Washington State Tax

Tax Avoidance Rules: Aircraft Leasing Structures & Washington Rules 280 & 28003

In an effort to resolve a deep budget deficit during the recession, the 2010 Washington state legislature passed a broad tax bill commonly referred to as the “tax avoidance law.”¹ The tax avoidance law served to identify three specific types of arrangements or transactions that the Department of Revenue identified as "being contrary to the intent of the taxation statutes" and thereby potentially "unfair" in the avoidance of Washington tax. Where such an arrangement or transaction was both contrary to the intent of the taxing statutes AND unfair, the Department was provided with the statutory authority to disregard the taxpayer's arrangement, apply the tax as intended by the statutory scheme, and impose additional penalties for engaging or participating in the particular arrangement. In short, with the budget deficit in mind, the tax avoidance legislation was designed to eliminate a number of historical tax-planning strategies that the Department classified as loopholes.

One of the three types of tax strategies specifically identified as "potential tax avoidance" in the tax avoidance law was any transaction or arrangement through which a taxpayer "attempts to avoid Washington sales or use tax by vesting legal title or ownership of the property in another entity over which the taxpayer effectively retains control." These statutorily identified sales and use tax avoidance arrangements were not drafted with aircraft leasing or FAA regulatory compliance specifically in mind. However, given the law’s broad scope, the common ownership/operating structure where an aircraft is owned in a limited liability company or other special-purpose entity and leased to a related aircraft operator is "potential tax avoidance."

After working with stakeholders such as the National Business Aviation Association ("NBAA"), the Pacific Northwest Business Aviation Association ("PNBAA") and CenterPoint Aviation Law PLLC, over the course of the last five years, the Department of Revenue finally issued a set of substantive “tax avoidance rules” which provides an administrative framework that both the Department and taxpayers can use to evaluate the impact of the law and its application to a specific transaction or arrangement. The relevant provisions for aircraft ownership and leasing structures are contained in one of two new rules:

1) Washington Administrative Code ("WAC") 458-20-280 ("Rule 280") provides the general framework for identifying potential tax avoidance, the considerations by which the Department evaluates whether a potential tax avoidance arrangement is "unfair," and the Department’s proscribed remediation (i.e., penalties) for such a determination; and
2) WAC 458-20-28003 ("Rule 28003"), the auxiliary rule which applies specifically to "sales and use tax avoidance" arrangements.

The tax avoidance rules become effective May 3, 2015.

The new rules serve first to reiterate the basic statutory provisions while expanding on the required elements of a potential tax avoidance arrangement. Under the new rules, an aircraft transaction or arrangement is a potential sales or use tax avoidance transaction where the following elements are satisfied:

1) The taxpayer engages in a transaction in which the taxpayer, or a person(s) acting in concert with the taxpayer, vests title or any other ownership interest of the aircraft in an entity;
2) The taxpayer exercises control over the entity in such a manner as to effectively control the underlying aircraft; and
3) The aircraft is used by the taxpayer in Washington without payment of Washington sales or use tax on its fair market value at the time of first use in Washington.²

A taxpayer is deemed to exercise control over the entity when the taxpayer possesses, either directly or indirectly, more than 50% of the voting power of the entity, more than 50% of the power to direct the policies and management of the entity, or otherwise effectively exercises control over the entity by retaining the power to direct the use or disposition of the aircraft.³ Control over the aircraft is presumed when the taxpayer has control over the entity that owns the aircraft and a taxpayer may also have effective control based upon additional facts and circumstances at the discretion of the Department.4

A taxpayer may also have effective control over the aircraft based upon all the facts and circumstances, however control over the aircraft is presumed when the taxpayer has control over the entity which owns the aircraft.

Many aircraft that are held in a traditional leasing company structure, (i.e., aircraft ownership by a limited liability company or other special-purpose entity that dry-leases to a related party operator) meet the definition of “potential tax avoidance” under the statute and the required elements for tax avoidance under the new rule. At primary issue, then, is whether that same structure is unfair as described in the statute and interpreted by the new rule.

Is an aircraft leasing structure unfair? According to the general rule, an arrangement or transaction is unfair if it meets the required elements for potential tax avoidance AND, based upon “all the facts and circumstances” is determined to be “unfair tax avoidance.” 5 The rule goes on to state that a particular aircraft leasing structure is not “unfair tax avoidance” unless it is unfair in light of the following list of factors (which do not constitute a list of discrete elements that must be met to be deemed unfair):

1) Whether there has been a meaningful change in the economic positions of the participants apart from the tax effects (when the arrangement is considered in its entirety);
2) Whether substantial nontax reasons exist for entering into the arrangement/transaction;
3) Whether the arrangement/transaction is a reasonable means for accomplishing those substantial nontax reasons; and/or
4) Any “other relevant factors”.6

To the extent relevant, the Department may consider any or all of the factors listed above as part of its evaluation to determine whether a particular aircraft leasing structure should be respected. Perhaps more importantly, however, the rule makes clear that the Department may consider the taxpayer’s intent in establishing the aircraft leasing structure, but the Department is not required to prove that the taxpayer’s actual subjective intent was to avoid taxes.

In considering whether there is a meaningful change in the economic positions of the parties, the Department will look at all facts and circumstances relevant to both the lessor and lessee’s economic positions, including whether the leasing company structure results in substantial and bona fide increases in profits or reductions in costs or expenses.7 In a related-party leasing company structure, arguments certainly exist for meaningful changes (e.g., a significant reduction in federal income tax costs), but the rule makes clear that the mere shifting of profit, income, or values between lessor and lessee will not result in meaningful change as contemplated by this particular fairness consideration.

In addition, in evaluating unfairness, the Department can consider whether there are substantial non-tax reasons for entering into the leasing company structure. Under the new rule, a “substantial nontax reason” is a “bona fide nontax reason that is a substantial motivating factor” in the taxpayer’s decision to enter into the aircraft leasing structure.8 The rule notes that bona fide nontax reasons may even include obtaining tax benefits from another government assuming such benefits are not the same tax benefits as achieved in Washington under the leasing company structure (e.g., sales/use tax benefits).

With this backdrop in mind, bona fide nontax reasons for entering into an aircraft leasing arrangement would certainly include compliance with the Federal Aviation Regulations (“FARs”) – a true motivating factor for the leasing structure – as well as the desire to receive reimbursement for use of the aircraft, mitigation of civil liabilities and risk management, asset segregation, perfecting federal income tax benefits or burdens, and addressing privacy/security concerns just to name a few. Under a limited safe harbor, the Department will accept a stated non-tax reason as bona fide if both lessor and lessee are substantive operating businesses, adequately capitalized, and carrying on substantial business activities.9

Although the language noted above provides clarity regarding the general administration and implementation of the tax avoidance law, the new rules, and specifically Rule 28003 related to sales and use tax avoidance arrangements, provide a very important safe harbor for certain aircraft leasing companies. The safe harbor states:

The Department will not disregard title or ownership by a controlled entity when substantially all use of the property is under a lease, at a reasonable rental value or for a time-sharing fee, by a substantive operating business for bona fide business purposes, or by a person who is not related to the taxpayer, or a combination of these, PROVIDED that retail sales tax is collected and remitted on the lease payments.10

Here, the final rule makes clear that certain leasing arrangements for a bona fide business purpose are not tax avoidance strategies if the various safe harbor provisions are satisfied. The first notable consideration here is whether “substantially all use” of the aircraft is under a lease. Substantially all use for purposes of the rule means at least 95% of the use as determined by actual use and irrespective of location.11 What is not clear under the rule is how the 95% use threshold will be substantiated by the taxpayer or evaluated by the Department. The 95% test may be illusory in so far as all flights – 100% of flights – in a typical aircraft leasing company structure are subject to a lease. However, the additional safe harbor qualifications must also satisfy the 95% test.

The second requirement is that the lease must have a “reasonable rental value.”12 Reasonable rental value means the “reasonable rental value for the use of the property as determined as nearly as possible according to the value of such use at the places of use of similar property of a like quality or character.” While reasonable minds may differ as to whether a rate is reasonable under the rule, a reasonable rental rate is likely any rate that takes into account the same factors that any third-party leasing company might establish in determining the rate: cost of capital, market depreciation, lessor’s other miscellaneous costs, desired profit margin, etc. The Department is not in the business of determining fair market value, but it certainly can recognize a value that is not “fair.”

For the safe harbor to apply, the lessee must also be a “substantive operating business.” As described by the rule, a substantive operating business is a business that is adequately capitalized and carries on substantial business activities with its own property or employees.13 The substantive operating business concept is important in the context of the rule because it illustrates the Department’s biggest concern – subverting the sales/use tax laws by allowing for an exemption merely by vesting title in a formal entity. In an aircraft leasing company structure, if the lessee is an actual operating company, the substantive operating business requirement would generally be met. In this way, the rule benefits legitimate business aviation use.

Finally, to satisfy the safe harbor, at least 95% of the use must be for “bona fide business purposes.” The rule states in pertinent part as follows:

Use of tangible property serves a bona fide business purpose only when the use, in nature and quantity is ordinary and necessary for the business of the user. Use for entertainment purposes must be directly related or associated with substantial business activities of the user. A bona fide business purpose may include providing employee or director benefits when the business pays the lease, the employee or director is required to report the value of the benefit as compensation for state or federal tax purposes and the benefit is ordinary and reasonable in nature or quantity for the business.14

Interestingly, while 95% of the use must be for “bona fide business purposes”, the safe harbor treats as “bona fide business purpose” any use of the aircraft that is provided to employees or directors as part of a taxable fringe benefit. In substance, this means that any use by employees, officers or directors for their personal purposes (i.e., purposes unrelated to the lessee’s business) may be a “bona fide business purpose” of the lessee assuming that the value of the flights is imputed as income to the user. Recall that the flights may be valued based upon either the fair market value of the transportation (e.g., fair market charter rates), or as is more common, the Standard Industry Fair Level (e.g., the “SIFL” convention). Where such fringe benefit is “ordinary and reasonable” for the business, the personal use flights provided as a fringe benefit are treated as a “bona fide business purpose” for purposes of satisfying the 95% threshold.

Where all four requirements are met — 1) substantially all use of the property is under a lease; 2) at a fair market lease rate; 3) by a substantive operating company; and 4) for bona fide business purposes – the Department will respect the taxpayer’s leasing arrangement. Note that in addition to satisfying the four basic requirements, however, implicit in receiving benefits under the safe harbor is that the taxpayer is also collecting and remitting the applicable taxes on the fair market lease payments.

The rule is primarily focused on related party leasing structures. To the extent that the leasing arrangement in question involves a true third-party lessee, the safe harbor requires, in pertinent part, that substantially all use of the property be under a reasonable rental value lease by a substantive operating business for bona fide business purposes, OR by a person not related to the taxpayer, OR any combination of the two. Therefore, so long as 95% of the use is by a substantive operating business for bona fide business purposes, by a third-party or some combination of bona fide business and third-parties, the safe harbor will be satisfied.

In addition to the leasing company safe harbor described above, additional safe harbors exist where: 1) the aircraft arrangement/transaction does not result in any additional exemption, deduction, or other tax reducing benefit that would otherwise be available to the taxpayer had the taxpayer not vested title to the aircraft in a separate entity; or 2) where title is vested in a separate entity for purposes of a bona fide merger or sale of the business.15

¹ See Second Engrossed Substitute Senate Bill (2EESB) 6143 Sections 201-203, and codified as RCW 82.32.655.
² WAC 458-20-28003(2).
³ WAC 458-20-28003(2)(c).
4 WAC 45 8-20-28003(2)(e).
5 WAC 458-20-280(1)(b)(ii).
6WAC 458-20-280(3).
7 WAC 458-20-280(4).
8WAC 458-20-280(5).
9 WAC 458-20-280(5)(c).
10WAC 458-20-28003(2)(i).
11 WAC 458-20-28003(2)(i)(i).
12 WAC 458-20-28003(2)(i)(ii).
13 WAC 458-20-28003(2)(i)(iii).
14WAC 458-20-28003(2)(i)(iv).
15 WAC 458-20-28003(2)(g),(h)