Arizona’s state sales and use tax rate is scheduled to go down by 1% effective June 1, 2013, as a result of the automatic sunset of the temporary rate increase approved by voters in 2010. The Arizona Department of Revenue just published guidance on its website on how taxpayers, including prime contractors, should apply the reduced rate. Key provisions of the Department’s guidance related to the construction industry follow:
- Cash basis. For prime contractors reporting sales tax on a cash basis, the reduced tax rate applies to any receipts received after June 1, 2013, regardless of when the contract for construction services was signed.
- Accrual basis. For prime contractors reporting sales tax on an accrual basis, the Department takes the position that the tax rate in effect on the date the contract for construction services was signed determines what tax rate to apply. Apparently, the Department takes this position even if the work is performed and the revenue accrues after June 1, 2013. In short, the Department is attempting to grandfather pre-existing contracts in to the higher rate when a contractor reports sales tax on an accrual basis. The Department’s legal basis for this position is unclear, and we do not believe it is sound or supported by Arizona law. Arizona law only contains a grandfather clause for pre-existing construction contracts when the tax rate increases, but not when the rate decreases – see Ariz. Rev. Stat. § 42-5010(H). Nor is the Department’s position reflective of proper accrual basis reporting methods. Under the accrual method, gain is reported “in the reporting period in which the sale occurs regardless of when payment is received.” Ariz. Admin. Code R15-5-2211. The Department would be hard pressed to show that the signing of a construction contract constitutes a completed sale, when neither materials nor construction services have been provided to a customer. Additionally, for federal income tax reporting, gain is reported under the accrual method when the taxpayer has a fixed right to receive it. Treas. Reg. § 1.466(c)(ii)(A) (income accrues when “all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy”). The mere signing of a construction contract would not fix the right of a construction contractor to receive payment; rather, the right to receive payment is only triggered when the contractor performs the construction services called for in its contract. In fact, for federal income tax purposes and for long term construction contracts (those spanning more than one year), construction contractors use the percentage of completion method and accrue income based upon the percentage of the project that has been completed in that year. See Internal Rev. Code § 460(b); Treas. Reg. 1.460-4. The same concept should hold true for accrual sales tax reporting when a construction project extends over a one month period. A simple example illustrates how extreme the Department’s position is: If an accrual basis contractor signs a contract on May 31, 2013 for a $100 million project, starts work in September 2013, submits its first billing to the customer in October 2013 and completes the project in 2016, under the Department’s position the accrual basis contractor would have to pay tax at the higher rate for the entire project even though the only thing it did prior to June 1, 2013 was sign the contract. However, until and if the Department changes its position as to accrual basis construction contractors, such taxpayers that do not follow the Department’s position will run the risk of audit and an assessment for the additional 1% tax.
- Excess taxes. If taxpayers charge customers the higher tax rate after the rate reduction kicks in on June 1, 2013, then the Department instructs taxpayers that they must report the excess tax collected on their sales tax returns and remit the amount collected to the State. In other words, the benefit of the tax reduction must be passed on to the contractors’ customers.
See Transaction Privilege Tax Changes and News (Ariz. Dep’t of Revenue Effective June 1, 2013), a copy of which can be accessed on the Arizona Department of Revenue’s website, http://www.azdor.gov/, or by clicking here.