When can a California company's equipment sublease be tax-paid after it leases the property from an out-of-state sister company?

Plain-English summary

California rental company W--- said it obtained equipment from New York sister L--- under a “consignment” and rented it to California customers. L--- reportedly bought without New York tax and shipped directly to W---'s customer. W--- reported use tax on a consignment cost on return line 2, did not tax customer rent and deducted it as tax-paid rental on line 6.

Counsel found the explanation confusing. Without the agreement, he assumed it was a prime lease, W--- paid L--- rent based on a percentage of customer rent, and W--- reported use tax on that prime rent. A different transaction character would invalidate the answer.

For unrelated parties, timely use tax on the prime-lease rent would make the sublease tax-paid under Regulation 1660(c)(5). Related parties required an additional test: California would disregard the intercompany lease unless it was structured as if at arm's length.

The prime rent generally had to cover every L--- cost attributable to the lease: equipment cost; if manufactured, incorporated/consumed property plus direct and indirect labor; and overhead such as purchasing-employee, accounting and utility costs. The letter cites no distinct authority for this related-party test.

If the assumed prime lease was genuine, arm's length and timely taxed on rent, customer subleases were not continuing sales. Counsel said W--- was apparently reporting customer rent as nontaxable repair/installation—despite the request's line-6 description—and instructed line 10(e), other nontaxable receipts, explained as “tax-paid lease.” The source supplies no corrected return or later result.

The live annotation publishes the assumed percentage-rent and all-costs conditions but omits the direct-shipment facts, return-line discrepancy, missing agreement and conditional limits.

Common questions

Did timely tax on the intercompany rent automatically exempt the sublease?

No. Because the parties were related, the prime lease also had to be structured as if at arm's length.

What did arm's-length pricing require?

Rent generally had to cover all direct and indirect costs attributable to the leased property.

Which manufacturing costs counted?

Property incorporated or used in manufacturing plus direct and indirect labor, along with attributable overhead.

What if the consignment agreement was not actually a lease?

The opinion said its analysis would not apply.

How did counsel say to report nontaxable customer rent?

On line 10(e) as other nontaxable receipts with “tax-paid lease” as the explanation—not as repair and installation.

Did the request and opinion identify the same return line?

No. The quoted request says W--- deducted rent on line 6, while counsel says it was apparently reported as nontaxable repair/installation and directs line 10(e). No return is supplied to resolve this.

Was the intercompany agreement reviewed?

No. Counsel expressly could not determine whether the consignment was a lease without it.

Was a completed tax outcome supplied?

No. There is no implemented pricing, return amendment, audit, assessment, payment, claim or appeal.

Citations and references

• Revenue and Taxation Code sections 6006(g)(5), 6006.1 and Regulation 1660 — continuing-sale/same-form/acquisition-tax rules
• Regulation 1660(c)(5) — tax-paid sublease rule
• Related-party arm's-length/all-costs rule — stated without separate authority
• June 8, 1992 requester letter — confusing consignment/return treatment quoted, standalone letter absent
• W---–L--- consignment agreement — not supplied or reviewed
• Enclosed Regulation 1660 — absent from the PDF
• Official Annotation 330.1875 — publishes the assumed all-costs result without source limits

Source

• Annotated Legal Opinions collection: https://cdtfa.ca.gov/taxes-and-fees/annotations-menu.htm
• Annotation page: Annotation 330.1875
• Original supporting opinion: https://cdtfa.ca.gov/lawguides/annotations/330-1875.pdf

Original ruling text

330.1875

STATE OF CALIFORNIA

STATE BOARD OF EQUALIZATION

WILLIAM M. BENNETT
First District, Kentfield

1020 N STREET, SACRAMENTO, CALIFORNIA
(P.O. BOX 942879, SACRAMENTO, CALIFORNIA 94279-0001)
(916) 445-5550

BRAD SHERMAN
Second District, Los Angeles
ERNEST J. DRONENBURG, JR.
Third District, San Diego
MATTHEW K. FONG
Fourth District, Los Angeles

July 8, 1992

GRAY DAVIS
Controller, Sacramento

BURTON W. OLIVER
Executive Director

Mr. G--- A--Comptroller
P--- A--- L--- W---, Inc.
XXXXX --- ---, Unit #X
--- ---, California XXXXX
Re:

S- -- XX-XXXXXX

Dear Mr. A---:
This is in response to your letter dated June 8, 1992 regarding the application of use tax to your leases of tangible personal property. P--- A--- L--- W--- (“W---”) does not own the equipments it rents. It acquires the equipment it will rent to its customers from its sister organization in New York, P--- A--- L---, Inc. (“L---”). You explain: “There exists a consignment agreement between the firms to facilitate this arrangement. The cost of this agreement, a function of the rental income generated by the equipment, is borne by W--- and included as an expense subject to use tax on line 2 of the quarterly return. “Thus, L--- NY who does own the equipment but has paid no sales tax to NY on their purchase of it transfers it directly to the customer of W---. “Whereby W--- will incur sales tax on the equipment cost due California and consequently not burden our customer with this tax nor include the rental income arising from this transaction as a taxable event. It is treated as a ‘tax-paid rental’ and deducted as an exempt transaction on line 6 of the quarterly return.”

Mr. G--- A---

-2-

July 8, 1992
330.1875

Initially, I note that I am confused by your explanation, in particular the first paragraph quoted above. So that I can provide you some guidance at this time, my opinion will be based on the following assumptions. I will assume that the document you refer to as a “consignment agreement” is simply a lease between W--- and L---. This would mean that W--- is subleasing the equipment to W---’s lessees. By cost of the agreement being borne by W---, I will assume that you mean W--- pays L--- a rental fee. It appears that this rental fee is a percentage of the rentals W---’s lessee’s pay to W--- and that W--- is reporting this rental as subject to use tax. Since W--- is leasing the property from a related entity, there is a special rule applicable, which I will discuss below. First, however, I will discuss the general rules applicable to leases of tangible personal property in California. The lease of tangible personal property in California is a continuing sale subject to use tax measured by rentals payable unless the lessor leases the property in substantially the same form as acquired and has paid California sales tax reimbursement or use tax to its vendor or timely reports to California use tax measured by purchase price. (Rev. & Tax. Code §§ 6006(g)(5), 6006.1, Reg. 1660, a copy of which is enclosed.) Similarly, a sublease of tangible personal property is a continuing sale subject to use tax measured by rentals payable from that sublease unless the subleased property is leased in substantially the same form as acquired and, as relevant to your inquiry, the sublessor has timely paid use tax measured by the rentals payable under the prime lease. (Reg. 1660(c)(5).) Thus, if W--- and L--- were unrelated parties, your timely payment of use tax measured by rentals payable to L--- would mean that your sublease of the leased equipment would not be a continuing sale and would not be subject to use tax. However, since the lessor and prime lessee/sublessor are related parties, further analysis is required. In such circumstances, for purposes of application of sales and use tax, we disregard the transaction between the related parties unless that transaction was entered into as if at arms length. In the context of your inquiry, if we were to conclude that the transaction between W--- and L--- was not structured as if at arms length, we would disregard it, which would mean that we would regard the lease to W---’s customer as a continuing sale subject to use tax measured by the rentals payable from that lease. A lease transaction between related parties is generally regarded as being entered into as if at arms length if the rentals payable under that lease cover all costs of the lessor with respect to that lease. The term “all costs” includes the cost of the leased property. If manufactured by the lessor, it includes all costs of property incorporated into the leased property or used during the manufacturing process and the cost of all direct and indirect labor. The term “all costs” also includes overhead costs attributable to the leased property (which would include costs such as employee costs of purchasing the property and accounting costs, utility costs, etc.).

Mr. G--- A---

-3-

July 8, 1992
330.1875

Provided the assumptions made above are accurate and W--- timely reports use tax measured by the rentals payable under those leases, then we agree that, if the leases between W-- and L--- are as if at arms length, W---’s subleases of the equipment are not continuing sales and are not subject to use tax. Please bear in mind, however, that without reviewing the contract between W--- and L---, we are unable to ascertain whether we would regard it as a lease or as some other type of arrangement. If we were to conclude it is not a lease, the opinion above would not be applicable. W--- is apparently currently reporting the rentals from its leases as receipts from nontaxable repair and installation. These receipts are from neither repair nor installation. Assuming the leases are not subject to tax, as discussed above, W--- should report such amounts under line 10(e) of the return (other nontaxable receipts) with the explanation “tax-paid lease.” If you have further questions, feel free to write again. Sincerely,

David H. Levine
Senior Tax Counsel
DHL:cl
Enclosure