Tax-Exempt Leases of Tangible Personal Property

Hybrid Leases

Leases of tangible property are generally treated as a sale or purchase of the property, and therefore require the collection of sales tax (or self-assessment of use tax) based on the full consideration in the transaction [NYCRR 20 section 526.7 (b)]. For example, if a New York resident rents a demolition hammer for three days, sales tax must be collected on the full amount of the rental charges paid. Similarly, if a New Jersey contractor who regularly conducts business in New York (and is therefore required to collect and remit New York sales tax on sales made there) rents a dump truck in New Jersey that is used at a construction site located in New York City, he must pay use tax to New York based on the differential tax rate (1%) that is extant between both locations (New York Sales Tax Bulletin TB-ST-765, 10/09/2013).

Under the tax laws of many states, services are presumed to be exempt from sales tax unless specifically enumerated by statute. Under New York tax law, for example, consulting services, such as those pertaining to the design and pricing of a computer system or the maintenance, repair, or servicing of computer software, are exempt from tax, while repair or maintenance services performed on computer hardware are specifically enumerated as services subject to tax (e.g., New York Advisory Opinion TSB-A-07(28) S, 11/14/2007). Services can be subject to agreements for a term of years like leases of tangible property, such as enlisting an HVAC contractor for system maintenance (subject to sales tax) or hiring a structural engineer to determine the required load capacity of a new warehouse roof (a consulting service exempt from sales tax; N.Y. Tax Law section 1115). In certain transactions, however, a nontaxable service is bundled with the lease of tangible personal property. In this type of situation, what charges (if any) will be subject to sales tax? Will the charges be completely exempt or taxable, or perhaps partially taxable, and how can one make the determination?

In certain cases, tax regulations provide reasonably clear guidance for general bundled transactions. For example, the rental of a crane or bulldozer is subject to sales tax as a lease of tangible property. If the rental charge also includes the services of a professional operator (a non-taxable service), guidance to determine whether all or part of the transaction is taxable can be found in NYCRR 20 section 526.7(e)(6).

The amount charged for providing the operator of the equipment will be exempt if the lessor has the right to direct and controlthe use of the equipment. The operator’s wages, when separately stated, are excludible from the receipt of the lease, provided they reflect prevailing wage rates. Conversely, if the work performed by the equipment and the operator are directed and controlled by the lessee (customer) then the full invoice amount will be subject to sales tax. NYCRR 20 sections 526.7(e)(6) and 541.2 provide basic guidance to determine if the service portion of the transaction will be subject to sales tax. In most cases, the language of the lease agreement will determine whether any services provided in tandem with the tangible personal property being leased are exempt from sales tax.

In addition to the above, with respect to some lease transactions of tangible personal property, the service component is predominant to such an extent that the overall transaction can be viewed as the purchase of a service rather than as a lease of tangible property. The lease agreement might also stipulate the degree of control the lessor may exert over the lessee’s use of the equipment once the lease has been executed. These factors must be analyzed to determine if the overall agreement will be considered the lease of tangible personal property that is subject to sales tax or the purchase of a nonenumerated service that is exempt from sales tax.

New York State regulations provide some guidance for determining the taxability of rentals, leases, and the license to use tangible personal property provided by a lessor to a lessee that also include the services of a driver or operator. Under NYCRR 20 section 541.2 (p)(2)(i)-(v), if dominion and control of the tangible personal property remains with the owner or lessor (and is supported by the contract or rental agreement), the true object of the transaction will be the sale of a service and all the charges will, therefore, be exempt from sales tax.

In this context, dominion and control will exist when the contract or agreement provides that the lessor—

• does not transfer possession, control and/or use of the equipment or vehicle to the lessee during the term of the agreement or contract;
• maintains the right to hire and fire the drivers or operators;
• uses its own discretion in performing the work (even though the lessee may designate the area where material is to be picked up and delivered) and generally selects its own routes;
• retains responsibility for the operation of the equipment or vehicle; and
• directs the work and pays all operating expenses, including drivers’ or operators’ wages, insurance, tolls, and fuel.

An illustration of the above can be found in New York Advisory Opinion TSB-A-08(32) S, 7/21/2008, which involved a construction company (petitioner) that occasionally required the use of a crane that it obtained from a third party. The cranes were set up, torn down, and operated by the employees of the crane provider; the crane provider maintained the right to hire and fire the crane operators and used its own discretion in performing the work; and the crane provider retained responsibility for the operation of the crane, directed the work, and paid all costs associated with operating and maintaining the crane, including paying insurance, fuel, and wages of the operator. The TSB-A held that the petitioner itself did not meet any of the requirements to gain dominion and control over the crane since discretion over the relevant factors remained with the lessor. To reach a specific conclusion, however, the TSB-A noted that the contract for the services with the provider would have to be examined (it was not submitted with the ruling request). Nonetheless, based on the relevant facts, it appeared that the crane provider was providing nontaxable construction services rather than leasing tangible personal property to the construction company; the entire lease agreement was, therefore, exempt from New York sales and use tax. [See also TSB-M-84-(7) S, where it was determined that services provided by a bus company constituted the sale of a tax-exempt transportation service, and not the rental of equipment, because the lessor of the bus retained complete dominion and control over its operation.]

Fractional Ownership

Fractional ownership programs are commonly used to acquire the use of costly tangible property (e.g., heavy construction equipment, tour buses, noncommercial aircraft) as a way for a group of companies to obtain the right to use the property without an outright purchase. Each participant in the program can collectively purchase access to the asset for a specified amount of time over the duration of the contract. Incidentally, fractional ownership only refers to ownership of the fractional interest; it does not refer to a percentage of ownership of the asset. There is no outright transfer of change of ownership or transfer of title of any part of the asset to the group of companies desiring to obtain the use of the property. Therefore, fractional ownership closely resembles a lease agreement of tangible property shared among a limited number of lessees.

Whether a fractional ownership program subjects the group to sales or use tax can only be determined by an analysis of the corresponding contract; if dominion and control of the asset remains with the company that owns it, then the fractional ownership arrangement will be exempt from sales tax. [Note that, although the sales or lease of noncommercial aircraft became exempt from New York sales tax on September 1, 2015, many fractional ownership agreements executed before that date are still operative. See TSB-M-15(3) S, 7/24/15.]

New York Advisory Opinion TSB-A-09(23) S (June 5, 2009) provides a good illustration of the way a fractional ownership program works. This TSB-A involved a petitioner that was a subsidiary of a company that designed, manufactured, and serviced helicopters. The petitioner was the owner of a helicopter that, pursuant to an aircraft purchase agreement, was purchased in fractional interests by various owner/customers. The agreement also contained put and call options to effectuate the transfer of the co-ownership interest back to the petitioner and procedures for determining the buyback price.

In addition, a subsidiary of the petitioner entered an aircraft service agreement with the co-owners that established the terms under which the subsidiary would provide services to the co-owners, as well as the rights, duties, and responsibilities of the co-owners and the subsidiary. The co-owners also had an agreement among themselves stating that each co-owner relied on the others to abide by the terms of the program documents.

The petitioner requested guidance to determine if these transactions constituted leases of tangible property or sales of nontaxable transportation services. The fractional ownership agreement stipulated the following conditions:

• Pursuant to the various program agreements, the co-owners made no decisions relative to scheduling, weather considerations, aircraft, pilots, or route. These decisions were made at the discretion of the petitioners.
• The petitioner made all takeoff, flight, and landing arrangements. The only decisions made by the co-owners are the times and pickup/destination points.
• The petitioner was solely responsible for determining the need and arranging for all inspection, maintenance, service, repair, overhaul, or testing required for any aircraft in the program.
• The petitioner paid all standard out-of-pocket operating expenses, such as fuel, hangar costs, landing fees, and insurance.
• The petitioner maintained all records, logs, and other materials required by the FAA.
• All manuals used in providing the service remain the exclusive property of petitioner.
• Possession, command, and control of the aircraft were not transferred to the co-owners.

None of the conditions referenced in TSB-M-84(7) S to demonstrate that fractional share owners obtained dominion and control over the aircraft were met; therefore, it was determined that the petitioner was engaged in the sale of a tax-exempt transportation service.

Forewarned Is Forearmed

Many auditors and taxing authorities will presume that any hybrid lease or fractional ownership program that includes both a tangible asset and the provision of an operator will be subject to sales tax. Complex lease agreements and other arrangements with contracts stipulating that the lessor/owner retains dominion and control over the tangible asset may, however, be exempt from New York sales tax, and taxpayers under audit by the New York State Department of Taxation and Finance should be prepared to challenge these assumptions. It is therefore crucial to review the applicable contracts and fully understand the limitations of the parties to the transaction. This is a complex area, and CPAs need to be aware of the rules when advising taxpayers.