As you may be aware, leases of tangible personal property (except for mobile transportation equipment) are considered continuing sales. As such, sales tax generally applies on the lease receipts unless the lessor timely elects to pay tax on the cost. The question often comes up as to whether or not a contract is really a lease, or a service. For example, this month I was involved with a client who “leased” off road construction equipment. Although their contract referred to the parties as lessor and lessee, it also clearly stated that the “lessor” would provide the operator. Except for the terminology in the contract, the true agreement was simply a service. If I wanted some grading done, for example, I could hire a landscaper to come in with a tractor. Our agreement could be a fee for service and we would not enter into a lease. A contract for performing services is exempt while a contract for renting tangible property is taxable. The fact that equipment is involved in performing the service does not cause the exempt service contract to become a taxable lease.
To distinguish between a lease and a service, the State looks to both the contract and the use of the equipment. To keep it out of the lease category, make sure the contract doesn’t use the words “lease agreement” or other similar verbiage. Also, the equipment must be operated by the service provider.
This second point was one of the factors the California Supreme Court used in the case of Culligan Water Conditioning. Here the issue was whether Culligan was leasing the water conditioning unit to its customers or simply providing an exempt service. The court concluded that because the customers had the use of and full dominion and control over the units while connected to their water systems they constituted leases of tangible personal property. (Culligan Water Conditioning v State Board of Equalization, Supre, 17 Cal 3d at P.96).
In a more recent case, however, (MCI Airsignal v State Board of Equalization) an appeals court ruled in favor of the taxpayer even though the customer had possession of the property. The issue was whether the furnishing of paging devices constituted a lease of tangible property or the incidental transfer of property pursuant to a contract where the true object was a service. Since the paging devices were useless without the paying service, the courts ruled this was entirely an exempt service contract and not a taxable lease.
Unlike water softeners or heavy equipment, paging devices are useless in and of themselves without the accompanying paging service.
Conclusion:
Whether you have a service contract or a lease depends on the wording in the contract and the control the lessor or service provider has over the property. The true object test can come in to play but is very restrictive.
If tax is paid at source or reported timely on the Sales Tax Return, this whole issue doesn’t matter. It’s only when this election isn’t made or if property is not leased in the same form as acquired that this distinction becomes important. In these cases, the right service agreement will prevent the future income stream from being subject to tax.
