In 2010, the Washington State Legislature resolved its budget impasse with a broad tax bill which included amongst its provisions, specific language designed to disregard certain transactions the legislature had identified as “unfair tax avoidance”. As it may relate to an aircraft entity structure and any related leasing operations, the new law identified as potential “tax avoidance” any transaction or arrangement through which a taxpayer “attempted to avoid sales or use tax on property located in Washington by vesting legal title or ownership in another entity over which the taxpayer effectively retains control.” (See RCW 82.32.655(3)(c))
In Washington, one of the longstanding tax planning ideas used by aircraft owners was to purchase the aircraft in a separate entity (special purpose entity or “SPE”) that would lease the aircraft back to the ultimate user(s) of the aircraft — generally the owner(s) or member(s) of the entity. Assuming the formalities of the structure were followed, this planning complied with the regulatory provisions of the Federal Aviation Regulations (FARs) which otherwise limit the ability of an aircraft owner to seek any reimbursement for the costs incurred for use of the aircraft. In addition to resolving some of the regulatory complexity regarding cost reimbursement, the structure had the secondary benefit of satisfying the resale provisions of Washington tax law. Under the leasing company structure, the aircraft-owning entity avoided tax on the initial purchase, but collected sales tax on the fair market value lease payments that were made by the aircraft users.
Under the tax avoidance provisions, however, the Department of Revenue was provided with the statutory authority to disregard the otherwise exempt resale nature of the initial aircraft acquisition by the leasing company assuming the transaction met the statutory definition of “unfair tax avoidance.” That is, the Department could treat the aircraft as if it was always owned directly by the individual owner, LLC member, or user of the aircraft, thereby invalidating the “resale” exemption as applied to the original purchase.
To date, the Department of Revenue has been working with taxpayers and other stakeholders including the PNBAA and NBAA to develop a regulation better defining the scope and intended impacts of the tax avoidance statute to aircraft transactions and operations, however, no regulation has yet been promulgated. Because of the broad language of RCW 82.32.655(3)(c) though, and without any additional clarification that may result from an interpretative regulation, the typical aircraft entity structure employed by most businesses may be deemed “unfair tax avoidance” in a subsequent Department of Revenue audit. The impact of such a result would include an assessment of sales/use tax on the purchase price of the aircraft, as well as tax avoidance penalties equaling 35% of the unpaid tax related to the purported “avoidance” – this is in addition to the other statutory penalties and interest resulting from any assessment.
On June 3rd, 2014, the Department finally published its initial “preproposal”; the first official draft of a proposed regulation to commence the rule-making process for a “tax avoidance” regulation. Given the efforts of the PNBAA, the NBAA, and other interested stakeholders, the Department of Revenue’s initial draft regulation now contemplates certain safe-harbors designed specifically to address general business aviation operations.
As currently contemplated by the initial draft rule, for property such as an aircraft that is owned by a “controlled” entity, the following elements create a “potential tax avoidance arrangement”:
- The taxpayer engages in a transaction in which the taxpayer, or persons acting in concert with taxpayer, vests title or any other ownership interest of tangible personal property in an entity; and
- The taxpayer exercises control over the entity in such a manner to effectively control the underlying tangible personal property; and
- The tangible personal property is used by the taxpayer in Washington without payment of sales or use tax on its “its full value”.
Whether or not a taxpayer controls an entity is based upon the following considerations:
- The taxpayer possesses directly or indirectly more than 50% of the voting power or more than 50% of the power to direct or cause the direction of the management and policies of the entity; or
- The taxpayer effectively retains control over the underlying tangible personal property by virtue of the taxpayer’s right to control the use or disposition of the property.
At present, the current draft regulation includes the following “safe harbors”, which if satisfied, would prevent the Department from disregarding title in or ownership by a controlled entity:
1) Arrangements by which no additional exemption, deduction, or reduction in sales or use taxes accrues to the benefit of the taxpayer which would have otherwise been available if the taxpayer owned the property directly;
2) Arrangements arising out of or related to the sale of stock or ownership interests in a substantive operating business, including as part of a statutory merger; and most relevant to aircraft-leasing structures . . .
3) Arrangements where substantially all use of the property is under a lease, at a reasonable rental value, by a substantive operation business, for bona fide business purposes.
For purposes of the leasing safe harbor, “substantially all” is currently defined to mean at least 95% of the use of the property, as determined by actual use and irrespective of the location of such use. According to the proposed rule, “reasonable rental value” is determined as nearly as possible by the “value of such use at the places of use of similar property of like quality and character.” A “substantive operating business” is a business that is adequately capitalized and engaged in substantial business activities using its own property or employees. Finally, “bona fide business purposes” is use of the property that is ordinary and necessary for the business of the user. Although the presence of this safe-harbor is positive, PNBAA believes that this safe-harbor can be made more workable with a more suitable threshold.
The official rule-making process for the “tax avoidance” regulation will commence with an initial public meeting at 10:00 a.m. on July 1st, 2014 at the Department of Revenue’s office in Olympia. As part of the formal rule-making process, stakeholders will be provided with the opportunity to address concerns related to the proposed rule, including open issues, unintended, or even unacceptable tax consequences resulting from application of the rule. To this end, as part of the ongoing efforts of interested taxpayers or their representatives in any rulemaking process, it is not uncommon for the final as-promulgated rule to differ significantly from the Department’s initial draft. While the public meeting represents the first opportunity to interact directly with the Department in a formal capacity, it will likely not be the only or final opportunity to do so. As it pertains to the business use of aircraft, the rulemaking process may involve several meetings with the Department to better understand the regulatory framework impacting taxpayers, the specific language of the rule and corresponding examples, and a discussion regarding the Department’s goals and concerns regarding both imposition and administration. Given the broad imposition of the tax avoidance statute, however, the presence of the initial leasing safe-harbor represents a significant move forward by the Department of Revenue in recognizing and understanding the legitimate and necessary uses of business aircraft.
 See Washington 2ESSB 6143 (2010).
 The Federal Aviation Regulations effectively require that the lease of an aircraft in non-commercial operations be in the form of a so called “dry lease,” i.e., a “bare” lease of the aircraft not accompanied by pilots who fly it, in order to avoid FAR Part 135 “for-hire” requirements.
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