The Questionable Road of Indiana’s Sales Taxation of Construction Contracts The Questionable Road of Indiana’s Sales Taxation of Construction Contracts

The Questionable Road of Indiana’s Sales Taxation of Construction Contracts

For decades, the Indiana Department of Revenue’s regulations created a critical distinction between “lump sum” and “time and materials” contracts for sales tax purposes with respect to real property improvements. Specifically, the Department’s regulations provided that a contractor purchasing materials (tangible personal property) for use in completing a time and materials contract could purchase materials exempt from Indiana sales tax, but then were required to collect and remit sales tax when the materials were "sold" to the customer. The customer was viewed as the taxable “end user.” For lump sum contracts, contractors were required to pay sales tax when purchasing the materials, and were not obligated to collect and remit sales tax from the customer, as the contractor was viewed as the taxable end user. In general, the Department obtained more sales tax revenue on time and materials contracts as the “retail price” to the customer on the materials was generally higher than the “wholesale price” to the contractor on those materials.

In 2014, the Indiana Tax Court struck down these regulations, holding that the Department did not have the statutory authority to distinguish for sales tax purposes between time and material contracts and lump sum contracts, holding that the contractor was taxable on its purchases and need not collect sales tax from its customers, regardless of the form of the contract. Lowe's Home Centers, LLC v. Indiana Dep't. of State Revenue, 3 N.E.3d 52 (Ind. Tax Ct. 2014). That was the law taxpayers were obligated to follow until action this year by the Indiana Legislature.

The Legislature had two concerns with the Tax Court’s holding. The first was that the State, prospectively, would lose annual revenue since the smaller wholesale transactions would be taxed in all cases instead of the larger retail transactions. The second concern was that the State would be obligated to issue refunds on the sales tax refund claims that were filed and were anticipated to be filed as result of the Tax Court’s decision, for all open years. That concern was exacerbated by the fact that a “customer” would fill the refund claim on the entire sales tax paid on the sale to the customer, and the Department, as a practical matter, may be unable to collect from the contractor on the wholesale transaction before the statute of limitation expired. As a result, the State might lose much more than just the difference between the sales tax on the wholesale price and the retail price.

To address these concerns, the Legislature statutorily attempted to reinstate the distinction previously reflected by the Department’s regulations. The newly enacted legislation provides that a contractor is required to collect sales tax from the customer on a “time and material contract” (as defined in the statute) at the time that tangible personal property is converted into real property, and provides the contractor with a “use tax” exemption on its purchases of materials for a time and materials contract. P.L.181-2016, Section 21. This is compared to a lump sum contract where the contractor must pay sales tax on the materials at the time of its purchase, or alternatively, remit use tax to the State if the materials were purchased exempt from sales tax. P.L.181-2016, Section 18.

Presumably in order to cut off refund claims, the Legislature made these statutory revisions retroactive to January 1, 2010. That retroactive change is highly unusual, if not unprecedented, action by the Indiana Legislature on state tax matters.

At a minimum, between the issuance of the Lowe’s decision and the enactment of Public Law 181-2016, a contractor making real property improvements under a time and materials contract could not lawfully collect sales tax from its customer “as agent for the State.” However, as a result of this retroactive legislation, that same contractor is liable to the Department for failing to collect that sales tax from its customer during that time. In fact, the liability could technically be for more than the sales tax on the difference between the wholesale and retail price if the contractor paid use tax and failed to collect sales tax, two different taxes. The contractor may need to file use tax refund claims. Even if the contractor paid sales tax, the Department might view the contractor’s own sales tax liability on the wholesale transaction different from the contractor’s obligation to collect the customer’s sales tax on the retail transaction. The contractor might need to file sales tax refund claims as well.

The Legislature’s methodology for this action may raise other issues as well. Historically, transactions are exempted from “sales tax” and then that exemption is picked up for use tax purposes. Here, the Legislature did not follow this historic model. Instead, the exemption for the contractor on time and material contracts is a “use tax” exemption. So is the contractor’s purchase subject to sales tax? While the Department has informally stated that it is not, because of the purchase for resale exemption from sales tax in Indiana Code § 6-2.5-5-8, the purchase for resale exemption has various qualifications, including the requirement that the property is purchased for resale without changing its form.

Finally, these statutory changes are based on the questionable premise that contracts today neatly fall into one of two categories, when they do not. There are a myriad of “hybrids” between a time and materials contract and a lump sum contract, not to mention contracts which are intended to be lump sum contracts but nevertheless provide a breakout between labor and materials.

A contractor needs to be aware of these developments and we would recommend that the contractor closely review its transactions since the Lowe’s decision, as well as pay very close attention to how it is managing this issue on future transactions. We understand that the Department is working on guidance and may reissue Information Bulletin #60, but that Bulletin will not address all of the issues in all likelihood.
While the consequences of this retroactive legislation may be, in part, unintended, that does not change the risks to taxpayers who previously acted in good faith in trying to comply with the law, and now find themselves with a potential liability.

Mark Richards has practiced federal and state tax law for over 30 years, and has experience in resolving tax controversies. Matthew Ehinger concentrates his practice on state and local tax planning, compliance and controversy. Mark can be reached at mark.richards@icemiller.com or (317) 236-2471, and Matt can be reached at matthew.ehinger@icemiller.com or (317) 236-2183.
 
This publication is intended for general information purposes only and does not and is not intended to constitute legal advice. The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader’s specific circumstances.
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