time of purchase. This can be especially troublesome when it comes to bidding a project that has characteristics of both modification activities and MRRA activities. There are various scenarios in TPN 14-1 that certainly help to unravel the mystery, but the puzzle is certainly not solved.

Another impact of these reforms on the hybrid contractors involves the treatment of materials on hand as of January 1 (transition inventory) and the handling of ongoing materials purchases. For the transition inventory, contractors need to identify those materials on hand as of January 1. Then, as materials are used for an MRRA project, retail TPT must be reported and paid on the purchase price of the materials, with the tax on such materials to be sourced to the jurisdiction of the contractor’s principal place of business within Arizona. For ongoing purchases of materials, absent further legislative changes, contractors may only make tax-free purchases if the materials will be incorporated into a prime contracting TPT project (i.e., not an MRRA project). For many contractors, this will create a situation where some inventory will have been taxed and other inventory will not have been taxed. This dual treatment and the complications it brings become more significant if materials are purchased in bulk and if excess materials from a particular job are regularly brought back into inventory.

A third area of impact involves change orders. Currently, the Department of Revenue’s position, based on similar treatment for change orders when a new tax rate takes effect, is that each new change order is treated independently of the original contract and all other change orders. For example, an original contract and certain change orders will be subject to prime contracting TPT if they involve modification activities, while other change orders will be subject only to retail TPT on the materials if the change orders involve only MRRA activities. It’s not difficult to see how this dual treatment of any one project could create confusion and be difficult to administer for the industry, especially if any of the materials are pulled out of inventory.

2015 Legislative Proposal

To address the complexities brought about by this TPT reform effort, the Arizona Builders’ Alliance has spearheaded the legislative effort for the 2015 legislative session on behalf of the construction industry as a whole. The draft legislation will include many provisions aimed at addressing several of the more troubling issues facing contractors under the new law. Among other things, the proposed new legislation is slated to include:

• Clarification as to whether a project is a prime contracting TPT project or an MRRA project
• A uniform method for purchasing materials tax-free, whether used in a prime contracting TPT project or an MRRA project
• For an MRRA project, the reporting and payment of retail TPT on the cost of materials based on the location of the job when the materials are used
• A more uniform and simplified method for taxing change orders to a contract
• A method for a contractor (whether licensed for prime contracting TPT purposes or not) to purchase materials tax-free without needing to resort to an agency agreement structure when hired for either:
  • An MRRA project for a tax-exempt hospital so that the contractor can purchase materials tax-free without the use of an agency agreement, or
  • An on-reservation MRRA project for an Indian tribe or an enrolled member of a tribe
• A credit for taxes paid on materials in the event that a project is ultimately determined to be a prime contracting TPT project and not an MRRA project
• Other changes to help streamline the contractors’ tax compliance requirements so they can focus on operating and growing their business

These legislative changes are critical to bring this ongoing tax reform effort to a close with as few casualties as possible, and your support of the legislative effort is important.

Notes:

^[1] The city tax equivalent to the prime contracting TPT is the construction contracting privilege tax. All references to “prime contracting TPT” are intended to include city construction contracting privilege tax unless otherwise specifically stated.