Virginia gives contractors tax relief

State puts an end to a system that kept companies guessing about some transactions

Virginia’s General Assembly has finally addressed a tax policy issue that had vexed contractors based in the state for years. Now companies are assessing the new provisions.

Under the old rules, the state’s Department of Taxation could declare that some federal contracts were services contracts, and agencies had to pay sales tax on products purchased through those contracts. Purchases made for direct resale to government agencies are still tax-exempt, but in the past if a contractor purchased goods to use in the course of fulfilling a contract, those goods were taxed.

The state relied on a “true object” test to determine whether a contract was primarlily for products or for services. Vendors encountered difficulties, however, when bundled contracts combining products and services became more common. Virginia authorities sometimes imposed taxes on purchases that contractors believed should have been tax-free.

“The world changed around us in Virginia,” said Josh Levi, vice president for policy at the Northern Virginia Technology Council (NVTC). “The federal government started to go to more bundled contracts for both goods and services. When you had those hybrid contracts, it was not always clear whether it was a taxable transaction or not.”

The state’s new budget, passed in June, changed that policy. Now tax authorities must look at individual task orders and statements of work to determine what is taxable rather than make judgments about the entire contract. The Department of Taxation has until June 30, 2007, to issue rules implementing the new system. They will apply to all contracts entered into on July 1, 2006, or after.

NVTC has lobbied for a change in the rules for the past decade, Levi said. The determinations are sometimes arbitrary, and federal agencies won’t always pay the taxes, he said. Bobbie Kilberg, president and chief executive officer of NVTC, said several state lawmakers and Gov. Tim Kaine were supportive of the effort.

“We have been at this for a while and finally reached critical mass this year,” Kilberg said. “NVTC’s lobbying team had a full-time presence in Richmond, and this issue was of high priority for us.”

The old rule was subjective and not always predictable, Levi said. “There’s a lot of uncertainty for companies. Smaller companies that have not dealt with a lot of contracting vehicles don’t know about this,” he said.

Even larger companies often got hit unexpectedly. Pat Herrity, chief financial officer at Arrowhead Global Solutions, recalled his days at Signal in the late 1990s, when that company had to cough up $90,000 on short notice.

“The biggest hit we took was through our [General Services Administration Federal Systems Integration and Management Center] contract,” Herrity said. “It was a services contract, but the government kept adding equipment to it. We had to actually get a letter from the state saying we were owed the tax because the Fedsim contracting officer didn’t want to pay it.”

Eventually, Signal had to pay the tax out of its profits, Herrity said.

“It comes down to a business decision, and neither alternative is a good one,” he said. “You bid the sales tax and end up being 5 percent higher than companies from other states, or you don’t bid it and it ends up coming out of your thin profit margin. Either way, Virginia is putting its contractors at a disadvantage.”

Companies looking for a home have chosen sites in Maryland or even Pennsylvania to avoid the Virginia tax uncertainty, Herrity said.

“The technology community did not really get involved in this until four or five years ago,” said state Sen. Jeannemarie Devolites Davis, one of the legislators who backed the change. “That was during the time when we were going through the mini-recession and all of the states had to cut billions from their budgets. We were not going to entertain any tax credits at that time. We’ve seen a complete reversal on that. We have made up those lost revenues.”

Davis sees the change as state law catching up with the times. “Technology has created new goods that are not as tangible, and the tax department has never caught up to that,” she said.

The old rule’s effect was limited in scope, said Carl McNair, special assistant for government relations in corporate communications at Computer Sciences Corp. It affected fixed-price contracts, for example, but not cost-plus deals in which the government agrees to pay the contractor’s costs. However, when the rule did kick in, it could be devastating.

“People think you make a lot of money in the government, but on some very high-value things you might get up to [a] 6 percent or 7 percent” profit margin, he said.

Christopher Toven, former vice president and general counsel at AnviCom, said the state subjected the company to what he considered a Draconian use of the old tax law. An 8(a) firm at the time, AnviCom was posting annual revenues in the mid-$20 million range when it won a contract from the Defense Information Systems Agency, he said.

During the first couple of years of the contract, the company ordered about $12.5 million worth of products on behalf of its client. In the third year, the state conducted a tax audit.

“We were just acting as a purchasing agent,” Toven said. “We didn’t receive the product. We didn’t have it delivered to our company.”

However, the auditor determined that the products were taxable and that the company owed several hundred thousand dollars. AnviCom appealed the decision.

Sravant Lavu, AnviCom’s current general counsel, said the company is still awaiting a final determination. The new tax policy is good for the future, he said, but it’s unlikely to have any bearing on older conflicts.

“They feel it’s the right thing to do, but they don’t want to make it retroactive,” he said. “Little companies like ours are going to get squeezed. It’s difficult for us to know how they’re going to apply this new guidance.”

The Department of Taxation “essentially took a one-way stance,” Toven said. “My impression was they weren’t really interested in being fair or actually looking at what it said. They were interested in the potential for reporting taxable revenue.”

The change in the law could be helpful, Toven said, but the ultimate benefit depends on how strictly state officials follow it. “I advise people to still be on their guard,” he said.

Legislators and policy-makers who resisted past efforts to reform the tax policy were largely motivated by fear of lost revenues, Davis said. But in the end, the argument that prevailed was one warning of even more dire consequences.

“You lose more than that 5 percent sales tax,” she said. “You lose a lot more if someone decides to leave the commonwealth.”

At a glance: Virginia's new sales tax rules

Virginia officials must follow new rules in deciding whether a contract is subject to state sales tax. The following are major provisions of the new rules.

  • Beginning July 1, the Department of Taxation had to stop applying the “true object” test to entire contracts to determine tax status.

  • Beginning with contracts signed on or after that date, the department must determine individual taxability for each work order, task order or statement of work.

  • The state’s tax commissioner must work with industry to develop a regulation on or before June 30, 2007, to implement the provisions. The regulation must include specific examples to demonstrate when the purchase of goods is taxable and when it is not.

— Michael Hardy

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