The Maryland Tax Court recently held that lease termination payments for computer equipment are not subject to the state’s sales tax because they are not "sales." In so holding, the Tax Court rejected the Comptroller’s assertion that a lease termination payment was a payment of the taxable price paid. See Citicorp Int’l Communications, Inc. v. Comptroller, No. 02-SU-OO-0068 (Md. T.C. Feb. 23, 2004).

In the mid-1990s Citicorp International Communications, Inc. ("CICI"), a subsidiary of Citicorp, leased computer and related equipment from IBM Credit Corporation ("IBM") for use in its Maryland data center. Subsequently, CICI notified IBM that it wished to negotiate an early termination of the lease. The parties executed a lease termination agreement, pursuant to which IBM agreed to relieve CICI of its remaining obligations under the lease in consideration for a lump-sum payment of approximately 90 percent of the remaining lease payments and the return of the leased equipment.

CICI paid Maryland sales tax on its lease termination payment and requested a refund, which the Comptroller denied.

CICI appealed the Comptroller’s denial to the Maryland Tax Court. The Comptroller argued that because the Petitioner had an "absolute and unconditional" obligation under the lease to make rental payments, the lump-sum payment was "part and parcel" of the lease and merely an acceleration of the rental payments due thereunder. The Comptroller reasoned that the payment is taxable "consideration of any kind required to be paid to the lessor under the terms of the lease," in accordance with the Comptroller’s regulations. See Md. Regs. Code 03.06.01.28E(1).

CICI argued that the Comptroller’s position was contrary both to the terms of the lease, which allowed for "modification" or "termination" by written consent of the parties, and to the doctrine of "freedom of contract," which is incorporated in Maryland Commercial Law. See Official Comment to Md. Code Ann., Com. Law § 2A-101 ("The common law of leasing is dominated by the need to preserve freedom of contract."). Furthermore, CICI argued that the lump-sum payment was made pursuant to a separate lease termination agreement and not pursuant to the lease itself. Accordingly, the lease termination transaction was not a "sale" as defined by Md. Code Ann., section 11101(g)(1), because the payment was not consideration for the transfer of title or possession of property, but rather, was consideration for the relinquishment of the right to possess or use property.

The Tax Court found that the termination agreement "is a separate and distinct agreement from, and not an amendment to," the lease. Further, the Tax Court agreed with CICI’s interpretation of the lease and the sales tax statute and concluded that "[t]he clear and unambiguous provisions of the [lease and the lease termination agreement] and the lack of any transfer of title of the leased property to the Petitioner establish that the lease termination payment was not made pursuant to a transaction that is a ‘sale’ as defined by §11-101(g)."

Notwithstanding the Tax Court’s well-reasoned decision, the Comptroller has filed an appeal in the Circuit Court for Baltimore City.

Michael A. Pearl served as lead counsel for Citicorp International Communications, Inc. in this matter.

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