Is a charter school's 25-year build-to-suit campus lease an exempt improvement-to-realty contract that lets the landlord buy construction materials tax-free?

Plain-English summary

The Texas Comptroller ruled that a charter school's 25-year build-to-suit lease of a new elementary/middle-school campus IS an exempt improvement-to-realty contract under Section 151.311, so the landlord who built the campus may buy construction materials and qualifying services tax-free.

Section 151.311 exempts a contractor's purchases when improving real property for the "primary use and benefit" of an organization exempt under Section 151.310, tested by a two-prong standard from Comptroller's Decision No. 28,391 (1993): (1) the benefiting party must be a qualified exempt entity, and (2) the lease term must be sufficiently long relative to the improvements' useful life. The charter school easily met prong one as a qualified 501(c)(3) educational nonprofit whose campus is legally deemed state property in trust for students under the Texas Education Code. On prong two, the Comptroller used its own 22-year useful-life benchmark for buildings (from the State Property Accounting Process User's Guide) and found the lease's 25-year term comfortably exceeded it, with no early-termination provision undercutting the term — unlike a companion ruling issued around the same time where a 25-year lease with a 20-year termination option FAILED this same test. Because the school here retained the property for the improvements' full useful life without an early-exit right, the lease qualified as exempt.

What this means for you

Charter schools, churches, and other exempt organizations doing build-to-suit leases

A lease term that exceeds the Comptroller's 22-year useful-life benchmark for buildings — with no meaningful early-termination rights — is a strong candidate for the Section 151.311 exemption. Contrast this with a companion 2018 ruling where an otherwise-adequate 25-year term failed because a 20-year termination option let the tenant walk away before the buildings' useful life ran out.

Developers and landlords building for tax-exempt tenants

If your lease term safely exceeds the property's expected useful life and doesn't give the tenant an early-exit option that could cut the effective term short, you have a stronger basis to claim the improvement-to-realty exemption and accept exemption certificates on the construction contract.

Accountants and tax professionals

The controlling framework is the two-prong test from Comptroller's Decision No. 28,391 (1993), with the 22-year Class Codes useful-life figure from the Comptroller's State Property Accounting Process User's Guide serving as the practical benchmark against which lease terms are measured. Note that under 34 Tex. Admin. Code § 3.1(d)(1), this ruling is prospective only and doesn't resolve any past refund claim — those follow Rule 3.325's separate requirements.

Common questions

Q: What lease term is "long enough" to qualify for the Section 151.311 exemption?
A: There's no fixed statutory ratio, but the Comptroller measures against its own useful-life benchmark for the type of improvement (22 years for non-componentized buildings, per its Class Codes guidance) and looks for the absence of early-termination rights that would undercut an otherwise-sufficient term.

Q: Does this exemption require the exempt organization to own the property?
A: No. Section 151.311 doesn't require ownership — a lease can qualify, as it did here, so long as both prongs of the test are met.

Q: Can another charter school rely on this ruling for its own lease?
A: No. This ruling binds the Comptroller only as to the specific taxpayer and facts presented, and cannot be relied on by any other taxpayer — every lease's term and termination rights need independent review.

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) (Contractors — exempt contract definition)
• 34 Tex. Admin. Code § 3.322 (Exempt Organizations)
• 34 Tex. Admin. Code § 3.1(d)(1) (prospective reliance); § 3.325 (Refunds and Payments Under Protest)
• Tex. Educ. Code §§ 12.105, 12.106, 12.128 (charter schools as public property held in trust)
• Comptroller's Decision No. 28,391 (1993) (originating two-prong test)
• Comptroller's Decision No. 31,505 (1994) (five-year lease failed second prong)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/201805018L

Original ruling text

May 30, 2018

RE: Private Letter Ruling No. 2018022608443

** Taxpayer No. **

Dear **:

We issue this private letter ruling in accordance with Rule 3.1, Private Letter Rulings and General Information Letters.[ ENDNOTE: 1] We are responding to your request dated Feb. 23, 2018. 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 and taxable services 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

*** (Taxpayer) 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 Sept. 8, 2011. As of Aug. 19, 2013, Taxpayer met the qualifications for exemption from Texas Sales or Use Tax as outlined in Rule 3.322 (Exempt Organizations).

Taxpayer provided its federal exemption letter, documentation regarding its charter, and a Build to Suit Lease and Option (Lease). The facts are based on information contained within the documentation provided by Taxpayer. Our response is based on these facts as presented, without independent verification or approval of the Taxpayer’s application of the State Property Accounting Process User’s Guide.

On May 26, 2013, Taxpayer entered into a charter contract with the Texas Education Agency (TEA) to operate an open-enrollment charter school through July 31, 2018. The TEA authorized Taxpayer to add an additional campus located at **, CITY, Texas * (Campus). The Campus includes an elementary and a middle school.

On June 22, 2017, Taxpayer entered into the Lease with COMPANY (Landlord) to finance the construction of the Campus. Under the Lease, Landlord agreed to acquire a site for the Campus, construct new facilities on the Campus per Taxpayer’s specifications, and lease the Campus to Taxpayer for a term beginning on the Commencement Date, as defined in the Lease, and continuing for a period of 25 years after the Rent Commencement Date, which is defined in the Lease as the Substantial Completion Date. Per Taxpayer’s letter dated Feb. 23, 2018, Substantial Completion will occur no later than August 5, 2018. Under the Lease, Taxpayer has an option to purchase the Campus during the period described in the Lease.

The site of the new campus requires the construction of new facilities on previously unimproved real property. The Lease requires Landlord to implement the construction projects and make all of the improvements to the Campus described within Exhibit C to the Lease. The costs of the improvements are incorporated into the Lease and paid for by Taxpayer in monthly installments using funds received from the State of Texas (State). All construction plans are subject to Taxpayer’s approval, and Landlord shall adopt any changes to the plans requested by Taxpayer unless the changes would not comply with applicable governmental rules and regulations.

The Campus is leased by and used exclusively by Taxpayer as an open-enrollment charter school. Texas Education Code Section 12.105 (Status) states that an open- enrollment charter school is a part of the Texas public school system.

Taxpayer receives its funding from the State through a funding system known as the Foundation School Program as authorized by Texas Education Code Section 12.106 (State Funding). Taxpayer uses state funds to lease the Campus. Texas Education Code Section 12.128 (Property Purchased or Leased with State Funds) states that property, whether purchased or leased, is considered public property for all purposes allowed by state law and is deemed state property held in trust by the charter holder for the benefit of the students. The property may be used only for a purpose for which a school district may use school district property.

Taxpayer holds the deemed state-owned property in trust for the benefit of the attending students. If Taxpayer 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).

Taxpayer 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. This response relies upon the Taxpayer’s assertion that the useful life of the facilities is 22 years.

Questions, Rulings, and Analysis

Our restatement of your questions is shown below, followed by our responses and analysis.

Question One: Is the Lease between Taxpayer and Landlord an exempt contract under Section 151.311?

Ruling One: The Lease is an exempt contract under Section 151.311 because it is a contract to improve realty for the primary use and benefit of an exempt entity.

Question Two: Can Landlord issue exemption certificates in lieu of paying tax on purchases of taxable items for use in performance of the contract with Taxpayer?

Ruling Two: Landlord may issue exemption certificates in lieu of paying tax on purchases of taxable items for use in performance of the exempt contract. Taxable items include tangible personal property incorporated into the realty in the performance of the exempt contract; tangible personal property, other than machinery and equipment, necessary and essential for the performance of the exempt contract and completely consumed at the job site; and taxable services that meet the requirements in Section 151.311(c).

Analysis:

In relevant part, Section 151.311 addresses contracts for an improvement to realty for an organization exempted from sales and use tax under Section 151.310. Section 151.311 does not require that the exempt organization own the real property improvements. The Section may apply where the exempt organization leases the real property.

An “exempt contract” includes a contract with a non-exempt entity to improve real property for the primary use and benefit of an organization exempted under Section 151.310. See Rule 3.291(a)(5) (Contractors). The Comptroller 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 (1993).

First, the lessee must qualify for exempt status. Based on the facts presented, Taxpayer is a qualified tax-exempt entity under Section 151.310; therefore, Taxpayer 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. The Comptroller has consistently applied this test. See, for example, Comptroller’s Decision No. 31,505 (1994), 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 years.

Determining the life of the real property improvements for the second prong of the test is a fact issue, and the Comptroller has not developed a standard for when the test is met.

Using the Class Codes guideline, the Campus’s expected useful life of 22 years is less than the 25-year term found in the Lease. Therefore, the 25-year term of the Lease is sufficiently long to ensure that Taxpayer has 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 Section 151.311.

Section 151.311 creates an exemption from sales tax on the purchase of tangible personal property that is incorporated into the realty in the performance of an exempt contract. Section 151.311(a). Section 151.311 also exempts the purchase of tangible personal property, other than machinery or equipment and its accessories and repair and replacement parts, in the following circumstances: (1) the tangible personal property is necessary and essential for the performance of the exempt contract; and (2) the tangible personal property is completely consumed at the job site. Section 151.311(b).

The statute further provides that the purchase of a taxable service for use in the performance of an exempt contract is exempt if the service is performed at the job site and either (1) the contract expressly requires the specific service to be provided or purchased by the person performing the contract, or (2) the service is integral to the performance of the contracts. Section 151.311(c).

Under Rule 3.1(d)(1), these rulings may be relied on prospectively from the date of this response and do not address the validity of any refund claim that might be submitted by Taxpayer. Any refund request is subject to the requirements of Rule 3.325 (Refunds and Payments Under Protest).

Comptroller’s Decisions cited are 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. 2018022608443 .

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.