When an energy system is installed under a title-retaining lease with a purchase option, are the payments taxable as a lease or exempt as a capital improvement?

Plain-English summary

Hershey Enterprises, Inc. designs and installs energy-conservation control systems for existing heating and air-conditioning facilities. Under its "Fuel Savings Participation" method, the customer pays about 30% up front and the balance in monthly payments equal to the actual fuel savings, under a lease agreement with a purchase option. The agreement keeps title with Hershey, states that the system remains personal property even if affixed, and restricts transfer/removal. Hershey argued the installed system is a capital improvement, so the receipts should be exempt regardless of how they're paid.

The Department held it's a taxable lease — with a capital improvement arising only if and when the customer buys the system.

• A capital improvement requires (among other things) intent to be a permanent installation. Under § 1101(b)(9) (20 NYCRR 527.7(a)(3)), a capital improvement must add value or prolong useful life, become permanently affixed, and be intended to become a permanent installation.
• The agreement's terms make this a lease. A "rental, lease or license to use" is a transfer of possession without a transfer of title, and whether a transaction is a sale or a lease is determined by the agreement's provisions (20 NYCRR 526.7(c)). Here title stays with Hershey and the customer has only an option to buy, so the arrangement is a lease under § 1101(b)(5).
• So the lease payments are taxable. Because the system is leased, it is a sale of tangible personal property and sales tax must be collected on the total charge, including installation. It is not a capital improvement, because title is reserved to Hershey and there is no intent to convey a permanent addition to real property. Each payment is taxed at the rate in effect where the installation is made.
• The buyout is a separate, later capital improvement. When the customer exercises the purchase option, it is then buying a capital improvement: that option payment is exempt from State and local tax. At that point Hershey, as the contractor, owes tax on the equipment and materials transferred, based on their depreciated value (standard depreciation) as of the option-exercise date.

What this means for you

Retaining title turns "install and improve" into a taxable lease. Even permanently affixed equipment is a lease — not a capital improvement — while the provider keeps title and the customer only has an option to buy.

The written agreement controls the sale-vs-lease question. New York looks to the agreement's terms (title, options, restrictions) to decide whether you have a taxable lease or a nontaxable capital improvement.

A later buyout can flip to capital-improvement treatment. When the customer exercises the option, that payment is exempt as a capital improvement — but you (the contractor) then owe tax on the depreciated value of the equipment and materials transferred.

Charge tax on the full lease payment, including installation. For a taxable lease, the installation charge is part of the taxable amount, billed at the rate where the system is installed.

Common questions

Q: I install a permanent energy system but keep title and let the customer pay over time with an option to buy. Is that a capital improvement?
A: No, not while you retain title. It's a taxable lease under § 1101(b)(5); you collect tax on each payment, including installation.

Q: What happens when the customer exercises the purchase option?
A: That converts it to a capital improvement. The option payment is exempt, and you (as contractor) owe tax on the depreciated value of the equipment and materials transferred.

Q: Does calling the system "permanent" in my materials make it a capital improvement?
A: No. Because you retain title and there's only an option to buy, the agreement's terms make it a lease regardless of how permanent the installation is physically.

Citations and references

Statutes and regulations:

• Tax Law § 1101(b)(5); 20 NYCRR 526.7(c) — lease/license = transfer of possession without title; agreement controls
• Tax Law § 1101(b)(9); 20 NYCRR 527.7(a)(3) — definition of "capital improvement"
• Tax Law § 1105(a) — tax on retail sales, including leases

Source

• Landing page: https://www.tax.ny.gov/pubs_and_bulls/advisory_opinions/sales_ao_1981.htm
• Opinion: https://www.tax.ny.gov/pdf/advisory_opinions/sales/a81_60s.pdf

Original ruling text

New York State Department of Taxation and Finance

Taxpayer Services Division
Technical Services Bureau

TSB-A-81(60)S
Sales Tax
December 1, 1981

STATE OF NEW YORK
STATE TAX COMMISSION
ADVISORY OPINION

PETITION NO. S810703A

On July 3, 1981, a Petition for Advisory Opinion was received from Hershey Enterprises,
Inc., 642 Kreag Road, Pittsford, New York 14534.
The issue raised is whether Petitioner's "Fuel Savings Participation" method of sale is subject
to sales tax as a lease of tangible personal property or exempt from sales tax as a capital
improvement to real property.
Petitioner is engaged in the design and installation of energy conservation control systems
for existing heating and air conditioning facilities. These systems are installed and sold by two
separate methods. A customer may pay the full purchase price for the system upon completion of the
installation. Alternatively, under the Fuel Savings Participation method, the customer pays a portion
of the purchase price (normally 30%) upon completion of the installation, and the balance of the
purchase price is paid in monthly amounts which are equal to the actual fuel savings achieved by the
system during the prior month. Such payments continue until the full purchase price of the system
has been paid. This latter method of payment is made under the terms of a lease agreement with a
purchase option entered into between the customer and Petitioner.
Petitioner contends that the installation of an energy conservation control system ultimately
results in a more efficient heating and air conditioning system which serves to enhance the value of
the system. By increasing the efficiency of the system, its useful life is necessarily prolonged. The
method of installation, moreover, is such that the control system becomes an integral and permanent
part of the heating and air conditioning facility. The control system consists of several component
parts which are installed in various locations throughout the existing heating/air conditioning facility.
Its installation requires both the removal of elements of the existing units and the permanent addition
of control system components to that system. Once installed, it cannot be removed without
significant damage to the original heating system. Any removal would require substantial
modifications and replacements to the original system so as to restore it to its original state.
Petitioner has never had occasion to completely remove any system that it has installed, or to attempt
to restore a heating/air conditioning facility to its original state.
Under the terms of the lease agreement, the lessor leases the "heat control system" to the
lessee. The rental for the system is payable monthly. Pursuant to section 4 of the Fuel Savings
Participation Agreement, title to the heat control system remains with the lessor during the initial
term of the lease agreement or any renewal thereof. Section 4 also provides that the heat control
system remain personal property, even though it may be affixed to the realty.

JAMES H. TULLY., COMMISSIONER
TP-8 (4/80)

LOUIS M. JACOBSON, DEPUTY COMMISSIONER
FRANK J. PUCCIA, DIRECTOR

-2­
TSB-A-81(60)S
Sales Tax
December 1, 1981
The Agreement also contains restrictions on the transfer of the heat control system to any other
person or corporation, removal of the system from the facility in which it is initially installed, and
assignment by the lessee. Upon termination of the lease agreement, the lessee must deliver the
system to lessor complete and in good condition unless the purchase option is exercised. Lessee shall
have the right at the termination of the agreement to purchase the heat control system on an as-is
where-is basis.
Petitioner contends that the installation of an energy conservation control system constitutes
a capital improvement and that the receipts from such transactions are exempt from sales tax
regardless of the method of payment.
The Tax Law and the Sales and Use Tax Regulations define the term "capital improvement"
as "an addition or alteration to real property (i) which substantially adds to the value of the real
property, or appreciably prolongs the useful life of the real property and, (ii) which becomes part of
the real property or is permanently affixed to the real property so that removal would cause material
damage to the property or article itself, and (iii) is intended to become a permanent installation." Tax
Law §1101(b)(9) and 20 NYCRR 527.7(a)(3).
The Regulations also provide that: "The terms 'rental, lease, license to use' refer to all
transactions in which there is a transfer of possession of tangible personal property without a transfer
of title to the property. Whether a transaction is a 'sale' or 'a rental, lease or license to use' shall be
determined in accordance with the provisions of the agreement." 20 NYCRR 526.7(c).
When Petitioner sells and installs an energy conservation control system under the Fuel
Savings Participation method, the terms of the agreement entered into between the customer and
Petitioner clearly indicate that title to the system remains vested in Petitioner and that the customer
has the option to purchase the system upon termination of the agreement. Therefore, the Agreement
constitutes a "rental, lease or license to use" pursuant to section 1101(b)(5) of the Tax Law and
section 526.7(c) of the Sales and Use Tax Regulations.
As the system is leased to the customer, it is a sale of tangible personal property and sales
tax must be collected on the total charge to the customer including installation. This type of
transaction is not a capital improvement as title to the system has been reserved to Petitioner, and
there is no intent to sell the system as a permanent addition to real property or otherwise. In such a
lease/purchase agreement, each payment is subject to State and local sales and use tax at the rate in
effect where the installation is made.
However, when Petitioner's customer subsequently elects to exercise the option to purchase
the system, the customer will be considered to be purchasing a capital improvement. Accordingly,
the option payment made to Petitioner by the customer at that time will be exempt from State and
local sales tax. Further, Petitioner, as a contractor, is liable for tax on the equipment and materials
transferred to the customer as a capital improvement pursuant to the exercise of option. Such tax
shall be based on Petitioner's depreciated value of the equipment and materials (using standard
depreciation method) as of the effective date of the exercise of option by the customer.
DATED: November 13, 1981

s/LOUIS ETLINGER
Deputy Director
Technical Services Bureau