In a related-party sale-leaseback used to restructure debt within a corporate group, are the lease payments taxable, and does it matter whether the leaseback is structured as an operating lease or a financing lease?

Plain-English summary

A corporate holding company restructured a Texas partnership by having one commonly-owned subsidiary (COMPANY A) buy some of the partnership's assets and lease them back to the partnership -- a maneuver aimed at working around debt restrictions on the partnership itself, entirely within a group of commonly-owned affiliates. The partnership had already paid sales tax on the assets when it originally bought them.

The initial asset sale from the partnership to COMPANY A qualified as an exempt resale transaction under Rule 3.285(a)(B) and (b)(1) -- that piece wasn't in dispute. The real question was the tax treatment of the leaseback itself, and the Comptroller drew a sharp line based on lease structure:

• If the leaseback is an operating lease, the periodic lease payments are subject to sales tax -- full stop, regardless of the related-party, debt-restructuring context.
• If the leaseback is instead a financing lease -- specifically, one where the partnership (lessee) will become the property's owner at lease termination for little or no additional consideration -- the lease payments are not taxable.

The letter then defines "little consideration" precisely: under Rule 3.294(a)(1)(ii), a purchase option amount counts as "nominal" (i.e., little consideration) only if it's less than 10% of the property's estimated value at the time the option would be exercised, with that value projected as of the lease's inception. But there's a separate path to financing-lease treatment: under Rule 3.294(a)(1)(i), if the end-of-lease payment isn't an option at all but is required under the contract's terms, the transaction is still treated as a financing lease even if the required amount exceeds the 10% threshold -- the "required vs. optional" distinction matters as much as the size of the payment.

What this means for you

Corporate groups restructuring debt via intra-group sale-leasebacks

The fact that a sale-leaseback is entirely between commonly-owned affiliates, and done for a legitimate debt-restructuring reason, does not by itself determine the tax outcome -- the lease's legal structure (operating vs. financing) is what controls whether lease payments are taxed, so structure the leaseback deliberately with the desired tax outcome in mind.

Businesses drafting purchase-option terms in lease agreements

If you want financing-lease (non-taxable) treatment via a purchase option, keep the option price under 10% of the property's projected end-of-lease value. If you'd rather build in a larger required payment, structure it as a mandatory contract term (not an "option") to still qualify for financing-lease treatment regardless of the amount.

Accountants and tax professionals

A clean two-rule framework (Rule 3.294(a)(1)(i) vs. (ii)) for the recurring operating-vs.-financing-lease classification question, worth pairing with the more detailed operating-lease-mechanics letter elsewhere in this corpus (9904410L) when advising on lease structuring generally.

Common questions

Q: Are sale-leaseback lease payments taxable between related companies?
A: The related-party context doesn't matter -- taxability depends on whether the leaseback is an operating lease (taxable) or a financing lease (not taxable).

Q: What makes a leaseback a "financing lease" rather than an "operating lease"?
A: The lessee becomes the owner at lease termination for little or no additional consideration -- either a nominal purchase option (under 10% of projected value) or a required (non-optional) contract payment.

Q: Does a required end-of-lease payment over 10% of value disqualify financing-lease treatment?
A: No, as long as it's required under the contract terms rather than an optional purchase -- the 10% nominal-option threshold only applies to true options.

Q: Can I rely on this letter for my own sale-leaseback structure?
A: No. It is based on the specific facts presented and can only be relied on by the taxpayer to whom it was issued.

Citations and references

Statutes and rules:

• 34 Tex. Admin. Code Rule 3.285(a)(B), (b)(1) (sale for resale)
• 34 Tex. Admin. Code Rule 3.294(a)(1)(i), (a)(1)(ii) (financing vs. operating lease; nominal purchase option)

Source

• STAR search: https://star.comptroller.texas.gov/search?doc_type_code=L&tax_type_code=SST
• Opinion: https://star.comptroller.texas.gov/view/9904335L

Original ruling text

April 23, 1999

Dear Mr. **:

Thank you for you letter inquiring about the taxability of a sale leaseback
transaction involving your client (C-Corp). You provide the following facts:

C-Corp has recently purchased the remaining interest (bought the other
partner's interest) in a Texas partnership located in Texas. Two C-Corp
subsidiaries purchased a 100% interest in the partnership. To overcome debt
restrictions imposed on the partnership, the partnership would like to sell
some of its assets to another C-Corp subsidiary (COMPANY A) which would lease
the assets back to the partnership. The partnership had paid all sales taxes
on the assets at time of purchase. All companies and partnerships involved are
owned by the same holding company and would have identical indirect ownership.
COMPANY A is permitted to collect sales tax in Texas.

The sale of assets from the partnership to COMPANY A would qualify as a resale
transaction as described in TAC Sec. 3.285 (a)(B). Resale transactions are
exempt from sales tax in TAC Sec. 3.285 (b)(1).

You wish to get our opinion on the tax treatment of the following transactions:

1. If the partnership enters into a sales/leaseback arrangement with COMPANY A
   to lease the assets back to the partnership as part of an operating lease,
   would the periodic lease payments be subject to sales or use tax?

2. If COMPANY A leases the assets back to the partnership in a sale/leaseback
   financing lease, where the partnership has a "security interest" in that upon
   compliance with the terms of the lease the partnership shall become the owner
   of the property for little or no additional consideration, the transactions
   would be considered merely a financing arrangement and the lease payments would
   not be subject to sales or use tax.

Response:

The lease payments under transaction No. 1 where the leaseback is an operating
lease would be subject to the sales tax.

No tax is due under transaction No. 2 if COMPANY A leases the assets back to
the partnership in a sale/leaseback financing lease, under which the
partnership at termination of the lease, for little or no additional
consideration, will become the owner of the property subject to the lease. In
order for any consideration given to be deemed "Little consideration," the
projected value of the property at termination of the lease must be determined
at the inception of the lease. The purchase option amount must be "nominal"
which is defined as less than 10 percent of the estimated value of the property
at the time that the purchase option is exercised. TAC Sec. 3.294 ( a)(1)(ii)

However, If the consideration given at termination of the lease for the
property is not an option but required under the terms of the contract, the
transaction is viewed as a financing lease even if the amount is greater than
the 10 percent of the estimated value. TAC Sec. 3.294 (a)(1) (i)

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

You may call me toll free at 1-800-531-5441, ext. 3-4675. The direct line is
(512) 463-4675. You also may write to Tax Policy Division, Comptroller of
Public Accounts. You may also e-mail our tax help section at:
[email protected]>

Sincerely,

Tom Soto
Tax Policy Division