Did one rail sale-leaseback qualify as financing when the deal covered units originally owned by both a parent and its subsidiary?

Plain-English summary

A redacted rail company agreed to sell locomotives and rail cars and simultaneously lease them back for five years. At term end it had to buy for a 36.47% balloon payment or sell to a third party and remit that amount. It kept excess proceeds and covered a shortfall only up to 18.24% of purchase price. The lessor claimed no income-tax benefits, and stated 10.48% annual interest was nonusurious.

Financing required a sale at inception, no purchaser/lessor federal or state tax benefit and nonusurious imputed interest. A sale at inception meant the original seller was certain to end with title. For parent-owned units, mandatory purchase or sale made the parent the real third-party seller and left the lessor only security. No sales or use tax applied.

The request did not mention that an approximately 99.9%-owned subsidiary also sold units under the agreements. Those were sold to the lessor, leased to the parent and mandatorily subleased to the subsidiary. Such a three-party chain could still be financing if the original subsidiary owner kept tax benefits and was certain to end as owner, but tax-benefit proof is absent.

An absent master-agreement schedule covered all units. Paragraph (f) let the parent terminate early and acquire title; under some conditions an individual lessor could require parent repurchase. Without early termination, the parent had to buy or cause a third-party sale. Those terms preserved financing for parent units.

Absent sublease Exhibit C required the parent to resell subsidiary units to the subsidiary only if the parent chose early termination. If it did not, the parent could purchase without any required resale. The subsidiary therefore was not certain to regain its units, so that portion was a true taxable sale/leaseback rather than financing.

The requester said section 6368.5 exempted sale and use of some subsidiary units. No unit list or exemption support appears, so the opinion preserved that and any other statutory exemption without deciding coverage.

The request, actual lease, master schedule, sublease exhibit, tax-benefit evidence, unit/exemption proof, execution, reporting, audit and outcome are absent. Live Annotation 330.5250 gives the general chain and end-ownership rule but omits the numeric terms, how subsidiary facts surfaced, individual-lessor repurchase right, unproved tax-benefit premise and exemption-evidence gap.

Common questions

What were the financing-test requirements stated in the letter?

The lease had to be a sale at inception, the purchaser-lessor could not claim federal or state income-tax benefits, and the financing-equivalent interest could not be usurious.

Why did the parent-owned units qualify?

The parent had to purchase or arrange a third-party sale and retained the economic ownership; the lessor's interest was only security.

Why did the subsidiary-owned units fail?

The agreements did not guarantee that the subsidiary would regain title. The parent could end up owning units that the subsidiary had originally sold.

When did the parent have to resell units to the subsidiary?

Only if the parent exercised the optional early-termination provision, according to the described sublease.

Were the subsidiary units necessarily taxable?

Not if a stated statutory or other exemption applied. The letter expressly identified Revenue and Taxation Code § 6368.5 as a possible exemption for some units.

Was section 6368.5 coverage proved?

No. The requester said some units qualified, but the units and supporting facts are absent.

Were the agreements published with the opinion?

No. The lease, master schedule and sublease Exhibit C are only described.

Citations and references

• Historical Sales and Use Tax Regulation 1660(a)(3)(A) — financing requirements
• Historical Sales and Use Tax Regulation 1660(a)(2) — sale-at-inception/end-ownership test
• Historical Revenue and Taxation Code section 6368.5 — asserted exemption for some subsidiary units; support absent
• Live Annotation 330.5250 — generalized ownership-retention chain
• Request/agreements, tax-benefit/unit/exemption proof, execution, returns/audit and outcome — absent

Source

• Annotated Legal Opinions collection: https://cdtfa.ca.gov/taxes-and-fees/annotations-menu.htm
• Annotation page: Annotation 330.5250
• Original supporting opinion: 330.5250 PDF

Original ruling text

330.5250

STATE OF CALIFORNIA

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

February 23, 1990

Mr. R--- W. H--Senior Tax Counsel
B--- N--T--- and S--- A--Box XXXXX
--- ---, CA XXXXX
Re:

S--- P--- T--- Co.
SZ -- XX-XXXXXX

Dear Mr. H---:
This is in response to your letter dated January 17, 1990 regarding the application of sales or use tax to a transaction structured as a sale-leaseback. You describe the transaction as follows. S--- P--- T--- Company (S---) purchased locomotives and rail cars (units) and has entered into an agreement to sell the units to lessor and simultaneously lease them back over a five-year period. You believe that this transaction qualifies as a nontaxable financing transaction under subdivision (a)(3)(A) of Regulation 1660 because: “S--- is required to purchase the units for 36.47% of the purchase price (balloon payment) or sell the units to a third party and remit the balloon payment to the trustee. If the latter option is elected, and the proceeds exceed the balloon payment, S--- keeps the excess. If the proceeds are less than the required balloon payment, S---is required to make up the difference; however, S--- will not have to pay an amount in excess of 18.24% of the purchase price. In addition, the lessor will not claim any deduction, credit or exemption with respect to the units for federal or state income tax purposes. Finally, the interest charged amounts to 10.48% annually, which is not usurious under California law.”

Mr. R--- W. H---

-2-

February 23, 1990
330.5250

Subdivision (a)(3)(A) of Regulation 1660 provides:
Transactions structured as sales and leasebacks will be treated as financing transactions if (1) the ‘lease’ transaction would be regarded as a sale at inception under paragraph (a)(2) of this regulation, (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. Transactions treated as financing transactions are not subject to sales or use tax.” These rules are applied to determine whether a transaction structured as a sale-leaseback is actually a financing transaction. The reason for these rules is that under a financing transaction, the borrower retains ownership of the property and transfers only a security interest to the lender. Since the borrower retains ownership, the borrower also retains the incidents of that ownership, such as the right to claim deductions, credits, or exemptions with respect to the property for federal or state income tax purposes. A transaction designated as a lease is actually a sale at inception under subdivision (a)(2) of Regulation 1660 when, at the end of the lease term, the “lessee” is certain to obtain title to the “leased” property. The reason the “lease” transaction in a sale-leaseback must be regarded as a sale at inception in order for the sale-leaseback to qualify as a financing transaction is that the “seller” must be certain to retain ownership of the property at the end of the “lease” term. If the lease is not a sale at inception and it is therefore not certain that there will be no true transfer of title, then the transaction must be regarded as a sale and a leaseback, just as it is structured. Based on your description of the transaction, the second and third conditions of subdivision (a)(3)(A) of Regulation 1660 are clearly satisfied. We also regard the transaction, as described, as satisfying the first condition since S--- is required to either purchase the units or to sell them to a third party. Under the actual lease provisions you have furnished us, we would regard S--- as being the actual seller to the third party and we would regard the interest acquired by the “lessor” as merely a security interest. However, we note that there is an aspect to the transaction that is not discussed in your letter. S--- L--- S--- R--- Company (Subsidiary), which is an approximately 99.9% owned subsidiary of S---, is also involved in the transaction. That is, the agreement provides that S--- will cause Subsidiary to sell certain units to the lessor, and those units would be leased to S---. S--- is then required to sublease those units to Subsidiary. Of course, the usual financing agreement structured as a sale-leaseback does not involve a sale from one person to another for lease to a third party for sublease back to the original owner. However, we would nevertheless regard this as a nontaxable financing arrangement if the conditions set forth in subdivision (a)(3)(A) of Regulation 1660 were satisfied. With respect to this transaction, the critical condition for this analysis is that the seller/lessee retain ownership of the leased property at the end of the lease term.

Mr. R--- W. H---

-3-

February 23, 1990
330.5250

With respect to the property sold by Subsidiary, S--- is required to lease that property from the purchaser/lessor and is required by that agreement to sublease those units to Subsidiary. If Subsidiary retained the income tax benefits and, at the end of the lease term, was certain to retain ownership of these units, we would conclude that the agreement constitutes a financing agreement with respect to those units. However, as discussed below, my understanding of the lease agreement is that Subsidiary is not certain to retain ownership of the units. Attached as part of the master agreement is a schedule that sets forth the provisions regarding ownership of the units at the end of the lease term. These provisions cover all the units sold to the lessor, including units previously owned by S--- together with units previously owned by Subsidiary. Paragraph (f) provides an election to S--- for early termination of the lease whereby S--- would acquire title to all the leased units. Also under paragraph (f) is a provision for an election under certain circumstances for each individual lessor to require S--- to repurchase certain units. If early termination is not affected under paragraph (f), S--- must elect to repurchase the units at the end of the lease term or to cause the units to be sold to a third party, as set forth in your letter. As discussed above, these provisions satisfy the first condition for a transaction to qualify as a financing transaction with respect to units sold to the lessor by S---. However, these provisions also pertain to the units originally owned by Subsidiary. Attached to the master agreement is Exhibit C, the sublease to be entered into between S--and Subsidiary. Section 2 of the sublease provides that if S--- exercises its option for early termination under paragraph (f) of the schedule discussed above, S--- is required to sell, and Subsidiary is required to purchase, the units subleased to Subsidiary (that is, the units originally owned by Subsidiary). However, S--- is not required to exercise the election under paragraph (f) of the schedule. If S--- does not exercise that election, S--- is required to either purchase the units or cause them to be sold. If S--- purchases the units under these provisions, I have found no provision in any of the agreements that requires a resale to Subsidiary. That is, the agreement permits S---, upon termination of all agreements, to own units originally owned by Subsidiary. As discussed previously, a primary condition to the treatment of a transaction structured as a sale-leaseback as a financing transaction is that, at the end of the sale-leaseback arrangement, the original owner remains the owner of the “leased” property. With respect to units originally owned by Subsidiary, it is not certain, at the beginning of the agreement, that Subsidiary will remain the owner of those units at the end of the term of the agreement. Thus, the agreement cannot be regarded as a financing transaction under subdivision (a)(3)(A) of Regulation 1660. Rather, the agreement, structured as a sale-leaseback, must be regarded as a sale and a leaseback with respect to units originally owned by Subsidiary. Had Subsidiary simply sold the units to S---, such sale would not be a financing transaction. Since the same result may be obtained with respect to the transaction examined herein, it also cannot qualify as a financing transaction. In conclusion, with respect to units originally owned by S---, we regard this arrangement as a financing transaction, and no sales or use tax applies. With respect to units originally owned by Subsidiary, we regard this transaction as a sale and leaseback. You note that the sale and use of some of these units are exempt from sales or use tax under Revenue and Taxation Code

Mr. R--- W. H---

-4-

February 23, 1990
330.5250

Section 6368.5. If not exempt under this or some other statutory exemption, the sale and leaseback of units originally owned by Subsidiary will be subject to sales or use tax. If you have further questions, feel free to write again. Sincerely,

David H. Levine
Tax Counsel

DHL:wak/1946C