If I sell equipment to a leasing company and lease it back under an operating lease, is that a nontaxable financing arrangement or a taxable sale?

Plain-English summary

The Texas Comptroller ruled that a sale-leaseback of equipment does not automatically escape sales tax just because the parties call it a "financing arrangement." In this December 11, 1992 letter ruling, Company A bought a Scitex machine in November 1990 and paid sales tax on that purchase. In August 1991, Company A sold the machine to Company B and leased it back, keeping physical possession the whole time; Company B charged tax on the monthly lease payments. Company A argued the whole transaction was really just financing and that the lease payments shouldn't be taxable — and, on audit in June 1992, the Comptroller's office actually re-assessed tax on the original purchase too.

The Comptroller explained that a sale-leaseback avoids sales tax only when the "lease" is truly a financing lease — a security device where a sale never legally occurs. Here, the lease required the equipment to be returned to the lessor (Company B) at the end of the term, and the purchase option exceeded 10% of the equipment's fair market value at lease inception. Both facts meant the arrangement was an ordinary operating lease, which Texas law treats as a "sale." As a result: (1) Company A owed tax on its original purchase of the machine, (2) the sale from Company A to Company B was itself a taxable sale (though Company B could give a resale certificate since it was going to re-lease the machine), and (3) Company B owed tax on each monthly lease payment.

What this means for you

Businesses considering a sale-leaseback

Simply labeling a transaction a "financing arrangement" does not make it tax-free. To be treated as a nontaxable financing lease rather than a taxable sale, the arrangement generally must either (1) transfer title to the lessee at lease-end, or (2) give the lessee an option to buy at a nominal price at lease-end. Absent that, Texas presumes a financing lease only if the lease term is 75% or more of the equipment's estimated economic life with no provision for return of the property, or if the residual value is less than 10% of fair market value at inception with no return provision. If your leaseback requires the equipment to go back to the lessor and offers anything more than a nominal purchase option, expect it to be classified as an operating lease — i.e., a taxable sale.

Accountants and tax professionals

This ruling illustrates the Comptroller's mechanical application of 34 Tex. Admin. Code Rule 3.294's financing-lease tests, and its rejection of a taxpayer's reliance on Bullock v. Citizens National Bank of Waco where the contract terms don't support a true security-device characterization. Watch the contract language closely — the Comptroller looked specifically at the lease's return-of-property clause and the purchase-option pricing, not at the parties' subjective financing intent.

Common questions

Q: We intended our sale-leaseback purely as financing — doesn't that intent control?
A: No. The ruling states that "[t]he intent of the parties may have been to enter into a nontaxable financing arrangement, but such an intent cannot overcome the contract as written." The Comptroller looks at the actual contract terms, not stated intent.

Q: Is the sale from the original owner to the leasing company itself taxable?
A: Yes, in this fact pattern the sale from Company A to Company B was taxable, though Company B could issue a resale certificate in lieu of paying tax on that purchase because it intended to re-lease the equipment under an operating lease (and thus collect tax on the lease payments instead).

Q: Does charging tax on the lease payments mean the original purchase is exempt?
A: No. The ruling treated the original purchase, the sale to the leasing company, and the ongoing lease payments as three separate taxable events under this fact pattern.

Q: Can a sale-leaseback ever avoid sales tax?
A: Yes, if it is genuinely structured as a financing lease under 34 Tex. Admin. Code Rule 3.294 — for example, title transfers to the lessee at lease-end, or the lessee has a nominal purchase option, or the statutory economic-life/residual-value presumption tests are satisfied with no return-of-property provision.

Citations and references

Statutes and rules:

• Tex. Tax Code § 151.005(2) (definition of "sale")
• 34 Tex. Admin. Code Rule 3.294, Rentals and Leases, Section (a)(4) (operating lease vs. financing lease)
• 34 Tex. Admin. Code Rule 3.294, Section (a)(1)(A) and (B) (presumption tests for financing leases: 75%+ economic life or <10% residual value, with no return provision)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9212716L

Original ruling text

December 11, 1992

Dear **:

Your letter of October 15, 1992, addressed to Terry Zaruba, concerning the
taxability of a sales-leaseback transaction has been referred to me for review
and response. I apologize for the delay in answering your letter.

As I understand it, COMPANY A purchased a Scitex machine in November 1990.
COMPANY A accrued and remitted sales tax on the purchase to this office.
COMPANY A began using the equipment February 24, 1991.

In August 1991, COMPANY A entered into a transaction with COMPANY B whereby
COMPANY B would purchase the equipment from COMPANY A and lease the equipment
to COMPANY A. Possession of the equipment always remained with COMPANY A at
their location. COMPANY B charged COMPANY A tax on the monthly lease payments.
Because COMPANY B was charging sales tax on the monthly lease payments, COMPANY
A took a credit on a sales tax return. In an audit of COMPANY A in June 1992,
an auditor from this office re-assessed tax on the original purchase of the
equipment

You conclude that this sale-lease back agreement is a financing arrangement and
that the monthly lease payments are not taxable. You ask for confirmation of
this conclusion. This letter explains why such confirmation cannot be given.

For a nontaxable sale-leaseback transaction to occur, the financing arrangement
must be a financing lease such that the "lease" is a security device, the
lessor is in the position of a secured creditor, and a "sale" does not occur.

The contract between COMPANY A and COMPANY B is an operating lease because it
does not meet the definition of a financing lease. See Rule 3.294, Rentals
and Leases, Section (a)(4). Operating leases are "sales" as defined in Section
151.005 (2) of the Texas Tax Code.

By definition, financing leases must (1) transfer title of the property to the
lessee at the end of the lease; or, (2) the lessee must have an option to
purchase the property at a nominal price at the end of the lease. Also, a
written lease agreement will be presumed to be a financing lease if (1) the
lease term is 75% or more of the estimated economic life of the property and
the contract makes no provision for the return of the property to the lessor;
or, (2) the residual value of the leased property is less than 10% of the
property's fair market value at the inception of the lease and the contract
makes no provisions for the return of the property to the lessor. Section
(a)(l)(A) and (B) of Rule 3.294.

The contract is not a financing lease because Section 18 of the Master
Equipment Lease Agreement stipulates that the equipment be returned to the
lessor upon expiration of the lease and the Purchase Option Rider allowing the
lessee to purchase the equipment exceeds 10% of the property's fair market
value at the inception of the lease.

Because operating leases are sales as defined in Section 151.005 (2), your
reliance on Bullock v. Citizens National Bank of Waco is misplaced. In that
case, the court found that the financing arrangement was intended as a security
device without a sale taking place. In this situation, a "sale" has definitely
occurred. The intent of the parties may have been to enter into a nontaxable
financing arrangement, but such an intent cannot overcome the contract as
written.

Sales tax is a transaction tax. Each sale of a taxable item is taxed unless a
properly completed resale or exemption certificate is accepted in good faith by
the seller. The tax due on the fact situation presented in your letter is as
follows: (1) COMPANY A owed sales or use tax on the original purchase of the
Scitex machine; (2) The sale of the Scitex machine by COMPANY A to COMPANY B is
also taxable; however, since COMPANY B is going to re-lease the machine under
an operating lease, COMPANY B may issue a resale certificate in lieu of tax;
(3) COMPANY B is required to collect tax on each monthly payment.

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

If you have any questions or need additional information, you may call toll
free 1-800-531-5441, ext. 50037 or the regular Austin number is 512-475-0037.
You also may write to Tax Administration Division.

Sincerely,

Lindey Osborne
Tax Administration Division