Arizona’s 2015 TPT Amendments Have 99 Problems, but Origin Sourcing ain’t One

By Stephen P. Kranz, Diann Smith, Mark Yopp and Lauren A. Ferrante on January 29, 2015

Actually, there are really only two issues, but they are big issues.
Arizona’s Transaction Privilege Tax has always been an anomaly in the traditional state sales tax system. Contrary to some commentators, however, the recent amendments do not, and could not, impose an origin tax on Arizona retailers for remote sales delivered out-of-state. That is not to say that these amendments are benign. Oddly, the amendments provide incentives for Arizona residents shipping items out-of-state to purchase these items over the internet rather than visit Arizona retailers in person. Furthermore, these amendments create complexities for Arizona vendors shipping to foreign jurisdictions. Finally, these amendments create additional administrative problems for retailers that are difficult to address with existing software and invite double taxation problems that should not exist in a transaction tax world.

Background: Arizona Transaction Privilege and Use Tax
For retail sales, Arizona, like most states, has two complementary transaction-based taxes, but each tax is imposed on a different entity. The first tax, the Transaction Privilege Tax (TPT), is imposed directly on the retailer. Ariz. Rev. Stat. § 42-5001.13. A retailer will be subject to the TPT on the gross proceeds from a sale if “the location where the sale is made” is Arizona. Ariz. Rev. Stat. § 42-5034.A.9. A retailer subject to the TPT is allowed but not required to collect the amount of TPT it owes from its customers. Ariz. Admin. Code §§ 15-5-2002, 15-5-2210.

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SB 1413 Could Create Large AZ Transaction Privilege Tax Savings for Manufacturers

Recently the Arizona Legislature passed a series of tax reform laws and incentive programs (predominantly aimed at enticing Apple to build a manufacturing facility in this state). The manufacturing sector of Arizona is a beneficiary of the tax reform package and is billed as a way to diversify the Arizona economy. On April 8th Senate Bill 1413 was passed by the House and sent on its way to Governor Brewer to be signed in to law. S.B. 1413 is designed to take the tax burden off certain manufacturers operating in Arizona. According to Chad Heinrich, the Vice President of the Greater Phoenix Chamber of Commerce and an advocate for S.B. 1413, the law is premised on the belief that lowering the tax burden on manufacturers will attract more manufacturers to Arizona and help diversify our economy. The law includes three distinct provisions that may substantially affect the tax liability of our manufacturing clients. S.B. 1413:

1. Exempts from the Arizona Transaction Privilege Tax (TPT) sales of electricity or natural gas to a business that is principally engaged in manufacturing or smelting operations AND that uses at least 51% of the electricity or natural gas in the manufacturing or smelting operations.

2. Exempts the purchase price of electricity or natural gas by a business that is principally engaged in manufacturing or smelting operations that uses at least 51% of the electricity or natural gas in manufacturing or smelting operations from use tax.

3. Provides that municipalities must either adopt S.B. 1413 in its entirety or not, they may not change definitions or otherwise alter the law.

Basically, any of our clients that purchase electricity and/or natural gas of which over half is used in their manufacturing process should not be charged AZ TPT by their vendor. Also, they will be relieved from self-assessing any use tax for electricity and/or natural gas used in the same manner — if they purchase those materials from an out-of-state vendor. However, it is unclear how manufacturers are going to prove their eligibility to take advantage of S.B. 1413, but it will likely require purchasers to use some sort of exemption certificate. Furthermore, our clients should be on the look-out for whether the jurisdictions in which they operate have chosen to follow or deviate from S.B. 1413. But, in either event, manufacturing clients who fit the use threshold, should see fairly significant tax savings once S.B. 1413 becomes effective, which at this point is still up in the air.

CHANGES IN TAX LAW PRESENT POTENTIAL TAX SAVINGS FOR COMMERCIAL RENTALS IN ARIZONA

The Arizona State Legislature enacted HB 2324 removing a burdensome tax weighing on a common leasing arrangement. Prior to HB 2324, the cities of Arizona were allowed to tax commercial leases between affiliated businesses, where the same leases were exempt from the Transaction Privilege Tax (TPT), Arizona’s version of the sales tax. Specifically, the new law exempts commercial leases of real property between “affiliated companies, businesses, persons or reciprocal insurers,” from city sales tax as well as Arizona TPT.

Prior to the enactment of HB 2324, LLCs, partnerships, trusts and even sole proprietors were subject to tax on their commercial leases between affiliated businesses. However, rentals between affiliated corporations were not. The law essentially treated economically similar transactions differently based on the form of the parties, rather than differences in the leases themselves.

The complexity of the old law became apparent to lessors of real property, whose rental of such property to a related entity was subject to city sales tax, but not the State TPT. The divergent treatment between related parties received at the state level versus the city level made compliance difficult. In an effort to remedy this complexity, the Arizona State Legislature broadened the exemption to include commercial leases to include many more forms of the same leasing transaction.

Affiliated Persons

HB 2324 broadens the TPT exemption to include commercial leases of real property between “affiliated companies, businesses, persons or reciprocal insurers.” These terms are defined as:

• A lessor that holds a controlling interest in the lessee;
• A lessee that holds a controlling interest in the lessor;
• An affiliated entity that holds a controlling interest in both the lessor and the lessee; or
• An unrelated person that holds a controlling interest in both the lessor and lessee.

Furthermore, the term “controlling interest” means direct or indirect ownership of “at least 80% of the voting shares of a corporation or of the interests in a company, business or person other than the corporation.” Direct ownership is fairly straight-forward as it is readily apparent how much of a company is owned by another. However, determining “indirect ownership” is slightly more complex and requires taxpayers to look at the relationship between the lessee and lessor, at the individual level to determine if either of them owns at least 80 percent of the other party.

Cities’ Broader Interpretation

Strangely enough, the cities affected by HB 2324 allowed the broadened exemption to take effect over two months earlier than the law became effective at the State level. In addition, the affected cities took it upon themselves to add some clarity on what constitutes an “affiliated person” for purposes of the broadened exemption on related party leases.

The cities’ clarity took the form of guidance issued by several cities imposing the tax on related-party rentals. The long and short of the guidance is: cities are taking into consideration family members when determining the exemption. Further, some cities are requesting that entities provide proof that they qualify for the common ownership exemption. The counties follow the state effective date and definitions.

Examples of some leasing scenarios that will no longer be subject to a city sales tax include:

• ABC Company (lessor), a limited liability company, leases a warehouse located in Scottsdale, Arizona to XYZ Company (lessee), a limited partnership. ABC Company owns 80 percent of XYZ Company.
• Op-Co (lessee), a subchapter S corporation, leases an office building in Phoenix, Arizona from Building-Co (lessor), a limited liability company. Op-Co owns 100 percent of Building-Co.
• Land-Co (lessor), a limited liability company, leases a parcel of vacant land located in Chandler, Arizona to Invest-Co (lessee), a limited liability company. Hold-Co, a subchapter S corporation, owns 75 percent of both Land-Co and Invest-Co. John Smith owns 100 percent of Hold-Co and 5 percent of both Land-Co and Invest-Co.
• Bob owns a building, and leases the building to his sister Jane, a sole proprietor. Bob, through family attribution, will be considered an affiliated entity of Jane and Jane’s payment of rent to Bob will not be subject to city sales tax.

Finally, since this is an exemption from city sales tax, as opposed to a deduction, if your business was previously filing only to report the commercial leases of real property between affiliated entities, in some cities you will be able to file a final return and close your TPT account relating to those affiliate leases.

The considerations above are just the tip of the iceberg. The questions raised by leasing activities are very complex and it is therefore vital to seek the advice of a trusted tax advisor. Certain taxpayers that own property and commercially lease it to a related party will pay less tax in Arizona. But, in order to determine the extent of the exemption, it is important to look at the facts and circumstances surrounding the lease.