Texas Letter Ruling 9209L1195D01: Financing Lease Vs. Operating Lease — Nominal Purchase Option And Fair Market Value

Subject

Financing Lease Vs. Operating Lease — Nominal Purchase Option And Fair Market Value

Plain-English summary

A taxpayer asked the Comptroller about the fair market value of used equipment at the end of a lease, and how that affects whether the lease is a "financing lease" or an "operating lease" for Texas sales and use tax purposes. The Comptroller responded by enclosing Rule 3.294 - Rental and Lease of Tangible Personal Property, which defines both terms in Rule 3.294(a). The distinction matters only for determining a lessor's tax responsibilities under each type of lease — it does not affect anything else.

The key point in this letter: Texas does not require that the purchase price of equipment at the end of a lease equal the "then" fair market value. In the facts presented, the lessee put down a deposit equal to 10% of the equipment's original market value, and that deposit clearly exceeded the equipment's actual fair market value at the end of the lease period. Because of that gap, the Comptroller said the lease would not be treated as a financing lease unless title to the equipment actually transfers to the lessee at the end of the lease.

If the lease instead has a purchase option at the end equal to that deposit amount, it is treated as an operating lease with a purchase option. Under an operating lease, tax on the rental payments is due based on the monthly billings (or when the monthly payments are actually made), rather than all at once. However, if the lessee later exercises the purchase option, sales and use tax is also due on the purchase price at that time.

By contrast, under a financing lease, Rule 3.294(f)(3)(B) requires the lessor to collect all of the tax due on the entire lease up front — at the time the lessee takes possession of the equipment or when the first payment becomes due.

The Comptroller noted this opinion is based on the facts presented, and could change if the facts are different.

What this means for you

Equipment lessors

Whether you must collect tax all at once (as a financing lease) or spread it out over monthly billings (as an operating lease) turns on how the end-of-lease purchase option is structured relative to the equipment's actual fair market value at that time — not on whether the option price happens to be low. A purchase price that is far below fair market value, standing alone, does not automatically make a lease a financing lease; title actually has to transfer at lease-end for that to happen. If it doesn't, and instead there's just a purchase option, you are dealing with an operating lease with a purchase option, and you owe additional sales/use tax only if and when the lessee exercises that option.

Lessees entering equipment leases

If your lease includes a deposit or option price that is well below what the equipment will actually be worth at the end of the lease term, that alone doesn't convert your lease into a financing lease under Texas rules. Ask whether title transfers automatically at the end of the lease term — that is the trigger the Comptroller pointed to here.

Accountants and tax professionals

This letter is a useful illustration of how Rule 3.294(a)'s financing-lease/operating-lease distinction is applied to a "nominal option price" fact pattern: a 10% deposit that exceeds year-end fair market value does not, by itself, make the arrangement a financing lease — actual transfer of title at lease-end is the deciding fact. Once classified, remember the differing tax-collection timing rules: Rule 3.294(f)(3)(B) for financing leases (collect all tax at possession or first payment) versus Rule 3.294(b) and (f) for operating leases (tax on rentals as billed/paid, plus tax on the purchase price if the option is exercised).

Common questions

Q: Does the purchase price at the end of a lease have to equal the equipment's fair market value at that time?
A: No. The letter states plainly that Texas does not require the purchase price at the end of a lease to be the "then" fair market value of the equipment.

Q: If the end-of-lease deposit or option price is much lower than what the equipment will actually be worth, does that make it a financing lease?
A: Not by itself. In the facts described, the 10% deposit clearly exceeded the equipment's fair market value at the end of the lease, and the letter still concluded the lease would not be a financing lease unless title transfers at the end of the lease.

Q: How is tax collected differently under a financing lease versus an operating lease with a purchase option?
A: Under a financing lease, Rule 3.294(f)(3)(B) requires the lessor to collect all of the tax due at the time the lessee takes possession of the equipment or when the first payment becomes due. Under an operating lease, tax on the rental payments is due based on the monthly billings or when the monthly payments are made, and tax on the purchase price is due separately only if and when the lessee exercises the purchase option.

Q: What makes a lease a "financing lease" rather than an "operating lease" in this letter?
A: Title transferring to the lessee at the end of the lease is the deciding fact identified in this letter, not the size of the deposit or option price relative to fair market value.

Citations and references

Rules cited:

• 34 Tex. Admin. Code Rule 3.294 — Rental and Lease of Tangible Personal Property
• Rule 3.294(a) — defines financing lease and operating lease
• Rule 3.294(f)(3)(B) — requires a lessor to collect all tax due under a financing lease at possession or first payment
• Rule 3.294(b) and (f) — governs tax treatment of operating leases, including 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/9209L1195D01

Original ruling text

September 28, 1992

Dear **:

Thank you for your letter of September 8, 1992, concerning the fair market
value of used equipment.

I have enclosed Rule 3.294 - Rental and Lease of Tangible Personal Property.
Rule 3.294(a) defines a financing lease and an operating lease. The types of
leases are defined solely for the purpose of determining a lessor's tax
responsibilities under each type of lease. The State of Texas does not require
that the purchase price of equipment at the end of a lease be for the "then"
fair market value.

The deposit (10%) of the original market value of the equipment clearly exceeds
the fair market value of the equipment at the end of the lease period. What
this means is that the original lease would not be deemed to be a financing
lease unless title transfers at the end of the lease. Rule 3.294(f)(3)(B)
requires a lessor to collect all of the tax due under the terms of a financing
lease at the time the lessee takes possession of the equipment or when the
first payment becomes due.

If the equipment is leased under an operating lease that has a purchase option
at the end of the lease that is equal to the deposit, the lease would be
considered an operating lease with a purchase option. Under this type of
lease, the rental payments would be due based on either the monthly billings or
when the monthly lease payments are made. However, you should note that sales
and use tax is also due on the purchase price when a lessee exercises the
purchase option that is part of an operating lease. See Rule 3.294(b) and (f).

This opinion is based on the facts presented. If there are additional or
different facts, the opinion may change.

You may call 512/463-4683 if you have any questions or need more information.
You may write to Tax Administration Division, Comptroller of Public Accounts.

Sincerely,

Eddie Washington
Tax Administration Division