If a retailer of x-ray equipment loans machines free of charge to tax-exempt hospitals and depreciates the equipment on its books, does that count as tax-free demonstration/display use, or does the retailer owe sales tax?

Plain-English summary

A retailer of x-ray equipment ("Client") loaned x-ray machines free of charge to two tax-exempt hospitals. The hospitals paid no rent or maintenance costs — only expendables and utilities — and there was no written agreement covering usage, term of use, or any commitment to buy expendables or future equipment from the Client. The Client could remove and sell the equipment as used (charging sales tax at that time) and replace it with different equipment whenever it chose, entirely at its own discretion; the hospitals had no control over what equipment they got, when it would be removed, or when it would be replaced. Because the equipment declined in value while on loan, the Client's auditors required it to depreciate the equipment for GAAP purposes and to track its cost in a separate account.

The Client asked whether this loan arrangement qualified as tax-free "demonstration/display" equipment use by a non-profit/tax-exempt entity under Rule 3.285(e)(1), especially since the hospitals wouldn't owe sales tax even if the arrangement were treated as a sale.

The Comptroller's Tax Policy Division answered no. Rule 3.285(e)(1) provides that when property purchased under a resale certificate is used for any purpose other than retention, demonstration, or display, the purchaser owes sales tax based on the fair market rental value of the item for the period used (or, if no fair market rental value exists, on the purchase price). The hospitals' use of the equipment did not qualify as demonstration or display because the hospitals had no incentive to buy the equipment, and potential purchasers could not readily view or test it through this arrangement. The letter notes that under Rule 3.287 (Exemption Certificates), the Client could have issued an exemption certificate if, at the time of purchase, it knew the equipment was to be donated to an exempt entity for the entity's use — but that is a different fact pattern from the loan arrangement described here.

Because the Client had taken depreciation on the equipment, the Comptroller held that the depreciation itself constituted a taxable use, and the Client owed tax on the fair market rental value of the equipment's use (or its original purchase price if no rental value could be determined). The letter cites Hearing No. 30,303, in which an Administrative Law Judge held that taking depreciation on equipment held for resale constitutes a use, making the purchaser liable for sales tax on the fair market value of that use or on the original purchase price.

What this means for you

Retailers who loan or donate inventory to exempt organizations

Simply loaning equipment free of charge to a tax-exempt organization does not automatically qualify as tax-free "demonstration/display" use under Rule 3.285(e)(1). If the recipient organization has no realistic incentive to purchase the item and outside potential buyers can't readily view or test it through the arrangement, the use won't qualify as demonstration or display — and tax can become due based on the fair market rental value (or purchase price) of the item.

Businesses that depreciate loaned-out or resale inventory

Taking depreciation on equipment that was purchased tax-free for resale is treated as a taxable use of that equipment. If your books require depreciating items you're holding out as resale inventory (for example, because they decline in value while loaned out), expect the Comptroller to treat that depreciation as triggering sales/use tax liability on the fair market rental value of the item's use, or on its original purchase price if no rental value can be determined.

Businesses considering an exemption certificate for donated equipment

If you know at the time you purchase equipment that it will be donated to an exempt entity for that entity's use, Rule 3.287 allows issuing an exemption certificate for that purchase. This is a narrower path than the demonstration/display exemption and depends on that intent existing at the time of purchase.

Common questions

Q: Does loaning equipment free of charge to a tax-exempt hospital automatically make it tax-exempt "demonstration/display" use?
A: No. The Comptroller found that this loan arrangement wasn't demonstration or display because the hospitals had no incentive to buy the equipment and potential purchasers couldn't readily view or test it.

Q: Why did the retailer end up owing tax here?
A: Because the retailer took depreciation on the equipment for GAAP purposes. The Comptroller treated that depreciation as itself constituting a taxable use of equipment that had been purchased tax-free for resale.

Q: How is the tax calculated?
A: Tax is based on the fair market rental value of the item for the period it was used — the amount a purchaser would pay on the open market to rent the item. If there's no fair market rental value, tax is based on the original purchase price instead.

Q: Could the retailer have avoided tax by issuing an exemption certificate?
A: Possibly, under Rule 3.287, but only if the retailer knew at the time it purchased the equipment that it would be donated to an exempt entity for that entity's use. That is a different scenario from loaning out resale inventory and later depreciating it.

Q: What prior authority did the Comptroller rely on?
A: Hearing No. 30,303, in which an Administrative Law Judge held that taking depreciation on equipment held for resale constitutes a use, making the purchaser liable for sales tax on the fair market value of that use or on the original purchase price.

Citations and references

Regulations:

• 34 Tex. Admin. Code Rule 3.285(e)(1) (Improper use of items purchased for resale)
• 34 Tex. Admin. Code Rule 3.287 (Exemption Certificates)

Administrative decisions:

• Comptroller's Hearing No. 30,303

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9506L1350G12

Original ruling text

June 2, 1995

Dear ***:

Thank you for your letter requesting a sales tax ruling on x-ray machines that
your client ("Client"), a retailer of x-ray equipment, loans free of charge to
two tax exempt hospitals.

Your Facts:

The hospitals are not required to pay rent or maintenance costs on the
equipment. The only expense to the hospitals are expendables and utilities.
There is no written agreement between Client and the hospitals concerning any
aspect of usage, term of use, commitment to purchase expendable or future
equipment from taxpayer. Solely upon Client's discretion, he will from time to
time remove the equipment and sell it as used equipment at which time the
taxpayer charges the appropriate sales tax. In turn, Client at his discretion
will replace the x-ray machine with another machine of his choosing. The tax
exempt hospitals do not have any control over the type of equipment they are
given to use, when the equipment will be removed, nor when the equipment will
be replaced.

Because the equipment is declining in value during its use by the hospitals,
Client isolates the cost of the equipment in a separate account on its books
and for GAAP treatment is required by the Client's auditors to depreciate the
equipment.

Question:

Client views this equipment as demonstration/display equipment used by a
non-profit/tax exempt entity. Is this correct under Rule 3.285(e)(1) given
the additional fact that the entities using the equipment would not be subject
to sales tax even if the transaction was deemed to be a sale.

Response: Rule 3.285(e) provides:

Improper use of items purchased for resale.

(1) When an item is removed from a valid tax-free inventory for use in
Texas, Texas sales tax is due. Texas sales tax is not due on items
removed from a valid tax-free inventory for use outside the state. When
an item purchased under a resale certificate is used for any purpose
other than retention, demonstration, or display, the purchaser is liable
for sales tax based on the fair market rental value of the item for the
period of time used. The fair market rental value is the amount that a
purchaser would pay on the open market to rent the item for use. If the
item has no fair market rental value, the sales tax is due based upon the
purchase price.

The use of the equipment by the hospitals is not considered demonstration/
display of the equipment because the hospitals do not have an incentive to
buy the equipment and potential purchasers cannot readily view or test the
equipment. Under rule 3.287 - Exemption Certificates, Client could issue
an exemption certificate if he knew that the equipment being purchased was
to be donated to an exempt entity for its use.

Because, Client has taken depreciation on the equipment, Client owes tax
on the fair market rental value of or the original purchase price of the
equipment. In hearing 30,303, the Administrative Law Judge held that the
taking of depreciation on equipment held for resale constituted a use and
the purchaser was liable for payment of sales tax on the fair market value
of the use or on its original purchase price.

This opinion is based on the facts presented. Other facts though similar
may provide a different result. You may call me toll-free at 1-800-531-5441,
extension 3-4502. The direct line is 512/463-4502. You may also write to Tax
Administration, Comptroller of Public Accounts.

Sincerely,

Gilbert Zamora
Tax Administration Division

NOTE: Previous Accession Number 9506139L