Legal ruling 1994-2

Finance Leasing and Financial Corporations

Issues

1 Whether a corporation whose principal business activity is the finance leasing of tangible personal property is properly classified as a financial corporation under California Revenue and Taxation Code §23183. (This is the same issue addressed in FTB Notice 91-4, dated November 20, 1991.)

2.2 What is the meaning of the term "finance leasing" as used in the statement of the first issue?

Facts

1 Corporation A derives more than 50% of its gross income from the leasing of equipment. The leases are the type of lease permitted to be made by national banks. One or more of the conditions listed in Section 4 of Revenue Ruling 55-540 (1955-2 C.B. 39) is present in the leases. Corporation A is not entitled to a deduction for depreciation for the equipment.

2.2 Corporation B derives more than 50% of its gross income from the leasing of equipment. The leases are the type of lease permitted to be made by national banks. The leases meet all the conditions set forth in Revenue Procedure 7521 (1975-1 C.B. 71 5.) Corporation B is entitled to a deduction for depreciation.

Law

Revenue and Taxation Code §23183 provides:

1. An annual tax is hereby imposed upon every financial corporation doing business within the limits of this state and taxable under the provisions of Section 27 of Article Xill of the Constitution of this state, for the privilege of exercising its corporate franchises within this state, according to or measured by its net income, upon the basis of its net income for the next preceding income year at the rate provided under Section 23186.
2. For purposes of this article, the term "financial corporation' does not include any corporation, including a wholly owned subsidiary of a bank or bank holding company, if the principal business activity of such entity consists of leasing tangible personal property.

Section 14.52 of AB 66, Stats. 1979, Ch. 1 1 50, effective September 29, 1979, amended § 231 83 to add subdivision (b) above. Section 20 of Ch. 1 1 50 explained the legislative intent of the amendment:

SEC. 20 The amendment to Revenue and Taxation Code Section 23183 contained in this Act reaffirms the Legislature's longstanding purpose of insuring competitive parity between banks and financial corporations by subjecting both types of institutions to an equivalent tax burden. Equal tax treatment of banks and financial corporations promotes the continued existence of both types of institutions thereby affording a full range of financial services at competitive rates. Moreover, taxation of banks and financial corporations at the rate determined under Revenue and Taxation Code Section 23186 insures that their tax burden will be comparable to the combined state and local tax burdens of nonfinancial corporations subject to Revenue and Taxation Code Section 23151.

18 Cal. Code Regs. §23183 subsection (a) defines a "financial corporation' as a corporation which 'predominately" deals in money or moneyed capital in substantial competition with the business of national banks.

18 Cal. Code Regs. §23183 subsection (b)(1) provides that:

"Predominantly means over 50% of a corporation's total gross income is attributable to dealings in money or moneyed capital in substantial competition with the business of national banks. Generally, the determination of predominance will be made based upon the division of gross income for the year in issue. However, the classification of a corporation as a financial corporation or as a nonfinancial corporation will not be changed based upon an occasional year in which its gross income does not exceed the 50% level. For the classification of a corporation as a financial (or nonfinancial) corporation to be changed, there must be a shift in the predominant character of the gross income for two consecutive years and the average of the corporation's gross income in the current and the immediately preceding two years must fail (or satisfy) the predominance test. Where substantial amounts of gross income arise from an incidental or occasional sale of an asset of the taxpayers, such gross income shall be excluded for purposes of this subsection."

In the Appeal of Avcar Leasing, Inc., Cal. St. Bd. of Equal., March 31, 1982, the State Board of Equalization held that under the law as it existed prior to the addition of subdivision (b) to section 23183, an automobile leasing company was a financial corporation because its activities met the two-part test of (i) dealing in money or moneyed capital as distinguished from other commodities, and (ii) substantial competition with national banks.

The Board of Equalization in Agi2eal of Avcar Leasing, Inc., supra cited to M&M Leasing Corl2. v. Seattle First Nat. Bank, (9th Cir. 1977) 563 F.2d 1377. The Court of Appeals in this case, at page 1382, held that '. . . leasing, when in the light of all relevant circumstances the transaction constitutes a loan of money secured by the leased property ... is incidental to ... an activity expressly authorized by the National Bank Act."

The Court of Appeals, in Oesterreich v. Commissioner, (9th Cir. 1955) 226 F.2d 798, noted that reference to a transaction as a lease does not make it one, if the facts indicate otherwise. It is the substance, not the form, of the lease agreement which must govern the legal characterization of the transaction. (Frank Lyon Co. v. United States, (1978) 435 U.S. 561; Sun Oil Co. v. Commissioner, (3d Cir. 1977) 562 F.2d 258.)

The determination as to whether a particular transaction is a lease or financing transaction is made by reference to the distribution of the benefits and burdens of ownership. (Swift Dodge v. Commissioner, (9th Cir. 1982) 692 F.2d 651; Leslie Leasing (1 983) 80 T. C. 41 1.) Upon analysis of the leases in Swift Dodge v. Commissioner, sugra, the court found that the allocation of duties (the benefits and burdens of ownership) in the agreements was no different than would be true under a conditional sales contract, and thus Swift-Dodge did not retain the significant and genuine attributes of a lessor.

A national bank may engage in lease financing transactions as generally authorized by 12 U.S.C. 24(7) and lease financing transactions on a net lease basis as authorized by 12 U.S.C. 24(10). Leases authorized under 12 U.S.C. 24(7) are limited to net, full-payout leases representing a noncancelable obligation of the lessee. (Comptroller of the Currency-Regulations, Part 23-Leasing (added by 56 Fed. Reg. 28314, June 20, 1991, effective July 22, 1991).)

Bank holding companies or a subsidiary thereof may engage in leasing personal property or acting as agent, broker, or advisor in leasing such property if the lease is to serve as the functional equivalent of an extension of credit to the lessee of the property. (Regulation Y of the Federal Reserve System, 12 CFR 225.25.)

A corporation purchasing installment notes not acceptable to national banks can be a financial corporation. It is not necessary to show that national banks and competing irvestors solicit the same customers for the same loans or investments, but merely that competing investors make the same type of investments as those made by national banks (Appeal of Atlas Acceptance Corp., Cal St. Bd. of Equal., July 29, 1981.) A corporation engaging solely in purchasing conditional sales contracts and accounts for retail dealers in personal property consisting chiefly of household furniture and furnishings was taxable as a financial corporation (Crown Finance Corp. v. McColgan (1 943) 23 Cal. 2d 280).

Revenue Ruling 55-540 (1955-2 C.B. 39) sets forth federal guidelines to be used in determining the treatment, for federal income tax purposes, of the purported leasing of equipment for use in the trade or business of the lessee. Whether an agreement is a lease or a conditional sales contract depends upon the intent of the parties as evidenced by the provisions of the agreement, read in light of the facts and circumstances existing at the time the agreement was executed. This Revenue Ruling also provides six conditions which, if one or more are present, will warrant treatment of a transaction for tax purposes as a purchase and sale rather than as a lease or rental agreement, absent compelling persuasive factors of contrary implication. If the agreement is determined to be a lease, the lessor will be allowed a deduction for depreciation. If the agreement is determined to be a sale, the amounts received under the contract by the vendor will be considered to be payments -on the sales price of the equipment to the extent such amounts do not represent interest or other charges. If under the provisions of this Revenue Ruling, the agreement is to be treated as a sale, expenditures treated as payments for the purchase of the equipment may be recovered over the life of the asset through appropriate depreciation deductions by the purchaser.

Revenue Procedure 75-21 (1975-1 C.B. 715) sets forth guidelines the Internal Revenue Service uses for advance ruling purposes to determine whether certain transactions purporting to be leases of property are, in fact, leases for Federal income tax purposes. This Revenue Procedure also provides six conditions, all of which must be met, for the Internal Revenue Service to rule in advance that a transaction is a valid lease.

The California Court of Appeal in the case of Triple C. Leasing, Inc. v. All-American (1 976) 64 Cal.App.3d 244 stated that the intent of the parties in determining if a transaction is a lease or a purchase and sale is to be determined by the facts of each case. The Court of Appeal listed six guidelines in Trigle C. Leasing, Inc., sugra, to be used to determine if a transaction is a lease or a financing transaction.

Revenue and Taxation Code §24349 allows a deduction for depreciation of property used in a taxpayer's trade or business or held for the production of income. This section is based on and substantially similar to (with exceptions not here relevant) Internal Revenue Code § 167. Internal Revenue Code § 167 allows a deduction for federal income tax purposes for depreciation of property used in taxpayer's trade or business or held for the production of income.

The right of a taxpayer to deduct deprecation on certain property may not always follow the ownership of the legal title. A taxpayer who establishes either beneficial ownership or an investment in the property so that he 'bears the burden of wear and tear and exhaustion' of the property is entitled to deduct the depreciation of that property. (Helvering v. Lazarus and Co. (1 939) 308 U.S. 252.)

Analysis

The term "leasing" used in Revenue and Taxation Code §23183 subdivision (b) is undefined and therefore must be construed to give effect to the Legislative intent.

Ambiguity exists in subdivision (b) of Section 23183 by the Legislature's use of the phrase "leasing tangible personal property" because the Bank and Corporation Tax Law does not define "leasing." Accordingly, the wording of the statute is unclear in that it cannot be determined from that wording alone whether a corporation principally engaged in gM activities characterized by that corporation as "leasing" is intended to be excluded from the definition of financial corporation, or whether the exclusion applies only to those corporations engaged in non-financial leasing activities.

Given the ambiguity, it is necessary to construe subdivision (b) of Section 23183 so as to give full implementation to the Legislature's intent in adopting that provision. Intent expressed in Section 20 of Chapter 1 1 50, and elsewhere, indicates that AB 66 reaffirmed the Legislature's 'longstanding purpose" of ensuring "competitive parity" and "equal tax treatment' of banks and financial corporations. Such intent would be frustrated if subdivision (b) were read to prevent a corporation whose principal business activity consists of finance leasing of tangible personal property in substantial competition with national banks from being classified as a financial corporation. (See Aggeal of Avcar Leasing, Inc., supra; M&M Leasing Corp. v. Seattle First National Bank, supra.)

A corporation whose principal business activity is the finance leasing of tangible personal property must therefore be classified as a financial corporation because it predominantly deals in money or moneyed capital in substantial competition with the business of national banks. (See 18 Cal. Code Regs. §23183.)

The term 'finance leasing' must be construed to give full implementation to the Legislature's intent in adopting Revenue and Taxation Code §23183(b). Intent expressed in Section 20 of Chapter 1 1 50, and elsewhere, indicates that AB 66 reaffirmed the Legislature's "longstanding purpose' of ensuring "competitive parity' and "equal tax treatment" of banks and financial corporations. Therefore the meaning of the term "finance lease' must consider the type of finance leasing permitted to be conducted by banks, as well as the generally accepted definition and interpretation of the term 'lease' for tax purposes.

The lease must be of the type permitted to be conducted by banks to be considered a 'finance lease.' A corporation is not a financial corporation if it can be shown that the leases entered into by the corporation are of a type that may not be entered into by a national bank under federal banking laws and regulations. (12 U.S.C. 24(7); 12 U.S.C. 24(l 0); Comptroller of the Currency-Regulations, Part 23- Leasing (added by 56 Fed. Reg. 28314, June 20, 1991, effective July 22, 1991; Regulation Y of the Federal Reserve System, 12 CFR 225.25).)

A corporation engaged in the same type of transactions as a national bank, but transactions of a character such that a national bank declines to participate, may still be considered a financial corporation. An example of this situation is a loan by a finance company to a person after a bank has declined to provide credit to the individual. The finance company is considered to be a financial corporation even though a bank has declined to compete for that business. (Crown Finance Corp. v. McColgLan supra; A2peal of Atlas Acceptance Corp., supra.)

Under general tax principles, a "lease" is considered to be a financing arrangement rather than a true lease if it is within the guidelines set forth in the Internal Revenue Code, the California Revenue and Taxation Code, Revenue Ruling 55-540, or as determined after application of the guidelines provided in Triple C. Leasing, Inc. v. All-American, supra.

A taxpayer who establishes either beneficial ownership or an investment in the property so that he "bears the burden of wear and tear and exhaustion" of the property is entitled to deduct the depreciation of that property. (Helverin-ci v. Lazarus and Co., supra.)

Conclusions

1. A corporation whose principal business activity is the finance leasing of tangible personal property will be classified as a financial corporation because it predominantly deals in money or moneyed capital in substantial competition with the business of national banks. (This is the same conclusion provided in FTB Notice 91-4.)
2. A finance lease, for the purposes of determining whether a corporation is a financial corporation, is a lease which meets two requirements:

1. It is the type of lease permitted to be made by national banks; and
2. It is the economic equivalent of an extension of credit, i.e., the lease is not treated as a 'true" lease for federal income tax purposes; for example, the lessor is not entitled to a deduction for depreciation.

Holdings

1. Under the facts presented, the leasing activities of Corporation A constitute finance leasing because it is the type of lease permitted to be made by national banks, and it is the economic equivalent of the extension of credit, as evidenced by the state and federal income tax treatment of the lease as a financing arrangement rather than a sale. Because over 50% of Corporation A's activities consist of this type of lease, it is "predominantly" engaged in finance leasing and so classified as a financial corporation. It is therefore subject to the tax imposed on financial corporations.
2. Under the facts presented, the leasing activities of Corporation B do not constitute finance leasing because, although it is the type of lease permitted to be made by national banks, it is not the economic equivalent of the extension of credit, as evidenced by the state and federal income tax treatment of the lease as a true lease rather than a financing arrangement. It is therefore not subject to the tax imposed on financial corporations.

Effect on Other Documents

FTB notice 91-4, issued November 20, 1991, is hereby superseded and withdrawn.

Application

As authorized by California Revenue and Taxation Code Section 19503, when determining the reclassification of a corporation from a general corporation to a financial corporation, or vice versa, if its tax liability to cities and counties plus the franchise tax liability approximates its tax liability under the bank rate, or its tax liability under the bank rate approximates its tax liability to cities and counties plus the franchise tax liability, the Franchise Tax Board will require only a prospective change to a corporation's classification.

Drafting Information

The principal authors of this ruling are Ed Campion and Edward J. Kline, Franchise Tax Board. For further information regarding this notice, contact Mr. Campion or Mr. Kline at P.O. Box 1468, Sacramento, CA 95812-1468.

NOTE: ((---)) = Indicates obsolete information.