Written by Craig P. Wagnild

On June 9, 2011, Governor Neil Abercrombie signed into law Senate Bill 754, SD1, HD1, CD1 as Act 105, Session Laws of Hawaii 2011 (“Act 105”). Act 105 suspended numerous Hawaii General Excise Tax (“GET”) and Use Tax exemptions, exclusions and deductions, some of which dramatically affected the economic expectations of the construction industry in Hawaii. Act 105 was scheduled to sunset/repeal on its own terms on June 30, 2013 but many wondered if that would actually happen. It did, and the method by which it sunsetted raised almost as many questions and concerns as the grandfathering exemption rules that were established at the time Act 105 went into effect. This article discusses Act 105, including the original exemptions, and then explains the grandfathering guidelines that apply to contracts and agreements in place at the time of Act 105’s repeal.

1.     Summary of Act 105

For many years, owners, developers, contractors and other construction professionals contracted for the development of real property in Hawaii with a clear and reliable understanding of how projects would be taxed under Hawaii’s GET law.　 That tax scheme changed dramatically in 2011 with the passage of Act 105, a revenue-generating measure which suspended, among other things, certain standard exemptions contractors and owners/developers relied upon in determining and assessing project costs. 　In particular, Act 105 suspended the standard gross income deductions taken by contractors for GET calculation purposes on work performed by subcontractors and/or specialty contractors.　 The effect of this new law was a shock to the system.

The Act 105 suspensions were effective starting on July 1, 2011 and lasted for two years.　 Contractors executing construction contracts after June 30, 2011 were required to pay four percent (4.0%) GET on all income received under their contract, including income “passed through” to subcontractors or specialty contractors for work performed by them.　 Like any tax law, the details of the application and effect of these suspensions were complex, but at the time Act 105 went into effect, I was informing contractors and others in the construction industry of five things every contractor should know about Act 105:

• Certain pre-Act 105 construction contracts were exempt from the Act　105 suspensions.　 Contracts were exempt from Act 105 if they: i) were in writing; ii) were fully executed and binding prior to July 1, 2011; and iii) did not permit any increase in GET to be passed on to the project owner (or above-tier contractor).　 Contractors were not permitted to change an existing contract to comply with this exemption after Act 105 went into effect, but many construction contracts, including most fixed price contracts, entered into prior to the effective date of Act 105 actually met those requirements.
• Change orders to qualified existing contracts (contracts that qualified for the exemption from Act 105) were also exempt from the Act 105 suspensions.　 Contractors with a qualified contract were able to build in additional work through a change order and thereby avoid the additional GET caused by Act 105 that would necessarily result if the contractor had entered into a new contract for the work.
• Bids submitted or accepted bid awards granted on government projects prior to July 1, 2011 were also exempt from the Act 105 suspensions.　 Provided the bid or award ultimately resulted in a fully executed written contract, a bid submitted prior to July　1, 2011 in response to a local, state or federal government bid invitation was considered a binding written contract for the purposes of the exemption discussed in Item　#1 above.
• Act 105 only applied to GET and did not affect a contractor’s exemption from paying the Oahu Surcharge of (0.5%) on work performed by others. 　While after Act 105 went into effect contractors had to pay GET on work performed by subcontractors and others, they were not required to pay the Oahu Surcharge on income that was exempt prior to the Act 105 suspensions.　 Many contractors did not realize this and lumped GET and the Oahu Surcharge together on work performed by others down the chain. No one reasonably expected the City to figure it out and issue a refund.
• In additional to the “work performed by subcontractors and specialty contractors”, Act 105 suspended numerous other GET exemptions previously available to contractors. 　I strongly advised contractors to discuss the potential applicability of all of the Act 105 suspensions carefully with their tax professionals or an attorneys who understand the details of Act 105. Many who did found ways to avoid or recover money they thought was lost due to the Act 105 suspensions.

2.     The Sunsetting of Act 105

Act 105 sunsetted on June　30, 2013. Even halfway through the life of the exemption suspensions, it seemed pretty clear that the legislature was going to let the law sunset rather than extend it. What was unclear, even up to a month beforehand, was how the legislature was going to have the law treat contracts executed prior to the sunset date. Given the obligations addressed by Act 105, it was not terribly surprising that the legislature left the application details (both for implementation and sunsetting) to the State of Hawaii Department of Taxation (“Tax Department”). On June 5, 2013, the Tax Department issued Department of Taxation Announcement No. 2013-04 regarding the Sunset of Act 105, Session Laws of Hawaii 2011, Relating to Taxation (“Announcement 2013-04”). A copy of Announcement 2013-04 is available at:http://www6.hawaii.gov/tax/announce/ann13-04.pdf. Before reviewing how the Tax Department elected to handle the sunsetting of Act 105, it is helpful to consider some of the issues that arise when the exemption suspensions like this are removed.

Tax obligations typically change immediately upon the effective date of the law. That would mean that, without any other interpretation or guidance, irrespective of the execution date of a construction contract, after June 30, 2013, the general contractor would no longer have to pay GET on work performed by its subcontractors. However, the Tax Department could instead have decided that prior to the sunset date, the parties contracted with an expectation that the contractor would pay GET on the full amount of the general contract, so the suspension should continue to apply to existing contracts that started with that expectation. Since that was arguably a fundamental basis for the agreement, and because that interpretation would result in additional tax revenue to the State, such an interpretation would seem attractive without unreasonably upsetting the bargained-for expectations of the parties. Ultimately, that is not what happened, but a change in tax law application like this still has twists and turns, so a careful read of Announcement No. 2013-04 is important.

3.     The Grandfathering Guidelines

Announcement No. 2013-04 acknowledged that the Tax Department had received numerous inquiries regarding how Act 105 would apply to gross receipts received or accrued after the June 30, 2013 sunset date. Where such receipts were received or accrued based on contracts entered into during the exemption suspensions of Act 105, would there be a grandfathering that continued the suspensions? The short answer is “no.”

Gross receipts received or accrued on or after July 1, 2013 will be subject to all provisions suspended by Act 105, regardless of whether the contract from which the gross receipts arise was entered into prior to July 1, 2013 (a.k.a. no “grandfathering out”). In other words, the suspensions of deductions, exemptions, and exclusions under Act 105 will not apply to any gross receipts received or accrued after June 30, 2013.

Announcement No. 2013-04 on Page 4. The controlling factor in all of this is when the income is received or accrued. As simple as this would seem to be, whether income is taxable or a company can apply one of the exemptions to avoid the tax now hinges on when a payment is deemed “received” and whether the taxpayer is operating on a cash or accrual basis. Even the Tax Department acknowledged that “[t]his means that two different taxpayers entering into identical transactions could potentially pay general excise tax at two different rates.” Announcement No. 2013-04. This primarily affects those companies using an accrual method of accounting, which is rare in the construction industry.

For those construction company’s operating on an accrual basis, if the amount of income due for work performed prior to June 30, 2013 can be determined with reasonable accuracy, even if payment is received after June 30, 2013, GET may be owed. In the same situation, a company using a cash basis method of accounting would not pay GET because the sunsetting of Act 105 allowed it to take advantage of the exemptions. While it is likely too late to structure or time payments to avoid tax where a company operates on a cash basis, companies operating on an accrual method of accounting should carefully review and consider the amount of work that had been completed and for which payment had accrued as of June 30, 2013.

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