We recently wrapped up diligence proceedings for another GovCon M&A transaction, and the specter of sales tax exposure again reared its ugly head. Time and again we see contractors err in their evaluation of the implications of sales tax on the materials, supplies, software, and hardware they acquire in the course of performing work for government customers. Many contractors work for years under the erroneous assumption that because their customer is a tax-exempt entity, anything acquired and used in performance of the contract is also exempt from state sales taxation. States, however, take a different view on the matter.
Most states apply a “true object” test when evaluating the application of sales tax to a service provider. If the object of a contract is to provide property to a customer, a government contractor may be viewed as a reseller of property to a tax-exempt customer. As such, the contractor is then not obligated to remit sales tax. Rather, the contractor is deemed to acquire the property with the intent of reselling it. A reseller’s exemption pertains then to the purchase of property by the contractor from its vendor, and the contractor need only provide the vendor a resale exemption certificate to ensure no application of the tax to its procurement transactions. However, when the “true object” of a contract is the provision of services to a government customer, the contractor is then deemed the end user of the items procured in providing the service and must either remit sales tax to its vendor or self-assess use tax and remit it to the relevant state.
The application and measurement standards related to this “true object” test vary by state. Some states have specific and detailed regulations, while other states rely on judicial determinations. A detailed review of the contractor’s agreements with its government customer is a key aspect of determining application of the proper provisions.
One other important note: if tax is not remitted by the contractor, the statute of limitations does not begin to toll. A contractor can have tax exposure dating back to the day it began doing business in a state. Assessment of interest and penalty on taxes can rapidly pyramid up the liability. This exposure can be mitigated on occasion via negotiations with tax authorities.
The views expressed in this article are those of the authors and do not necessarily reflect the position or policy of Berkeley Research Group, LLC.
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