When did California refuse to treat equipment sale-leasebacks as nontaxable financing transactions?

Plain-English summary

Van Nuys audit staff asked about a redacted company financing equipment for subcontractors through agreements structured as sale/leasebacks. The auditor thought most reviewed contracts qualified as financing but questioned two lessee forms because they were not sales at inception and apparently lacked purchase-order/invoice assignment.

The general rule required a sale at inception, no federal or state income-tax deduction, credit or exemption for the purchaser/lessor, and nonusurious imputed interest. A special route could cover a true lease while retaining the latter two requirements, but required unpaid original-vendor price, assignment of purchase-order/invoice rights, title transfer, vendor payment or assumption, and a qualifying option.

The source is internally inconsistent about payment. Its first special-rule paragraph says the initial-price balance is paid by the seller/lessee; the next says the purchaser/lessor must prove it paid some or all to the vendor or assumed an unpaid installment liability. The underlying request, agreements and transaction records are absent, so this page does not resolve the wording.

One contract failed both routes because the lessor expressly retained depreciation benefits and the lessee had to protect the lessor's after-tax return if those benefits were lost. It also failed sale-at-inception treatment because the lessee could extend the lease and could buy only for the greater of fair market value or 10 percent of the lessor's cost. That option also exceeded the special rule's fair-market-value-or-less ceiling.

A second form required return of equipment unless otherwise agreed and gave no purchase option, so a genuine sale/leaseback using it was not financing. But its other sections contemplated direct lessor purchases, and many forwarded invoices named or billed the lessor while shipping to the lessee. Those were vendor-to-lessor sales with no initial lessee sale.

Only two forwarded invoices named the lessee as buyer. Those initial sales could be taxable if the lessee used the equipment before resale; any later sale/leaseback still failed financing for the stated reasons.

The March 1 request, contract forms, full invoice set, orders, title/payment proof, tax-benefit and usury records, pre-resale use, tax computations, returns, audit result and later outcome are absent. The memo gives no final tax amount. Live Annotation 330.5110 publishes only the first contract's depreciation, extension and greater-of-fair-value-or-10%-cost failures. It omits the second contract, direct-vendor invoice branch and internal payment wording conflict.

Common questions

Does calling an agreement a sale-leaseback make it financing?

No. The source applied Regulation 1660's substantive tests to the rights, tax benefits, payment flow, title, and end-of-term terms.

Can the purchaser-lessor claim depreciation and still get financing treatment?

Not under the rules applied here. Retaining depreciation or related income-tax benefits defeated both the general and special financing routes.

Why did the purchase option matter?

The option was the greater of fair market value or 10 percent of cost. That prevented a sale at inception and could exceed the special rule's permitted fair-market-value-or-less option.

Were all of the second lessee's transactions sale-leasebacks?

No. The memorandum said invoices naming the lessor as buyer showed direct vendor-to-lessor sales. Only two forwarded invoices indicated an initial sale to the lessee.

What if those two lessee purchases were used before resale?

The memo says those original sales would be taxable; their later sale/leasebacks still would not qualify as financing.

Who had to pay the original vendor balance under the special rule?

The source conflicts: one paragraph says seller/lessee, while the next requires purchaser/lessor payment or assumption. The underlying records do not resolve it.

Did the memo compute or finally assess tax?

No. It analyzes contract and invoice categories without the audit computation or later result.

Citations and references

• Historical Sales and Use Tax Regulation 1660(a)(3)(A) — general financing route
• Historical Sales and Use Tax Regulation 1660(a)(3)(B) — true-lease financing route
• Historical Sales and Use Tax Regulation 1660(a)(2)(A) — sale-at-inception test
• Live Annotation 330.5110 — first contract only
• Request, contracts, invoices/orders, title/payment/tax/use records, audit and outcome — absent

Source

• Annotated Legal Opinions collection: https://cdtfa.ca.gov/taxes-and-fees/annotations-menu.htm
• Annotation page: Annotation 330.5110
• Original supporting opinion: 330.5110 PDF

Original ruling text

State of California

Board of Equalization

Memorandum

To:

Mr. Brian Manuel
Associate Tax Auditor – Van Nuys

From:

David H. Levine
Tax Counsel

Subject:

L--- F--- C--- (L---)
SN -- XX-XXXXXX

330.5110

April 12, 1990

ATSS 485-5550
(916) 445-5550

This is in response to your memorandum dated March 1, 1990 regarding sale-lease back transactions. L--- finances equipment purchased by [---] subcontractors through the use of agreements structured as sale and leaseback agreements. You have concluded that most of the contracts you reviewed qualified as financing transactions. However, you believe that the agreements with S--- S--- and W--- do not qualify under subdivision (a)(3)(A)1 of Regulation 1660 (the leases do not constitute sales at inception) or under subdivision (a)(3)(B)2 (the seller/lessee apparently did not assign the purchase order and invoice to the purchaser/lessor). You ask our opinion on the proper application of tax. As you know, the general rule under which a transaction structured as a sale-leaseback will be regarded as a financing transaction is when: 1) the “lease” is a sale at inception; 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 as a financing agreement, is not usurious under California law. (Reg. 1660(a)(3)(A).) The special application rule of subdivision (a)(3)(B) of Regulation 1660 allows a transaction structured as a sale-leaseback to be regarded as a financing transaction even when the lease is a true lease and not a sale at inception (the other two requirements of the general rule remain applicable). To qualify for this special rule, the seller/lessee must still owe the original equipment vendor some or all of the initial purchase price of the equipment and the seller/lessee must assign to the purchaser/lessor all of its right, title, and interest in the purchase order and invoice, the balance of the initial purchase price being paid by the seller/lessee. You ask what the parties must show in order to satisfy subdivision (a)(3)(B)2 of Regulation 1660. Actually, subdivisions (a)(3)(B)2 and (a)(3)(B)3 should be viewed together. In summary, title to the equipment must be transferred to the purchaser/lessor and the purchaser/lessor must establish that it paid some or all of the initial purchase price of the

Mr. Brian Manuel

-2-

April 12, 1990
330.5110

property to the original equipment vendor (the person selling the property to the seller/lessee). If part of the initial purchase price remains to be paid at the time of the audit (which would normally be a case where the seller/lessee purchased the property on installments payable to the original equipment vendor), the purchaser/lessor must establish that it has assumed that liability from the seller/lessee. The lease between L--- and S--- S--- will not be treated as a financing transaction under Regulation 1660. Section 11.06 of the lease provides that L---, as owner of the equipment, is entitled to depreciation under applicable income tax law. Furthermore, Section 11.02 provides that, under certain circumstances, the lessee must reimburse the lessor, if any such income tax benefits are lost, so that L---’s net after-tax return will be the same as if L--- had not lost the income tax benefits. Since L--- retained the right to take income tax benefits as an owner of the leased equipment, the lease agreement cannot be treated as a nontaxable financing transaction under the general or special rule. (Reg. 1660(a)(3)(A)2, (a)(3)(B)4.) Even if the lease did not contain the provisions discussed above regarding the taking of income tax benefits, we would nevertheless conclude that this agreement cannot be treated as a nontaxable financing agreement. At the end of the lease term, the lessee may elect to extend the lease. (§ 4.01.) The lessee may also elect to purchase the equipment for the greater of the fair market value of the equipment at the time the lease term expires or an amount equal to ten percent of L---’s cost. This clearly does not constitute a sale at inception under subdivision (a)(2)(A) of Regulation 1660 and, on this basis, the transaction does not qualify for treatment as a financing transaction under the general rule of (a)(3)(A) of Regulation 1660. Even if all other requirements of the special rule were satisfied (they were not), to qualify the lessee must have an option to purchase the property at the end of the lease term at an option price of fair market value or less. (Reg. 1660(a)(3)(B)6.) Under the L--- - S--- S--- lease, the option price is the greater of fair market value or ten percent of L---’s cost. That is, fair market value is the least that the option will be, and it might be greater. The lease therefore cannot be treated as a financing transaction even if all other requirements of the special rule were satisfied. The lease between L--- and W--- does not contain an option for W--- to purchase the leased property at the end of the lease term. Rather, Section 17 specifically states that, unless otherwise agreed in writing, W--- is to return the leased equipment to L---. Therefore, since the lease is not a sale at inception, and since there is no option to purchase the property at fair market value or less, when this lease is part of a sale-leaseback transaction, the transaction cannot be regarded as a financing transaction. However, it is not entirely clear to me that all of the L--- - W--- leases were part of sale-leaseback transactions. Sections 2 and 3 of the lease contemplate that property to be leased to W--- will be purchased by L---. A number of the invoices you have forwarded to us indicate that this is what occurred, that is, that the vendors sold the equipment to L--- (the property was shipped to W--but shown on the vendor’s sale invoice as being sold to or billed to L---). These invoices indicate that title passed directly from the vendor to L--- and that there was no sale transaction

Mr. Brian Manuel

-3-

April 12, 1990
330.5110

between the vendor and W---. Of the invoices you have forwarded to us, only two indicate that the property was sold to W---. If this is the case, these sales to W--- would be taxable if W--used the property prior to resale to L---. The sale-leasebacks would not qualify for treatment as financing transactions for the reasons discussed above. If you have further questions, feel free to write again.

DHL:wak
2074C

330.5110.doc