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Arizona Modifies Transaction Privilege Tax Landscape for Contractors

Posted 12:00 PM by

Effective Jan. 1, 2015, Arizona has made drastic changes to the application of the transaction privilege tax (TPT) for contractors. As a result of these changes, contractors will have to make a determination of how they are classified for TPT purposes and apply the corresponding tax treatment. 

Arizona’s Historic Treatment

Arizona has historically applied a unique taxing method to real property contractors. Contractors would purchase construction materials exempt from tax. They would then calculate their gross proceeds by making adjustments provided by statute (e.g., the sale of land was not included in the tax base). This adjusted proceeds figure was then taxed at a rate of 65% under the prime contracting classification.  

A New Classification Is Added

While retaining the historic treatment under the prime contracting classification for certain projects, Arizona has added a second classification with a different tax application. This new classification applies to projects involving the Maintenance, Repair, Replacement or Alteration of real property (MRRA), where the work is performed directly for the property owner or authorized party. Under this taxing regime, each contract is evaluated on its own, so it is quite possible that a contractor could be deemed a prime contractor on one project and a MRRA contractor on another.

How to Determine the Difference Between MRRA and Prime Contracts

While distinguishing between MRRA and Prime Contracts requires making subjective determinations and considering exceptions, it is a necessary first step for any contractor in Arizona. As a starting point, contractors should determine if the activity falls into any of the four MRRA categories, as defined by Arizona TPN 15-1 (Revised 6/22/2015) as follows:

  1. Maintenance – The upkeep of property or equipment (e.g., restaining a deck)
     
  2. Repair – An activity that returns real property to a usable state from a partial or total state of inoperability or non-functionality (e.g., fixing a leak in a shower)
     
  3. Replacement – The removal from service of one component or system of existing property or tangible personal property installed in existing property — including machinery or equipment — and the installation of a new component or system or new tangible personal property — including machinery or equipment — that provides the same, similar or upgraded design or functionality, regardless of the contract amount and regardless of whether the existing component or system or existing tangible personal property is physically removed from the existing property (e.g., removing a sprinkler system and putting in a new one)
     
  4. Alteration – An activity or action that causes a direct physical change to existing property; the Alteration definition only applies as follows (Note: These determinations are made at the time into which the contract is entered. To the extent that there are subsequent changes to the project scope, the project can still be deemed Alteration if the thresholds are exceeded by no more than 25% at completion.):

    a. For Residential Projects – To be considered Alteration, the contract price cannot        exceed 25% of the property’s most recent assessed value as determined by the        county for property tax purposes.
    b. For Non-Residential Projects – To be considered Alteration, three tests must be          met: 1) the contract amount cannot exceed $750,000; 2) the project scope cannot      relate to more than 40% of the existing square footage; and 3) the project                    scope cannot expand the square footage by more than 10%.

The Prime Contract classification extends to “modification activities,” which is defined to include “ground up” construction, grading and leveling ground, and wreckage or demolition activities, to the extent they cannot otherwise be characterized as MRRA activities. It can be thought of as a catch-all (i.e., if the project does not fall under one of the four MRRA categories, they will likely be deemed to be Prime Contracts).

Even if a project could meet the definition of an MRRA category, it could still be treated as a Prime Contract if an exception applied. The most significant exception is for projects with both MRRA and modification components.

If modification activities constitute more than 15% of the total receipts, the entire contract will be treated as a Prime Contract. There are other exceptions that may apply (e.g., certain government projects are automatically deemed Prime Contracts). 

Resulting TPT Treatment

Once a determination is made as to whether a project should be classified as either an MRRA or a Prime Contract, contractors will have to apply the respective rules to the job. Under the new taxing regime, the contracts are taxed as follows:

  1. Prime Contracts – Arizona’s historic tax treatment applies. Contractors should not pay tax upon acquiring materials (Form 5000 can be presented to the retailer). The contractor will be subject to tax on 65% of their adjusted proceeds under the Prime Contracting classification.
     
  2. MRRA Contracts – The new tax treatment applies. Contractors owe tax on their materials (either paid to the vendor or accrued directly to the state). Proceeds from MRRA Contracts are not subject to additional tax under the Prime Contracting classification.

Contractors who operate under just one of the two classifications should be able to build systems to adjust to the new taxing regime without many complications. Contractors operating under both classifications will have more difficulty, especially if materials are acquired without knowing which project they will be used in. Contractors in this situation may want to consider acquiring all materials exempt from tax and accruing tax on materials later incorporated into MRRA projects. 

While the legislative intent may have been simplification, the resulting changes are a drastic departure from the previous treatment of contracting activities in Arizona. These changes will force contractors to wade through more complex rules and details to correctly comply. 

In addition to reviewing the high-level guidance discussed above, we would encourage any contractor with Arizona activity to thoroughly read Arizona TPN 15-1. Other issues — such as the treatment of subcontractors, exempt projects and local taxes — can add an extra layer of complexity that must be considered.

About the Author
Ron Lenz is the partner-in-charge of Katz, Sapper & Miller’s Construction Services Group. Ron's particular areas of expertise include accounting and auditing matters, tax planning and business structuring, mergers and acquisitions, and succession planning. Connect with him on LinkedIn.

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