At long last, the Arizona Legislature has rectified an ongoing problem for business owners who have created a separate entity to hold real property used to house business operations. Arizona imposes a tax under the commercial lease classification on “the business of leasing for a consideration the use or occupancy of real property.” Ariz. Rev. Stat. § 42-5069(A). The tax rate on commercial leases is 0% at the state level, but counties in Arizona (who piggy-back on the state tax classifications), still tax commercial leases. Likewise, municipalities, like counties, tax rentals of real property (note that the state/county tax only applies to commercial leases, but cities also tax residential rentals in addition to commercial leases). Model City Tax Code § 445.
Previous law – exemption limited to leases between affiliated corporations. Under previous law, the commercial lease classification contained an exemption for leases of real property by a “corporation” to an “affiliated corporation.” Ariz. Rev. Stat § 42-5069(C)(5). At the same time, state law also prohibited cities from taxing commercial leases between a “corporation” and an “affiliated corporation.” Ariz. Rev. Stat. § 42-6004(A)(11). Additionally, some cities have elected to exempt gross income for leases of real property to a “corporation” if “the lessor’s aggregate holdings in the lessee corporation amount to at least eighty percent (80%) of the voting stock of the lessee corporation. Model City Tax Code § 445(i). Taxing jurisdictions have taken a narrow and technical read of these exemptions and have taken the position that they only applies to leases between affiliated “corporations” and do not extend to leases between any other types of entities. For example, if a corporation leased commercial real property to an affiliated LLC, taxing jurisdictions took the position that the exemption did not apply. As LLCs are the most common type of business entity, many businesses did not qualify for the exemption.
House Bill 2324 – exemption expanded to cover leases between any type of affiliated company. The Arizona Legislature has now repealed the exemption for leases between affiliated corporations and has replaced it with much more broad exemption for leases between “affiliated companies, businesses, persons or reciprocal insurers.” House Bill 2324. For purposes of the new exemption “affiliated” companies include those where: (1) the lessor holds a controlling interest in the lessee; (2) the lessee holds a controlling interest in the lessor; (3) an affiliated entity holds a controlling interest in both the lessor and the lessee; or (4) an unrelated person holds a controlling interest in both the lessor and lessee. In determining if companies are affiliated, a controlling interest is defined as an 80% direct or indirect ownership (based on voting shares for corporations, or ownership interests for other entities). House Bill 2324 also adds an identical municipal tax exemption.
Effective date. On July 11, 2013, the Arizona Department of Revenue published guidance on its website addressing the effective date for the new exemption added by House Bill 2324. It instructed taxpayers that the state and county exemption takes effect on September 13, 2013, while the municipal exemption took effect on July 1, 2013. The difference in effective dates is attributable to the fact that the Model City Tax Code was formally amended to take House Bill 2324 into account effective July 1, 2013 (while the exemption at the state and county level does not kick in until the normal effective date of House Bill 2324). A copy of the Department’s guidance on the effective date can be accessed here.