My colleague Chris McLaughlin correctly noted in 2019 that “[s]ales taxes are, for the most part, a state government issue.” The North Carolina Department of Revenue (“NCDOR”)—not North Carolina’s local governments—administers and collects sales and use taxes. The North Carolina General Assembly—not North Carolina’s local governments—determines how NCDOR must distribute the proceeds of sales and use taxes. And although North Carolina’s counties may levy certain local sales and use taxes in addition to the statewide sales and use tax, the General Assembly—not North Carolina’s local governments—decides which transactions are subject to both state and local sales and use taxes.
Unlike the legislatures of thirty-eight other states, the General Assembly has not broadly exempted North Carolina’s local governments from paying sales and use taxes when they purchase or consume goods or services. Instead, just like other individual and corporate consumers, a local government that enters into a taxable transaction either must pay sales tax to a selling retailer or use tax directly to NCDOR unless state law expressly exempts the transaction from tax.
North Carolina’s local governments collectively enter into thousands of contracts each year to construct or repair real property (e.g., buildings or horizontal infrastructure like water and sewer systems) and to repair or maintain tangible personal property (e.g., lawnmowers or motor vehicles). Since the General Assembly expanded the sales and use tax base to tax certain “repair, maintenance, and installation services” (“RMI Services”) (see S.L. 2015-241, s. 32.18.(b)), local government contractors have had to determine whether they must charge and collect sales tax from local governments in connection with these types of contracts.
State law does exempt certain purchases of RMI Services from sales and use tax—but it does not excuse units of local government from paying sales or use tax when purchasing RMI Services solely because a local government is purchasing an RMI Service. When purchasing any service from a third-party provider, local governments and their contractors should determine (1) whether the local government is purchasing an RMI Service, (2) if so, whether state law exempts the particular purchase from taxation, and (3) if no exemption exists, the applicable rates of sales and use taxes. These determinations can be difficult—and this blog post aims to assist.
Taxation of RMI Services Generally
North Carolina law imposes sales tax at the general State and applicable local rates upon (1) “[t]he sales price of or gross receipts derived from repair, maintenance, and installation services to tangible personal property or certain digital property,” and (2) “the sales price of or the gross receipts derived from repair, maintenance, and installation services for real property.” G.S. 105-164.4(a)(1)c. (State – personal property and digital property); G.S. 105-164.4(a)(16) (State – real property); G.S. 105-467(a)(1) (Art. 39); G.S. 105-483 (Art. 40); G.S. 105-498 (Art. 42); G.S. 105-507.2, G.S. 105-509.1, G.S. 105-510.1, G.S. 105-511.3 (Art. 43); G.S. 105-538 (Art. 46). But what do these services encompass?
RMI Services include five broad categories of “activities” (each of which is set forth in the table below). See G.S. 105-164.3(225). The cost of a service has no bearing on its status as an RMI Service. Instead, RMI Services are defined by the character and purpose of a contractor’s activities.
RMI Services
INCLUDE
RMI Services can be performed upon real property (e.g., installing kitchen countertops), personal property (e.g., repairing bicycle gears), and even digital property (e.g., removing viruses or malware from a computer operating system). In each case, a provider of RMI Services must collect applicable State and local sales taxes from a purchaser of the RMI Services unless state law exempts the transaction in question from tax. See G.S. 105-164.4(b). If the provider fails to collect sales tax where it applies, the purchaser must pay use tax to NCDOR at the equivalent rate of sales tax. See G.S. 105-164.6(a)(3).
Counties, municipalities, and certain other units of local governments may receive an annual refund of sales and use taxes paid incident to the provision of RMI Services. See G.S. 105-164.14(c). But the availability of that annual refund does not relieve providers of RMI Services from making an initial collection of sales taxes from units of local government in connection with their purchase of RMI Services. Instead, eligible local governments must pay applicable taxes to a provider of taxable RMI Services and reflect those payments in their annual requests for refund submitted to NCDOR.
Tax law is comprised of a complicated set of legal rules, exceptions to those rules, and exceptions to those exceptions. For that reason, a flowchart or decision tree can be a useful tool to determine which rules govern the taxability of a particular transaction.
Flowchart #1 (“Is a Local Government Contractor Providing a Taxable RMI Service?”) can enable units of local governments and their contractors to determine whether a service contractor is providing a taxable RMI Service for which it must charge and collect sales tax from the unit. It involves three steps: Step #1 (“Prior to Bidding and Contracting”) contains actions that a local government should take prior to bidding and contracting for a service; Step #2 (“Prior to Final Payment”) contains actions that a local government should take before issuing a final payment to a service contractor; and Step #3 (“After Completion of Transaction”) explains what actions a local government should take after a transaction is completed. By following each of the steps and consulting the appendices attached to Flowchart #1, a local government and its contractors can analyze the potential taxability of a particular service under North Carolina sales tax laws and ensure that, if eligible, a unit’s claims for sales and use tax refunds are properly completed.
Step #1 – Determine Taxability Prior to Bidding and Contracting
A unit of local government should determine whether a contractor’s scope of work will constitute a taxable RMI service no later than (1) the time that the unit seeks bids, or (2) if not seeking bids for a particular service, the time that the unit enters into a contract.[1] Doing so will both enable a service provider to determine the taxability of the purchases that it must make to fulfill its contract with a local government, and allow a local government to better understand the total cost of contracting for a service.
Determining Type of Property Upon Which Contractor Will Perform Service
The first step of Flowchart #1 asks users to determine the type of property upon which a contractor will perform a service. It does so because the type of property (i.e., real, tangible personal, or digital) informs whether a service might constitute a non-taxable “real property contract” under North Carolina law.
Taxation of RMI Services vs. Taxation of “Real Property Contracts”
A RMI Service performed upon tangible personal property or digital property is taxable unless state law specifically exempts the type of service performed from tax. Appendix 5 in Flowchart #1 contains a list of exemptions that might apply to RMI Services performed upon personal and digital property.
Certain services performed to real property are not RMI Services, but are instead non-taxable “real property contracts.” A “real property contract” is a “contract between a real property contractor [(e.g., a general contractor)] and another person [(e.g., a local government that owns or leases real property)] to perform a capital improvement to real property.” G.S. 105-164.3(207). A “capital improvement” includes one or more of the services listed in G.S. 105-164.3(31) (and listed in Appendix 2 to Flowchart #1) which includes, among other things, “[n]ew construction, reconstruction, or remodeling.”
A local government contractor that performs a “capital improvement” for a local government must pay to its suppliers applicable State and local sales taxes on materials that it purchases to complete the “capital improvement.” See G.S. 105-164.4H(a). However, when a contractor performs a “capital improvement” to real property owned or leased by a local government, the contractor need not collect State or local sales taxes from the local government in connection with the service.
North Carolina law imposes certain “substantiation” (i.e., recordkeeping) requirements upon interested parties to ensure that a job is in fact a non-taxable “capital improvement.” See G.S. 105-164.4H(a1). When a local government enters into a “real property contract” (i.e., a contract with a contractor to perform a capital improvement to real property), it can substantiate that the transaction is a capital improvement in one of two ways: (1) by maintaining records that establish that the transaction is a “real property contract”; or (2) by providing an affidavit of capital improvement (NCDOR Form E-589CI) to its contractor. See id. By receiving an executed NCDOR Form E-589CI from a local government, a contractor that may treat the contract as a non-taxable “real property contract” for purposes of North Carolina sales and use tax.
If a contract for services to real property does not involve the performance of a “capital improvement” as defined in G.S. 105-164.3(31) and the services fall within the definition of RMI Services, a local government must ensure that the service provider collects both State and applicable local sales taxes on the cost of the RMI Services. In such a case, the provider of RMI Services to a local government need not pay sales tax upon materials purchased from suppliers if the provider incorporates those materials into local government property. State law treats the purchase of those items as a “purchase for resale,” and the provider of RMI Services may purchase those materials tax-free. See G.S. 105-164.13(61b); N.C. Department of Revenue, 2021 Sales and Use Tax Bulletin 75-8(A). Ultimately, however, the provider of RMI Services would collect sales tax upon those items when reselling the materials to the local government.
Mixed Transaction Contracts
It might be the case that a contract contains separate scopes of work, one of which includes elements of a “real property contract” (i.e., a “capital improvement”) and the other of which encompasses unrelated elements of taxable RMI Services. For example, assume that a contractor agrees under a single contract for $40,000 to replace all of the windows in a municipal building and also paint all of the building’s doors.[2] The former scope of work would constitute RMI Services while the latter scope of work would constitute a “capital improvement” (see G.S. 105-164.3(31)e.)).
These types of contracts—labeled “mixed transaction contracts” (G.S. 105-164.3(105)) under state law—are taxable in accordance with G.S. 105-164.4H. See G.S. 105-164.4(a)(16). If the allocated sale price of the RMI Services is less than or equal to 25% of the contract price, then the entire contract may be treated as a “real property contract.” See G.S. 105-164.4H(d)(1). But if the allocated sale price of the RMI services is greater than 25% of the contract price, then the RMI portion of the contract price is subject to tax unless an exemption applies. See G.S. 105-164.4H(d)(2).
If, in the example above, the portion of the work to replace the windows costs $35,000 (i.e., 87.5% of the total cost) and the portion of the work to paint the building’s doors costs $5,000 (i.e., 12.5% of the total cost), then the RMI Services portion would be taxable to the local government.[3] If, hypothetically, those numbers were reversed, the entire contract could be treated as a non-taxable real property contract.
Step #2 – Prior to Final Payment
If a contractor fails to pay the proper amount of sales taxes upon materials that it incorporates into real property in North Carolina, the contractor and the owner or lessee of the capital improvement (e.g., a local government) are jointly and severally liable for use taxes (at a rate equal to the applicable rates of sales tax) on these items. See G.S. 105-164.6(b). However, the liability of an owner or lessee (i.e., a local government) is extinguished by receipt of an affidavit from its contractors (and any subcontractors) certifying that the proper sales tax has been paid.
As noted above, real property contractors that performs a “capital improvement” for a local government must pay to its suppliers applicable State and local sales taxes on materials that it purchases to complete the “capital improvement.” And if a real property contractor fails to pay applicable sales taxes, a local government that owns or leases the improved real property into which the materials were integrated could be liable for use tax imposed upon such materials. Therefore, to extinguish any potential liability, a local government should obtain a real property contractor an executed affidavit of sales and use taxes prior to issuing a final payment to them.
Step #3 – After the Transaction
North Carolina law entitles municipalities, counties, and certain other units of local government to annual refunds of (1) sales and use taxes paid on “direct purchases of items” (i.e., “[t]angible personal property, digital property, or a service”) (see G.S. 105-164.3(113)), and (2) sales and use tax liability “indirectly incurred . . . on building materials, supplies, fixtures, and equipment that become a part of or annexed to any building or structure that is owned or lease by the governmental entity and is being erected, altered, or repaired for use by the governmental entity[.]” G.S. 105-164.14(c). Therefore, local governments eligible for annual refunds should ensure that they include in their annual requests for refund (1) any North Carolina sales and use taxes paid to a provider of RMI Services, and (2) any North Carolina sales and use taxes incurred by their real property contractors on materials that those contractors purchase and integrate into local government property.