When a single landlord builds one facility housing two charter-school campuses and leases it for 25 years with a purchase option limited to years one through four, does the § 151.311 construction exemption still apply?

Plain-English summary

A Texas nonprofit charter-school operator had a single new facility built to house two of its campuses. It entered a build-to-suit lease and purchase option with a landlord: the landlord builds the shared facility to the school's specs and leases it back for a 25-year primary term, with the school's option to buy the campus limited to a window running from the first through the fourth anniversary of the "Commencement Date" (i.e., not exercisable at any time, only in years one through four).

The Comptroller applied the same 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 (300-month) lease term exceeds the campuses' 22-year (264-month) expected useful life (the school's own figure, from the state's capital-asset depreciation schedule), so yes.

Because both prongs are met, the lease is an exempt § 151.311 contract. Bundling two campuses into a single leased facility and limiting the purchase option to a fixed early window (rather than an anytime option) didn't change the analysis — the test still turns solely on the lease term versus the building's useful life.

What this means for you

Charter schools combining multiple campuses into one leased facility

Housing more than one campus in a single build-to-suit facility doesn't require a separate exemption analysis per campus — the Comptroller applied the same two-prong test to the facility as a whole.

Schools and landlords negotiating purchase-option windows

A purchase option restricted to a specific early window (years one through four here, versus an unrestricted "anytime" option seen in a companion ruling) made no difference to the outcome — the Comptroller's test doesn't examine purchase-option timing at all, only the lease term against useful life.

Related rulings

This ruling is part of a same-day/next-day (September 1-2, 2015) batch of build-to-suit charter-school lease rulings applying the identical two-prong test. It's distinguished from its companions by combining two campuses under one 25-year lease with a single landlord and a fixed years-1-4 purchase-option window (compare a companion ruling with the same term and window structure but multiple landlords).

Common questions

Q: Does combining multiple campuses into one build-to-suit lease change the exemption analysis?
A: Not per this ruling — the Comptroller applied the standard two-prong test to the facility as a whole, without separately analyzing each campus.

Q: Does limiting the purchase option to a specific window (rather than anytime) matter?
A: Not per this ruling — the analysis turned only on the lease term compared to the building's useful life, not on when the purchase option can be exercised.

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.

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/201509414L

Original ruling text

September 2, 2015

RE: Private Letter Ruling # 143430646

Dear *****:

We issue this private letter ruling in accordance with Rule 3.1 in response to
your request dated December 3, 2014. Detrimental reliance is provided in
accordance with Rule 3.10, the Taxpayer Bill of Rights.

You 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 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. On August 19, 2013, ** 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. * recently had a new facility
constructed at *, CITY, Texas for the * and *
Campuses (“Campus”). * entered into a build-to-suit lease [ENDNOTE
1] and purchase option (“Lease”) 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. Under
the Lease, ** has the option to purchase the Campus during the period
beginning after the first anniversary date of the Commencement Date, as defined
in the Lease, through the fourth anniversary of the Commencement Date.

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 was
improved for, leased by, and used by **** as 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 3.291 (Contractors).
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 or 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 Texas Tax
Code 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 (300
month) 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 part 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
https://www.window.state.tx.us/taxhelp/ and reference Private Letter Ruling

143430646.

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.