Did an equipment lease with a purchase option equal to 10% of original cost automatically qualify as a Texas financing lease?

Plain-English summary

An equipment lease ran for 60 months and gave the lessee a $30,307.40 purchase option equal to 10% of the equipment's original cost. The requester asked whether that made the contract a financing lease.

Rule 3.294 treated a purchase option as nominal when, at contract execution, the option price was estimated to be less than 10% of the property's fair market value when the option would be exercised. The rule had been amended December 6, 1991, to clarify “nominal price” and remove the word “substantial.”

The Comptroller could not decide the submitted contract because the expected fair market value was missing. A 10%-of-original-cost option was not enough by itself. The lease would qualify if the option price met the fair-market-value test or if another provision in Rule 3.294(a)(1)(A) or (B) applied.

An auditor would look for evidence about the equipment's estimated economic life, fair market value, and residual value at the end of the lease.

What this means for you

Equipment lessors and lessees

Do not compare the option only with original cost. The historical rule compared the option with projected fair market value at exercise, based on estimates made when the parties signed.

Accountants and tax professionals

Retain contemporaneous valuation support. Without projected economic-life, residual-value, and fair-market-value evidence, the Comptroller could not classify this lease.

Common questions

Did a 10%-of-cost option automatically make the lease a financing lease? No.

What was the nominal-price test? The option had to be estimated at contract execution to be less than 10% of fair market value when exercised.

Did the Comptroller classify this contract? No, because the fair-market-value information was not provided.

Citations and references

• 34 Tex. Admin. Code Rule 3.294(a)(1)(A) and (B) (financing leases and nominal purchase options)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9202L1156C01

Original ruling text

February 13, 1992

Dear **:

Your letter concerning the taxability of a lease contract with a
10% purchase option has been assigned to me for review and response.
I appreciate your patience and apologize for the delay in responding.

You enclosed a sample contract for our review. I have restated
your questions followed by my response:

1. Would this contract be considered a financing lease because
   of the 10% purchase option? Is the 10% purchase option considered
   a nominal purchase option? How is the term "substantially less
   than fair market value (FMV)" defined?

Response: Subsection (a)(1)(A)(ii) of the enclosed Rule 3.294,
Rental and Lease of Tangible Personal Property, defines a written
lease contract to be a financing lease if it contains the
following provision: "an option to purchase the property at a
nominal price is available to the lessee at the end of the lease
(a price is nominal which is, at the time the contract is
executed, estimated to be less than 10% of the fair market value
of the property at the time the option is to be exercised)."

This subsection of Rule 3.294 was recently amended (December 6,
1991) to clarify "nominal price" and to delete the word "substantial".

Therefore, in the lease contract that you submitted, if at the
end of the lease term (60 months) the $30,307.40 option price
(10% of the original cost of the equipment) is estimated to be
less than 10% of the FMV or the lease contract meets any one of
the other three provisions contained in subsection (a)(1)(A) or
(B) of this rule, the lease would be a financing lease.

2. If you deem this contract to be a financing lease, what
   evidence must be provided to an auditor to establish that the
   purchase option is substantially less than FMV?

Response: I am unable to make a determination as to whether this
is a financing lease from the information provided (i.e., FMV not
given). An auditor would be interested in reviewing any
information having to do with the leased equipment's estimated
economic life and estimated FMV and estimated residual value at
the end of the lease term.

This opinion is based on the facts presented. Other facts though
similar may provide a different result.

If you have other questions or need more information, you may
call 512/463-4600, or 1-800-252-5555 from outside Austin. You
may write to Tax Administration Division.

Sincerely,

Gilbert Zamora
Tax Administration Division