Taxation of Sales and Use Tax in Construction: Contracts
Taxation of sales and use tax in construction: It starts with the contract.
I wrote a recent white paper on the sales and use taxation of construction companies, I reviewed all aspects of the construction process, including the construction contract. In this blog, I focus in more detail on the contract. The proper drafting of the rights and responsibilities of the parties in the construction project is critical for correctly determining the sales and use tax obligations of the parties. This is clearly illustrated in a recent construction case in Canada (Anand v. The Queen, 2019 TCC 119, May 23, 2019). Although this case involved another kind of indirect tax — goods and services tax (GST) — it nevertheless shows just how critical the contract really is in determining the rights and responsibilities of the parties to the contract.
A quick review of the construction process in general
Most often the construction “process” starts with a would-be homeowner who plans to build or renovate some real property and lays out the plans and specs in sufficient detail to invite construction companies to bid on the project. Typically, the company prepares an estimate of the costs of materials, tax, labor, overhead and profit and bids on the project. If the bid is accepted, a contract is written and executed that spells out the rights and responsibilities of all the parties.
Once a building permit is obtained, the project is off and running. During the actual construction, there may be changes at various stages that usually takes the form of change orders. Taxes generally start to accrue when construction transactions actually begin. Liability for paying the taxes on these transactions depends on the nature of the transactions and the rules of the taxing jurisdictions. The more detailed the terms of the contract are spelled out in the contract, the greater the chance that the rights and responsibilities of the parties are understood by both the parties to the contract and the tax authorities.
U.S. state definitions of types of contractors and contracts — A brief review
Although the Anand case is not a U.S. state case, and therefore does not rely on the various US state definitions of types of contracts and contractors, a brief review of the U.S. rules will demonstrate the general similarity in approach in Canada as well.
Lump-Sum Contracts. Although every state treats these types of contracts differently and must be researched individually, in general, a lump-sum contract is one in which the agreed-upon contract price is one lump-sum amount. The charges for materials are built right into the job and are not separate from the charges for labor. With this type of contract, the contractor is considered the final consumer. This means that the contractor owes sales and use tax on the purchases of materials, equipment, consumable items and taxable services. The contractor does not collect tax from the customer when using a lump-sum contract.
Separated or Time and Materials Contracts. A separated or time and materials contract is one in which the agreed-upon contract price is divided into separately stated agreed-upon prices – one for materials and one for labor. Under this type of contract, the contractor is considered a retailer of the materials and must collect sales tax from the customer. The contractor may maintain a tax-free inventory of items held for resale. Items purchased exclusively for resale may be purchased tax-free by issuing a resale certificate to suppliers. The contractor must hold a sales tax permit to issue a resale certificate. However, the contractor owes tax on the purchases of equipment, accessories, most consumable items and in some states, taxable services (for example, Texas).
The Canadian case — Instructive for those in both the U.S. and Canada
The key parties in the case were typical of most construction projects in both the US and Canada— the homeowner, the primary builder, Anand, and the various subcontractors. The key facts are as follows:
- The owner and his wife (“Homeowner”) purchased an existing home in an upscale neighborhood on a large lot, which they planned to tear it down and build a new custom-designed home on the lot. They paid approximately $650,000 for the land and building.
- The homeowner then hired an architect to prepare detailed plans for his family’s new home. A close family member suggested that his friend, Anand, could supervise the home construction project. The Homeowners were not very knowledgeable about construction.
- Anand is a foreign-trained engineer but is not licensed to practice in Canada. Prior to beginning the construction project, he was working as a salesperson. He had previously overseen the construction of his current family home in Oakville, Ontario. On that project, Anand’s wife handled the interior design of the home.
- The owner hired Anand to assist him with:
- the establishment of a budget;
- the hiring of qualified trades-people;
- the sourcing of all materials and supplies;
- supervision of the execution of the work over the planned construction period; and
- the interior design of the home.
For all of the above services, the owner and his wife agreed to pay Anand and his wife $150,000 payable in three equal installments over the three-year construction period.
The contract — A downloaded internet contract
A contract template downloaded from the Internet was used to provide the contract terms. And as the Court put it “… they were careless in documenting their arrangement.”. The problem arose when a Canada Revenue Agency (“CRA”) auditor read the contract and interpreted it differently. The auditor considered that the contract was a “fixed-price contract” by which Anand agreed to supply a house to the homeowners for $1,550,000 inclusive of GST/HST. In addition, he purchased all the material required to construct the home purely on his own account and hired subcontractors to assist him in the construction of the home according to the plans supplied to him by the Homeowners. As such, Anand was required to collect and remit GST/HST.
According to Anand, he acted solely as a construction project manager in connection with the home construction project, while his wife was hired by the Homeowners to provide interior design services. Together they earned $150,000 over a three-year period for their services. The agreement was for them to split the $150,000 fee on a 50-50 basis. According to Anand, he and his wife were not required to collect GST on the fees charged to the Homeowners because they qualified as “small suppliers”.
How to determine the role of Anand in providing construction services to the Homeowners. Did he act as a project manager, potentially making him an agent of the Homeowners, or as a general contractor as argued by the CRA If he is found to be a project manager, does this mean that he was an agent of the homeowners?
Starting Point. Both parties agreed that the contract did not accurately reflect their bargain. Nonetheless, the court stated that the contract itself remains an important piece of evidence and is a reasonable starting point for determining the rights and responsibilities of the parties. However, when the contract has inconsistencies, the court can conclude that the contract is ambiguous and therefore, other evidence may be considered in determining the rights, responsibilities and tax obligations of the parties.
The Court concluded that when the factual context in which the Agreement was negotiated is considered, as well as the parties’ subsequent conduct, it is clear that the agreement does not accurately reflect their true intent. While they were careless in documenting their arrangement, there are enough inconsistencies in the agreement to render its interpretation difficult without consideration of evidence determined by the conduct of the parties.
Results of the case
When the court considered all the evidence, it concluded that Anand did not agree to act as a general contractor. Instead, he acted as a project manager. In this capacity, he represented the Homeowners when he hired, paid and supervised subcontractors on their behalf, as well as when he purchased materials used in the home construction project. In both cases, Anand was reimbursed for these expenses by the Homeowners. In other words, an implied agency relationship existed as Anand acted as a conduit between the suppliers and the Homeowners. And because under Canadian GST law, he was considered a small supplier, he was not obligated to register and collect GST/HST with respect to his $75,000 project management fee.
Bottom line — The contract matters
What is important to take away from this case is that because the contract did not spell out properly the rights and responsibilities of the parties, both the Homeowner and Anand had to spend an enormous amount of time and money to make their case.
A better-drafted contract would probably have solved the problem before it became a problem. The taxpayer needed the tools and professional guidance to avoid the painful experience of an audit and worse a long, expensive court case.