Can a contractor buy construction materials tax-free when building a retail shopping center on land owned by a tax-exempt university, if a for-profit university subsidiary is the actual tenant?

Plain-English summary

The Texas Comptroller ruled that a contractor's purchases of construction materials for a retail shopping center built on university-owned land are NOT tax-exempt, even though the land is owned by a tax-exempt university and the university has final approval over construction plans — because the actual tenant benefiting from the retail development is a for-profit subsidiary the university created to shield itself from liability, not the university's own educational operations.

The university formed a wholly-owned for-profit corporation to lease and develop retail, office, hotel, and arena space as part of the university's broader campus growth plan. Under the ground lease (running through 2055), the subsidiary holds title to the new improvements until the lease expires, when title reverts to the university; the university also has approval rights over construction plans and guaranteed the subsidiary's construction loan. None of that mattered to the outcome. Section 151.311's exemption for improvement-to-realty contracts requires that the improvements be for the primary use and benefit of the exempt organization itself — and the Comptroller applies a facts-and-circumstances test that has, in other rulings, found exempt-organization-benefiting leases (like university dormitories) to qualify. But retail space leased to for-profit subtenants (restaurants, telecom providers, a bookstore) who use it for their own general business purposes, open to any member of the public rather than serving students/faculty/staff specifically, benefits the for-profit tenant — not the university — even though the university ultimately gets the building back decades later and financially backstops the construction loan.

What this means for you

Universities and other exempt organizations creating for-profit real estate subsidiaries

Setting up a for-profit subsidiary to develop and lease commercial space on your exempt organization's land does NOT extend your Section 151.311 tax exemption to that subsidiary's construction contracts — even if you retain approval rights, guarantee financing, and will eventually own the improvements. The exemption follows who primarily benefits from the improvement now, not who eventually owns it.

Developers and contractors building on exempt-organization-owned land

Don't assume a construction contract is tax-exempt just because the underlying landowner is a tax-exempt entity. Check who the actual tenant is and what the space will be used for — retail/commercial space serving the general public, leased to a for-profit entity, is a strong signal the exemption won't apply, contrasted with facilities (like dormitories) restricted to the exempt organization's own constituents.

Accountants and tax professionals

The controlling distinction is between STAR Accession Nos. 201405903L and 200108598L (university dormitory leases found exempt, because use was restricted to students) and Comptroller's Decision No. 41,946 (2003) (a for-profit café lessee at a tax-exempt airport found NOT exempt, following Attorney General Opinion No. MW-94 (1979)). Financial backstops like loan guarantees don't affect the primary-use-and-benefit analysis, per Comptroller's Decision Nos. 44,896 and 47,235 (2009).

Common questions

Q: Does a tax-exempt organization's ownership of the underlying land make construction on that land tax-exempt?
A: No. The exemption under Section 151.311 turns on who primarily uses and benefits from the improvements, not on who owns the land or who will eventually own the finished building.

Q: What made university dormitories exempt in other rulings but this retail center not exempt?
A: Dormitories serve the university's own students exclusively, directly supporting the university's educational mission. This retail center serves the general public and generates revenue for a for-profit subsidiary and its subtenants — a different primary beneficiary.

Q: Does the university's guaranty of the subsidiary's construction loan change the analysis?
A: No. The Comptroller has held that financial backstopping like a loan guarantee doesn't affect the primary-use-and-benefit determination.

Q: Can another university-affiliated developer rely on this ruling?
A: No. It's binding on the Comptroller only for the requesting taxpayer and facts presented, and cannot be relied on by any other taxpayer.

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 § 3.291(a)(5) (exempt contract, definition); § 3.291(c)(2)(B) (private-party-benefit exclusion)
• 34 Tex. Admin. Code § 3.322(b)(5) (Exempt Organizations — educational institutions)
• Comptroller's Decision No. 41,946 (2003) (for-profit café lessee at tax-exempt airport, not exempt)
• Comptroller's Decision No. 33,049 (1996)
• Comptroller's Decision Nos. 44,896 and 47,235 (2009) (loan guarantees don't affect primary-benefit analysis)
• STAR Accession No. 201405903L (May 9, 2014); STAR Accession No. 200108598L (Aug. 20, 2001) (dormitory leases, exempt, distinguished)
• Tex. Att'y Gen. Op. No. MW-94 (1979) (church-lessee improvements for private lessee's benefit, not exempt)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201803006L

Original ruling text

March 1, 2018

RE: Private Letter Ruling No. 2017010129

Dear ***** :

We issue this private letter ruling in accordance with Rule 3.1, Private Letter Rulings and General Information Letters. [ENDNOTE: 1] 1 We are responding to your request dated Dec.1, 2016. Detrimental reliance relief is provided in accordance with Rule 3.10, Taxpayer Bill of Rights.

You requested guidance on the exemption in Section 151.311 (Taxable Items Incorporated Into or Used for Improvement of Realty of an Exempt Entity) for tangible personal property purchased for use in the performance of a contract to improve realty for an organization exempt under Section 151.310 (Religious, Educational, and Public Service Organizations).

Facts Presented

We derived the facts below from the documentation you submitted in your private letter ruling request.

In 1988, * (University), a Texas nonprofit corporation and educational institution, formed * (Taxpayer), a for-profit corporation, to reduce University’s liability exposure and protect against various legal claims. Taxpayer is a wholly owned subsidiary of University. University selects Taxpayer’s board of directors and officers, and each officer is a University administrator.

University and Taxpayer have executed a lease (Ground Lease) that leases to Taxpayer two parcels of land containing three retail buildings (Leased Premises). Taxpayer states that improving the Leased Premises is part of University’s Master Plan to support its growth initiatives, including increasing enrollment and modernizing its campus facilities. Taxpayer also states that construction will be in phases and will include retail space, an office building, a hotel, a new parking structure, and an arena for University events.

The Ground Lease will expire on Aug. 16, 2055. It states, “Tenant shall use the Leased Premises for [sic] solely for the purpose of the operation of a retail shopping center….” University also has control and approval over any improvements that Taxpayer decides to add to the Leased Premises. The Ground Lease provides that:

Tenant shall make no alternation or addition to the Leased Premises without the prior written consent of Landlord. … Prior to the commencement of construction of any additional improvements on the Leased Premises, Tenant shall submit to Landlord, for Landlord’s approval, which approval shall not be unreasonably withheld, delayed or conditioned, detailed plans and specifications therefor and cost estimates prepared by an architect or engineer…. Once approved by Landlord, Tenant shall make no alteration or modification of such plans and specifications without Landlord’s prior approval.

Under the Ground Lease, Taxpayer will hold title to any new improvements until the expiration date at which time title will transfer to University. Taxpayer is required to preserve all built improvements in good condition and maintain them in “attractive appearance.” University has no duty to repair and maintain the Leased Premises or replace any improvements.

The Ground Lease does not identify the subtenants for the space, but Taxpayer must receive University’s prior written approval over any subtenant. Taxpayer states that subtenants will include restaurants, telecommunications providers, and a bookstore.

Taxpayer has entered into a contract with **** (Contractor) to construct improvements to the retail space. Contractor’s purchases of construction materials pursuant to this contract are the transactions relevant to this response. The contract does not mention University, but the University has guaranteed Taxpayer’s loan to finance the construction of improvements. A loan guarantee, provided with the request, shows this agreement.

Question, Ruling, and Analysis

Our restatement of your question is shown below, followed by our response and analysis.

Question: Are Contractor’s purchases of construction materials pursuant to a contract with Taxpayer, a for-profit, wholly-owned subsidiary of an exempt organization, to make improvements to retail space exempt from sales tax?

Ruling: Contractor’s purchases of construction materials to make improvements to retail space are not exempt from sales tax under Section 151.311 and Rule 3.291(a)(5) (Contractors).

Analysis:

Section 151.311 exempts from sales and use tax certain purchases of taxable items for use in the performance of a contract for an improvement to realty for exempt entities. This exemption applies even when the contract is between a nonexempt entity and a contractor, if the contract is an “exempt contract.” Comptroller’s Decision Nos. 44,896 and 47,235 (2009). Rule 3.291(a)(5) defines an “exempt contract” as “a contract with a nonexempt entity to improve real property for the primary use and benefit of an organization exempted under Tax Code, §151.309 or §151.310, provided that the improvements relate to the exempt purpose of an organization that is exempted under Tax Code, §151.310(a)(1) or (a)(2).”

Rule 3.291(c)(2)(B) further provides, “A contract with a private party to improve real property owned by an exempt entity, other than a governmental entity described in Tax Code, §151.309, is not an exempt contract if the improvement to real property is for the primary use and benefit of the private party.” See also Comptroller’s Decision No. 41,946 (2003); STAR Accession No. 201405903L (May 9, 2014); STAR Accession No. 200108598L (Aug. 20, 2001).

The contract between Taxpayer and Contractor involves the incorporation of tangible personal property for the improvement of real property. University is an exempt educational institution under Section 151.310(a)(2) and Rule 3.322(b)(5) (Exempt Organizations). To qualify for the exemption, therefore, the improvements contemplated by the Ground Lease must be for the primary use and benefit of University.

Where the exempt organization is the lessor and the taxable entity is the lessee, the agency will use a facts and circumstance test. Under this test, Tax Policy has previously stated that leases between exempt universities as lessors and nonexempt lessees to build dormitories for universities can be for the primary use and benefit of the exempt lessor. See STAR Accession Nos. 201405903L; 200108598L. When a taxable entity will use an improvement primarily for a business purpose for its benefit, however, a contract executed pursuant to a lease between an exempt entity and a taxable entity will not constitute an exempt contract. See Comptroller’s Decision No. 41,946 (2003).

Taxpayer’s facts differ significantly from the facts in STAR Accession Nos. 201405903L and 200108598L. These letters involved the construction of dormitory facilities and leases that explicitly stated that the improvements were for the benefit of the exempt entities. Under the Taxpayer’s facts, the Ground Lease and construction contract are for retail space and do not indicate that the improvements are for the primary use and benefit of University. The operation of retail space will also not enhance the operations of the University in the same manner as the operation of dormitory facilities. Further, universities can restrict the use of dormitories to students, excluding anyone else.

By contrast, the retail space contemplated by the Ground Lease will not specifically enhance the operations of the University because the operation of the retail space will not solely serve the students, faculty, or staff. University will allow any patrons to shop at the retail space. Further, Taxpayer and its subtenants are not required to hold their interest in the retail space for the benefit of the University or inure any benefit to the University through its use of the retail space. Instead, they are able to utilize their leasehold interest for their own benefit. Therefore, University will not primarily benefit from the operation of the retail space.

Taxpayer’s situation is analogous to the situation in Comptroller’s Decision No. 41,946 (2003). In that hearing, a corporation (lessee) had a lease with a tax-exempt airport (lessor) for the operation of a café at the airport. The airport had final approval over the construction done on the café. A construction company claimed that its contract with the lessee for improvements to the café was exempt. The Comptroller followed Attorney General Opinion No. MW-94 (1979), in which a church granted its private lessee permission to remodel improvements on the church’s land to suit its business needs. The Attorney General determined that the contract was not an exempt contract because the dominant purpose of the lease contracts was to make the improvements for the private lessee. Following this reasoning, the Comptroller held that the lease between the airport and the corporation to make improvements to the café was for the primary use and benefit of the corporation.

Taxpayer and its subtenants will primarily use the retail space for their general business needs. Taxpayer will use the retail space to generate revenues from the subtenants through rent. The subtenants will generate revenues from sales of their products and/or services. Aside from approving the specific subtenant, University will not be able to oversee the operations of the retail space or require that the subtenants operate their business for its benefit.

Like a café, the dominant purpose of the Ground Lease is to construct a retail facility to provide shopping for customers, not to serve the University’s students, faculty, or staff. This means that the primary use and benefit will go to Taxpayer. See Rule 3.291(c)(2)(B); Comptroller’s Decision No. 33,049 (1996). Further, University’s guaranty of Taxpayer’s debt does not circumvent the requirements under primary use and benefit because responsibilities for payment are not determinative to the primary use and benefit determination. See Comptroller’s Decision No. 44,896 and 47,235 (2009).The contract between Taxpayer and Contractor is not an exempt contract.

Comptroller’s Decisions and STAR documents cited are available on the Comptroller’s State Tax Automated Research (STAR) system. The Texas Tax Code, Texas Administrative Code, and the STAR system are accessible at www.comptroller.texas.gov/taxes/.

If you have questions about this private letter ruling, please email us through our website at https://comptroller.texas.gov/web-forms/tax-help/ and reference Private Letter Ruling No. 2017010129.

Sincerely,

Tax Policy Division – Indirect Taxes

Texas Comptroller of Public Accounts

ENDNOTE:

1. Unless otherwise indicated, all references to “Section” are to the Texas Tax Code, and all references to “Rule” are to Title 34 of the Texas Administrative Code.