Nadler: The Va. contractor tax

Virginia has consistently been a leader among the states in receiving federal contract dollars, ranking second only to California in each of the past five years. In fiscal 2004, Virginia companies completed federal contract work worth more than $29 billion. However, an inequitable interpretation of the sales

and use tax by the Virginia Department of Taxation, known as the true object test, jeopardizes this distinction and the commonwealth's competitive position in the federal marketplace.

The government is exempt from sales taxes, and contractors do not pay taxes on items resold to the federal government. In most states, they pay taxes on items they purchase to use in providing a service to the government. Under the true object test, federal contractors in Virginia must pay taxes on all tangible personal property they purchase if the Department of Taxation deems the true object of the contract to be the provision of services.

The contractor must pay the taxes even if it buys products for the federal government and does not use or consume them while providing services. In effect, the government could pay 5 percent more by using a Virginia contractor. No other state seems to interpret the tax requirement this way.

Adding the 5 percent sales and use tax to goods purchased for delivery to the government puts Virginia-based government contractors at a disadvantage. Given the razor-thin margins in the federal technology market, that 5 percent tax could easily mean the difference between winning and losing significant government contracts.

The effect of the true object test is especially harsh on small and midsize companies, many of which are unaware of this liability until they get hit with a tax assessment after the terms of the contract end. Some government contractors are leaving the commonwealth or moving projects to other states to avoid the tax, which deprives Virginia of jobs and income tax revenues.

The true object test is unworkable because it is unduly subjective and seeks to pigeonhole every contract as one for either goods or services. When the test arose, single object contracts for either goods or services were the norm.

In today's environment, however, systems integration and other contracts that bundle products and services are prevalent. In those contracts, the government wants both goods and services, so the contract does not have a single true object. Today's contracts also are often multiyear efforts in which the nature of the work can change.

The application of the true object test to government contractors is based on an interpretation of the law by Virginia's tax commissioner and is not a policy mandated by the legislature. Therefore, the governor can fix the problem through administrative action. Alternatively, if the governor does not act, the legislature can and should repeal the test by statute.

Nadler is a partner at the law firm Dickstein Shapiro Morin and Oshinsky, where he specializes in government contract matters. He can be reached at (202) 828-2281 or NadlerD@dsmo.com.