Taxpayer is an out-of-state business trust which
"holds" automobile leases generated by its parent banking corporation
and entered into with leasing customers in Indiana and other states. Taxpayer
receives auto lease revenue in the form of down payments, lease stream
payments, "gap" insurance, late fees, termination fees, and
end-of-term fees such as excess mileage fees and wear-and-tear fees. Taxpayer
is registered in Indiana as a "retail merchant" and collects sales
tax from its leasing customers.
The Indiana Department of Revenue ("Department")
conducted an audit review of Taxpayer's tax returns and business records and
concluded that Taxpayer incorrectly failed to collect sales tax on certain
payments received from Third-Party car dealers and attributable to lease
agreements it had entered into with its Indiana customers. As a result, the
Department assessed Taxpayer additional gross retail (sales) tax.
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The issue is whether Taxpayer was required to collect sales
tax on the money it received from Third-Party car dealers when one of
Taxpayer's Lessee/customers decided to terminate a automobile lease agreement,
arranged for a Third-Party automobile dealer to acquire the leased vehicle, and
where the Third-Party automobile dealer paid the remaining lease obligations
due Taxpayer on the leased vehicle.
It is the audit's position that "[l]ease payments
and/or lease termination fees that are satisfied by the dealer payments are
taxable" because the payments relieved the lessee of its taxable
obligations under the parties' agreement, and because "[a]ll consideration
received and provided for in the lease contract for the rental of property is
subject to tax."
It is the Taxpayer's position that the agreement which
allows the Third-Party car dealer to acquire the vehicle is strictly between
itself and the Third-Party car dealer because the transaction "does not
involve the exercise of the [Lessee's] early termination option," the
Third-Party car dealer's payments are not made on behalf of the Lessee, and
that the entire Third-Party car dealer's payment constitutes
"consideration paid by the [Third-Party] dealer for the purchase of the
vehicle from [Taxpayer]."
It is the audit's position that the Third-Party car dealer
pays off the Lessee's obligation under the lease agreement, that there is
nothing in the agreement which permits the Third-Party car dealer and Taxpayer
to deal directly with each other ignoring the rights and obligations of the
Lessee, and that the payment made by Third-Party car dealer is subject to tax
because Third-Party car dealer "stands in the shoes" of the Lessee
when it makes the payment. In other words – adopting Taxpayer's own analogy –
Third-Party car dealer acts as the Lessee's "rich uncle."
In reviewing the audit's position and the Taxpayer's
argument, it is appropriate to understand fully the nature and extent of the
obligations, rights, and responsibilities of both Taxpayer and the Lessees
spelled out under their written agreement; it is those "obligations,
rights, and responsibilities" which determine the tax consequences of the
transactions here at issue.
As stated above, the parties' agreement contemplates
circumstances in which the Lessee may decide to accelerate the remaining term
of the lease, shed responsibility for the remaining payments due under the
lease, and surrender possession of the vehicle. In those instances, the
contract requires that the Lessee make a series of payments. Lessee is required
to pay (1) "unpaid monthly payments." These charges are the value of
the remaining lease payments. For example, if – after 36 months of a 48 month
lease – the Lessee wants to rid himself of the responsibilities under the
remaining lease term, the Lessee is required to pay the "unpaid monthly
charges" equal – in this example – to the value of the 12 months remaining
on the lease. In addition, the Lessee will be required to pay a contractually
defined (2) "termination charge" which is composed of a flat fee and
an amount equal to 50 percent and up to 250 percent of a single monthly lease
payment. The "termination charge" acts as a penalty imposed in
exchange for allowing the Lessee to avoid the remainder of the lease. The
Lessee would also be required to pay the (3) "residual value" of the
vehicle. The residual value is the remaining value of the vehicle at the
conclusion of the contemplated 48 month lease. In addition, the Lessee may be
required to pay "excess damages fees" which is the amount due if the
Lessee exceeded the mileage limits set out under the lease agreement or if the
vehicle was somehow damaged during the course of the lease. After paying the
"unpaid monthly payments," the termination charge, and the residual
value, the Lessee is free to "walk away" from his or her obligations
under the lease but – in this admittedly unlikely scenario – does not acquire
ownership of the vehicle.
The agreement also contemplates circumstances in which a
Lessee may decide to accelerate the remaining term of the lease and acquire
full ownership of the vehicle. In those instances, the contract requires that
the Lessee pay the (1) "unpaid monthly payments," the (2)
"termination charges" along with the (3) "residual value"
of the vehicle. As noted above, the "residual value" is the value the
car would have at the end of the original lease. In effect, the Lessee
accomplishes two things; the Lessee concludes the lease and acquires full
ownership of the vehicle. Under this scenario, the lessee pays tax on the
unpaid monthly payments and the residual value. The Lessee does so because the
lease payments are subject to sales tax and the payment of the "residual
value" is treated as a purchase of the vehicle. See IC § 6-2.5-2-1; See
also IC § 6-2.5-4-10 ("[a] person is a retail merchant making a retail
transaction when the person sells any tangible personal property which has been
rented or leased in the regular course of the person's rental or leasing
business.")
The parties' agreement anticipates circumstances under which
the Taxpayer – and not the Lessee – may terminate the lease agreement under
certain, contractually specified circumstances under which the Lessee has gone
into default. Those circumstances may include: (1) the Lessee fails to make any
monthly payment by the due date; (2) the Lessee dies, is disabled, or becomes
incompetent; (3) the Lessee fails to acquire and/or maintain insurance on the
leased vehicle; (4) the Lessee provides incomplete or inaccurate information on
a credit application, financial statement, or on the lease application; (5) if
an outside party attempts to seize, levy, impound, confiscate the vehicle or if
a forfeiture is brought against the Lessee or the vehicle; (6) the Lessee
becomes insolvent, enters into bankruptcy, enters into receivership, or makes
any assignment for the benefit of creditors; (7) Taxpayer, "in its
reasonable commercial discretion," decides that it is
"insecure;" (8) Lessee defaults or fails to perform any promise or
agreement with either Taxpayer or any affiliate of Taxpayer; (9) the vehicle is
lost, destroyed, or stolen.
If the Lessee defaults on the lease agreement, Taxpayer is
entitled to collect: (1) a fixed amount based on the percentage of the
completed monthly lease payments; (2) the residual value of the vehicle as
defined under the agreement; (3) the total of all unpaid monthly lease
payments; (4) all collection costs, collection agency costs, and attorney fees;
(5) taxes, fees, fines, citations, and any other amounts due under the terms;
(6) minus any "unearned rent charges" as computed under a
"constant yield" method, deprecation amounts accrued during the
previous months, and the first base monthly payments and (7) minus any amount
received by Taxpayer from insurance payments, salvage sale, sale or re-lease of
the vehicle.
None of the aforementioned contract provisions are
specifically at issue here. The issue centers on those circumstances in which
the Lessee decides to acquire an entirely different vehicle from a Third-Party
car dealer before the lease on the original vehicle has fully run its course.
In those instances, the Third-Party car dealer intervenes in the lease, deals
directly with Taxpayer and – on behalf of the Lessee – agrees to pay the (1)
"unpaid monthly payments," the (2) "termination charges"
along with the (3) "residual value." It is important to note that
this transaction is initiated by the Lessee because it is Lessee's decision
which triggers the subsequent series of events. At the conclusion of the
transaction, the Lessee has shed his or her responsibility for the original
lease, Third-Party car dealer has acquired ownership of the original leased
vehicle, and Taxpayer has been "made whole" pursuant to the terms of
the original lease agreement. Taxpayer maintains that none of the charges
listed above are subject to sales or use tax because the Taxpayer treats the
events as if the Lessee went into default while the Department maintains that
the "unpaid monthly payments" and the "amount received by [Taxpayer]
over and above the residual value" were subject to tax because that amount
was always the Lessee's liability whether the lease went full term or was
terminated early and because Third-Party car dealer assumed the contractual
responsibilities owed by the Lessee. In effect, the Department treated the
transaction between the Third-Party car dealer and Taxpayer the same as if the
transaction were between the original Lessee and Taxpayer.
There are two parties to each of the lease agreements at
issue. Both parties have certain specifically enumerated rights and
obligations. Both parties have the right to terminate the agreement, both
parties have the right to acquire ownership of the vehicles, and both parties
can become obligated to the other for certain defined costs and
responsibilities under the specific terms of the agreement. However, there is
nothing in the contract which expressly anticipates circumstances in which a
Third-Party car dealer intervenes to purchase the leased vehicle directly from Taxpayer;
conversely there is nothing in the agreement which expressly anticipates
circumstances in which Taxpayer has the authority to sell the leased vehicle to
Third-Party car dealer unless the Lessee has gone into default. Under the terms
of the parties' agreement, only the Lessee has the enumerated right to purchase
the vehicle and – under those enumerated rights – would become obligated to pay
sales tax. Although the Taxpayer has the right under certain circumstances to
declare that the Lessee is in default and regain possession of the vehicle –
and thereafter sell or dispose of the vehicle in any manner it sees fit – the
Lessee is nonetheless obligated to pay the sales tax on all the amounts
contractually owed by the Lessee as if the lease ran full term.
What is evident is that the Lessee is not purchasing the
vehicle, and the Taxpayer is not declaring that the Lessee is in default. That
being said, the Lease agreement is entirely silent on the subject transactions
here in dispute. Under circumstances in which a contract is silent, it is
appropriate to review the supplementary documentation exchanged between
Third-Party car dealer, Taxpayer, and the affected Lessee along with the
circumstances surrounding the transaction. Meridian Mut. Ins. Co. v. Richie,
540 N.E.2d 27, 28 (Ind. 1989) ("Only when ambiguities cannot be resolved
within the four corners of the contract is a fact finder needed to determine
those extrinsic facts upon which interpretation of the contract may
rest.")
The Department's audit reviewed the payments and
documentation sent and received by Taxpayer (or its designated payee) from the
Third-Party car dealers. The payments received by Taxpayer from the Third-Party
car dealer referenced the "payoff" of a specified lease account which
was identified by lease number and Lessee name. Taxpayer's internal lease
accounting system recorded the transactions as a "PAID OFF LEASE."
Entries in Taxpayer's accounting system included a payoff receipt amount
equaling the total payment and an allocation of the payment to various charges
such as "term charges," late charges, and satisfaction of various
contractual obligations. (It should be noted that during the course of the
administrative hearing process, Taxpayer was asked to provide examples of the
documentation defining the obligations between typical lessee/customer and
typical Third-Party car dealer but Taxpayer was unable to provide that
documentation.)
The audit report indicated that Taxpayer believed it had the
right to sell the vehicle to Third-Party car dealers under the
"default" provisions of the lease agreement. Under the terms of the
agreement, if the Lessee defaulted on the agreement, the Lessee lost the right
to use the vehicle and the Lessee was obligated to return the vehicle to Taxpayer.
If the Lessee did not willingly surrender the vehicle, Taxpayer had the right
to repossess the vehicle and then to sell or lease that vehicle to another
person. Presumably such a sale would be exempt under IC § 6-2.5-5-8(b) as a
"sale for resale" because the sale is simply a straight-forward
transaction between Taxpayer and a car dealer. However, the facts surrounding
the transactions at issue do not indicate that the Lessees failed to live up to
the terms of the agreement, that any of the contractual pre-conditions to
finding the Lessee in default existed, that Taxpayer ever took any actions
which would establish that the Lessees were in either actual or technical
default, or that there is anything in the lease agreement allowing a sale to a
Third-Party car dealer unless the Lessee was in default. "Default" is
defined as, "The omission or failure to perform a legal or contractual
duty." Black's Law Dictionary 428 (7th ed. 1999). In the transactions at issue, there is no
indication that the Lessees failed to perform their contractual duties under
the lease agreement.
In actual practice, it was the Lessees who initiated these
transactions when it contacted the Third-Party car dealers seeking to terminate
the pending lease agreement, acquire a substitute vehicle, and rid themselves
of the original leased vehicle. The Third-Party dealer did not contact Taxpayer
to determine what the Lessee's vehicle was worth but to determine the amount
necessary to free the Lessee from the contract and allow the Lessee to trade in
the leased vehicle. The Department is unable to conclude that in the
circumstances here at issue – where Third-Party car dealer acquired formerly
leased vehicles – the Lessees ever either omitted or failed to perform a duty
under the parties' agreement.
The Department is unable to agree that the example cited in
Sales Tax Information Bulletin 28L (July 2007) is dispositive of the issue
because the issue is not who does or who does not own the vehicle at the time
of the transaction but the nature of the payment made by Third-Party car
dealer. Is the payment made satisfy the obligations owed by Lessee or is the
payment made to simply purchase the car from Taxpayer? Under the circumstances
set out in Taxpayer's own contract, the Lessee is obligated to pay the taxable
amounts defined in the parties' agreement and those amounts are owed by Lessee
to Taxpayer. The Third-Party car dealer is advancing a payment on behalf of the
Lessee to relieve the Lessee of his or her obligation.
Bearing in mind that it was the Lessee that initiated the
transactions here at issue and not Taxpayer, the circumstances more closely
resemble the provisions under the agreement in which the Lessee decided to
accelerate the agreement, exercise the Lessee's option to purchase the vehicle,
or exercise the Lessee's option to "wind-down" the lease and rid
himself or herself of the vehicle. Whether the Lessee decides to terminate the
lease or purchase the vehicle, the Lessee is obligated to pay the remaining
lease payments and the taxes associated with those lease payments.
The Department is unable to agree with Taxpayer's assertion
that the purchase of the vehicle by a Third-Party car dealer is an
"extra-contractual," independent transaction between the Third-Party
car dealer and Taxpayer because: (1) there is no provision in the lease
agreement which permits or anticipates such a transaction unless the Lessees
were in default, and the Lessees here had clearly not defaulted on the
agreement; (2) the payments received by Taxpayer from the Third-Party car
dealers were designated as "payoffs" of the lease agreement by both
Third-Party car dealer and Taxpayer; (3) Taxpayer recorded the payoff amounts,
termination charges, late charges, rent payments, and as a payoff of the lease
agreement; (4) Taxpayer's payoff form sent to the Third-Party car dealer is
designated as a "Lease Payoff" and refers to the "payoff
amount."
Taxpayer objects arguing that the audit is attempting to tax
future lease payments and that – because the lease was terminated – there could
be no future lease payments. However, Taxpayer's assertion begs the questions.
The Department agrees with Taxpayer that the leases were indeed terminated, but
the issue is whether the "payoff" amounts were subject to sales tax.
The audit report does not indicate that the Department is attempting to tax
"future lease payments" pursuant to an agreement which has previously
been terminated. The audit report is consistent when it defines the issue as
whether or not the contractually defined payoff amount – as agreed to at the
outset of the parties' relationship – is subject to sales tax. The agreement
clearly states that unpaid monthly payments and termination charges are due
upon the Lessee's decision to terminate the agreement and either acquire the
vehicle or simply extricate himself or herself from the obligations under the
lease. Those unpaid monthly payments are derived from the capitalized cost
calculation used to determinate the original rental obligation while the
termination charges are contingent on the number of payments made through to
the date the agreement is terminated. Payments of both these amounts are
taxable as provisions of the rental contract for the use of tangible personal
property under IC § 6-2.5-2-1.
The Department recognizes that the audit report's conclusion
and the conclusion here are likely both unsatisfactory and unanticipated. But
the decision is driven by the terms of an agreement which Taxpayer drafted and
controlled, and the rule is long held that "ambiguities in a contract are
to be strictly construed against the party who employed the language and who
prepared the contract." Ruff v. Charter Behavioral Health System of
Northwest Indiana, Inc., 699 N.E.2d 1171, 1176 (Ind. Ct. App. 1998).
Nonetheless, the Department is unable to agree that Taxpayer entered into
exempt, independent extra-contractual agreements with Third-Party car dealers
allowing Taxpayer's Lessee customers to avoid fulfilling the terms of the
parties' agreement because the Lessees were in constructive "default"
of the agreement. The contract between Taxpayer and its customers contains no
provision anticipating such an agreement. The only stipulated obligation is
between Taxpayer and Lessee and that obligation remains unless the terms of the
agreement are fully satisfied. The satisfaction of that obligation by either
Third-Party car dealer or Taxpayer's hypothetical "rich uncle"
results in the payoff of the amount due Taxpayer by the Lessee and the tax
consequences in either case are identical. As set out in 45 IAC 2.2-4-27(d),
"The rental or leasing of tangible personal property, by whatever means
affected and irrespective of the terms employed by the parties to describe such
transaction is taxable," Either paid by "rich uncle" or
Third-Party car dealer, the payments are subject to sales tax.
