When a lessee exercises an option to buy leased equipment, is the 'finance charge' added at that point taxable, or is it non-taxable interest?

Plain-English summary

L.B. Smith, Inc. sells and leases heavy construction equipment. When a customer wants to buy but can't get financing, L.B. Smith may lease the equipment at the normal monthly charge and give the customer an option to purchase within a set period at the same price as an outright purchase. On exercising the option, the customer is credited for the rental payments made — but must also pay a "finance charge" equal to the prime rate plus a fixed percentage computed on the declining unpaid balance from the start of the lease. L.B. Smith argued this charge is non-taxable interest for financing the equipment. It asked whether the finance charge is taxable.

The Department held the "finance charge" is taxable as part of the total option purchase price.

• The rule for lease-with-option deals. Under 20 NYCRR 541.9(b)(4), when equipment or a motor vehicle is leased with an option to buy, each lease payment is subject to tax, and if the option is exercised, the amount subject to tax is the total option purchase price. The regulation's Example 2 expressly includes a percentage-per-month charge on the outstanding balance within that taxable total.
• No credit was extended. The original transaction was a lease, and the customer's payments were nothing more than rental payments — so L.B. Smith did not extend credit. The fact that the customer may later exercise a purchase option does not alter the nature of the earlier lease for sales-tax purposes.
• Result. Notwithstanding the "finance charge" label, the charge is subject to tax as part of the total option price.

What this means for you

Calling something a "finance charge" doesn't make it tax-free interest. New York looks at the substance of the deal. Where the arrangement is a lease with a purchase option — not a financed sale — the amounts the customer pays, including an interest-style charge added on exercising the option, are part of the taxable option price.

True financing interest requires an actual extension of credit. Because the customer here was making rental payments under a lease (not repaying a loan on a completed sale), there was no credit extended, so there was no exempt finance charge — just more taxable consideration for the equipment.

Structure follows tax. If you intend a financed sale (with genuinely exempt interest), document a sale with a separately extended loan — not a lease with an option — or expect the "finance charge" to be taxed as part of the option purchase price.

Common questions

Q: My customer leased equipment, then bought it, and I added a finance charge at closing. Is that taxable?
A: Yes. In a lease with an option to buy, the total option purchase price is taxable when the option is exercised, and a "finance charge" computed on the balance is part of that taxable price.

Q: Isn't a finance charge just non-taxable interest?
A: Only if you actually extended credit. Here the payments were rent under a lease, so no credit was extended — the charge is taxable consideration, not exempt interest.

Q: Does giving credit for the prior rental payments change the result?
A: No. Crediting the rental payments toward the purchase is how the option price is computed. The interest-style charge added on top is still part of the taxable total option price.

Citations and references

Regulation:

• 20 NYCRR 541.9(b)(4) — in a lease with an option to buy, each lease payment is taxable, and on exercise the total option purchase price is subject to tax (Example 2 includes a per-month percentage on the outstanding balance within the taxable total)

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/sales_ao_1985.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/sales/a85_19s.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-85 (19)S
Sales Tax
June 12, 1985

STATE OF NEW YORK
STATE TAX COMMISSION
ADVISORY OPINION

PETITION NO. S840208A

On February 8, 1984 a Petition for Advisory Opinion was received from L.B. Smith, Inc.,
2001 State Road, Camp Hill, Pennsylvania 17011.
The issue raised is whether a finance charge billed to a lessee who exercises a purchase
option is subject to tax.
Petitioner is primarily engaged in the business of selling heavy construction equipment.
Petitioner also leases such equipment for a monthly fee. Any costs incurred by Petitioner for the
equipment being leased, such as interest, insurance, supplies etc., are included in determining the
monthly lease charge and Petitioner charges sales tax on such charge.
In some instances the customer may actually want to purchase the equipment but cannot
obtain financing. Under such circumstances, Petitioner may agree to lease the equipment to the
customer for the same normal monthly lease charge and extend to the customer an option to purchase
the equipment within a specified time period. The purchase price at the time of exercising the option
is the same price the customer would have paid if he had purchased the equipment outright at the
time the lease agreement was executed.
Upon exercising the purchase option, the customer is given credit toward the purchase price
for all rental payments made to date. Additionally, however, the customer is required to pay a
"finance charge" consisting of the total of the prime rate plus a fixed percentage computed on the
declining unpaid balance from the date of commencement of the lease.
Petitioner maintains that this finance charge is the interest due from the customer in
consideration of Petitioner's financing the equipment for the term of the lease prior to the exercise
of the purchase option.
The issue as to the taxability of such charges has been addressed in the Sales and Use Tax
Regulations at 20 NYCRR 541.9(b)(4). Such Regulations state:
"(4) Leases with option to buy. If a contractor leases equipment or motor vehicles
with an option to buy, each lease payment is subject to tax. If the option is exercised,
the amount subject to the tax is the total option purchase price for the equipment or
motor vehicle.

RODERICK G. W. CHU, COMMISSIONER
TP-8 (3/83)

GABRIEL B. DiCERBO, DEPUTY COMMISSIONER
FRANK J. PUCCIA, DIRECTOR

-2­
TSB-A-85 (19)S
Sales Tax
June 12, 1985

Example 2:

A lease agreement or contract provides for an option to purchase at a stated
purchase price, less total lease payments made, plus one percent per month
computed on the outstanding balance after each lease payment. The stated
purchase price, less the lease payments, plus the one percent per month is the
total option purchase price subject to the tax."

Since the original transaction entered into between Petitioner and its customer was a lease
and the payments made by the customer were nothing more than rental payments, Petitioner did not
extend any credit to the customer. The fact that the customer may exercise a purchase option at a
future date does not alter the nature of the previous transaction for sales tax purposes.
Therefore, notwithstanding the fact that Petitioner characterizes its charge as a "finance
charge", such charge is subject to tax as part of the total option price.

DATED: May 20, 1985

NOTE: The opinions expressed in Advisory Opinions
are limited to the facts set forth herein.

FRANK J. PUCCIA
Director
Technical Services Bureau