Document Number
05-149
Tax Type
Corporation Income Tax
Description
Taxpayer does not meet the definition of a financial corporation
Topic
Allocation and Apportionment
Classification
Date Issued
09-08-2005

September 8, 2005



Re: Request for Ruling: Corporate Income Tax

Dear *****:

This will reply to your letter in which you request a redetermination of the Department's ruling regarding the proper apportionment method to be used by your client, ***** (the "Taxpayer") for Virginia corporate income tax purposes.

FACTS

The Taxpayer is a Virginia corporation that purchases and collects defaulted consumer debt from unrelated third parties. The Taxpayer requested a ruling from the Department as to whether it may be classified as a "financial corporation" for Virginia corporate income tax purposes, thereby allowing the Taxpayer to use the cost of performance method of apportionment pursuant to Va. Code § 58.1-418. The Department ruled that the gain on the collection of receivables purchased by the Taxpayer is not included in the classes of income required to qualify as a financial corporation pursuant to Va. Code § 58.1-418. See Public Document ("P.D.") 04-167 (10/4/04).

You believe the Department failed to give appropriate consideration to the nature of the Taxpayer's business or the rationale of its accounting methods and, therefore, request that the Department reconsider its ruling in P.D. 04-167.

RULING

Loan Processing Fees

The Department has held that companies that originate, process and collect loans are financial corporations. See P.D. 99-154 (6/21/99) and P.D. 81-57 (10/23/81). You contend that the Taxpayer provides the identical loan processing and collection services as loan originating companies.

In P.D. 81-57, the Department ruled that a mortgage broker whose income consisted of interest and service fees for acting as a collection agent, origination and other fees connected with the making of loans was a financial corporation. P.D. 99-154 states that as long as loan processing fees exceed 70% of its gross income, a taxpayer would meet the definition of a financial corporation.

In this case, the Taxpayer generates income from collecting defaulted receivable assets purchased from clients or providing collection services for customers. The fees and commissions earned for collection services on defaulted indebtedness would fall into the class of income under Va. Code § 58.1-418 B 1. As stated in P.D. 04-167, the gain recognized on the defaulted receivables purchased by the Taxpayer is not included in the classes of income required to qualify as a financial corporation.

Factoring Business

You contend that the Taxpayer acts, in fact, as a factor without recourse and that Title 23 of the Virginia Administrative Code ("VAC") 10-120-230 D, Example 2 provides that such a factor may be considered a financial corporation.

Title 23 VAC 10-120-230 D, Example 2, uses a factoring company in its example to illustrate where the cost of activities used to produce sales is to be apportioned. This regulation interprets Virginia law with regard to certain sales in the standard three-factor formula. It specifically provides "that taxpayer may be considered a financial corporation under § 58.1-418 of the Code of Virginia." [Emphasis added.] The fact that the example uses a factoring company for purposes of determining the cost of performance does not automatically make all factors financial corporations. The factoring corporation must be able to show that it derives more than 70% of its income from sources enumerated in Va. Code § 58.1-418 B.

Factoring occurs when an entity, called a factor, purchases receivables at a discount. There are two main types of factoring: recourse and nonrecourse. Under recourse factoring, the risk of loss does not transfer to the factor. If the debt becomes uncollectable, the seller must buy back the unpaid debt or exchange it with another receivable of equal or greater value. Because the factor has little or no risk, the fees are generated for services performed for the seller. Under this arrangement, the collection fees charged by the factor closely resemble the loan processing fees addressed P.D. 99-154.

With nonrecourse factoring, the risk of loss is transferred to the factor. If the debtor fails to pay, the factor cannot seek restitution from the seller. In essence, the factor takes on the bad debt risk and the seller recognizes a loss on the transferred receivable. The income generated when the receivables are collected more closely resembles a gain or loss on an asset than the provision of services. As noted in P.D. 04-167, the gain on collections of receivables is not included in the classes of income required to qualify as a financial corporation.

As a result, a factoring business primarily engaged in recourse factoring could meet the definition of a financial corporation under Va. Code § 58.1-418. Your letter indicates that the Taxpayer mainly engages in nonrecourse factoring.

Interest

You further contend the amount collected by the Taxpayer in excess of the cost of the receivable is interest. The Taxpayer purchases interest bearing debt obligations in which it substitutes itself for the original lender, with the profit on those loans being its charge or consideration for the obligations it has acquired. As such, you assert that the profits from the loans consist of interest as well as the market discount.

The Department agrees that the Taxpayer is purchasing interest-bearing obligations. When the Taxpayer purchases a receivable, it is purchasing the full amount of the debt as reported on the books of the seller. The amount recovered over the amount of the purchase price is essentially a recovery of a bad debt, not interest.

In addition, you quote a paragraph in B. Bittker and L. Lokken, Federal Taxation of Income, Estates and Gifts, 3rd Edition, p. 56-52 (Warren, Gorham & Lamont, 2000) to support your proposition that the proceeds generated by the Taxpayer from the collection of the receivables are interest. The section states:
    • When a bond is purchased for less that the amount payable at maturity, the economic nature of the discount to the purchaser is the same whether the bond is newly issued or is purchased on the secondary market. Because the face amount must be paid at maturity, the discount, whether OID or market discount, is a predictable return on the holder's investment in the nature of interest.

Regardless of the fact that the quote specifically addresses bonds (your letter inserts a broader term), this statement does not hold true in the Taxpayer's case. The face amount of the receivables is not paid. Although the Taxpayer collects 2.5 to 3 times the amount of the price at which the receivable pools are purchased, this amount falls well short of the face value of the pools. As such, there can be no predictable return.

Further, a market discount is determined comparing the interest rate on the indebtedness with the desired or going rate of return. The discount on the receivables purchased by the Taxpayer is determined based on an estimate of the amount of the face value that can be collected. Accordingly, the return on the discount obtained by the Taxpayer cannot be considered interest.

Securities Trading

You contend that the Taxpayer's purchase and collection of defaulted consumer receivables amounts to the trading of securities within the definition of Va. Code § 58.1-418. You argue that the receivables are "evidence of indebtedness" and that trading includes the "sale of property". You state that a common definition of trading securities includes the trading or purchase and sale of evidence of indebtedness.

While some of these receivables could be considered securities, the Taxpayer is not trading or selling them. Rather, the gain is attained by purchasing them at a discount and collecting a greater amount than they paid for them.

CONCLUSION

As set forth above, a factoring business may be considered a financial corporation if it derives more than 70% of its gross income from fees, commissions, other compensation for providing recourse factoring services and interest accrued on the face value of the debt.

The information provided indicates that the Taxpayer generates the vast majority of its income from nonrecourse factoring. Under these circumstances, the Taxpayer does not meet the definition of a financial corporation pursuant to Va. Code § 58.1-418.

The Code of Virginia sections, regulation, and public documents cited are available on-line in the Tax Policy Library section of the Department's web site, located at www.policylibrary.tax.virginia.gov. If you have any questions regarding this ruling, you may contact ***** in the Office of Policy and Administration, Appeals and Rulings, at *****.
                • Sincerely,

                    • Kenneth W. Thorson
                      Tax Commissioner



AR/54970B


Rulings of the Tax Commissioner

Last Updated 08/25/2014 16:46