When a landlord builds a new high-school campus for a charter school and leases it back for 25 years with a purchase option, does the construction contract qualify as tax-exempt under § 151.311?

Plain-English summary

A Texas nonprofit charter-school operator running two campuses had a new high-school campus built through a build-to-suit lease with purchase option. The landlord agreed to construct the campus to the school's specifications and lease it back for a 25-year primary term, with the school paying either through monthly payments or by exercising its purchase option.

Applying its standard two-prong test under § 151.311:

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, from the state's capital-asset depreciation schedule), so yes.

Both prongs being met, the build-to-suit lease is an exempt § 151.311 contract, letting the landlord buy construction materials and qualifying job-site services tax-free. As with the rest of this doctrine cluster, the ruling doesn't pass on any refund claim and applies prospectively only.

What this means for you

Charter schools building a new high-school campus via build-to-suit lease

A straightforward 25-year lease term against a 22-year useful-life figure comfortably clears the Comptroller's bar — this ruling is a clean, uncomplicated example of the standard two-prong analysis without any of the structural wrinkles (layered ownership, ground leases, lease amendments) seen in several companion rulings.

Related rulings

This is part of a large cluster of same-year (2015) build-to-suit charter-school lease rulings, all applying the identical two-prong test from Comptroller's Decision No. 28,391 to different campuses, landlords, and lease terms. This particular ruling involves a single high-school campus and a single landlord with a 25-year term — one of the more common, uncomplicated fact patterns in the cluster.

Common questions

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, while a 5-year lease against a longer useful life failed in a prior cited decision.

Q: Can the landlord who built the school building buy materials tax-free?
A: Per this ruling, once the contract qualifies as exempt, the landlord may issue an exemption certificate to avoid paying sales tax up front on qualifying materials and services, rather than paying and later seeking a refund.

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)
• 34 Tex. Admin. Code Rule 3.325 (Refunds and Payments Under Protest)

Cited prior guidance:

• Comptroller's Decision No. 28,391 (1993) — source of the two-prong "primary use and benefit" test
• Comptroller's Decision No. 31,505 (1994) — contrasting failure: 5-year lease term too short relative to improvements' useful life

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201509408L

Original ruling text

September 1, 2015

RE: Private Letter Ruling # 150970133

Dear *****:

We issue this private letter ruling in accordance with Rule 3.1 in response to
your request dated April 1, 2015. Detrimental reliance is provided in
accordance with Rule 3.10, the Taxpayer Bill of Rights.

ou requested guidance on the ’ interpretation
of the exemption in Texas Tax Code Section 151.311 for tangible personal property
and taxable services purchased for use in the performance of a contract to
improve real property for an organization exempt under Texas Tax Code
Section 151.310. The Comptroller’s office has addressed similar facts presented
by this inquiry, most recently in other private letter rulings, particularly
STAR DOCUMENT NOS. 201411982L, 201411981L, 201411980L, and 201409958L,
all issued in 2014. However, we issue this private ruling because guidance on
this issue is not expressly provided in statute or agency rule.

Relevant Facts Presented

**, is a Texas non-profit corporation granted tax-exempt status by the
Internal Revenue Service pursuant to Section 501(c)(3) of the Internal Revenue
Code. In addition, ** met the qualifications for exemption from Texas
Sales or Use Tax outlined in Rule 3.322 (Exempt Organizations).

**received a charter from the Texas Education Agency to operate an
open-enrollment charter school. *currently operates two campuses in
CITY, Texas, and recently has had a new facility constructed at CITY, Texas,
for a high school campus (“Campus”). To finance the construction of the Campus,
* entered into a build-to-suit lease (“Lease”) [ENDNOTE 1] with
*. (“Landlord”) where Landlord agreed to construct the Campus per
*’s specifications and to lease the Campus to ** for an
initial term of twenty-five (25) years with a purchase option.

Under the Lease, Landlord is required to implement a construction program to
build the Campus to **’s specifications with the cost incorporated
into the Lease and paid for by * either in monthly payments, or by
exercising its option to purchase. The Lease requires Landlord to make all
improvements described within the exhibits to the Lease. The Campus is being
improved for, leased by, and used exclusively by **** as an
open-enrollment charter school. Texas Education Code Section 12.105 states that
an open-enrollment charter school is part of the Texas public school system.

** 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. ** used state funds to lease the
Campus. Texas Education Code Section 12.128 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, **—holds the state-owned property in
trust for the benefit of the attending students. If ** 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).

Requested 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 291 (Contractors).
3.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 of 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 Texas Tax Code Sections 151.309 or
151.310 is exempt if the tangible personal property is incorporated into realty
in the performance of the contract. Texas 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 Texas Tax Code
Section 151.309 or 151.310. The Rule further provides that 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.

Texas 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 Comptroller’s office 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’S
DECISION NO. 28,391 (July 7, 1993), STAR DOCUMENT NO. 9307H1248D05.

First, the lessee must qualify for exempt status under Texas Tax Code Section
151.309 or 151.310. Based on the facts presented, ***** 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’S DECISION NO. 31,505 (April
20, 1994), STAR DOCUMENT NO. 9404H1297E01, 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 Comptroller’s office has not developed a
standard for when the test is met. ***** references Appendix A, titled
“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. [ENDNOTE 2]

The Campus’s expected useful life of 22 years is less than the 25 year term of
the Lease. Therefore, the 25 year term of the Lease is sufficiently long to
ensure that ***** will have the primary use and benefit of the
improvements under the Lease. The second prong of the test is met, and the
Lease is exempt under Texas Tax Code Section 151.311.

This ruling does not address the validity of any refund claim that might be
submitted by **. *may request a refund of Texas Sales and
Use Tax paid on taxable items purchased for construction of the Campus.
****must obtain a properly completed assignment of right to refund for
items on which it did not directly pay the Texas Sales and Use Tax that are
part of any refund request. Any refund request is subject to the requirements
of Rule 3.325 (Refunds and Payments Under Protest).

If you have questions about this private letter ruling, please email us at the
following link, https://www.window.state.tx.us/taxhelp/ and please be sure to
reference Private Letter Ruling #150970133.

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.”

2. In its request for a Private Letter Ruling, ** does not request a
   determination for the “building shell”. The guidance provided in this response
   does not approve or disapprove of **’s depreciation methodology or its
   choice of applicable class codes or descriptions.