How did Illinois distinguish taxable conditional-sale payments from rent under a true equipment lease?

Plain-English summary

Illinois separated the leasing company's transactions into two categories. A lease with a nominal or $1 purchase option was generally a conditional sale, because the property was effectively guaranteed to be sold. The lessor could buy for resale with a proper resale certificate, but all receipts under the conditional-sales contract were subject to Retailers' Occupation Tax.

A true lease generally had no buyout or only a fair-market-value option. The lessor was treated as the end user and owed Use Tax on its cost of property used in Illinois; Illinois imposed no tax on the rental receipts, so the lessee had no tax liability on the rent itself. A lessor could not label its own tax obligation as tax passed through to the lessee, although the parties could privately contract for reimbursement. Credit was available to the extent tax was properly due and paid to another state.

The GIL also summarized separate rules for software and maintenance agreements. Canned software was generally taxable, while qualifying custom software could be nontaxable. A canned-software license avoided Retailers' Occupation Tax only if it met all five regulatory conditions, including a written agreement signed by both parties. Separately sold optional maintenance agreements were generally not taxable when sold, but providers owed tax on property transferred during service; agreements containing non-separately-stated canned-software updates were fully taxable.

What this means for you

The contract's economic terms control more than its label. Identify whether the buyout is nominal or fair market value, keep software-license signatures and restrictions, and separately state taxable canned-software updates from other support charges.

Common questions

Q: Is rent under a true equipment lease subject to Illinois sales tax?
A: Under the 2010 rules described here, no. The lessor instead owed Use Tax on its cost of the property used in Illinois.

Q: Did the Department decide each interim-rent invoice listed in the request?
A: No. It gave general classification rules but did not separately analyze the delivered-versus-undelivered or sale-and-leaseback examples.

Citations and references

• 86 Ill. Adm. Code 130.2010 (conditional sales)
• 86 Ill. Adm. Code 130.220 (true leases)
• 86 Ill. Adm. Code 150.310(a)(3) (tax paid to another state)
• 86 Ill. Adm. Code 130.1935 (computer software)
• 86 Ill. Adm. Code 140.301(b)(3) (maintenance agreements)
• 2 Ill. Adm. Code 1200.120 (GILs)

Subject

Leasing

Source

• Landing page: https://taxarchive.illinois.gov/research/legal/letter-rulings/sales-tax/2010.html
• Original PDF: https://tax.illinois.gov/content/dam/soi/en/web/taxarchive/research/legal/letter-rulings/sales-tax/2010/st-10-0082.pdf

Original ruling text

ST 10-0082-GIL 09/08/2010 LEASING
Information regarding sales tax liabilities in lease situations may be found at 86 Ill. Adm. Code
130.220 and 86 Ill. Adm. Code 130.2010. (This is a GIL.)

September 8, 2010

Dear Xxxxx:
This letter is in response to your letter dated August 11, 2010, in which you request
information. The Department issues two types of letter rulings. Private Letter Rulings (“PLRs”) are
issued by the Department in response to specific taxpayer inquiries concerning the application of a
tax statute or rule to a particular fact situation. A PLR is binding on the Department, but only as to the
taxpayer who is the subject of the request for ruling and only to the extent the facts recited in the PLR
are correct and complete. Persons seeking PLRs must comply with the procedures for PLRs found in
the Department’s regulations at 2 Ill. Adm. Code 1200.110. The purpose of a General Information
Letter (“GIL”) is to direct taxpayers to Department regulations or other sources of information
regarding the topic about which they have inquired. A GIL is not a statement of Department policy
and is not binding on the Department. See 2 Ill. Adm. Code 1200.120. You may access our website
at www.tax.illinois.gov to review regulations, letter rulings and other types of information relevant to
your inquiry.
The nature of your inquiry and the information you have provided require that we respond with
a GIL. In your letter you have stated and made inquiry as follows:
We are a CA leasing company in the business of leasing computer equipment, canned
software, and related maintenance agreements. Prior to the actual commencement of a
lease, we invoice our lessees’ interim rent for FMV, nominal (‘$1-out’), and sale &
leaseback leases. Please let me know the tax treatment of interim rent invoice for the
following transactions:
1.

2.

Equipment have [sic] been delivered and placed in service in the lessee’s place
of business:
•

Interim rent invoice on a FMV lease where sales tax will be paid upfront
based on equipment cost.

•

Interim rent invoice on a $1-out lease where sales tax will be paid upfront
based on equipment cost.

•

Interim rent invoice on a sale & leaseback where sales tax will be paid
upfront based on equipment cost.

Equipment have [sic] not been delivered and placed in service in the lessee’s
place of business:

•

Interim rent invoice on a FMV lease where sales tax will be paid upfront
based on equipment cost.

•

Interim rent invoice on a $1-out lease where sales tax will be paid upfront
based on equipment cost.

•

Interim rent invoice on a sale & leaseback where sales tax will be paid
upfront based on equipment cost.

Please note that upfront sales tax will be paid upfront during the actual commencement
date. Attached are sample documentations for your review related to interim rent. We
appreciate all the help you can provide and please let me know if you have any
questions or need additional information.

DEPARTMENT’S RESPONSE:
Leases
The State of Illinois taxes leases differently for Retailers’ Occupation Tax and Use Tax
purposes than the majority of other states. For Illinois sales tax purposes, there are two types of
leasing situations: conditional sales and true leases.
A conditional sale is usually characterized by a nominal or one dollar purchase option at the
close of the lease term. Stated otherwise, if a lessor is guaranteed at the time of the lease that the
leased property will be sold, this transaction is considered to be a conditional sale at the outset of the
transaction. Persons who purchase items for resale under conditional sales contracts can avoid
paying tax to suppliers by providing certificates of resale that contain all the information set forth in 86
Ill. Adm. Code 130.1405. All receipts received by a lessor/retailer under a conditional sales contract
are subject to Retailers’ Occupation Tax. See 86 Ill. Adm. Code 130.2010.
A true lease generally has no buy out provision at the close of the lease. If a buy-out provision
does exist, it must be a fair market value buy-out option in order to maintain the character of the true
lease. Lessors of tangible personal property under true leases in Illinois are deemed end users of the
property to be leased. See 86 Ill. Adm. Code 130.220. As end users of tangible personal property
located in Illinois, lessors owe Use Tax on their cost price of such property.
The State of Illinois imposes no tax on rental receipts. Consequently, lessees incur no tax
liability. As stated above, in the case of a true lease, the lessors of the property being used in Illinois
would be the parties with Use Tax obligations. The lessors would either pay their suppliers, if their
suppliers were registered to collect Use Tax, or would self-assess and remit the tax to the
Department. If the lessors already paid taxes in another state with respect to the acquisition of the
tangible personal property, they would be exempt from Use Tax to the extent of the amount of such
tax properly due and paid in such other state. See subsection (a)(3) of 86 Ill. Adm. Code 150.310.
Under Illinois law, lessors may not “pass through” their tax obligation to the lessees as taxes.
However, lessors and lessees may make private contractual arrangements for a reimbursement of
the tax to be paid by the lessees. If lessors and lessees have made private agreements where the
lessees agree to reimburse the lessors for the amount of the tax paid, then the lessees are obligated
to fulfill the terms of the private contractual agreements.
Computer Software

Generally, retail sales or transfers of “canned” computer software are taxable in Illinois
regardless of the means of delivery. For instance, the sale or transfer of canned computer software
downloaded electronically would be taxable. However, if the computer software consists of custom
computer programs, then the sales of such software may not be taxable retail sales. See 86 Ill. Adm.
Code 130.1935(c). Custom computer programs or software must be prepared to the special order of
the customer.
Charges for updates of canned software are fully taxable pursuant to Section 130.1935. If the
updates qualify as custom software under Section 130.1935(c), they may not be taxable.
If transactions for the licensing of computer software meet all of the criteria provided in
subsection (a)(1) of Section 130.1935, neither the transfer of the software nor the subsequent
software updates will be subject to Retailers' Occupation Tax. A license of software is not a taxable
retail sale if:
A)

It is evidenced by a written agreement signed by the licensor and the customer;

B)

It restricts the customer’s duplication and use of the software;

C)

It prohibits the customer from licensing, sublicensing or transferring the software
to a third party (except to a related party) without the permission and continued
control of the licensor;

D)

The licensor has a policy of providing another copy at minimal or no charge if the
customer loses or damages the software, or permitting the licensee to make and
keep an archival copy, and such policy is either stated in the license agreement,
supported by the licensor’s books and records, or supported by a notarized
statement made under penalties of perjury by the licensor; and

E)

The customer must destroy or return all copies of the software to the licensor at
the end of the license period. This provision is deemed to be met, in the case of a
perpetual license, without being set forth in the license agreement.

Please note that it is very common for software to be licensed over the internet and the
customer to check a box that states that they accept the license terms. Acceptance in this manner
does not constitute a written agreement signed by the licensor and the customer for purposes of
subsection (a)(1)(A) of Section 130.1935. To meet the signature requirement for an exempt software
license, the agreement must contain the written signature of the licensor and customer.
A license of canned software is subject to Retailers' Occupation Tax liability if all of the criteria
set out in 86 Ill. Adm. Code 130.1935(a)(1) are not met.
In general, maintenance agreements that cover computer software are treated the same as
maintenance agreements for other types of tangible personal property. See 86 Ill. Adm. Code
130.1935(b). The taxation of maintenance agreements is discussed in subsection (b)(3) of Section
140.301 of the Department’s administrative rules under the Service Occupation Tax Act. See 86 Ill.
Adm. Code Sec. 140.301(b)(3). The taxability of agreements for the repair or maintenance of tangible
personal property depends upon whether charges for the agreements are included in the selling price
of the tangible personal property. If the charges for the agreements are included in the selling price
of the tangible personal property, those charges are part of the gross receipts of the retail transaction
and are subject to tax. In those instances, no tax is incurred on the maintenance services or parts

when the repair or servicing is performed. A manufacturer’s warranty that is provided without
additional cost to a purchaser of a new item is an example of an agreement that is included in the
selling price of the tangible personal property.
If agreements for the repair or maintenance of tangible personal property are sold separately
from tangible personal property, sales of those agreements are not taxable transactions. However,
when maintenance or repair services or parts are provided under those agreements, the service or
repair companies will be acting as service providers under provisions of the Service Occupation Tax
Act that provide that when service providers enter into agreements to provide maintenance services
for particular pieces of equipment for stated periods of time at predetermined fees, the service
providers incur Use Tax based on their cost price of tangible personal property transferred to
customers incident to the completion of the maintenance service. See 86 Ill. Adm. Code Sec.
140.301(b)(3). The sale of an optional maintenance agreement or extended warranty is an example
of an agreement that is not generally a taxable transaction.
If, under the terms of a maintenance agreement involving computer software, a software
provider provides a piece of object code (“patch” or “bug fix”) to be inserted into an executable
program that is a current or prior release or version of its software product to correct an error or
defect in software or hardware that causes the program to malfunction, the tangible personal property
transferred incident to providing the patch or bug fix is taxed in accordance with the provisions
discussed above.
In contrast to a patch or bug fix, if the sale of a maintenance agreement by a software provider
includes charges for updates of canned software, which consist of new releases or new versions of
the computer software designed to replace an older version of the same product and which include
product enhancements and improvements, the general rules governing taxability of maintenance
agreements do not apply. This is because charges for updates of canned software are fully taxable
as sales of software under Section 130.1935(b). (Please note that if the updates qualify as custom
software under Section 130.1935(c) they may not be taxable). Therefore, if a maintenance
agreement provides for updates of canned software, and the charges for those updates are not
separately stated and taxed from the charges for training, telephone assistance, installation,
consultation, or other maintenance agreement charges, then the whole agreement is taxable as a
sale of canned software.
I hope this information is helpful. If you require additional information, please visit our website
at www.tax.illinois.gov or contact the Department’s Taxpayer Information Division at (217) 782-3336.

Very truly yours,

Richard S. Wolters
Associate Counsel
RSW:msk