Rethinking the impact of sales taxes on government procurement practices: unintended consequences or good policy?

• Author: Carson, Michael D.

1. INTRODUCTION II. BACKGROUND AND GENERAL PRINCIPLES APPLICABLE TO SALES AND USE TAXES A. Sales and Use Taxes Defined B. Tax Computation III. THE DEVELOPMENT OF THE FEDERAL IMMUNITY DOCTRINE A. Implied Constitutional Immunity B. The Rejection of Absolute Immunity 1. Emergence of the Legal Incident Test 2. State Taxation of Government Contractors a. Examining the Relationship Between the Government and Its Contractors b. State Discrimination Against Government Contractors C. Federal and State Statutory Immunity IV. PRIVATIZATION AND COMPETITIVE SOURCING INITIATIVES A. Overview of Competitive Sourcing B. Overview of Military Housing Privatization Initiative C. Consequences of Applying the Legal Incidence of Tax V. AN ALTERNATIVE TO THE LEGAL INCIDENCE RULE A. Substance Over Form in Federal Tax Cases B. Analysis of the Rationales in Support of Economic Incidence of Tax VI. THE FUTURE OF THE FEDERAL IMMUNITY DOCTRINE VII. CONCLUSION An unlimited power to tax involves, necessarily, a power to destroy (1)

1. INTRODUCTION

   Tax considerations influence financial decisions of all businesses and the impact of sales taxes on Government (2) procurement practices is no exception. (3) It is estimated that federal procurement is a $378-billion-a-year business, involving nearly six million procurement actions. (4) The most obvious burden imposed by any form of taxation is the economic burden of the tax itself. As the Government continues to contract out more functions which are traditionally done in-house, the Government will face an increasing tax burden. (5) Although the United States Constitution is silent regarding state taxation of Government instrumentalities, immunity has nonetheless been implied by the courts.

   Government immunity from state taxation derives from the United States Supreme Court's decision in McCulloch v. Maryland. (6) In McCulloch, the Court recognized that the freedom of one sovereign from taxation by another sovereign is a fundamental aspect of the United States federal system. (7) This absolute federal immunity from state taxation was greatly restricted in the decades following McCulloch but the core of the doctrine remains. (8) At present, protection from state taxation is determined by the "legal incidence of tax." (9) Thus, purchases made directly by the Government are immune from state and local taxation. (10) However, when the Government decides to contract-out a particular project or tap into the expertise of industry leaders, the right to an exclusion from state and local taxes may not necessarily rest on the Government's immunity. (11) Instead, absent an exemption by the taxing jurisdictions, the contractor's purchase of goods and services might trigger state and local sales taxes. (12) Consequently, state and local sales taxes imposed on private contractors and passed through to the Government, whether through cost-reimbursement or otherwise built into the overall contract price, (13) can severely reduce the Government's buying power. (14)

   This article analyzes whether the "legal incidence of tax" is the appropriate test to apply in Government contractor immunity cases when United States sovereignty is at stake. This article also addresses the need to critically look at the federal immunity doctrine and explores an alternative approach that examines the economic substance of a particular state sales tax through the common law doctrine of substance over form. A firm understanding of the impact of state and local sales tax on Government contracting initiatives, like the Department of Defense's (DOD) competitive sourcing program (15) and the privatization of military housing, (16) is crucial to formulating successful contract strategies, developing effective contracts, and achieving maximum efficiencies and savings. Failure to achieve projected savings from competitive sourcing and military housing privatization will handicap the DOD's ability to maintain its day-to-day readiness or continue critical modernization programs without seeking additional funding from Congress. (17) Obtaining additional funds will prove to be a challenging and painful process for future military leaders as the battle for the taxpayers' dollar escalates. (18) In fact, many states have already made a preemptive strike by proposing big sales tax increases to pump up their own sluggish revenues. (19)

   Part II of this article begins with an introduction to state sales and use taxes including a look at their increasing importance to state governments. (20) Part III outlines the development of the federal immunity doctrine from McCulloch to the present, and includes an in-depth examination of the tests developed by the Supreme Court in determining a contractor's implied constitutional exemption from state taxation. Part IV tests the current federal tax immunity law against two of the DOD's cost-savings initiatives--competitive sourcing and military housing privatization--demonstrating its inadequacy. Part V then proposes an alternative solution by examining the substance of the state levied sales or use tax rather than its form. Finally, Part VI addresses the future of the federal immunity doctrine and the policy decisions that must be addressed before any changes are made.

2. BACKGROUND AND GENERAL PRINCIPLES APPLICABLE TO SALES AND USE TAXES

   Before addressing the impact of sales taxes on Government procurement initiatives, this article will preview the basic principles and guidelines associated with a state imposed sales or use tax. This section introduces key concepts associated with a tax levied upon the sale of goods and services and forms the foundation for the analysis and conclusions presented in subsequent parts of this article.

   1. Sales and Use Taxes Defined

      Sales taxes are creatures of state law comprising the most significant source of tax revenue for state governments in the nation. (21) Three distinguished authorities have defined a sales tax as "any tax which includes within its scope all business sales of tangible personal property at the retailing, wholesaling, or manufacturing state, with the exceptions noted in the taxing law." (22) The most significant form of sales taxation in the United States is the state retail sales tax (hereinafter "state sales tax"), which consists of a "broad-based tax on the sale of goods and selected services to the ultimate consumer." (23) Although various types of sales taxes have endured a long history throughout the world, (24) the state sales tax movement was the states' response to an acute revenue need borne of the Great Depression. (25) Currently, forty-five states and the District of Columbia impose some form of sales tax. (26)

      State sales tax statutes generally contain similar features operating in a uniform manner. (27) Despite their similarities, however, sales taxes typically fall into one of three categories--vendor taxes, consumer taxes and a hybrid category. (28) Under vendor type sales tax statutes, the legal incidence of the tax falls on the gross receipts of the seller, who, therefore, has primary responsibility for paying the tax. (29) For example, Illinois imposes a tax on the seller's gross receipts for the privilege of selling tangible personal property to consumers. (30) With consumer type sales taxes, however, states impose a tax on the retail "sale" of tangible personal property or services, and are measured by the sales price to the buyer. (31) Thus, rather than being a tax on the seller's gross receipts, the legal incidence of the tax falls on the purchaser or consumer who is primarily responsible for paying the tax. (32) The seller serves purely as an agent who is responsible for collecting the tax on the state's behalf. Hybrid taxes contain features of both with the primary responsibility for paying the tax falling upon both the purchaser and the seller who charges, collects and remits the tax to the state. (33)

      As a way to avoid paying a particular sales tax or to obtain a lower sales tax rate, consumers would often travel outside the state to purchase property. (34) A state cannot tax the privilege of selling property where the sale takes place beyond its borders. (35) To compensate for such tax avoidance and the resultant loss of revenue, state legislatures enacted the compensating, or use tax, to tax the privilege of using, storing, or consuming property within the state, regardless of the place of purchase. (36) Thus, a use tax is designed to protect a state's revenues by eliminating the advantages of shopping for the forum with the lowest tax rate. It also protects local sellers from out-of-state competitors who are able to offer the same goods and services at a much lower price because of a lower or nonexistent tax burden. (37) A use tax also complements the sales tax and generally applies to the use of goods and services that have not already been subjected to a sales tax. (38) As such, unless otherwise noted, all references in this article to sales taxes and exemptions apply to use taxes as well.

   2. Tax Computation

      As previously mentioned, the seller either pays or collects sales taxes from the purchaser on a transaction-by-transaction basis. (39) The sales tax is thus maintained as a discrete charge apart from the price of the item purchased. (40) In determining the sales tax due, the applicable sales tax rate is applied against the purchase or sales price, which is generally the consideration paid for goods or services by the buyer. (41) For example, the amount of sales tax due on a $1,000,000 purchase at a rate of six percent would be $60,000. (42) The seller collects this amount and remits it to the taxing authority. (43) In comparison, the measure of a state's use tax generally is at the same rate as the sales tax, although it may be described as consideration paid to the seller. (44)

      The example above illustrates the tax implications in a relatively small purchase pursuant to a Government contract. Projects involving the...