In our last NC sales tax update released in October, we discussed major changes that will affect the taxation of real property trades or businesses effective January 1, 2017. In summary, if a contract is considered a “Real Property Contract”, then sales tax will not be assessed on the sales price of the contract to the customer. If the contract falls under the category of “Repair, Maintenance, and Installation Services” (RMI), then sales tax will be assessed on the sales price of the contract. In the case of a real property contract, the contractor will pay sales tax on the materials incorporated into the job, but no sales tax will be assessed on the labor. Alternatively, if the job is classified as an RMI contract, then the contractor will purchase the materials incorporated into the job exempt from sales tax. The contractor would then charge the customer sales tax on the entire sales price of the contract (labor included).
A unique compliance aspect of the new laws effective January 1, 2017, will be the requirement to issue a Form E-589CI, Affidavit of Capital Improvement, to substantiate that the underlying work performed under the contract will, in fact, rise to the level of a capital improvement. If you will recall from our last update, if the work results in a capital improvement, then the contract will be considered a real property contract. Please do not confuse this form with Form E-595E, Certificate of Exemption, used to purchase materials exempt from tax that will be incorporated into an RMI contract. Form E-589CI is brand new and is used to substantiate that the contract qualifies as a real property contract meaning that the underlying materials incorporated into the job are subject to sales tax, but sales tax is not assessed on the sales price to the end consumer. Failure to issue this form to substantiate that a contract is a real property contract subjects the transaction to tax as a retail sale of or the gross receipts derived from RMI services for real property. In other words, the sales price will be subject to sales tax even though sales tax has already been paid on the underlying materials by the contractor.
Except for certain exceptions discussed below, the customer will be required to issue the Form E-589CI to each subcontractor the customer oversees. According to Directive Number SD-16-3 released November 15, 2016:
When a homeowner remodels and oversees the entire activity, including obtaining bids, selection of subcontractors, and payment of all invoices or billings issued by any real property contractor, the homeowner must complete Section I of Form E-589CI and issue the form to each subcontractor to give notice that the transaction is a real property contract with respect to a capital improvement.
So, if the homeowner oversees a remodeling job, then the onus is on the homeowner to determine that the improvement rises to the level of a capital improvement and issue Form E-589CI to each subcontractor. We foresee a lot of future failures to comply with this requirement in this particular scenario. If a subcontractor does not clue the homeowner in to this compliance requirement, then most homeowners will not have the wherewithal to determine whether or not the work rises to the level of a capital improvement. So we may see many remodeling jobs taxed as RMI contracts when they really should have been taxed as Real Property Contracts.
There are two exceptions to the requirement to issue Form E-589CI to substantiate that a contract is a real property contract with respect to a capital improvement listed in SD-16-3 issued by the NC Department of Revenue.
In these two scenarios listed below, the general contractor must keep records that establish that a transaction is a real property contract with respect to a capital improvement:
1. A real property owner or other person hires a “general contractor” to oversee the entire contract and the contract by definition is for “new construction.”
2. A real property owner or other person hires a “general contractor” to oversee the entire contract and the contract is to rebuild or construct again a prior existing permanent building, structure, or fixture on land.
In these two exceptions, the onus is not on the homeowner to issue Form E-589CI. New construction and reconstruction are obviously capital improvements, so the onus is shifted to the general contractor to maintain records substantiating the transaction as a real property contract.
However, it does not mean the general contractor is off the hook just because Form E-589CI is not required to be issued by the homeowner in these scenarios. The general contractor must issue a Form E-589CI, filling out Section I of said form, to each subcontractor each time work is performed unless the work of a subcontractor meets certain requirements. If the general contractor and a subcontractor have a recurring relationship, then the general contractor may be able to fill out Section II of Form E-589CI and issue the form once to a subcontractor as a “Blanket Use” form.
SD-16-3 states that this will generally apply to the following:
- Builders who hire the same contractors for new construction.
- Contractors who hire the same contractors for reconstruction.
- Contractors who hire the same subcontractors for remodeling and it is clear that the activities performed by the subcontractors are never repair, maintenance, and installation services for real property.
- Contractors who exclusively hire the same subcontractors to perform all or a portion of its real property contracts with respect to capital improvements.
So in the instance where a general contractor hires a subcontractor to work on real property contracts and RMI contracts, then the general contractor must issue a Form E-589CI each time to the subcontractor when the subcontractor performs work related to a real property contract. The “Blanket Use” affidavit cannot be used in this scenario.
As you can see, this new requirement to issue Form E-589CI to substantiate real property contracts will introduce a substantial amount of compliance and record keeping that was not present before January 1, 2017. Directive SD-16-3 is a good place to start to gain an understanding of how this form will be implemented. However, we are sure the directive will leave many of your questions regarding specific scenarios unanswered. We will have to wait for further guidance from the department once the form is finalized and made available on the department’s website.
A link to Directive SD-16-3 is www.dornc.com/practitioner/sales/directives/SD-16-3.pdf