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Breaking The Integrity Of The General Excise Tax

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By Lowell L. Kalapa

(Released on 3/16/08)

Since the general excise tax was established in the 1930’s as Hawaii’s approach to the traditional retail sales tax found on the mainland, the tax has stood the test of time, if not the courts. Those who understand the tax know that it is a tax on gross income for the privilege of doing business in the state.

While there have been some changes to the law over its 75-year run, none has been as significant as the effort to reduce the tax on services sold for resale by the purchaser. This is known as de-pyramiding of the general excise tax and until 1999 whenever services were sold, the tax rate was almost always imposed at the full retail rate of 4%. While there has been some confusion over how the de-pyramiding applies to a sale of a service, the easiest way to explain it is that if the purchased service will subsequently be subject to the 4% rate, the current transaction is eligible for the lesser half percent (0.5%) rate.

For example, a couple of years ago, the legislature wanted to create a special exemption for payments to a clinical laboratory that represented amounts that would be disbursed to the employees of the laboratory on the basis that the clinical laboratory would be owned by its employees through an employee stock ownership plan. This is because a group of doctors had established a clinical lab testing facility within their practice but now wanted to divest themselves of the laboratory. The doctors would still need the services of the laboratory for their patients. And while the amounts disbursed as compensation to the lab employees would be exempt, other amounts paid to the lab for overhead, such as rent and utilities, would still have been subject to the 4% general excise tax.

However, when it was pointed out that all the income received by the laboratory was from lab services which were billed by the doctors to their patients, as the services are resold to the patients, the tax rate would be 0.5% instead of 4%. That’s because when the doctors billed the patients for their services and those of the laboratory, they paid 4% on the entire amount received from their patients.

Such is not the case with a measure that is currently under consideration by this year’s legislature. In this case, the manufacturers of automobiles don’t think they should have to pay the general excise tax on warranty work done by car dealers locally as they don’t pay any sales taxes on work done by dealers in other states. That is a result of the fact that no other state with a sales tax imposes the tax on the sale of services as broadly as does Hawaii. That’s one of the unique features of Hawaii’s general excise tax.

The car manufacturers and the dealers argue that when the car is sold to the customer, the dealer pays the 4% general excise tax on the purchase price. Included in that purchase price is the payment for the warranty. Yes, that’s right, the customer is paying the manufacturer for the promise that he is not buying a lemon. At least that is what the car dealers are saying. And you thought that the car manufacturer was promising to fix a defect should one occur?

As a result, say car dealers, when they bill the manufacturer for the warranty work done on the customer’s car, the 4% tax has already been paid by the customer and, therefore, the work should only be subject to the lesser 0.5% rate. Never mind that if there had been no defect, and thus no warranty work done, that the customer paid 4% for something that amounted to nothing more than a promise.

When one sits down to truly analyze what amounts to performing warranty work, one realizes that the real consumer is indeed the manufacturer. The manufacturer is making good on a promise made to the customer that the product, which in this case is an automobile, had no defects. If the car had no defects, the customer never would have needed the service. Thus, it is the manufacturer who is buying the service to correct the defect and should, therefore, be viewed as the consumer and be charged the 4% rate.

What is interesting is that the tax department “took no position” on the measure yet cites a $2.8 million loss of revenue while the car dealers estimate a loss of revenue of only $1.7 million. And while that might be true if this proposal only addressed warranty work for automobiles but, as drafted, the preferential rate would be extended to any warranty work. When you consider all the toasters, televisions, even the shingles on a house, we could be looking at a substantial hit to the state general fund all because there is a lack of understanding of the general excise tax.

Finally, since this is a so-called “clarification” of the law adopted in 1999, there just may be the possibility that taxpayers could sue the state.

Lowell L. Kalapa is the president of the Tax Foundation of Hawaii. Mr. Kalapa’s commentary is printed each week in the Maui NewsWest Hawaii TodayGarden Isle News, and the HawaiiReporter.com.

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