This article discusses the difference between leases and sales of tangible personal property (property), the rules applied to leases, and how sales tax applies to leases of mobile transportation equipment in California.
A lease is a temporary transfer of possession and control of property for consideration (i.e., something of value, usually money), and the property is later returned to the lessor. In a sale title to the property is transferred for consideration, so ownership changes and the property is not later returned.
The California State Board of Equalization (Board) has promulgated Regulation 1660, which explains the law as it applies to leased property in general, and transactions that may look like leases, but are actually outright sales. Making the distinction between a true lease or sale at the outset is crucial, because for sales, the tax must be timely reported on the return covering the period in which the sale is made, whereas with leases, the lessor has the option of timely paying tax on the purchase price of the property or paying tax over time, on rental receipts.
Regulation 1660 also discusses sales under security agreements and sales and leaseback transactions, which are treated as financing transactions. Generally, a transaction will be considered an installment sale (not a lease), if the so called “lessee” automatically obtains title to the property at the end of a fixed term after making all the required payments, or has the option to purchase the property for a nominal amount, at the end of the fixed term. In other words, if the so called “lessee” will obtain title to the property, the transaction is considered an installment sale, and the lease rules do not apply. A sale can also occur where a lessee later exercises an option to purchase the leased property.
The regulation also describes certain temporary transfers of property which are excluded from the term “lease”, the person transferring possession is considered the consumer (and will owe tax on cost unless an exemption or exclusion applies), and any charges for the temporary use of the property are not subject to tax. This includes transfers of property for less than one day, use is restricted to the owner’s premises, and the charge is less than $20. Examples include (but are not limited to) laundromats, coin-operated amusement devices, and golf courses that furnish golf carts for use on the course.
There are also certain types of transfers which are recognized as leases, but the lessor is required to pay tax on cost, rather than rental receipts. The lessor must pay tax on the cost of linens and similar articles which include the recurring service of laundering and cleaning, and for household furnishings which will be leased with realty, where the lessor also owns the realty. There are also leases of items such as portable toilets and video cassettes (remember those?), tapes, and discs, where tax is due on rental receipts, regardless of whether the lessor paid tax on cost.
Tax must also be paid on rental receipts where the property is not leased in the same form as acquired. This occurs when the lessor obtains materials/component parts, which are fabricated or assembled into the finished property that is leased. The general rule is that if there is a substantial increase in the value of the property, it will not be considered leased in the same form as acquired. However, if tax is paid on the materials/component parts, and the labor to fabricate and assemble them into the finished product that is leased, it may be considered leased in the same form as acquired. This issue forms the basis of numerous legal opinions and it is advisable to consult with a sales and use tax expert before making a final determination on your products.
Assuming that you have cleared all of the hurtles noted above, you then have the option to pay tax on the purchase price (cost) of the property, or rental receipts. If you want to pay tax on cost, the election must be made timely, by either paying tax to the vendor, or timely self-reporting the tax on the return covering the period when the property is first placed into service. To be considered timely the purchase must be reported on the correct return, and the return and payment must be submitted timely as well. If you fail to make a timely election to pay tax on cost, tax must be paid on rental receipts, while the property remains in California. Once the election is made (by choice or default) it is generally considered irrevocable, and with few exceptions, it cannot be changed at a later time.
The advantage to paying tax on lease receipts is that payment can be spread out over a period of time. However, there are also disadvantages, including: 1) the lessor must register for a seller’s permit and will incur the associated administrative costs for filing returns; 2) the lessor must determine what items are includable in taxable lease receipts; 3) if the lessor uses the property, tax may be due on cost anyway; and 4) a sale of tax paid property (with the assignment of an existing lease) may be more attractive to a potential buyer.
Where tax is due on lease receipts this is referred to as a continuing sale and purchase (as opposed to a nontaxable lease), and the applicable tax is a use tax on the rentals payable, by the lessee. However, when the lessee is not subject to use tax then sales tax (on the lessor) applies, except with leases to the United States Government, which are exempt. Generally, transactions that qualify as exempt sales will also qualify as exempt leases. The lessor is required to obtain a resale or exemption certificate from the lessee, to document the non-taxable status of the lease. A typical problem occurs where the lessor decides to pay tax on cost, then later enters into an exempt lease, such as with the United States Government. Since the election to pay tax on cost is irrevocable, the lessor is not likely to get a refund.
If lease receipts are subject to tax, the general rule is that tax applies to any payments required by the lease. However, there are noted exceptions in the regulation, including charges that are truly optional. In any event, where lease charges are subject to tax the lessor must separately state the tax amount on the invoice, or make an appropriate notation explaining why tax does not apply.
Where there is an assignment of a lease, the matter can get complicated. You have to determine if there is just an assignment of the right to receive lease receipts, or if the assignment also includes a sale of the leased property, with the new owner assuming the duties under the existing lease. This will require a reading of the assignment itself. If the assignment also includes a sale of the property, the new owner/lessor will step into the shoes of the prior owner/lessor, and the tax status of the lease receipts will typically remain the same. Thus, if the lease payments were not subject to tax before the sale (i.e., a lease of tax paid property), the lease payments will continue to be nontaxable, and the new owner/lessor must pay tax on the purchase price of the leased property. However, if lease payments were subject to use tax (i.e., a continuing sale and purchase), the new owner/lessor must continue paying use tax on lease receipts. Therefore, the new owner/lessor acquires the property subject to the terms of the existing lease, and does not have the typical option of paying or not paying tax, on the purchase price of the property. However, if the property is not subject to an existing lease (or rental) when it is sold, the new owner (and soon to be lessor) will have the option of paying tax on cost, or rental receipts.
The same rules apply to subleases. If tax paid property is subleased no tax is due on lease payments, and where the lease payments are taxable, tax only needs to be paid on either the prime lease, or one of the subleases.
Issues can arise in determining: 1) which charges are included in taxable lease receipts; 2) the lessor’s liability for any use or loans of the property; 3) the application of tax on parts which are used to repair leased equipment; 4) whether the lessor is entitled to credit for tax paid to another jurisdiction; 5) whether fixtures attached to realty can be taxed as leases of tangible personal property; and 6) whether a transfer of property with an operator, is considered a lease. In addition, if the lease is between related entities and the Board determines that the lease payments are artificially low (i.e., at or below cost), it could invalidate the lease, and assess tax on cost.
Leases of Mobile Transportation Equipment
Regulation 1661 discusses the application of tax to leases of mobile transportation equipment (MTE). Thus, before Regulation 1661 can apply, you must first make sure that the property at issue is MTE, and that you are going to lease the MTE, rather than use it for yourself.
MTE is equipment used for transporting persons or property for substantial distances. This includes trains, vessels over 30 feet, busses, trucks, (except “one-way rental trucks”), truck tractors and trailers, dollies, bogies, chassis, reusable cargo shipping containers, aircraft, and tangible personal property which is, or becomes a component part of MTE. Because of the transitory nature of MTE, there are certain exemptions that apply for aircraft, watercraft, vessels, passenger transportation vehicles, rail freight cars, MTE used in interstate or foreign commerce, and MTE which is not purchased for use in California. These exemptions apply whether or not the MTE is being leased.
The rules in Regulation 1661 for MTE are different than the rules in Regulation 1660, for leases of property in general. This is why it is extremely important to properly classify the leased property as MTE, or non-MTE. Whether a person purchases MTE for his or her own use or leasing, he or she is always the consumer of the MTE. Thus, a lease of MTE is never a continuing sale and purchase, because (unlike leases of property in general), no use tax is imposed on the lessee. Rather, the sale of MTE to the purchaser/lessor is a retail sale with tax applying to the sale or use of the MTE, absent an exemption or exclusion from tax.
Therefore, in determining whether an exemption or exclusion from the sale or use of MTE applies, the use of MTE by the lessee will be deemed use by the lessor. This means that the lessor must maintain all the necessary records to show the lessee’s use of the MTE.
Assuming that no exemption or exclusion from tax applies, and that the owner of MTE decides to lease rather than use it, the owner then has the election of paying tax on the purchase price, or fair rental value. The term “fair rental value” usually means the payments required by the lease, but (unlike leases of property in general), the actual lease receipts are not being taxed, since the tax is imposed on the lessor (not lessee), and the lessor is simply being given the option of spreading out his or her already accrued tax liability over a period of time, by using fair rental value as the measure of tax.
To summarize, for leases of property in general (non-MTE), it is the lease receipts that are subject to use tax (unless sales tax applies), the person owing the tax is the lessee, the lessor collects the tax, and pays it to the Board. With leases of MTE the tax is always imposed on the lessor and not on lease receipts, although the lessor is nevertheless given the option of paying the tax on fair rental value. Sound confusing? It is, but understanding the difference is extremely important.
If the person purchasing MTE wishes to pay tax (over time) on fair rental value, he or she is allowed to issue a resale certificate to the vendor (although the MTE is not actually being purchased for resale), and then must make a timely election by reporting the use tax when the equipment is first leased, or first enters California. The term “timely election” means the same as with leases of non-MTE (discussed above).
However, if the lessor of MTE fails to make a timely election to report tax on fair rental value, tax is due on cost. You will note that the outcome is just the opposite, with non-MTE. If a timely election is made it is irrevocable, and the lessor must continue to report tax on fair rental value while the MTE is being leased (even if the lessee does not make all the required payments or the MTE is outside California), because the lessor’s use tax liability has already been fully accrued, and the payment is merely being spread out over time, measured by fair rental value. Again, this outcome is just the opposite as with non-MTE which can only be taxed while the property is situated in California, since the tax is on the use by the lessee, and measured by the rentals payable. Even more confused by now?
Although a lessor of MTE is allowed to separately charge and collect use tax from the lessee, a problem could arise where the charge is simply itemized as “use tax”, without specifying that it is not a use tax on the lessee. The best approach is for the lessor to merely bury the cost of the tax into the rate charged to the lessee.
Despite the differences between leases of MTE and non-MTE, there are some similarities. For example, the taxable measure included in fair rental value for MTE, is essentially the same as taxable rental receipts with non-MTE. It includes any payments required by the lease, and the listed exceptions (detailed in Regulations 1660 and 1661), are essentially the same. The same rules apply in determining whether a transfer is a lease or a sale at inception, if the lessor uses the property it could trigger any remaining tax due on cost, and the advantages and disadvantages or paying tax on cost vs. over time, are very similar.
Where an MTE lease is assigned, title to the MTE also transfers. The new owner (assignee) is the consumer of the MTE, and has the same options as the previous owner. Where the lessee fails to make the required payments under an MTE lease the lessor is not entitled to bad debt deductions, since the use tax liability is solely on the lessor.
Final Thoughts on Leases of MTE and Non-MTE
This article is not meant to be exhaustive examination of the rules relating to leasing. As you can see, the rules for leases can get complicated. If you are contemplating the purchase and lease of MTE or non-MTE, it is advisable to consult with an expert. There are numerous items which may be classified as MTE, and various exemptions and exclusions from tax that apply to the sale or use of certain types of MTE, whether they are leased or not. Some of the exemptions apply test periods to determine if the use of the MTE meets the requirements for the exemption. The record keeping requirements can be overwhelming. The taxpayer must also decide whether to pay tax up front then file a claim for refund once the requirements for the exemption have been complied with, or wait until the test period is concluded, before determining if tax is due.