Companies that provide financing to customers in Texas to purchase and lease equipment may be shocked to learn that their interest expense may not be deductible as a cost of goods sold (“COGS”). In Texas, a “lending institution” that offers loans to the public is authorized to subtract an amount equal to their interest expense as COGS. Tex. Tax Code Ann. § 171.1012(k) . However, it is unclear what the phrase “loans to the public” means.

A recently released Policy Letter Ruling did little to clarify this, and only muddied the waters further regarding what “loans to the public” means when a multi-state financial services company provides loans for the purchase or lease of a related affiliate’s equipment. The ruling denied the deduction of interest expense as a COGS to a wholly-owned finance subsidiary that qualified as a “lending institution” and was engaged in the business of financing heavy construction equipment sold or leased by its parent company to unrelated third-party customers. Tex. Pol. Ltr. Rul. No. 201101133L (Jan. 6, 2011) (released July 2011). A qualifying “lending institution” includes an entity that makes loans and is regulated by a federal regulatory authority, the Texas Department of Banking, Office of Consumer Credit, Credit Union Department, Department of Savings and Mortgage Lending. Tex. Tax Code Ann. § 171.0001(10).

The Texas Comptroller determined that, based on the facts provided, because the company only offered financing for the purchase of equipment manufactured by an affiliate, as opposed to the purchase or lease, the loans were not “offered to the public.” Although a 2008 Policy Letter Ruling previously ruled that a motor vehicle sales finance company “offered loans to the public” and qualified for the deduction, the ruling itself was devoid of any facts that illustrated the basis of the Comptroller’s decision. The Comptroller did not make this distinction in Tex. Pol. Ltr. Rul. No. 200809207L (Sept. 24, 2008), where the Comptroller ruled that a motor vehicle sales finance company “offered loans to the public” and qualified for the deduction.

This conclusion is puzzling in many respects, especially because the facts state that the company was “engaged in the business of financing heavy construction equipment sold or leased by the Taxpayer.” Tex. Pol. Ltr. Rul. No. 201101133L (Jan. 6, 2011) (emphasis added). The simplest basis for the decision may be that the specific leasing transactions described in the ruling did not explicitly involve financing. In the leasing transactions, the company leased equipment from an unrelated third party dealer of its parent’s equipment and then entered into leasing agreements with customers for the equipment (no mention of financing). In contrast, in a purchase transaction, the company provided financing to customers that purchased its parent company’s equipment.

Also interesting is that the Comptroller disallowed the entire interest expense deduction relating to the sale and leasing transactions instead of permitting the company to take the deduction for the loans it made (to the public) in the purchase transactions. Hopefully the “Loan” Star state’s decision was based on misguided facts and not on undecipherable policy objectives.