Can a landlord buy construction materials tax-free for a charter-school campus while it's still under construction, under a 25-year lease that hasn't started yet?

Plain-English summary

The Texas Comptroller ruled that a charter school's 25-year build-to-suit lease — for a new campus still mid-construction, financed by a group of three landlord entities — IS an exempt improvement-to-realty contract under Section 151.311, so the landlords may buy construction materials and qualifying services tax-free even while the building work is still underway.

This ruling confirms the exempt-contract analysis doesn't wait for the building to be finished or the lease term to formally start. At the time of the request, "Substantial Completion" of the campus had not yet occurred, and the 25-year lease term (which runs from the Substantial Completion / Rent Commencement Date) hadn't technically begun. That timing didn't matter: applying the same two-prong test from Comptroller's Decision No. 28,391 (1993), the school qualified as an exempt entity, and the 25-year term — measured against the Comptroller's 22-year useful-life benchmark for buildings — was sufficiently long once it does start, so the contract to build the campus qualified as exempt from the outset.

What this means for you

Landlords and developers building school campuses mid-construction

You don't need to wait until construction is complete or the lease term has formally started to rely on the Section 151.311 exemption — if the eventual lease term will be sufficiently long relative to the improvements' useful life, the contract to build qualifies as exempt while work is still in progress.

Charter schools structuring multi-party landlord financing

This ruling involved a lease with three separate landlord entities financing the build — the exemption analysis focuses on the lease terms and the tenant's exempt status, not on how many parties are on the landlord side of the deal.

Accountants and tax professionals

Same framework as companion 2018 rulings on other charter-school campus leases: Comptroller's Decision No. 28,391 (1993) two-prong test, measured against the 22-year Class Codes useful-life benchmark. Note again the 34 Tex. Admin. Code § 3.1(d)(1) prospective-only caveat — this ruling doesn't resolve any refund claim for tax already paid on the in-progress construction.

Common questions

Q: Does the improvement-to-realty exemption require the building to already be complete?
A: No. As this ruling shows, the Comptroller applies the same two-prong test to a lease whose term hasn't formally started yet, so long as the eventual lease term will be sufficiently long relative to the improvements' useful life.

Q: Does having multiple landlord entities affect the exemption analysis?
A: Not based on this ruling — the analysis turned on the lease term and the tenant's exempt status, not the landlord's corporate structure.

Q: Can another mid-construction school project 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) (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/201805020L

Original ruling text

May 30, 2018

RE: Private Letter Ruling No. 20170926094822

** 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 Sept. 20, 2017 and letter dated Nov. 27, 2017. 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 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.

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’s campus located at **, CITY, Texas * (Campus). The Campus includes an elementary and a middle school.

On Aug. 10, 2017, Taxpayer entered into a lease with COMPANY A, COMPANY B, and COMPANY C (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 Nov. 27, 2017, Substantial Completion had not occurred. Under the Lease, Taxpayer has the 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 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).

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 exempt 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 is 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.

Taxpayer did not state the Campus’s expected useful life. The Comptroller’s State Property Accounting Process User’s Guide – Appendix A – Class Codes (Class Codes) provides guidance when calculating the expected useful life for building improvements. According to the Class Codes, the useful life for buildings and building improvements – non-componentized is 264 months (22 years).

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. 20170926094822.

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.