Texas Comptroller Proposes To Codify Economic Substance Doctrine for Aircraft Purchases and Extend the Doctrine to all Sales for Resale

August 7, 2014
In response to numerous tax planning devices for the purchase of aircraft, the Texas  Comptroller has been using letter rulings and administrative adjudications to require economic substance.  The Comptroller originally limited the policy to aircraft.  Now, the Comptroller is proposing to codify its economic substance policy for aircraft and expand the application to all resale transactions.  Under these draft rules, any entity that sells or purchases items for resale will be subject to a higher level of agency scrutiny.

Draft Rule 3.285 – Sales for Resale

The Comptroller claims that the draft rule mostly memorializes existing policy, but in some instances, the Comptroller is simply announcing new rules of the game. And in some instances in which the Comptroller is memorializing existing policies, the policies are of dubious merit and will be harder to change if they are codified in a rule.  Here are some items that are of particular concern:

  • Narrow definitions of “normal” and “regular” course of business.
The Texas Tax Code defines “sale for resale” as the sale of TPP or a taxable service to a purchaser for the purpose of reselling it in the “normal” course of business.  The Tax Code also provides that a purchaser can issue a resale certificate for TPP or taxable services to be sold in the “regular” course of business.

The draft preamble states that “normal” and “regular” have the same meaning, and the draft rule defines “regular” course of business to require a sale “at fair market value in an arm’s length transaction that is part of the day-to-day operation of a business.”

This definition amounts to an economic substance test and more.  Keep in mind that Comptroller Rule 1.40 provides that a taxpayer has the burden of proving exemptions by clear and convincing evidence.  If this draft rule is adopted, arm’s length and fair market value will be elements of proof in every resale case.  Furthermore, even if the transaction is arm’s length and fair market value, the Comptroller could still reject the transaction if it is not day-to-day.  What if an arms-length transaction occurs once every month?

  • New requirement of “engaged in the business of selling, leasing, or renting tangible personal property.”
The Texas Tax Code provides that a seller may accept a resale certificate from a purchaser “who is in the business of selling, leasing, or renting taxable items.”

The draft preamble candidly admits that the phrase is not repeated in the statutory definition of “sale for resale,” but the draft rule adds the phrase to the definition in the draft rule.

It remains to be seen whether the addition of this phrase to the definition of “sale for reseale” in the draft rule means that the Comptroller intends to reassert arguments that were rejected in litigation such as Strayhorn v. Raytheon E-Systems, Inc.  In Raytheon, the Comptroller lost its argument that the resale exemption did not apply because the company was in the business of "selling machines of war" and not reselling pencils and employee awards to the government under title passage clauses.

  • Narrow definition of “integral part” of a taxable service.
The Texas Tax Code provides that the sale for resale exemption applies to the purchase of tangible personal property or a taxable service to be used as an “integral part” of other tangible personal property or taxable service.

The draft rule provides that to be an “integral part,” the item must be “necessary, as opposed to merely desirable, for the completion of the second item, and if the second item could not be provided as a whole without the taxable item.”

This draft definition could mean that only the bare bones of a taxable item qualify for the sale for resale exemption.  Handle bar grips, headlights, reflectors, and fenders may only be desirable and not necessary parts of a bicycle.

  • Narrow definition of “tax free inventory.”
The Texas Tax Code does not use the term “tax free inventory,” but the Comptroller rules have used the term for many years without defining it.  For example, the Comptroller rules provide that a contractor may issue a properly completed resale certificate instead of paying tax on items that are purchased for a tax-free inventory when the contractor does not know at the time of purchase whether the item will be resold or used in the performance of a lump-sum contract.  The contractor must later remit tax if the items are not resold.

The draft rules propose a new requirement that a tax free inventory is only available if “the purchaser intends to sell more than 50% of the tangible personal property acquired.”   The draft rule would mean, for example, that a contractor might have to pay tax on 100% of items purchased and then request a refund on any items resold under in a separated contract.

Draft Rule 3.280 - Aircraft

The Comptroller proposes a new Rule 3.280 to replace portions of the current Rule 3.297. The draft rule contains many significant changes intended to foreclose common tax planning devices used by aircraft purchasers.

  • Narrow definitions of “normal” and “regular” course of business.
Draft Rule 3.280 adopts the definition for “normal” and “regular” course of business stated in draft Rule 3.285. See the discussion above.  The Comptroller intends to use the requirements of “fair market value,” “arms-length transaction,” and “day-to-day operations” to attack resale transactions without economic substance.

  • Strict requirements to qualify for resale exemption through aircraft lease.
Draft Rule 3.280 codifies many specific requirements for aircraft purchasers that the Comptroller has developed through prior rulings.  Owners must prove they purchased aircraft for the “sole purpose of leasing or renting to another person.”  The lease or rental must be without a pilot or crew.  The owner must make no personal or business use of the aircraft prior to its transfer by lease, may not reserve the right to use the aircraft for his own purposes at any time, and must hold a valid sales and use tax permit.  If the owner uses the aircraft after leasing to a third party, the owner must pay fair market value rental rates in an arm’s length transaction.

In determining whether a lease occurs in the normal course of business where the lease is between affiliated entities, the owner “must show that a similar transaction would take place between unrelated entities.” The Comptroller will consider whether the aircraft was marketed for lease to unrelated parties, whether lease payments are sufficient to service any debt and defray all overhead and operating expenses, whether the aircraft has appreciated in value, and the terms of any insurance policy.  Furthermore, the proposed Rule 3.280 states “an aircraft is not leased in the normal course of business if the effective monthly lease rate . . . is less than 1.0% of the purchase price for the aircraft.”

  • Other language directed at business purpose.
The draft definition of “regular” course of business states that the term does not include the transfer of title or possession by means of a contribution to an affiliated entity.  This provision appears to take a swipe at tax planning devices in which a taxpayer would purchase an aircraft out of state and then contribute it to a newly formed LLC prior to the use of the aircraft in Texas. This strategy relied on the idea that Texas sales tax did not apply to the original purchase because it occurred out of state, and Texas use tax did not apply to the subsequent use in Texas by the LLC because the LLC did not purchase the aircraft and so there was no purchase price subject to use tax.

Note that this tax planning strategy does not depend on the sale for resale exemption.  So technically, this planning technique is not disqualified because it is excluded from the definition of “regular” course of business in the resale rule.   Nevertheless, taxpayers should expect the Comptroller to continue its “substance over form doctrine” that is referenced in the draft preamble and expressed through other policy statements, audit assessments, and administrative rulings.

  • New narrow definition of the term “licensed and certificated carrier.”
The current definition of a “licensed and certificated carrier” broadly includes “a person authorized by the appropriate US agency” or state agency “to operate an aircraft.” The proposed Rule 3.280 limits the term to persons authorized “by the FAA” under “Parts 121, 125, or 135.” The new definition eliminates the possibility of claiming certain sales tax exemption for licensed and certificated carriers when the Taxpayer is operating under Part 91.

  • New criteria for determining in state use of aircraft for use tax purposes.
The proposed Rule 3.280 revises important language related to the determination of an aircraft’s use inside the state. Current Rule 3.297 provides that “an aircraft is not subject to use tax if it is hangared outside this state and is used more than 50% outside this state.” The Comptroller proposes to restate this as “an aircraft that is not hangared in this state is subject to use tax in Texas when it is used more than 50% of the time inside this state.”

In determining the percentage of time an aircraft is used in state, the Comptroller proposes to consider “all time spent on the ground in this state and all flight time in this state.” This is a departure from the current Rule 3.297 which states only that “the Comptroller will consider all flight time in this state.” In-state usage may now exceed 50% for certain owners whose aircraft previously did not trigger application of the use tax.

  • Broad definition of “hangared in Texas.”
Under the draft rule, an aircraft is subject to use tax in Texas if it “stored in this state for longer than a temporary period.”  Additionally, the proposed Rule 3.280 adds two new factors to the determination of whether an aircraft is hangared in Texas, including whether the aircraft owner is a resident of Texas, and whether the aircraft owner is engaged in business in Texas.


Although we commend the Comptroller’s effort to more clearly state its interpretations of the sales tax statutes, in many instances, the Comptroller proposes to codify policies that potentially disqualify transactions that fall within the intent of the sale for resale exemption.  At this point, the proposed rules are in draft form -- the Comptroller has circulated the rules for preliminary comment before publishing the proposed rules in the Texas Register for formal comment.  So there is still time for industry input.  If you would like a copy of any of the draft proposed rules, let us know.  The firm is working on comments and we would like your input.

The information in this article and any attached or referenced pages have been written or gathered for informational purposes only, are not legal advice, and may now be outdated. Persons receiving information from this article should not act upon the information without seeking professional legal counsel.