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The flexibility of leasing transactions is appealing and has caused rapid growth in the leasing industry in the past 50 years.

Everyone is familiar with leasing a car, but did you know you can also lease an airplane, a copier, a computer, a horse trailer or an excavator?

Leasing is an agreement between a lessor and a lessee, where the lessor conveys the right to use an asset for an agreed upon period of time in return for an agreed upon payment or series of payments.

Dissecting a leasing transaction for tax purposes can be extremely difficult because of the many different issues that must be considered from the beginning to the end of the lease.

The following looks at why leasing transactions can cause such a headache and what it takes to keep up with sales and use taxes within the leasing industry.

Taxware understands the challenges faced by lessors and lessees in a leasing transaction and we support robust functionality to help you get the right tax result.

In the U.S., upon entering the leasing arena, it is necessary to first determine the type of lease and the location where tax must be paid/collected.

Operating Lease A lease of goods without option to own up on lease termination.

Nominal Lease A lease where the lessee may purchase the goods at the end of the lease on payment of a small, fixed amount (according to the Streamlined Sales Tax Project, a nominal lease results when a buyout is less than $100 or 1% of the total required payments).

Fair Market Value Lease

A lease that allows the lessee to purchase the goods for the fair market value of the property upon termination of the lease.

Conditional Sale A conditional sale is defined to include the situation where the customer/lessee takes possession of the item but title remains with the lessor/seller until such time as payments are complete. In order to protect their interests; the lessor/seller takes a security interest in the item being leased/sold. At the end of the “conditional sale” contract, there may be a final balloon payment and once that final payment is made, title will vest with the purchaser/lessee. Conditional sales are not a lease according to the Streamlined Sales Tax Project.

Types of Leases

Determining both the lease type and the tax collection point is:

• If your contracts are straight-forward • If all of the assets you are dealing with originate

and terminate in the same location

• If you begin a multi-jurisdictional business • If your assets have wheels

Easy

Challenging

In order to determine where to properly pay/collect tax, you must be familiar with each state's individual sourcing rules, which dictate where the tax obligation lies at all stages of the leasing transaction and vary widely from state to state.

In the past decade, many states have attempted to make sourcing rules and lease tax obligations more clear by joining the Streamlined Sales Tax Project (SSTP).

To date, there are 24 states that are full and associate members of the project, which is a collaborative effort among member states to simplify sales and use tax collection and administration.

Robust tax software solutions have incorporated the SSTP and non-SSTP state sourcing rules into their systems concurrently, thereby allowing users to pass standard transaction parameters throughout the life of the lease to help you achieve:

• the right tax rate • in the right jurisdiction (at all levels) • at the right time

After determining the sourcing location of a leasing transaction, you must look at:

As if figuring out the nuances that determine the amount of the tax is not enough, there are multiple variations on the laws governing the mode by which sales and use tax can/must be paid, domestically.

• Amount of tax that needs to be paid • Time when the tax must be paid

(during the life of the lease) • Who must pay the tax

The amount of tax to be paid can be a result of the general sales and use tax rate or can be the result of a special lease tax rate, which may or may not take the place of the general sales and use tax rate.

Massachusetts Applies the same tax rate to leases as they do to sales.

Alabama Has completely separate lease/rental rates.

City of Chicago

Is more complex in that it does not apply the general Illinois sales tax rate, but instead applies an additional 8% tax on the lease of personal property inside the city.

Examples of Applied Tax Rates for Leases:

Upfront States

Treat leases the same as any other sale of tangible personal property and require that tax be collected in full at the inception of the lease. This results in the lease stream payments being exempt from tax.

Stream States Allow tax to be collected upon each individual lease payment. Adding another layer to the complexity, some states also give the lessor the choice of collecting tax upfront or on the lease stream.

Exempt States (i.e. Maine)

Exempt leasing transactions altogether and require that the lessor pay tax when the asset is purchased for future lease. This does not preclude the lessor from passing the tax on to its customer down the line; however, it does not make the task of tracking any easier.

There is no single “U.S.” rule to follow; individual state laws apply.

Sample Tax Collection Scenarios

To add to the confusion, the duration of the lease can also result in additional rates of tax, surcharges, limitations, jurisdiction-based exemptions or tax reductions.

Texas Duration of the lease can also result in additional rates of tax or surcharges.

South Carolina

In order to qualify for the $300 maximum sales tax, leases of motor vehicles, certain light weight construction equipment, and horse trailers must be in writing and remain in effect for more than 90 continuous days.

Urban Enterprise Zones

If a qualified business is located in one of these zones, the lease of certain equipment used in that area may qualify for an exemption or a reduced rate of tax.

Examples

Then the issue of how to tax the initial piece of the transaction arose, as well as how to track what.

It was not until companies got creative with their categorization of what they define as a lease (possibly in order to get a tax advantage, such as a deferred tax payment) that laws slowly became more complex.

With the end of a true operating lease, the lessee takes the asset and goes along his/her way. But what if…

• The lease ends because of an early termination? • A buy-out option is exercised? • It’s an early termination in a state that taxes the lease up-

front? Should the lessee be entitled to a refund of the tax already paid?

• What about the next lessee, should they have to pay tax?

Buy Outs At first glace, buy-outs may seem simple; simply tax the buy-out after the lease is over, the same way you would tax a regular sale of tangible personal property. Most states agree, but some, like Wisconsin and Kentucky, disagree. These two states actually say that buy-outs must be taxed at the initial inception of the lease.

What if the lessee decides not to exercise the buy-out option?

Tax Exempt Example: Maine How about in Maine where leases are generally exempt from tax? Once a buy-out is exercised, tax must be paid on the buy-out amount, as well as on all lease payments made up to that point!

Imagine if you have hundreds of leasing transactions running in Maine and you have to track each individual one?

With recent technology developments in automated tax calculation software, figuring out these transactions can actually be as easy as: 1. Passing information to the software that indicates that a buy-out is being exercised

2. Allowing the software to recalculate the tax for you

Despite market challenges that all global businesses face, the interest in leasing in the worldwide arena is also on the rise. In general, the lease of equipment is subject to VAT, CST or GST internationally.

Fair Market Value leases and conditional sales are usually used for equipment and the VAT treatment varies depending on the country.

Azerbaijan Fully exempt lease transactions

Czech Republic & Russia Fully tax lease transactions

Bulgaria Only the interest element is exempt from VAT

Taxable equipment leases are usually subject to standard VAT rates, which range from 2% to 27% depending on the country. Additionally, the classification of the lease will dictate whether supply of goods or supply of services rules apply. Many of the same issues that face a customer in the U.S. are also a concern worldwide and must be analyzed and addressed by the tax calculation system.

Examples

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