How did Texas distinguish taxable lease assignments, collateral pledges, sales of leased property, and operating versus financing leases?

Plain-English summary

The Texas Comptroller defined three different transactions. A taxable assignment of an operating lease's payment rights caused the original lessor to report tax on all remaining lease payments when assigned, without reducing tax for a discounted sale. A nontaxable assignment was a written loan transaction pledging lease contracts as collateral; the lessor kept collecting lease payments and tax and remitted under its accounting method. A sale of the lease and leased property made the buyer the new lessor, requiring a sales-tax permit and allowing a resale certificate while the buyer collected tax as it recognized lease income.

The ten scenarios applied those categories:

• Successive transfers of both lease and title were sales of lease and property; each owner needed a permit and could give a resale certificate.
• Selling certificates in the lease payment stream without a written debt instrument was a taxable assignment. The original lessor paid the accelerated tax; the securities firm and investors had no liability and did not own the tangible property.
• A lessee's later default did not create a refund after a taxable assignment when the lessor had received its money and was not obligated to repay the bank. The bank had paid no tax to refund.
• A written collateral loan was a nontaxable assignment, so the lessor continued collecting and remitting. Lessee payments directly to the bank could imply a taxable assignment; the letter needed more facts to decide the nonrecourse-loan variation.
• A later one-time bank portfolio sale did not create another tax if the original taxable-assignment tax had been paid. If the underlying transfers were sales of lease and property, the permit, resale-certificate, and income-recognition rules continued to apply.
• For the aircraft bankruptcy hypothetical, a taxable assignment accelerated tax, while a nontaxable assignment left the lessor collecting on payments. Renegotiated lower payments were taxed at the reduced amount, and a subleasing lessee needed a permit, a resale certificate, and collection from its sublessee. The letter lacked enough facts about the returned aircraft.
• A taxable assignment of a steel-press lease was not undone when the lessee later moved the press out of Texas and another corporation assumed the lease.
• Assigning a copier lease's payment stream was a taxable assignment even though the original lessor retained title and collected payments, so tax on all lease payments was due at assignment.
• If a bank bought both a combine lease and the property, it became the lessor. A cash-basis bank owed no tax on payments never collected after default; a bank that accrued and paid tax could take a bad-debt deduction.

For classifying a lease, Comptroller Rule 3.294 controlled even though the Tax Division found FASB materials useful. The letter said the Texas rule had unique wording and did not always follow FASB, GAAP, or federal tax rules. GAAP treatment, FASB definitions, federal depreciation records, the asset's actual use, and the taxpayer's books could provide evidence, but federal guidelines were not determinative.

What this means for you

The label "assignment" was not enough. Texas looked at whether the transaction sold a payment stream, pledged it under a real debt instrument, or transferred both the lease and property. It also followed who received payments, who held title, when income was recognized, and whether tax had already been paid.

Common questions

When did assignment accelerate tax on remaining lease payments? When an operating lease's payment rights were sold or factored as a taxable assignment.

Did pledging leases as written loan collateral accelerate tax? No. The lessor continued collecting and remitting under its accounting method.

What happened when both lease and property were sold? The buyer became the lessor, used a permit and resale certificate, and collected tax as it recognized income.

Did a later default automatically create a refund? No. The answer depended on who paid tax and whether the lessor had a bad debt or repayment obligation.

Did FASB or federal tax rules control lease classification? No. Rule 3.294 controlled, with accounting and federal materials serving only as evidence or guidance.

Citations and references

• Comptroller Rule 3.294(f)(3)(A) and (h) — rental receipts, lease assignments, collateral pledges, and classification.
• Comptroller Rule 3.302 — bad-debt deductions.
• Comptroller Rule 3.297 — carrier exemption assumed unavailable in the aircraft hypothetical.
• FASB Statement No. 13 and FASB Current Text — accounting guidance discussed for lease classification, implicit interest, and economic life.

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/8702L0809E03

Original ruling text

COMPTROLLER OF PUBLIC ACCOUNTS

STATE OF TEXAS

AUSTIN, 78774

BOB BULLOCK

Comptroller

February 27, 1987

Dear ***:

Thank you for your recent letter on behalf of "***".

As you are aware, the word "assignment" may mean different things to different people. Before responding to your questions, I'd like to write a brief preamble to define my terms and assign an abbreviation to each.

"Taxable Assignment - defined in Rule 3.294(h) A lessor may factor or assign to a third party the lessor's right to receive all lease payments due under the agreement with the lessee. At the time the lease agreement is factored or assigned, tax is due on all remaining lease payments. The lessor is responsible for reporting the tax to the Comptroller's department at the time the lease agreement is assigned or factored. No deduction in the amount of tax due and payable by the lessor is allowed if a transfer at a discount is made to a third party.

This would only apply to operating leases because tax is due on financing leases when the lessee takes possession of the goods or when the first payment is due. The rationale for the Taxable Assignment is found in rule 3.294(f)(3)(A).

(A) Under an operating lease, tax must be reported in the period in which the rental receipts are considered income under the lessor's method of accounting."

When a lessor factors or assigns a lease he receives payment and so tax is due in that period. If the lessee defaults in payment to the assignee and the lease is thrown back on the lessor, he may be able to claim a bad debt deduction as described in Rule 3.302 attached.

Non-Taxable Assignment - is also defined in rule 3.294(h) as The assignment or pledge of lease contracts by a lessor to a third party as loan collateral." In this instance there is a written debt instrument between the lessor and the creditor. The lessor would

continue to collect the lease payments and tax from the lessee. The lessor would remit tax to the state in the period in which he considers the receipts as income based on his method of accounting. The creditor is not involved other than to receive his payments from the lessor.

"Sale of Lease and Property" - Occasionally a lessor may sell both anoperating lease and title to the leased property to a third party. Assuming that the full amount of tax due over the life of the lease has not already been paid by the lessor to the state, the third partypurchaser must begin collecting and remitting tax as he recognizes the income under his accounting method. He must have a sales tax permit and can give the original lessor a resale certificate in lieu of tax. In this case the original lessor is not responsible for remitting tax on the remaining lease payments.

With this in mind, your letter is restated with response below.

On behalf of my clients, Texas Lessors for Fair Taxation, I would like to request a ruling on the following questions regarding the taxability of leasing transactions in the State of Texas:

1. Lessor A assigns to Bank B a 60-month true lease. In month three (3), Bank B assigns the lease to Bank C who retains it for full term. In each assignment legal title is transferred.

A. Is sales tax due on the assignment from A to B?

B. Is soles tax due on the assignment from B to C?

C. Can A, B or C rely on a resale certificate from a predecessor in the stream?

RESPONSE: As we discussed, this is a "Sale of Lease and Property" with the tax consequences described above. A, B and C must each hold a sales tax permit and may give their supplier a resale certificate.

2. Lessor A assigns a 60-month true lease to Securities Firm B. B sells one thousand (1,000) certificates of ownership participation in the lease to individuals, trust funds, banks and pension funds.

A. How is this transaction regarded for sales tax purposes?

B. Does B have a responsibility to collect and remit the tax on behalf of the 1,000 investors?

C. If not, is each investor responsible for remitting sales tax on This portion of the total consideration?

D. Can B give a resale certificate?

RESPONSE: As we discussed, this is a sale of the lease (paper) only with no written debt instrument. Therefore, it is a "Taxable Assignment". Lessor A will pay the tax as described under that heading. Securities Firm B and the 1000 investors have no tax liability. The investors are not considered to have ownership of the tangible personal property.

3. Lessor A assigns a 60-month true lease to Bank B and pays tax on all anticipated future payments at the time of the assignment. Lessee defaults in month 12 and Bank B repossesses the equipment.

A. Is the tax for the lost forty-eight (48) months refundable?

B. If so, to whom?

RESPONSE: Based on our conversation, I am assuming that this is a "Taxable Assignment" as defined above and that lessee was making payments directly to Bank B who had a lien on the equipment.

The tax is not refundable. Lessor A received their money and properly paid the tax. Lessor A does not have a bad debt for sales tax purposes unless they are obligated to repay Bank B. Bank B did not pay any tax and so is not entitled to a refund.

4. Lessor A executes a 60-month true lease with Lessee. Bank B makes a loan to Lessor A secured by an interest in the equipment and the lease. Lessor A retains legal title to equipment and collects all payments.

A. Should Lessor A collect and remit sales taxes on the monthly lease payments?

RESPONSE: As we discussed, there is a written debt instrument. This is a "Non-Taxable Assignment" and Lessor A will collect and remit the tax based on his method of accounting.

B. Is there a different result if Bank B collects the lease payments? If so, why?

RESPONSE: Not necessarily, but if the lessee is making payments to Bank B, that implies a "Taxable Assignment" as previously described.

C. Does the result change if the loan is made on a non-recourse basis? If so, why?

RESPONSE: Need more specific information.

5. Bank A purchases five hundred (500) 60-month true leases over a three (3) year period from ten (10) different Lessors for $5,000,000.00.

At a later date, Bank A sells a loan and lease portfolio and all assets therein including the 500 leases in a one-time transaction to Bank B for $20,000,000.00 due to demands of banking regulators to increase liquidity.

A. Is the tax due upon the sale from A to B?

RESPONSE: No. If these were "Taxable Assignments" between the lessor and Bank A, the tax would have been paid by the lesser. If it were a "Sale of Lease and Property", all parties would need a sales tax permit and each could give their supplier a resale certificate in lieu of tax. Each would be responsible for collecting and remitting tax based on their method of accounting.

6. Lessor A leases six (6) DC-10's to Aircraft Company (Lessee) over a 72-month term. Lessor A assigns leases to Bank B. Lessee subsequently files for Chapter II reorganization and, under the plan, is allowed to:

7. Continue the lease at a lower payment for an additional number of months on three (3) DC-10s, and

8. Sublet two (2) DC- 10s to another carrier, and,

9. Return one (1) DC-10 to Bank B for future sale and re-lease.

A. What are the sales/use tax consequences of 1, 2, and 3?

RESPONSE: At your request, we will assume that neither of the lessees is a licensed and certificated carrier so that the exemption from Rule 3.297 would not be available and that these are true (i.e. operating) leases.

If Lessor A makes a "Taxable Assignment" to Bank B, the sales tax would be due and payable on the total of the lease payments. Unfortunately there are not enough facts given to allow a more detailed answer.

If Lessor A makes a "Non-Taxable Assignment" to Bank B, he would collect and remit tax based on his accounting method assumably based on the monthly payments. Again we don't have enough facts; however, if the lease is renegotiated to allow for situation (1), then tax would be due on the reduced payments. In situation (2), again considering a renegotiated contract the Lessee would take out a sales tax permit, issue a resale certificate to Lessor A and collect tax as appropriate from his Lessee.

I do not have enough facts to respond to situation 6, Question 3.

7. Lessee A (a Texas subsidiary of ABC Corporation of New York) leases a $15,000,000 V Steel press from Lessor B on a 60-month term. Lessor B subsequently then assigns the lease to Insurance Company C. After 12 months, Lessee A ceases operations in Texas and ABC Corporation of New York agrees to move the steel press to its Albany plant and continue making all lease payments.

A. What are the sales/use tax consequences of the assumption of the lease by ABC and removal of the equipment to N.Y. State?

B. What are the sales tax consequences to Lessor B?

C. To Insurance Company C?

RESPONSE: As we discussed, we will consider this to be a true (operating) lease and a "Taxable Assignment" from Lessor B to Insurance Company C. Therefore, tax would be due and payable by Lessor B on the total of the lease payments at the time the lease is assigned. Later assumption of the lease or removal of the property from Texas does not change the consequences of what already has occurred.

8. Lessor A executes a 36-month true lease to Lessee on a copier/sorter. Lessor A assigns the payment stream to Bank B. Lessor A continues to collect payment on behalf of Bank B. Lessor A retains title to the equipment, pays personal property taxes and receives all funds (after 36 months) which are paid to either renew the lease or sell the used equipment.

A. Should Lessor A collect and remit tax monthly? Please explain.

RESPONSE: This is a "Taxable Assignment" as previously described. Therefore tax is due on the total of the lease payments in the period in which the lease is assigned.

9. Lessor A. leases a $100,000.00 combine to Lessee B on a five-year true lease, with annual payments due in arrears. Lessor assigns the lease to Bank C. In 11 months, Lessee B files for Chapter 7 and returns the equipment to Bank C. never having paid a lease payment.

A. What are the sales and use tax consequences of the assignment?

B. Is any sales tax due on this transaction since no lease payments have been made? If so, what are the tax liabilities of the parties?

RESPONSE: As we discussed, for purposes of this situation we will assume that the agricultural exemption will not apply. We will also assume that the sale occurs promptly after the lease is signed.

If this is a "Sale of Lease and Property" as previously described, Bank C is now the Lessor. They would have given Lessor A a resale certificate in lieu of tax and would remit tax on their method of accounting. If Bank C is on a cash basis of accounting, then they would owe no tax since no defaulted payments were collected. If they had accrued and paid tax to the state, then Bank C could take a bad debt deduction.

10. In determining whether a lease is a true (operating) lease, or a finance lease, shall the Comptroller's Office base such determination on FASB, GAAP, or IRC guidelines?

If FASB or GAAP, what benchmark will be used to set the interest rate at which present value analysis is calculated?

Which "estimated economic life" guidelines shall be used for the 75% rule - Class life ADR midpoint? FASB 13 recommendations? Other IRC guides? Can these be modified due to excessive or concentrated use or permitted by IRS (Example: Drill press used 24 hours a day by a "3 shift" factory).

RESPONSE: In determining whether a lease is an operating lease or a financing lease the Tax Division has found the Financial Accounting Standards Board, Accounting Standards, Current Text, most useful in helping to reach that conclusion; however, Comptroller Rule 3.294 is controlling in determining the distinction between an operating lease and a financing lease. It should be noted that the Rule on Rental and Leases of Taxable Items has particular wording that is in some instances unique and does not follow FASB, GAAP, or IRC.

You have asked whether FASB or GAAP will be used to determine the interest rate at which present value analysis is calculated. Since the Financial Accounting Standards Board (FASB) is used by the accounting profession to determine what the interpretation of Generally Accepted Accounting Principles are, we are a bit confused by your question. We would look at GAAP to determine if a taxpayer has used an appropriate treatment and would use FASB to interpret what GAAP is. Again, the FASB Current Text does provide useful guidance. It states:

L10.412 Interest rate implicit in the lease. The discount rate that, when applied to (a) the minimum lease payments, excluding that portion of the payments representing executory costs to be paid by the lessor, together with any profit thereon, and (b) the unguaranteed residual value accruing to the benefit of the lessor causes the aggregate present value at the beginning of the lease term to be equal to the fair value of the leased property to the lessor at the inception of the lease, minus any investment tax credit retained by the lessor and expected to be realized by him. (This definition does not necessarily purport to include all factors that a lessor might recognize in determining his rate of return; for example, refer to paragraph L10.146.)[FAS13.1 5k].

With regard to the question of "estimated economic life", FASB does provide a good definition of what is met by that term. FASB's Current Text states:

L10.406 Estimated economic life of leased property. The estimated remaining period during which the property is expected to be economically usable by one or more users, with normal repairs and maintenance, for the purpose for which it was intended at the inception of the lease, without limitation by the lease term. [FAS13, paragraph 5g]

You have asked about other Internal Revenue Code (IRC) guidelines. The IRC may be a source one would look at to determine the estimated economic life of an asset but certainly would not be determinative of an asset's life. We would note in passing that if a taxpayer depreciated an asset on its books and records in accordance with the IRS regulations, this would be evidence that the taxpayer considered the assets useful life to be in accordance with those regulations. It is possible that a taxpayer could have two sets of books with asset estimated useful lives recorded at different values. We would then look at the above definition to make the determination of the correct application of an asset's economic life. The above definition makes an allowance for your example of a drill press used 24 hours a day by a "3 shift" factory; however, if the taxpayer recorded the economic life of the asset on its books and records as if it were a drill press used 8 hours a day by a "I shift" factory, such treatment could cause a controversy with this agency as to the true economic life of the asset.

This opinion is based upon the facts presented. If there are additional or different facts, this opinion may change.

Please feel free to contact me if you have additional questions. You may write me, or telephone 463-4600.

Sincerely,

Al Van Allen

Tax Policy

Tax Administration Division