WLN Columns

The Impact of Sales Tax on Leasing Transactions – Part II

The first article in this series (WLN, Sept 16, 2008) discussed when sales tax may be due on the most common types of leasing contracts. Depending upon the state and depending upon the type of contract, tax may be due at contract inception (upfront) or over the course of each periodic payment (on the lease stream). We also noted that some states may require tax at the time the leased asset is purchased by the lessor while other states may give the lessor several options as to how to remit tax.

In this concluding article we will consider how lessors should determine which jurisdiction is entitled to the tax on a given lease payment and what happens when leased assets cross state borders. We will also discuss the appropriate tax rate to apply to lease transactions and which charges that are ancillary to a lease may be subject to tax. In conclusion, we will mention the advantages of using a transaction tax calculation engine in determining leasing tax liability.

Who Gets the Tax?

Once a lessor determines whether or not an asset is taxed upfront or on the lease stream, the next critical question is determining which jurisdiction is entitled to the tax payment. Assuming that the lease contract is properly taxed over the lease stream, the majority of states take the position that the initial payment on a lease is sourced to the location where the item is delivered and any periodic payments are sourced to the primary location where the item was situated during the relevant time period. In fact, this approach is expressly required in those states that are members of the Streamlined Sales Tax Agreement. As of today, there are 22 member states and the list is growing.

Streamlined Sales Tax Agreement Member States

* – Associate Member States

The issue gets decidedly more complicated when the asset crosses state lines during the course of a lease. Although a specific jurisdiction may not have a law or regulation that directly addresses this issue, most states will respect another taxing jurisdictions authority to levy tax on the stream of lease payments that are due while the asset is located in the other jurisdiction. However, this still leaves open the question of what would happen when an asset moves from a state that applies tax on an upfront basis to a state that applies tax over the course of a lease stream. Does tax get collected and remitted twice – once in the “upfront” state and then on each lease payment to the state where the property is now located?

Again, few states have rules that specifically address this contingency. However, New Jersey is a notable exception. While New Jersey generally taxes long-term leases on an upfront basis, they provide that if property originally leased in New Jersey is permanently relocated to another state, the lessee is entitled to a partial refund of any upfront New Jersey tax paid, to the extent that the payment can be allocated to the period of the time where the asset in question was not in New Jersey. Likewise, if an asset originally leased outside the state is re-located into New Jersey, the law provides that tax is due on each lease payment made while the asset is inside New Jersey.

What is the Proper Rate?

In most jurisdictions, long term leases of tangible personal property are subject to tax at exactly the same rate as sales of similar items. However, there are two notable exceptions. While the state of Delaware does not have a sales tax, they do apply tax to leasing transactions at the current rate of 1.536 percent. Just to give you some sense of the complexity surrounding tracking these rates, the Delaware leasing rate is scheduled to increase to 1.92 percent as of January 1, 2009 and then to revert back to the original rate on April 1, 2012.

The state of Alabama is relatively unique in that at the state, county and city level, they impose a special rate on the lease and rental of tangible personal property that is separate and distinct from the standard sales tax rate.

How are Ancillary Charges Taxed?

As a general rule, most states apply their sales tax to all sales (and leases) of tangible personal property but exempt the vast majority of services. Nonetheless, it’s not uncommon for states to take the position that certain service charges become taxable when charged in conjunction with a taxable lease transaction. The rationale is that such charges are really part and parcel of the underlying lease and should be taxed in the same way. Under this rationale, items such as late charges, administrative fees, collection fees, legal fees, and early termination fees may be appropriately subject to tax.

The Advantages of Using a Transaction Tax Calculation Engine

In the course of these two articles, we have considered how states apply their sales tax rules to the most common forms of leasing contracts. Needless to say, the rules are decidedly complex, not entirely transparent under existing law, and are subject to change in a moments notice. For example, as states amend their sales tax laws so as to qualify for membership in the Streamlined Sales Tax Agreement, they are required to adopt language noted in the opening example indicating that the initial payment is sourced to the location where the item is shipped with any subsequent payments sourced to the primary property location.

Especially in the context of long term leases of expensive equipment, the potential cost of making a sales tax mistake can be extraordinarily high. Not only would a company be required to compensate the state for any under collection of tax, but a company making these errors may also be subject to substantial interest and penalty charges.

If your organization is in the business of leasing equipment, then scarce intra-company resources are always better spent on achieving core objectives rather than pursuing correct results under arcane sales tax rules. When leasing is a significant budget item, using a transaction tax calculation engine to determine sales tax liability is almost always a cost effective option. However, in order to be effective, the system you choose must be able to delineate between the various leasing contract types, determ
ine the proper taxing locat
ion, determine the proper tax rate, and, ideally, also perform tax calculations for any accompanying leasing charges.