At a Glance...
Welcome to the Reed Smith's 2018 mid-year update on recent developments in state and local tax affecting the aviation industry. In this update, we will focus on some noteworthy sales and use tax law changes, cases, rulings, and secondary legal guidance, as well as review a newly filed New Jersey corporate income tax case involving transfer pricing adjustments to the payments under an intercompany aircraft lease.
Arkansas exemption for parts applies to sale of aircraft for dismantling. On January 8, 2018, the Arkansas Department of Finance and Administration (DFA) ruled that the sale of an aircraft that was delivered in Arkansas to be dismantled and parted out was exempt from sales and use tax under the state's statutory exemption for commercial jet aircraft parts. This ruling follows a prior ruling (Opin. No. 20170630, July 3, 2017) reaching the same conclusion.
The transaction involved a nonresident leasing company, which sold a commercial aircraft to a nonresident domestic airline. The aircraft was delivered to a maintenance facility in Arkansas where title was transferred from seller to buyer. Once title transferred, the buyer entered into an agreement with the maintenance facility to dismantle the aircraft for its useable parts. The aircraft engines were immediately shipped out of Arkansas. The other useable aircraft parts were either (i) stripped from the aircraft and then shipped to the buyer outside of Arkansas, (ii) left at the maintenance facility for refurbishment or repair, or (iii) stored at the maintenance facility until the aircraft parts were needed by the buyer.
The DFA concluded that the airline buyer was not acquiring an aircraft per se, but only the desired aircraft parts and components for subsequent incorporation into other commercial jet aircraft. The DFA analogized purchasing the aircraft to purchasing a container of assorted parts for refurbishment and incorporation into a qualifying aircraft, which transaction it viewed as clearly falling within the state's aircraft parts exemption. Despite the fact that portions of the aircraft were not useable and would be sold for scrap metal, the DFA concluded that the non-useable parts had de minimis value and were also not the true object of the transaction. Ark. Opin. No. 20171107 (Jan. 8, 2018).
Arkansas fly-away rule is available for corporations based in foreign countries. The seller and buyer sought a ruling from the DFA concerning whether a foreign buyer was "a resident of another state" for purposes of the state's fly-away exemption. The DFA ruled that the foreign corporate purchaser qualified for the fly-away exemption because the buyer was organized under the laws of a country comprised of sovereign units, and these sovereign units fell within the dictionary definition of "state" (that is, a component unit of a sovereign nation in a federal system that is more or less independent and sovereign over its own internal affairs). Ark. Opin. No. 20170725 (Jan. 25, 2018).
Colorado General Information Letter interprets aircraft-parts exemption more broadly than aircraft exemption. Colorado exempts from sales and use tax aircraft used by commercial airlines in interstate commerce. Colorado also exempts parts "permanently affixed to aircraft." While the state's aircraft exemption is limited to aircraft used in interstate commerce by commercial airlines, the letter ruling acknowledges that there is no similar limitation on the exemption for aircraft parts. Accordingly, the Colorado Department of Revenue determined that aircraft parts permanently affixed to an aircraft qualify for the exemption, regardless of whether the aircraft is used in interstate commerce. Colo. Gen. Info. Ltr. No. GIL-18-005 (Feb. 12, 2018).
New statutory exemption for rotary-wing aircraft. Effective July 1, 2018, there is a new Mississippi sales and use tax exemption for rotary aircraft. Under the new provision, a sale of a rotary-wing aircraft is exempt if the aircraft is exported from Mississippi within 48 hours and is registered and first used in another state. 2018 Miss. Laws, Ch. 389 (adopted Mar. 19, 2018).
Department of Revenue rules that aircraft oil and lubricant are taxable. Missouri law provides for a sales and use tax exemption for "[a]ll materials, replacement parts, and equipment purchased for use directly upon, and for the modification, replacement, repair, and maintenance of aircraft." Because the tax laws do not define the terms "materials," "parts," or "equipment," the Department of Revenue considered the dictionary definitions of these terms, and concluded that oil and lubricants do not qualify for the exemption, notwithstanding the fact that these products may be purchased to perform required aircraft maintenance. Mo. Priv. Ltr. Rul. No. LR 7898 (Dec. 6, 2017, released May 24, 2018).
To be more competitive with neighboring states, New Hampshire has reduced its aircraft registration fees. Effective January 1, 2019 (and earlier for aircraft not previously registered or aircraft due for registration renewal after September 1, 2018) aircraft owners will now pay a flat registration fee based on the aircraft's maximum certificated gross weight, with the fee not exceeding $3,500 for aircraft with maximum certificated gross weight of more than 12,500 pounds. (Previously, New Hampshire's aircraft registration fees were based on the age, list price, and weight of the aircraft, resulting in some aircraft owners facing registration fees in the hundreds of thousands of dollars.) See H.BV 124-FN, eff. Jan. 1, 2019; N.H. Rev. Stat. Ann. § 422:31, III.
Aircraft lessee files New Jersey Tax Court petition challenging corporation business tax assessment based on the Division of Taxation's adjustments to intercompany lease payments. This petition involves a taxpayer that owned and dry-leased aircraft to an affiliate. The Division audited the taxpayer and determined that the lease payments from the affiliate were at below arm's-length prices. The Division applied a 10 percent markup to the taxpayer's lease receipts. At the same time, the Division also disallowed deductions claimed by the taxpayer for expenses incurred by the taxpayer in providing its leases. Thus, the resulting adjustments had the double effect of increasing the taxpayer's revenue and reducing expenses, resulting in a substantial increase in the taxpayer's corporation business tax base. Making matters worse for the taxpayer, the Division also recomputed the taxpayer's available net operating loss deduction by applying similar transfer pricing adjustments to prior years. As a result, the taxpayer received a multi-million-dollar assessment.
The taxpayer appealed the assessment within the Division and then to the Tax Court, where the case is currently pending. The taxpayer is challenging the Division's transfer pricing adjustments on the basis that the Division failed to show that a transfer pricing adjustment was warranted, because the Division failed to first establish that the taxpayer's net income was distorted. The taxpayer is also challenging the Division's methodology for adjusting the lease payments, claiming that no transfer pricing expert was consulted and the Division lacked the expertise to compute the transfer pricing adjustments. Finally, the taxpayer is challenging the Division's authority to apply its transfer pricing adjustments to prior years through adjustments to the taxpayer's net operating loss deduction, because those prior years were closed under the statute of limitations.
Reed Smith takeaway: We already know that many states scrutinize captive lease arrangements for sales and use tax purposes, but will we see an increase in income tax transfer pricing cases targeting aircraft leases? In the national landscape, it is common to see separate-company states – states that require each legal entity to file a separate income tax return in lieu of a combined return for affiliated entities – audit and adjust revenue and expenses related to transactions between affiliates. As national trends move toward combined reporting, intercompany pricing decisions may seem less important because the revenue and expenses simply cancel each other out on a combined return. However, taxpayers should not be lax about how they document and structure intercompany transactions. This is particularly true for transactions involving aircraft, which are easily identifiable assets, and intercompany aircraft leasing arrangements can be particularly target rich environments for taxing bodies, if not priced at arm's length.
Texas private letter ruling concludes that termination and replacement of aircraft lease and use of aircraft by lessor do not prevent application of the resale exemption to lessor's original purchase of the aircraft. A taxpayer that purchased an aircraft in an exempt sale for resale and then leased the aircraft to an affiliate requested a ruling on whether its post-purchase actions would have any effect on the resale exemption claimed for the original purchase. After the taxpayer's initial purchase and lease, the affiliate-lessee hangared the aircraft in Texas, and for a period of at least one year, the affiliate-lessee had operational control over 100 percent of the aircraft's departures. More than a year after the initial purchase and lease, the taxpayer-owner and affiliate-lessee desired to cancel the original lease and enter into a new lease with lower monthly payments. Under the new lease, the taxpayer-owner would have the right to use the leased aircraft.
As an initial matter, the Comptroller agreed that the taxpayer's purchase of the aircraft and subsequent lease to its affiliate was a sale for resale. Next, the Comptroller concluded that the subsequent termination of the original lease and entering into the new lease would not invalidate the sale for resale exemption claimed with respect to the initial purchase of the aircraft, as long as the affiliate-lessee had operational control over more than 50 percent of the departures in the year following the initial purchase (here they had control over 100 percent in the first year). Finally, the Comptroller concluded that the taxpayer's use and operational control over the aircraft following the initial one-year lease term would not affect the applicability of the resale exemption because the resale requirements had been met by the lessee's operational control in the year following the initial purchase. Tex. Priv. Ltr. Rul. No. 201801014L (Jan. 12, 2018).
Reed Smith takeaway: Divergent use rule does not apply to aircraft. Under Texas law, the acquisition of property with an intent to resell the property will normally lose its character as an exempt sale for resale if the purchaser makes taxable use of the property prior to reselling it. However, under certain circumstances, the Texas Legislature has carved out aircraft purchases from the state's divergent use rule. The above ruling, along with Ruling No. 201804013L discussed below, confirm that an aircraft that meets the state's resale test (for example, the lessee exercises operational control over the aircraft for more than 50 percent of the aircraft's departures in the year following the initial purchase) will not be taxable, even if taxpayer-owner uses the leased aircraft.
Texas Comptroller releases revised aircraft sales and use tax publication. The Texas Comptroller's Office has published an updated version of its sales and use tax publication 94-168: Aircraft and Texas Sales and Use Tax. The publication discusses, among other topics, the sales and use tax treatment of (i) aircraft purchased and used outside Texas, (ii) leased aircraft, (iii) aircraft used for agricultural use, (iv) aircraft purchased in Texas for use outside the state (the "fly-away" exemption), (v) occasional sales of aircraft, and (vi) aircraft maintenance and repair services. Tex. Comptroller Pub. 94-168: Aircraft and Texas Sales and Use Tax (Feb. 2018).
Texas Comptroller upholds use tax assessment on aircraft owner unable to prove aircraft were marketed for sale. A recent Comptroller's decision involves a use tax assessment on three aircraft located in Texas. The taxpayer challenged the use tax assessment, arguing the aircraft were exempt from use tax as purchases for resale because the aircraft were marketed for sale by the taxpayer. The taxpayer also argued that use of the aircraft while being held for resale was largely limited to maintenance and test flights to keep the aircraft in good working order.
The Administrative Law Judge (ALJ), however, found little evidence to support the taxpayer's argument that the aircraft were being actively marketed for sale, other than the taxpayer's own testimony. According to the ALJ, the flight logs indicated that most of the flights by the aircraft were not test or maintenance flights. Accordingly, the ALJ upheld the assessment of use tax. Tex. Comptroller's Dec. No. 107,713 (Feb. 2, 2018).
Reed Smith takeaway: The resale exemption can apply for extended periods of time when the seller is actively looking for a buyer. The resale exemption applies to property acquired "for the purpose of selling, leasing, or renting it in the regular course of business...." If an aircraft is acquired to be resold or leased, but remains in inventory for an extended period until a buyer is found, the aircraft can still qualify as an exempt purchase for resale as long as the aircraft is not used in a taxable manner while being held for resale. In the above case, it appears the taxpayer's downfall was a lack of evidence to demonstrate that the aircraft were being actively marketed and held out for resale and not used for personal use.
Texas letter ruling concludes transfer of an aircraft in complete dissolution of company for no consideration was not subject to sales tax and did not invalidate initial sale for resale. A taxpayer who purchased an aircraft in 2015 for the purpose of leasing the aircraft to its sole limited partner and other lessees requested a letter ruling. During the first year after the purchase of the aircraft, the taxpayer did not use the aircraft and all use of the aircraft was conducted under operational control of the lessees. In June 2017, the taxpayer's sole limited partner was acquired by a new company (Parent) such that Parent indirectly became the beneficial owner of 100 percent of the equity interests in the taxpayer. Federal Aviation Administration rules prohibited the taxpayer from being the registered owner of the aircraft at the same time that it was indirectly owned by Parent. Therefore, the taxpayer transferred all of its membership interests directly to Parent and then liquidated. As part of the liquidation, the aircraft was distributed to Parent for no consideration and free and clear of any lien or encumbrance. The taxpayer asked for a ruling on whether the distribution of the aircraft invalidated the sale for resale exemption claimed on the initial purchase and whether the distribution was a separate sale transaction subject to sales tax.
Similar to Priv. Ltr. Ruling No. 201801014L, discussed above, the Comptroller concluded that the sale for resale provisions were met based on the lessees' operational control over the aircraft in the first year. As a consequence, the subsequent use (the liquidation) by the taxpayer had no effect on the resale exemption claimed with respect to the initial purchase. In addition, the Comptroller held that the transfer of the aircraft to Parent in the liquidation of the taxpayer was not subject to sales and use tax because it was a transfer of property without consideration and therefore was not a taxable "sale." Tex. Priv. Ltr. Rul. No. 201804013L (Apr. 20, 2018).
West Virginia enacts new sales and use tax exemption for services, parts, and equipment to repair, remodel, and perform maintenance on aircraft operated under a fractional ownership program. Unlike many states, West Virginia generally imposes sales and use tax on all sales of services. The new exemption, which applies to sales of services made on or after September 1, 2018, creates and exemption for services performed on fractional-owned aircraft. The exemption applies to:
- Sales of services to repair, remodel, or perform maintenance on aircraft or an engine or other component part of an aircraft.
- Sales of tangible personal property that is permanently affixed or attached as a component part of an aircraft as part of performing the services indicated above.
- Sales of machinery, tools, or equipment directly used or consumed exclusively in performing the services indicated above.
To qualify for the exemption, the services must be performed on an aircraft that is operated under a fractional ownership program. The new law defines "fractional ownership program" as any system of aircraft ownership and exchange that consists of all of the following:
- The provision for fractional ownership program management services by a single fractional ownership program manager on behalf of the fractional owners.
- Two or more airworthy aircraft.
- One or more fractional owners per program aircraft, with at least one program aircraft having more than one owner.
- Possession of at least a minimum fractional ownership interest in one or more program aircraft by each fractional owner.
- A dry-lease aircraft exchange arrangement among all of the fractional owners.
- Multi-year program agreements covering the fractional ownership, fractional ownership program management services, and dry-lease aircraft exchange aspects of the program.
2018 W. Va. Acts Ch. 235.
This article is presented for informational purposes only and is not intended to constitute legal advice.