91-009

 

July 11, 1991 Response from Tax Commission

May 18, 1991 Letter from XXXXX of XXXXX

 

 

July 11, 1991

 

XXXXX

 

Re: Advisory Opinion - Sales and Leaseback

 

Dear Mr. XXXXX:

 

This letter is in response to your recent request for a Tax Commission ruling on whether the sale of fixed assets which were taxed upon purchase and used by your customer and later leased back to the same customer are subject to sales tax on the lease payments. It is your opinion that a "financing" lease is not a "true" lease, and therefore, not taxable.

 

The Tax Commission policy is to refer such requests to the division most qualified to analyze the request and make recommendations concerning it. As such, your request was referred to the Tax Commission's Auditing Division for their analysis and recommendation. The division's recommendations is as follows:

 

1. The nature of the Utah sales and use tax law is to impose tax on the transaction constituting a sale (or lease). Each transaction is a closed transaction and stands on its own. The law then provides certain exemptions. The sale by the customer of its used fixed assets is exempt because XXXXX is entitled to the resale exemption. There is no exemption provided for the lease of personal property to an, otherwise, taxable customer. Thus, your lease would be considered a taxable lease.

 

2. There is no distinction in the sales tax law or rule for a lease "intended as security" from a regular lease. There is no definition or intention to tax only "true leases." The FMA case cited is a civil case and has no bearing on sales tax. The reference to "true" or "financing" leases is irrelevant.

 

3. In XXXXX's case, there is an actual change of legal ownership on the sale by the customer to XXXXX. There will be another actual change of ownership when the customer exercises the option to buy the assets at the end of the lease term.

 

4. XXXXX states as a reason that no tax should be due on lease payments, that they don't take physical possession of the assets and that the customer will have the benefits and burdens of ownership. In the case of a normal lease, lessors often do not take possession of assets, and in the case of normal capital leases, the lessee also has the benefits and burdens of ownership, but without legal ownership or title.

 

5. Sales Tax Rule R865-19-32S was recently amended to allow the lessee, at his option, to treat conditional sales leases as a purchase. This only changes which transaction is taxable, the sale or the subsequent lease payments.

 

6. California has an option, like Utah now has, to treat financing leases as purchases. That option also applies only to the original transaction. Although other states, such as California, allow certain sale and leaseback agreements to be treated as financing arrangements, no such provision exists in Utah.

 

In summary, there is no provision in the Utah sales tax law or rule to allow an exemption for lease payments in a sale and leaseback agreement.

 

Based upon the facts presented in your letter, we are in agreement with the Auditing Division's recommendation. Obviously, if there are deviations from these facts, this opinion may be negated.

 

If you do not agree with this determination, you may appeal to the Tax Commission for a formal hearing. The results of that hearing would constitute a declaratory judgment and be appealable to the Utah State Supreme Court. A Notice of Appeal Rights is attached.

 

For The Commission,

 

Joe B. Pacheco


 

 

May 18, 1991

 

Mr. XXXXX

Utah State Tax Commission

160 East Third South

Salt Lake City, Utah 84134

 

Dear Mr. XXXXX:

 

XXXXX, a Utah corporation, ("XXXXX") is contemplating a transaction (the "Transaction") in the State of Utah on which it will need an advisory opinion as to whether or not there is a taxable event for sales tax purposes. I respectfully request that the Commission issue a written ruling in this matter.

 

XXXXX has a Utah customer who wishes to sell to and leaseback from XXXXX non-inventory items of equipment which customer currently owns and uses in its business operations ("fixed assets"). The customer is a retailer of tangible personal property which is different from the fixed assets it desires to sell and lease back. The customer paid Utah sales tax on the fixed-assets at the time of their original purchase. The customer now wishes to use those assets as collateral to obtain additional operating capital, and there are accounting reasons why a sale-leaseback would be more beneficial than a loan on the assets.

 

The Transaction is a sixty (60) month lease. Customer will be obligated to pay base monthly lease payments in a fixed amount, which, later in the lease, will increase in the monthly amount ("contingent rentals")if there occurs any increase in the Consumer Price Index during an initial period of the lease. At the end of the lease term, customer is required to make a final lump sum payment to XXXXX (in an amount predetermined at the commencement of the lease) at which time customer will be deemed the owner of the fixed assets. The foregoing terms are fixed and irrevocable.

 

The Transaction will be structured as a non-tax lease in that customer will remain the owner for federal income tax purposes and the transaction will not constitute a sale as defined in the Internal Revenue Code. The assets will remain on the customer's "tax" books and will continue to be depreciated by the customer for federal and Utah income tax purposes in accordance with its previously established methods. The fixed assets will remain in customer's possession at their current Utah location and will continue to be used by customer in the same manner after the lease is in place. XXXXX will never take possession of the fixed assets. The customer will retain all of the burdens and benefits of ownership of the fixed assets, including the obligation to pay property taxes, insurance, and maintenance. As mentioned in the preceding paragraph, at the end of the lease, customer shall be deemed the owner of the fixed assets for no additional consideration beyond payment of the minimum lease payments called for in the contract. Because the parties deem the transaction to be a non-tax lease, XXXXX will not claim depreciation or other income tax benefits with respect to its purchase of the fixed assets.

 

Based upon the following analysis, it is XXXXX’s conclusion that neither its purchase nor lease of the fixed assets as set forth above is subject to imposition of the Utah sales or use tax:

 

I. Under Utah case law. the Transaction is a "lease intended as security" and not a "true lease", and customer will remain the legal and beneficial owner of the fixed assets.

 

Notwithstanding attempts to characterize a transaction as a lease of personal property, the Utah Supreme Court has continually held such transactions to be "leases intended as security", "conditional sales" or "financing arrangements" and not "true leases" where lessee has received or retained substantially all of the burdens and benefits of ownership of the personal property. FMA Financial Corporation v. Pro-Printers, 590 P2d. 803 (1979); Arnold Machinery Company v. David M. Balls et al., 624 P2d. 678 (1981); Colonial Leasing Company v. Larsen Brothers Construction, 731 P2d. 483 (1986); First Security Financial v. Oakland Ltd. Inc., 750 P2d. 195 (1988). Such cases also hold the lessee/user to be the legal and beneficial owner of the property subject to the transaction.

 

The Utah Supreme Court's analysis of the "true lease" versus "lease intended as security" issue has arisen principally in the context of determining whether the "security interest" provisions of Article 9 of the Utah Uniform Commercial Code ("UCC") apply to a transaction denoted as a "lessee": If the transaction is a "true lease", then the user has no ownership interest in the personal property and Article 9 does not apply; if, however, the transaction is not a "true lease", but is a "lease intended as security" or "conditional sale", then the user is deemed to be the owner of the personal property rather than the lessor, and lessor is deemed to have a security interest in the equipment by virtue of Article 9.

 

The Utah Supreme Court first addressed this issue in FMA Financial Corporation v. Pro-Printers (supra). In that case, the Court focused upon Section 70A-1-201(37) of the UCC which provided in part,

 

"Whether a lease is intended as security is to be determined by the facts of each case; however, (a) the inclusion of an option to purchase does not of itself make the lease one intended for security, and (b) an agreement that upon compliance with the terms of the lease the lessee shall become the owner of the property for no additional consideration or for a nominal consideration does make the lease one intended for security."

 

The Court then focused upon the question of what constitutes "nominal consideration" and concluded to apply a three-pronged test used by other courts:

 

"(1) Compare the option price with the original list price or cost of the property; (2) Compare the option price with 'sensible alternatives'; and (3) Compare the option price to the fair market value of the property at the time the option is to be exercised."

 

With respect to the above tests, the Court then stated:

 

"We believe it unwise to restrict our analysis of the problem to one specific test, in view of the fact that all three tests are somewhat related, and each can offer insight into the nature of the transaction which is being examined."

 

The Court then proceeded to apply the three-pronged test to the facts of the case, which were as follows:

 

As in the instant Transaction, the case involved a sale-leaseback arrangement wherein XXXXX ("XXXXX") purchased printing equipment from XXXXX and leased the equipment back to him for 60 fixed monthly lease payments. At the time of lease, XXXXX orally promised XXXXX he could buy the equipment at the end of the lease for a "minimal fee" determined by the Court in this case to be 10% of the original equipment cost to XXXXX. With the permission of XXXXX, XXXXX then assigned the lease to XXXXX ("XXXXX"). Thereafter, XXXXX failed to make certain lease payments and XXXXX repossessed and sold the equipment. By legal action, XXXXX endeavored to enforce collection of a deficiency against XXXXX, and the lawsuit ensued.

 

In applying the first two test of the three-pronged test to the facts, the Court concluded the transaction to be a "lease intended as security" because the Court considered the 10% purchase option to be "nominal" within the Utah UCC definition and concluded that when the purchase option amount was compared to and found to be only 6% of the total lease payments, "the lessee in this case [was left with] no sensible alternative but to purchase the equipment." Inasmuch as no testimony was provided at trial as to the equipment's fair market value at the time the option to purchase was to be exercised, the Court did not apply the third test.

 

Later Utah cases (cited above) have confirmed the holding of the Court in the XXXXX case regarding the test to determine "true lease" or "lease intended as security" status.

 

Section 70A-1-201(37) of the UCC was subsequently amended and now provides as follows:

 

"(b) Whether a transaction creates a lease or security interest is determined by the facts of each case; however, a transaction creates a security interest if the consideration the lessee is to pay the lessor for the right to possession and use of the goods is an obligation for the term of the lease not subject to termination by the lessee, and:

 

(i) the original term of the lease is equal to or greater than the remaining economic life of the goods;

 

(ii) the lessee is bound to renew the lease for the remaining economic life of the goods or is bound to become the owner of the goods;

 

(iii) the lessee has an option to renew the lease for the remaining economic life of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement;

 

(iv) the lessee has an option to become the owner of the goods for no additional consideration or nominal additional consideration upon compliance with the lease agreement.

 

(c) A transaction does not create a security interest merely because it provides that:

 

(i) the present value of the consideration the lessee is obligated to pay the lessor for the right to possession and use of the goods is substantially equal to or is greater than the fair market value of the goods at the time the lease is entered into;

 

(ii) the lessee assumes risk of loss of the goods, or agrees to pay taxes, insurance, filing, recording, or registration fees, or service or maintenance costs with respect to the goods;

 

(iii) the lessee has an option to renew the lease or to become the owner of the goods;

 

(iv) the lessee has an option to renew the lease for a fixed rent that is equal to or greater than the reasonably predictable fair market rent for the use of the goods for the term of the renewal at the time the option is to be performed; or

 

(v) the lessee has an option to become the owner of the goods for a fixed price that is equal to or greater than the reasonably predictable fair market value of the goods at the time the option is to be performed.

 

(d) For purposes of this subsection:

 

(i) Additional consideration is not nominal if, when the option to renew the lease is granted to the lessee, the rent is stated to be the fair market rent for the use of the goods for the term of the renewal determined at the time the option is to be performed, or when the option to become the owner of the goods is granted to the lessee the price is stated to be the fair market value of the goods determined at the time the option is to be performed.

 

(ii) Additional consideration is nominal if it is less than the lessee's reasonably predictable cost of performing under the lease agreement if the option is not exercised.

 

(iii) 'Reasonably predictable' and 'remaining economic life of the goods' are to be determined with reference to the facts and circumstances at the time the transaction is entered into.

 

(iv) 'Present value' means the amount as of a date certain of one or more sums payable in the future, discounted to the date certain. The discount is determined by the interest rate specified by the parties if the rate is not manifestly unreasonable at the time the transaction is entered into; otherwise, the discount is determined by a commercially reasonable rate that takes into account the facts and circumstances of each case at the time the transaction was entered into."

 

In addition to the foregoing definition/tests, Utah Sales Tax Rule R865-19-32S, defines a "conditional sale lease" as a transaction in which:

 

" 1. the consideration the lessee is to pay the lessor for the right to possession and use of the property is an obligation for the term of the lease not subject to termination by the lessee, and

 

2. the total consideration to be paid by the lessee is fixed at the time the lease is executed and cannot be modified by use, condition, or market value, and either:

 

a. the lessee is bound to become the owner of the property; or

 

b. the lessee has an option to become the owner of the property for no additional consideration or nominal additional consideration upon compliance with the lease agreement. Nominal consideration in this sense means ten percent or less of the original lease amount."

 

The Rule was promulgated to give the possessor/user of equipment the option of treating the transaction either as a "sale" or "lease" for sales tax purposes; that is, the possessor/user has the option to pay sales tax up front on the calculated sales price, or it may pay sales tax on each lease payment as made. The Rule recognizes the true intent of the parties concerning a transaction falling within the Rule's definition; that it is essentially a "sale" or "financing arrangement" and not a "true lease". The Rule no doubt was promulgated to comprehend the typical "conditional sale lease" transaction, which is where a seller (lessor), at the request of a purchaser (lessee), acquires property from a third party vendor specifically to sell (lease) to the purchaser (lessee). For accounting or other reasons, the parties label the transaction as a "lease", but they really intend a "sale".

 

The above Transaction, is different from a typical "conditional sale lease" in that the lessor (XXXXX) is acquiring the fixed assets not from a third party vendor, but from the lessee (customer), with the intent of allowing the lessee (customer) the continued possession and use of those assets. In this sense, the Transaction should not be viewed as two consecutive "sales" of assets (i.e.. from customer to XXXXX and from XXXXX back to customer), but rather as a "financing arrangement" where XXXXX is providing financing and is using the fixed assets as collateral. Essentially, from start to finish, customer is the legal and beneficial owner of the equipment. While the parties use "lease language" to satisfy accounting or other purposes, the Transaction is nothing more than a financing.

 

That no "sale" will be deemed to occur under the Transaction is further supported by the analysis that under the XXXXX case, the Court determined that, notwithstanding the parties' labeling of the transaction as a lease, XXXXX merely had a security interest in the property. By legal definition, a party is not deemed to create or possess a security interest in property which it already owns. That is not the intent of Article 9 which governs security interests.

 

While there is considerable overlap between the definition and tests for determining a "true lease" and a "lease intended as security" under Utah case law, the UCC and the Sale Tax Rule, there is no contradiction between these definitions and tests.

 

The Transaction falls within the above definition of a "lease intended as security" under the revised UCC, and the "conditional sale lease" under the Sales Tax Rule in that under the Transaction, upon payment by customer of the scheduled lease payments (including the final lump sum payment), customer will be deemed the owner of the fixed assets at termination of the lease for no additional consideration.

 

Furthermore, the Transaction meets the three-pronged test set forth in the XXXXX case in that at the end of the lease, the customer will become the owner of the equipment for no additional consideration.

 

Section 59-12-103(1) of the Utah Code Annotated, as amended, provides for the imposition of sales tax [at subpart (a)] on the "retail sales of tangible personal property made within the state" and [at subpart (k)] on "leases and rentals of tangible personal property if the property situs is in this state. . ."

 

In accordance with the foregoing analysis, inasmuch as customer (and not XXXXX) will be deemed to be the owner of the fixed assets throughout the Transaction and notwithstanding the Transaction, no "sale" or "lease" should be deemed to have occurred which would give rise to the incidence of sales tax. Accordingly, neither XXXXX's "purchase" of the fixed assets from customer nor its "lease" of such fixed assets back to customer should create a taxable event for purposes of the Utah Sales Tax.

 

II. For sales tax purposes. other states have exempted similar transactions from sales and use tax where the transaction is more a "conditional sale" or "lease intended as security" than a "true lease":

 

California: California Sales and Use Tax Regulation 1660 at (a) provides in part:

 

"Where a contract designated as a lease binds the 'lessee' for a fixed term and the 'lessee' is to obtain title at the end of the term upon completion of the required payments or has the option to purchase the property for a nominal amount, the contract will be regarded as a sale under a security agreement from its inception and not as a lease."

 

Further, Pamphlet No. 46 entitled, "Tax Tips for Leasing of Tangible Personal Property in California" contains the following instruction:

 

SALE AND LEASEBACK TRANSACTIONS

 

In general, transactions structured as sales and leasebacks will be treated as financing transactions if:

 

(1) the "lease" transaction would be regarded as a sale under the security agreement from its inception under the above guidelines (Regulation 1660)

 

(2) the purchaser-lessor does not claim any deduction, credit or exemption with respect to the property for federal or state income tax purposes, and

 

(3) the amount which would be attributable to interest, had the transaction been structured originally as a financing agreement, is not usurious under California law.

 

South Carolina: In a private letter ruling (#90-13, 10-3-90), the South Carolina Tax Commissioner's office decided that a sale-leaseback transaction was a financing arrangement rather than an actual sale and lease and, therefore, was not subject to South Carolina sales and use tax. The transferor purchased equipment from several vendors and subsequently "sold" the property to the transferee, who then leased it back to the transferor. However, the transferor retained legal title to the property as well as the benefits and burdens of ownership. Additionally, the equipment was never physically conveyed to the transferee. Since it was the intention of the parties to create a financing agreement and not a transfer of tangible personal property, no sales or use tax was due on the transaction.

 

XXXXX would appreciate your earliest response to its request for a ruling as mentioned in the first paragraph.

 

Very truly yours,

 

XXXXX

General Counsel