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Using a Lease Back Strategy When Purchasing Mobile Transportation Equipment can Save Thousands of Dollars in Taxes
By ASSOCIATED SALES TAX CONSULTANTS, INC.
The use of a lease back arrangement is an excellent way to mitigate the sales tax on a major purchase of mobile transportation equipment. Sales and Use Tax Regulation 1661 contains all the language that sets out the guidelines. It states, in pertinent part;
Definitions
(1) “Mobile Transportation Equipment.” The term “mobile transportation equipment” includes only equipment for use in transporting persons or property for substantial distances . . . ”
Some of the items that can be classified as MTE are:
Air Compressor Licensed for Highway Use and pulled by a Trailer
Aircraft Engine
Airline Catering Trucks
Aircraft
Barge
Bus
Cement Mixers
Center Mount Crane
Concrete Pump attached to a truck
Debris Box
Derrick Barge
Feed Wagons
Hearse
Mobile Water Chilling Unit
Mobile Truck Crane
Mobile CT Scan Unit
Motor Coach
Rail Freight Car
Reusable Cargo Container
Sanitation Equipment
Ship
Street Sweeper
Trailer
Trailer Mounted Water Purification Unit
Truck Tractor
Vehicle Engine Hoist Licensed for Highway Use and pulled by a Trailer
Vessel
Yacht
The above list is not complete. It is intended to stimulate a professional to consider that the leaseback option is available to many types of businesses.
(b) Application of Tax
(1) With respect to leases of mobile transportation equipment, the sale to the lessor is the retail sale and the lessor is the consumer of the equipment. Accordingly, either the sale of the equipment to the lessor or its use in this state may be subject to tax. For example, if the sale and delivery occur within California, the transaction is subject to sales tax unless the lessor makes a timely election to report his or her tax liability measured by the fair rental vales as provided in (b)(2) below. On the other hand, if the sale and delivery occur outside California and the property is purchased for use in California, use tax will apply measured by the purchase price unless the equipment enters the state in interstate commerce and is used continuously thereafter in interstate commerce, or the lessor makes a timely election to report use tax liability measured by the fair rental value as provided in (b)(2) below.” (2) If the use of mobile transportation equipment purchased under a resale certificate is limited to leasing the equipment, the purchaser may elect to pay his or her use tax liability measured by the fair rental value if the election is made on or before the due date of a return for the period in which the equipment is first leased. The election must be made by reporting tax measured by the fair rental value on a timely return for that period. Tax must thereafter be paid with the return for each reporting period, measured by the fair rental value, whether the equipment is within or without the state. The election may not be revoked with respect to the equipment as to which it is made. Any separately stated amount collected from a lessee by a lessor electing to report use tax measured by fair rental value under the representation by the lessor that the amount is use tax imposed on the customer must be returned to the customer or paid to the board. A designation by the lessor of a separately stated amount as “use tax,” without further explanation, will be regarded as a representation that the amount is use tax imposed on the customer.”
(A) Fair Rental Value. “Fair rental value” means the rentals required by the lease, except where the Board determines the rental receipts are nominal. Fair rental value does not include any payment made by the lessee to reimburse the lessor for the lessor’s use tax. Whether or not the amount is separately stated, regardless of how the charge is designated in the lease documentation and invoices. Lump-sum charges to the lessee will be assumed to include reimbursement for the lessor’s use tax whether or not any statement to that effect is made to the lessee.
Example: XXX Leasing acquires some mobile transportation equipment (MTE) for a price of $500,000.00. The leasing company either has to pay $40,000.00 (presuming an 8% tax rate) in sales tax at the time of the purchase, or, give a resale certificate to the seller and purchasing it exempt from tax. If the leasing company purchases the MTE without tax, it must make a timely election to the Board that it will remit the tax based on the fair rental value. In the absence of making the timely election the tax is due immediately on the entire purchase price.
Regulation 1661 provides very precise wording that defines the steps that must be completed in order to use this method of remitting use tax to the Board of Equalization. In lay terms it gives you an option of paying the tax over the life of the asset based upon the fair rental value. In the absence of electing the option timely the tax is due on the sales price.
Many taxpayers interpret the “timely election” section as describing the situation to be one where the tax on the fair rental value is not due until the leasing company begins to collect rents on the use of the MTE. This is a common pitfall that invalidates this exemption.
In an actual case, a leasing corporation purchased an aircraft in June of 1990 and issued a resale certificate and signed a leasing Company Exemption Certificate which accepted delivery of the aircraft from the seller and stated that the equipment was purchased for the purpose of leasing. It immediately entered into a lease with a lessee effective June 1 of 1990 and established a flat rental per month.
The leasing corporation then filed monthly sales tax returns for June and July which reported zero rental receipts. Their records show that it first posted rental receipts on August 31, 1990. The first period that rental receipts were reported to the Board was for the August 1990 monthly period.
The audit staff determined that the reporting of rental receipts on the August 1990 return was not timely and assessed tax on the purchase price of the aircraft. The Board contended that the leasing company had use and possession of the aircraft from May of 1990. Repairs orders dated May, June and July of 1990 showed that the aircraft was being used in those months, even though only repairs were being made on the aircraft.
The key word that was missed by the taxpayer is in the first sentence of Regulation 1661 (b)(2). The word is “limited.” Although it is easy to bypass the word when the sentence is being read, the word “limited” impacts the meaning to the degree that it alters the understanding by the reader which causes the reader to misapply the law. The definition of “limited” that should be applied in this case is “confined or restricted within certain limits.”
The Board interpretation of the sentence reveals that they apply the exemption only in cases where one-hundred percent of the usage of the aircraft is invoiced by the lessor and charged to the lessee. When the Board reads the word limited it appears that they interpret it to mean that every hour the MTE equipment is used a rental invoice must be generated. It also makes clear that if the lessor has a signed lease it must report and pay the tax for each hour of usage of the lease even though no receipts were generated. The rate must be at “fair rental value.”
Fair rental value means the money required by the lease, except where the Board determines the receipts are nominal. There is a recognized potential for abuse where the parties are related and Sales and Use tax Annotation 330.1875 states in relevant part:
“Since the corporations are related parties, further analysis is required to determine if the lease is an arms length transaction. If the rentals payable under the lease covers all the costs of the lessor with respect to that lease, it is generally regarded as being entered into as if at arms length and considered the same as a lease between unrelated parties.”
There are no regulations that require a specific kind of usage by the lessee. Therefore, the lessees type of usage is not limited to business use. The only requirements are that all the guidelines are clearly met to the Boards satisfaction.
Additionally, there are no exclusions for any usage that must be paid for, including out-of-state usage. It isn’t like a sales tax transaction where the tax is not due because the sale occurred out-of-state. The lessor is the consumer of the MTE by definition. The tax is on the lessor for all usage. The application of tax to sales and leases of MTE is never a “sale” or “purchase.” (Rev. & Tax. Code 6006(g) (4) and 6010 (e) (4).) Thus, a sale of MTE which the purchaser subsequently leases is not a sale for resale; which means the purchasers, owners and users of the MTE, are liable for the use tax. The lessee has no California sales or use tax liability as a result of any lease from the lessor or use of the MTE pursuant to any such lease. It is irrelevant even if the lease is signed in or out-of-state.
Another area of the regulation that is easily misunderstood is, once the lessor has made his timely election to pay the tax based on fair rental value the tax must be paid on the rental as long as the lessor owns the MTE. This is a situation where the amount of time that a lessor intends to own the equipment can dramatically affect whether using the exemption granted under regulation 1661 is cost effective. An accurate analysis of the expected hours of usage over the life of the ownership can create a situation where significantly more tax is paid measured by fair rental value than if it had been paid on cost at the time of the purchase.
Example: If MTE is purchased for $500,000 and the option is exercised to pay on the fair rental value, the purchaser must have a good understanding of the expected usage and the ownership life of the asset otherwise the taxpayer may wind up paying a lot more tax than would have been originally due. Using a fair rental value of $500 per hour, the following table will show you when the fair rental method becomes more expensive than remitting the tax at the time of the transaction.
Regulation 1661 sets out the guideline for paying the tax based on fair rental value, which if the MTE equipment is going to be owned for a period of time that results in a usage rate that is calculated to create less tax than the original purchase price, it clearly is a legal viable option for mitigating sales tax.
Most of the failed attempts using Regulation 1661 are because the taxpayer didn’t understand the nuances of how the Board interprets the law. Although the Board publishes Regulations which are their interpretations of the law, it is nearly impossible for a novice to steer his own ship through the maze of Sales Tax laws and Regulations without years of research into the underlying documents of each case. The information that is buried in the annotations, Decisions and Recommendations and internal memos can take years to read through and understand. It takes a clear understanding of these documents in order to be certain of using any exemption strategy.
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If you have any questions regarding this article, other sales and use tax issues, or want to know if you qualify for an exemption contact Joseph Micallef at (916) 369-1200 or visit us on the web at www.ASTC.com.
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Audit Division