Are the interest spread and note-assignment proceeds taxable California sales receipts when an equipment finance company uses noncancelable contracts labeled as leases?

Plain-English summary

A woodworking-machinery finance company called its customer contracts "leases," but the parties agreed they were actually sales from inception: the agreements were noncancelable and customers could acquire the equipment at the end for a nominal amount, generally $25. Regulation 1641(b) therefore applied.

The dispute was not whether a sale occurred, but how much of the financing proceeds belonged in taxable gross receipts.

The recommendation concluded that the finance company's interest income was not taxable sales markup. The contracts separately stated the machinery cost and the customer's interest rate. The lender receiving the assigned contracts kept records applying payments between principal and interest. Under Regulation 1641(a), that accounting was enough to preserve the interest exclusion even though the finance company earned a spread over the lower rate it paid its lender.

The recommendation also concluded that:

• upfront prepayments did not increase the stated sales price or become disguised markup;
• discounting the installment contracts to the lender did not convert interest into taxable receipts;
• assigning the contractual right to payment and the security interest transferred intangible rights, not taxable tangible personal property; and
• the petition should be granted.

The result was explicitly fact-sensitive. The recommendation said it might have differed if the company had bought the machinery for resale without paying tax or had not disclosed the equipment cost to the customer.

What this means for you

Equipment finance companies

A document labeled "lease" can still be a sale where the customer is economically committed to buy. Separately state and accurately account for equipment price, principal, and interest if you want the finance-charge exclusion preserved.

Commercial lenders buying installment paper

Purchasing or taking assignment of payment contracts does not by itself make the underlying interest taxable sales proceeds. The source treated the assigned rights and security documents as intangibles.

Accountants and tax professionals

The lender's records mattered. The finance company's own books called some amounts commissions, but the holder of the contracts maintained a proper principal-and-interest allocation. Also preserve the caveats: tax had been paid on equipment cost, customer pricing disclosed that cost, and transactions were arm's length.

Common questions

Q: Why were the supposed leases treated as sales?
A: They were noncancelable and allowed the customer to acquire the machinery for a nominal amount, so the parties stipulated that they were sales from inception under Regulation 1641(b).

Q: Was the finance company's interest-rate spread taxable?
A: No. The recommendation treated the spread as interest because the contracts stated the rate and the lender properly accounted for principal and interest.

Q: Did assigning the contracts to the lender create a taxable property transfer?
A: No. The source characterized the assigned payment and security rights as intangible commercial paper or negotiable instruments.

Q: Would the same result apply if the machinery cost were hidden or acquired ex tax?
A: Not necessarily. The recommendation expressly said those different facts might change the conclusion.

Citations and references

• Cal. Code Regs. tit. 18, § 1641(a) (separate accounting for interest, finance, insurance, and carrying charges)
• Cal. Code Regs. tit. 18, § 1641(b) (contracts called leases that are sales in substance)
• Automatic Canteen Co. of America v. State Board of Equalization, 238 Cal. App. 2d 372, 383 (1965) — lawful tax planning
• March 27, 1992 appeals conference in Sacramento — participants identified or redacted in the decision; separate conference record not reproduced in the official PDF
• Petitioner's president's April 6, 1992 letter and Exhibits A through C — operating procedure, lender commitment, and customer lease described; separate letter and exhibits not reproduced in the official PDF
• Audit workpapers pages 33-52, Audit Items A, B, and D, refund claim, and notice of determination — described but not reproduced in the official PDF

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Annotation page: Annotation 200.0106
• Original supporting opinion: 200.0106 PDF

Original ruling text

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ATE OF ~LIFORNIA
BOARD OF EQUALIZATION

BUSINESS TAXES APPEALS REVIEW SECTION
In the Matter of the Petition
for Redetermination Under the
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DECISION AND RECOMMENDATION

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The Appeals conference in the above-referenced matter was held by Janice M. Jolley, staff Counsel, on March 27, 1992, in Sacramento, California. Appearing for Petitioner:

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Appearing for the
Sales and Use Tax Department:

Protested Items
The protested tax liability for the period January 1, 1988, through December 31, 1991, is measured by: State, Local and county A.

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B.

unreported sales consisting of
lease contracts which are sales
from inception, actual basis

$5,786,000

Credit for tax-paid purchases
resold

(4,311,889)

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Petitioner's contention
Petitioner did not receive. gross receipts from the sale of tangible personal property because it assigned its clients• installment contracts as negotiable instruments to a lender at a discount.

summary
Petitioner sells woodworking machinery and enters into a letter agreement with the purchaser which it designates as a "lease." At the conference both parties agreed that at the end of each such "lease," the purchaser could acquire the property outright for a nominal sum, generally $25.00, and that there were no cancellation provisions under the -agreement. The parties therefore stipulated that the transactions should be treated as sales from inception. Petitioner describes its general operating procedure in Exhibit A, an ADril 6, 1992. 1Atter from petitioner's president to
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• Petitioner would obtain a list
of the items to be acquired through a specified vendor from prospective purchasers, whom it described as individuals .generally incapable of obtaining credit direct from vendors of this type of machinery or who did not wish to disturb their lines of credit with their own banks for a · period o( sixty (60) months. Petitioner would obtain a credit application and then screen the purchaser to obtain relevant credit information. After confirming the purchase price quoted by the vendor with its client, petitioner submitted the clients' credit information to obtain a loan commitment from a lender. When the loan commitment payable over a specified period of time at a known interest rate was agreed upon with the lender, petitioner placed the order with the vendor. The lender was aware by having screened the client's credit information that petitioner would assign the client's "lease" in redemption of this loan commitment at the time the lender issued its commitment letter to petitioner (Exhibit B), but the lender remitted the loan proceeds by wire into petitioner's bank account so that petitioner could pay the vendor with its own check. Petitioner caused a "lease" to be drawn in which the purchaser agreed to pay a somewhat higher rate of interest than petitioner had obtained in the loan commitment and the higher rate of interest appeared on the face of the "lease." (Exhibit C) The "lease" was payable incrementally over the same term as the loan. Petitioner states that it did not mark up the machinery, and the cost of machinery on the customer "lease" is identical to the amount petitioner paid to the vendor. The "lease" reflects any sales tax reimbursement, delivery, or other miscellaneous charges

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petitioner paid to the vendor as part of the purchase price of the machinery being financed under the "lease." Petitioner acknowledges that it always received and retained one or more "prepayments" under the "lease." Petitioner also retained a security interest in the equipment as collateral under the "lease." Simultaneous with the execution of the "lease•• or very shortly thereafter, petitioner discounted its "lease" to the lender which provided the flooring loan and assigned its interest in the security agreement to· the lender. -sometimes petitioner obtained a cash discount on the.note in addition to the prepayment holdback. Petitioner submitted supporting documents for each phase of the transactions described in Exhibit A which appear at pages 33-52 of the audit workpapers. Petitioner. states that since it did not mark up the machinery, its profit was derived either (1) from the difference between the discounted interest under the "lease" when assigned to th·e lender and/or (2) the prepayments collected at the time the "lease" was entered into with the purchaser which were retained prior to transferring the client's note to the lender. The machinery was purchased tax paid by petitioner. Petitioner had the vendor ship the machinery direct to the purchaser. Petitioner erroneously paid transit district taxes on these sales where the vendor shipped the items direct to the client. An adjustment for these payments was made in Audit Item D. A claim for refund has been filed for those overpayments for the first quarter of 1989 and the fourth quarter of 1990 at
• These overpayments were offset against liabilities asserted in this notice of determination. The Sales and Use Tax Department (hereinafter "the Department") calculated the measure of tax by subtracting the known cost of the equipment sold and the amount of interest payable on petitioner's flooring loan from the total "lease" payments, including interest, which the client agreed to pay under the "lease." Since the "lease" bore a higher rate of interest than the note to the lender, the difference was deemed by the Department to be taxable gross receipts which constituted a disguised markup of the sales price of the machinery. The Department contends that the only documents reflecting the interest discount appeared on the financial institution's records and not on any books or records maintained by petitioner. The Department contends these discounts or prepayments were treated as commissions on petitioner's books. The audit workpapers state:

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·"Accordingly, the total receipts from the sale less the amount of discount interest shown to the customer would be considered to be the sale price."

Analysis and conclusion
I concur with the parties that the "leases" entered into by petitioner with the purchasers were really contracts to finance the equipment in which petitioner retained a security interest. Therefore, they constituted taxable sales under Sales and Use Tax Regulation 1641(b). The narrow issue to be decided is what is the measure of tax. The Department contends that since the "lease" did not reflect a mark up on the cost of the equipment, all proceeds received by petitioner in excess of its cost of equipment and interest due on its notes to the lender were taxable gross receipts. The prepayment advances were not taxable gross receipts. They were remitted at the formation of the contract and were no different than any other downpayment. They did not increase the sales price. They did not constitute a disguised mark-up. The amounts receive<i by petitioner from the lender as a discount of the note did not constitute taxable gross receipts. Sales and Use Tax Regulation 1641(a) provides as follows: "If tangible personal property is sold on credit, either under a security agreement, or otherwise the whole amount of the contract is taxable, unless the retailer keeps adequate and complete records to show separately the sales price of the tangible personal property, and the insurance, interest, finance, and carrying charges made in the contract. If such records are kept by the retailer, the insurance, interest, finance and carrying charges may be excluded from the computation of the tax." It is clear from inception of each "lease" that it was a sales financing agreement and that the purchaser agreed to pay interest at a competitive market rate measured by the known cost for the machinery acquired. The rate of interest is clearly set out on the fact of the "lease." (Exhibit C) Petitioner assigned its right to collect future interest under the "lease" to the lender. The amounts paid by the purchaser were at the higher

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interest rate under the "lease" than what petitioner had to pay under the loan commitment. Nevertheless, the lender had an enforceable right to receive payment in full because consideration passed between the client and petitioner. The interest was nonusurious. The Department stipulated that the lender's records applied amounts received from the purchaser to principal and interest despite petitioner booking amounts it received as prepayments or note discounts as "commissions." Thus,- I find •t hat the provisions of Sales and Use Tax Regulation 164l(a) concerning maintenance of adequate records of interest payments have been met. The party with the right to receive payment under the "lease" maintained a proper accounting of principal plus interest received. The amounts so applied by the lender must be treated as interest. Just as in those cases where a mortgage loan is discounted and sold to another lender, the purchaser is still entitled to deduct interest payable at the rate of the initial loan. Petitioner's purchase of tangible personal property from the vendor was a sale for resale . to petitioner's clients. Petitioner paid sales tax reimbursement on its cost. The contract between petitioner and its client although designated a "lease," was actually a contract of sale. All that was transferred to the lender was a contractual right to receive money. Both petitioner and the lender, as its assignee, were protected by a security interest in the tangible personal property which petitioner resold. The transfer of paperwork assigning a security interest in the collateral from petitioner to the lender was not a taxable transfer of tangible personal property. The Department stipulated during the conference that if petitioner had held each "lease" to termination so as to receive payment in full, the amounts received in excess of its cost of the machinery would have been interest. If the payments were allocable to principal and interest at the rate agreed to by the parties if held to term, the transfer of a right to reserve payment does not ipso facto convert interest into markup. I recognize that through proper structuring, petitioner has avoided incurring additional sales tax over that already paid by petitioner to its vendors. A taxpayer has a legal right to decrease the amount of what otherwise would be [its] taxes or altogether avoid them by means which the law permits. Automatic canteen co. v. state Board of Equalization (1965) 238 cal.App.2d 372, 383. Each of the assigned contracts appears to have been entered into in an arm's length transaction, each reflects tax was paid on cost, and each reflects that petitioner resold the machinery with no markup. Had petitioner issued resale certificates to acquire the items at wholesale or if the cost of machinery had not been disclosed to the client, I perhaps would have reached a different result. Under the facts of this case,

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however, the sales and use tax provisions of the revenue and taxation laws do not tax the transfer of intangibles such as commercial paper or negotiable instruments. Recommendation Grant the petition.

ce M. Jolley,
ibits A, B,

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