How did California treat a statutory merger followed by a subsidiary asset transfer, and a separate equipment agreement with a terminal rental adjustment clause?

Plain-English summary

The memorandum answered two different audit questions.

First, C---, which had 11 subsidiaries, merged into parent F--- on December 31, 1986. F--- simultaneously transferred about 75 percent of former C--- assets to subsidiary L---, then renamed New C---. The merger itself was nontaxable. The dropdown was a separate sale because New C--- did not assume old third-party debt; it created an equal payable to F---, which financed the transfer.

The dropdown was taxable unless it independently met the occasional-sale exemption. Common ownership satisfied the ownership test, but the parent still had to transfer at least 80 percent of all tangible property used in seller-permit activities. The memorandum assumed that threshold was not met, while noting that a different tangible-property breakdown could require further analysis.

Second, undefined MTE was placed under a terminal-rental-adjustment arrangement. Because counsel understood that possession never returned to C--- and the user had to buy all property or arrange third-party sales, the agreement was a sale at inception. The upstream purchase was for resale; C---'s transfer to B--- was the potentially taxable sale, subject to a grammatically broken final sentence about resale certificates and rental reporting.

Merger assumptions, new debt, complete TRAC mechanics, and unresolved audit

The March 5 auditor memorandum and forwarded New York district memorandum are not included. The corporate names and account are redacted. The source supplies no merger plan, corporate approvals, certificate, state statutes, balance sheets, assets, values, liabilities, loan agreement, intercompany ledger, asset-transfer agreement, invoices, return, or audit workpaper.

Counsel accepted statutory-merger treatment based on F---'s October 21, 1985 IRS ruling request—the source prints Octoberr—and the issued IRS ruling. Neither document is included. Regulation 1595(b)(3) made the merger nonsale. The same protection did not automatically cover the simultaneous F--- to New C--- dropdown.

The auditor had considered prior legal opinions and Gary Jugum's April 29, 1988 Macrodyne memorandum. Counsel agreed Macrodyne did not apply both because less than all division assets moved and because New C--- created new debt to seller F--- instead of assuming F---'s actual third-party liabilities. The source supplies no Macrodyne opinion text, cited reporter, Jugum memorandum, liability, debt amount, creditor, release, financing term, interest, maturity, payment, or book entry.

Sections 6006.5(b) and 6367 and Regulation 1595(b)(2) could exempt the dropdown only if F--- transferred at least 80 percent of tangible property used in seller-permit activity and at least 80 percent ownership remained unchanged. Wholly owned New C--- satisfied ownership. Counsel assumed F--- had other relevant tangible property and transferred below 80 percent, so the property limb failed.

The stated 75 percent covered all assets, probably including other property, not necessarily seller-activity tangible property. If former C--- assets were F---'s only such property, 80 percent or more of the relevant tangible property might have moved and further analysis was required. No asset categories, tangible-property numerator, total-property denominator, permit activities, values, or calculation appear.

The separate MTE transaction has confusing party labels: the auditor called a person F--- after noting C--- appears on every document. C--- bought MTE ex tax from T--- B--- Sales for lease to B---, which subleased it to T--- B--- Service. MTE is never defined. No party record, equipment description, invoice, price, delivery, title, lease, sublease, customer, payment, or use appears.

C--- did not report use tax on fair rental value. Seller invoices carried Tax Exempt Resale plus the seller's permit number of T--- B---, Inc., but counsel said T--- apparently did not take a valid resale certificate. No certificate, invoice, good-faith evidence, permit verification, return, rental receipts, fair rental value, rate, or payment is included.

The TRAC gave B--- an all-or-nothing fair-market-value purchase option at termination. If declined, B--- solicited third-party bids and bore the shortfall between proceeds and residual value, while C--- paid B--- any excess. If unsold after 30 days, realized value became zero and B--- paid residual value; later sale proceeds were refunded up to B---'s payment, apparently leaving B--- all proceeds if it had paid the full residual. No schedule, term, residuals, fair value, bids, sale, refund, or termination outcome appears.

Counsel understood the MTE could never return to C---, making C---'s interest security and B--- the actual third-party seller. If C--- could retake possession without default, the agreement likely was a true lease. The contract itself is absent, so this critical condition remains unverified.

Depreciation mattered only to a possible sale-leaseback financing question, not ordinary sale-at-inception classification. The source quotes a different prior lease form but does not include that agreement or opinion. It cites Regulation 1660(a)(2) and (3).

Counsel concluded T--- sold to C--- for resale, C--- sold MTE to B---, and assumed B---'s sublease was not itself a sale at inception. The final sentence then reads that we conclude that C--- took a valid and timely resale certificate, or unless B--- timely reported tax before saying C--- owed sales tax on full contract price less Regulation 1641 deductions. The grammar cannot establish whether C--- actually took a certificate or which unless condition controlled. No follow-up resolves it.

The live annotation publishes only the merger/dropdown transaction. It preserves the parent-subsidiary chain, merger, 75-percent asset transfer, retained actual debt, new intercompany payable, nonsale merger, taxable new-debt sale, assumed below-80 property result, section 6006.5(b), and date. It turns counsel's assumption into an unqualified statement that assets were substantially below 80 percent and omits the possible alternative calculation, IRS and Macrodyne provenance, missing records, entire MTE/TRAC issue, broken conclusion, and absent audit outcome.

What this means for you

Corporate groups restructuring after mergers

A nontaxable statutory merger does not shelter a later asset dropdown. New intercompany debt can be consideration, and the 80-percent asset test applies to the transferor's full seller-activity property base.

Equipment lessors and finance teams

TRAC labeling does not control. Preserve every purchase, return, default, residual, bid, sale, proceeds, refund, depreciation, resale-certificate, sublease, and rental-tax term. Whether possession can return without default was the decisive but unverified fact here.

Common questions

Q: Was the statutory merger taxable?
A: No. The memorandum accepted it as a qualifying statutory merger.

Q: Why was the simultaneous dropdown a separate sale?
A: The subsidiary incurred new debt to the parent equal to the merger liabilities, so the parent effectively financed the asset purchase.

Q: Did transferring 75 percent automatically fail the 80-percent test?
A: Not necessarily. The 75 percent covered all asset types; the required test focused on seller-activity tangible personal property, so the memorandum left room for a different factual calculation.

Q: Why was the equipment contract a sale at inception?
A: Under the stated understanding, the equipment never returned to the lessor and the user had to buy it or arrange its sale.

Q: Was 75 percent necessarily below the statutory 80-percent tangible-property test?

A: No. The 75 percent described all assets. Counsel assumed the relevant tangible-property fraction was below 80 but said another asset mix required further analysis.

Q: Did New C--- assume the merger's third-party debt?

A: No. F--- retained it, while New C--- created an equal new payable to F---.

Q: What did MTE mean?

A: The source never defines it.

Q: Could C--- retake possession after the TRAC term?

A: Counsel understood it could not, but the contract is absent. He said a nondefault return right would likely make the agreement a true lease.

Q: Did C--- take a valid resale certificate or did B--- report rental tax?

A: The final sentence is grammatically inconsistent and the underlying records are absent, so the source does not establish either fact.

Citations and references

• California Revenue and Taxation Code §§ 6006(g)(4), 6006.5(b), 6010(e)(4), and 6367
• California Sales and Use Tax Regulations 1595(b)(2), 1595(b)(3), 1641, and 1660(a)(2)–(3)
• Macrodyne Industries v. State Board of Equalization — named without reporter in this source
• October 21, 1985 IRS ruling request and issued ruling, April 29, 1988 Gary Jugum memorandum, March 5, 1990 auditor memorandum, New York-office memorandum, merger and asset records, liabilities, financing, MTE contracts, invoices, resale certificates, depreciation and rental records, values, returns, audit, assessment, payment, claim, appeal, and outcome — described or implicated but not included

Verbatim support

From the official April 12, 1990 David H. Levine memorandum:

That is, F--- carried the financing for its sale to New C---.

The percentage of assets transferred to New C--- was 75% of all assets (tangible personal property and, probably, other property) previously held by C---, and not necessarily 75% of the tangible personal property used in selling activities

However, please note that this conclusion is based on the understanding that the provisions of the contract provide that possession of the MTE is never returned to C---

If this understanding is incorrect and it is possible for C--- to retake possession without there being a default, we would likely regard this contract as a true lease.

Source

• Annotated Legal Opinions collection: CDTFA Annotated Legal Opinions
• Live annotation: Annotation 395.2070
• Original supporting opinion: 395.2070 PDF

Original ruling text

State of California

Memorandum

To:

Mr. Jack E. Warner
Out-of-State Auditing

From:

David H. Levine
Tax Counsel

Subject:

C--- F--- Corporation
SS --- XX-XXXXXX

Board of Equalization

395.2070

April 12, 1990

ATSS 485-5550
(916) 445-5550

This is in response to your memorandum dated March 5, 1990. You have forwarded a memorandum from your New York district office regarding two different transactions, and you ask our opinion. Merger Transaction C--- C--- Corporation (C---) was a wholly owned subsidiary of C--- F--- Corporation (F---). C--- had 11 wholly owned subsidiaries, one of which was C--- C--- L--- Services (L---). On December 31, 1986, C--- was merged into its parent F---, the surviving corporation. Simultaneously, approximately 75% of the assets previously owned by C--- were transferred by F--- to L---, whose name was then changed to C--- C--- Corporation (New C---). The indebtedness assumed by F--- in the merger was retained by F---, and an equivalent amount was treated as a loan to New C--- in connection with the transfer of assets and was set up as an intercompany payable account. That is, New C--- did not assume the actual indebtedness previously owed by C---. The auditor has concluded that the merger of C--- into F--- is not subject to tax, but that the simultaneous transfer to New C--- is subject to tax to the extent of the assumed liabilities. The auditor reviewed several opinions from the Legal Staff, including Assistant Chief Counsel Gary Jugum’s April 29, 1988 memorandum concerning the application of the Macrodyne case. The auditor concluded that all of the conditions of Macrodyne were met except that the assets of the entire division (which had previously been C---) were not transferred to New C---. The auditor therefore concluded that Macrodyne did not apply and that the sale was subject to tax. Since the audit will require considerable time to conduct, the auditor has requested a legal opinion prior to proceeding.

Mr. Jack E. Warner

-2-

April 12, 1990
395.2070

Based upon the ruling request made by F--- to the IRS dated Octoberr 21, 1985 and the ruling issued by the IRS, it appears that the merger between F--- and C--- was a statutory merger in compliance with the statutes of each of the two states of incorporation. Therefore, we agree that the merger transaction was not a sale subject to sales tax. (Reg. 1595(b)(3).) We also agree that the Macrodyne case does not apply to the transfer by F--- to New C---. As explained in Mr. Jugum’s memorandum, we do not believe that Macrodyne applies to a situation where less than all of the assets of a division is transferred to a wholly owned subsidiary. However, there is an even more basic reason that Macrodyne does not apply. New C--- did not assume the actual liabilities of F--- associated with the transferred assets. As disclosed in the ruling request to the IRS, the very reason for this transaction was to release C--from liability for that indebtedness. Under the agreement dated December 31, 1986 between F--and New C---, New C--- assumed an intercompany debt to F--- in an amount equal to the liabilities assumed by F--- in the merger. That is, F--- carried the financing for its sale to New C---. Macrodyne applies only in certain cases of assumed liabilities, and not in cases where new debt is created between the buyer and the seller, such as in this case. Since Macrodyne does not apply, the transaction is subject to sales tax unless a specific exemption applies. Based upon the facts presented, the relevant exemption is provided by Revenue and Taxation Code sections 6006.5(b) and 6367. To qualify for this occasional sale exemption, Financial must have transferred substantially all (at least 80%) the assets it used in the course of activities requiring a seller’s permit, and the ownership after the transfer must be substantially similar to that which existed before the transfer (at least 80% unchanged). (Reg. 1595(b)(2).) Since New C--- is a wholly owned subsidiary of F---, the second prong of the test is satisfied. I assume that F--- held tangible personal property for use in the course of activities requiring a seller’s permit other than the assets previously held by C---, and that F--- did not transfer at least 80% of all such assets to New C---. This means that the first prong of the test is not satisfied, and tax applies to the sale to New C--- because it does not qualify for the occasional sale exemption. A final note is that if the only tangible personal property used by F--- in selling activities were those assets previously held by C---, then further analysis would be necessary. The percentage of assets transferred to New C--- was 75% of all assets (tangible personal property and, probably, other property) previously held by C---, and not necessarily 75% of the tangible personal property used in selling activities (it is possible the 80% or more of the tangible personal property previously held by C--- was transferred).

Mr. Jack E. Warner

-3-

April 12, 1990
395.2070

MTE Transactions
C--- (the auditor refers to this person as F--- after noting that C--- appears on all the documents) purchased MTE from T--- B--- Sales [“T---”] for lease to T--- B--- [“B---”], who subsequently subleased the MTE to T--- B--- Service. C--- purchased the MTE ex tax and did not report use tax measured by fair rental value. The notation “Tax Exempt Resale
#SR- -- – XX-XXXXXX” (the seller’s permit number of T--- B---, Inc.) appears on the invoices from T--- to C---. An addendum to the agreement between C--- and B--- contains a terminal rental adjustment clause (TRAC). In the event B--- does not exercise the option to purchase the MTE at fair market value at lease termination, he is responsible for soliciting prospective purchasers and for the difference between the realized sale proceeds and the residual value of the equipment as set forth in the lease addendum. C--- contends that TRAC clause leases are sales at inception rather than true leases. The auditor believes that the transaction between C--- and B--- is a true lease since B--has an option not to purchase the equipment at the end of the lease term, notwithstanding some obligations of solicitation and responsibility for sale proceed differences. The auditor also notes that C--- claims depreciation tax benefits associated with the equipment. The auditor believes that if the transaction is a sale at inception, C--- could claim it to be a nontaxable sale for resale since it is known that a sublease is involved and that, if the transaction is a true lease, C--- is responsible for use tax as a lessor of MTE. The lease of MTE is not a sale or purchase of tangible personal property. (Rev. & Tax. Code §§ 6006(g)(4), 6010(e)(4).) Rather , the sale of MTE to a person for the purposes of leasing is a retail sale. Unless the seller accepts a timely and valid resale certificate in good faith, the sale is subject to sales or use tax measured by purchase price. T--- apparently did not take a valid resale certificate with respect to its sale of MTE to C---. Therefore, unless T--- can establish that C--- resold the MTE prior to use, it appears that sales tax is applicable to the transaction. If C---’s lease with B--- is actually a sale at inception, then T--- will be able to establish that it sold MTE to C--- for resale to B---. Otherwise, T--- made a retail sale because C--- was a lessor (consumer) of MTE. We have previously considered a lease with the following provisions to be a sale at inception: “Lessee is required to purchase the units for __% of the purchase price (balloon payment) or sell the units to a third party and remit the balloon payment to the lessor. If the latter option is elected, and if the proceeds exceed the balloon payment, the lessee keeps the excess. If the proceeds are less than the required balloon payment, lessee is required to make up the difference; however, lessee will not have to pay an amount in excess of _____% of the purchase price. In

Mr. Jack E. Warner

-4-

April 12, 1990
395.2070

addition, the lessors will not claim any deduction, credit, or exemption with respect to the leased property for federal or state income tax purposes.” This lease was regarded as a sale at inception because the lessor would not retake possession at the end of the lease term: the lessee was required to purchase the leased property or sell that property, in effect, for the lessee’s own account. The facts regarding depreciation were relevant only because the issue was whether a sale-leaseback should be regarded as a financing transaction. (See Reg. 1660(a)(3).) That is, whether income tax benefits are taken by a lessor has no relevance if the only question is whether the transaction is a sale at inception. (Reg. 1660(a)(2).) In the lease at issue, the lessee has an election to purchase all, but not less than all, the property subject to the lease schedule at fair market value. If the lessee elects not to exercise the option, the lessee is required to solicit bids for the leased units from third parties. If the realized value of any unit exceeds that unit’s estimated residual value as specified in the lease, then the lessor pays the lessee an amount equal to that excess. If the unit is not sold within 30 days after the end of the lease term, the realized value is regarded as zero (i.e., the lessee pays the lessor the residual value). If the property is thereafter sold, the proceeds are refunded to the lessee to the extent of amounts paid to the lessor with respect to that unit (if the lessee had paid the lessor the residual value, as required, the lessee apparently retains all sale proceeds). My understanding of this agreement is that the “leased” property is never returned to C---. Thus, this agreement is similar to the lease mentioned above, and we believe that this agreement is also a sale at inception. Under the agreement, we would regard the interest held by C--- as merely a security interest, and when the MTE is sold to a third party, we would regard B--- as being the actual seller to the third party. However, please note that this conclusion is based on the understanding that the provisions of the contract provide that possession of the MTE is never returned to C--- (i.e., that the parties’ interpretation of the contract is the same as my understanding). If this understanding is incorrect and it is possible for C--- to retake possession without there being a default, we would likely regard this contract as a true lease. C--- has contended that this lease is a sale at inception. Based upon the analysis above, we agree. Thus, the sale by T--- to C--- was a sale for resale. Since C--- sold the MTE to B---, and since B--- acquired the MTE for purposes of leasing (I assume by a lease which is not a sale at inception), we conclude that C--- took a valid and timely resale certificate, or unless B--timely reported tax measured by fair rental value, we believe that C--- owes sales tax on its sale of MTE to B--- measured by the full contract price, less the deductions allowed under Regulation 1641.

DHL:wak
2076C