Tax Type
Corporation Income Tax
Description
Addback of gain or loss realized on factoring transactions
Topic
Accounting Periods and Methods
Filing Status
Interest Payments
Subtractions and Exclusions
Date Issued
12-22-2010
December 22, 2010
Re: Ruling Request: Addback of gain or loss realized on factoring transactions
Dear *****:
This is in response to your letter, dated May 26, 2010, requesting an abatement of all additional Virginia corporate income tax and interest assessed by the Department of Taxation ("TAX") to your client in the assessment for taxable year 2005, dated February 9, 2009.
FACTS
***** ("Parent" or "Taxpayer") is engaged in business within the Commonwealth and files a Virginia corporate income tax return on a separate company basis. Parent's principal operating activity is the manufacture and sale of tangible personal property.
Parent owns 100% of ***** ("LLC"), a bankruptcy-remote, special purpose entity that facilitates the securitization of Parent's receivables. LLC has employees who perform its credit and collection services, facilitate the cash application process, and oversee the factoring and securitization program. For federal income tax purposes, LLC has elected to be taxed as a corporation.
LLC owns 100% of ***** ("DE"), a disregarded entity that is treated as a division of LLC for federal and state income tax purposes. Parent sells its receivables to LLC on an ongoing basis and LLC, in turn, sells these receivables to DE. DE borrows funds from a third-party lender ("Lender") and pledges the receivables as security for the loan. Because transactions between LLC and DE are disregarded for federal and state income tax purposes, LLC and DE will hereinafter be referred to collectively as "SUB."
Parent created SUB to reduce its third-party borrowing costs by securitizing its receivables. Under the terms of its credit agreement with Lender, Parent was required to transfer receivables to a bankruptcy-remote entity, which would then grant Lender a priority lien in the transferred receivables. These requirements ensured that, if Parent filed for bankruptcy, the transfer of the receivables to SUB would be treated as a sale and, therefore, the receivables would not be assets included in Parent's bankruptcy estate. This arrangement decreased the risk to Lender and allowed it to provide loans to Parent at more favorable rates.
Parent planned to use the proceeds from the arrangement with Lender to repay another outstanding loan that was subject to a higher interest rate. Prior to creating SUB and entering into an agreement with Lender, Parent compared Lender's terms with seven other financial institutions and determined that Lender had the most favorable rates. Parent also determined that entering into an agreement with Lender would create significant cost savings as a result of decreased interest expenses.
To obtain financing through Lender, Parent transferred its receivables to SUB at arm's-length market prices. The pricing structure Parent uses to sell receivables to SUB was determined using third-party pricing studies. These pricing studies were based on the fair market value of the receivables, with a discount to account for the time-value of money and credit risk.
When SUB collects receivables, it reports as interest income the difference between the amount collected and the purchase price of the receivables. Because the price paid for the receivables was less than the face amount, the sale of receivables to SUB resulted in a loss to Parent. On its 2005 and 2006 Virginia Corporation Income Tax return, Parent deducted these losses in computing its taxable income.
For federal income tax purposes, LLC has elected to be taxed as a corporation. LLC filed a separate company return in ***** ("State B"), reported the interest income, and paid taxes in accordance with the ***** ("State B Law"). Parent claimed an exception for 100% of the factoring expenses deducted on its federal income tax returns on the grounds that they were subject to tax in State B. On audit, TAX limited the amount claimed as an exception to the addback by reducing it to correspond to the amount of SUB's factoring expenses apportioned to State B and increased the corresponding net addback of factoring expenses.
The Taxpayer contests the assessments on the basis that all of the factoring expenses qualify for a full deduction because they were subject to tax based on or measured by net income imposed by State B. Further, the Taxpayer contends that the sale of receivables to a related entity should qualify for an exception because it has a valid business purpose other than the avoidance or reduction of taxes due.
DETERMINATION
Subject to Tax
Virginia Code § 58.1-402(B)(8)(a) provides that there shall be added back to the extent excluded from federal taxable income:
-
- [T]he amount of any intangible expenses and costs directly or indirectly paid, accrued, or incurred to, or in connection directly or indirectly with one or more indirect transactions with one or more members to the extent that such expenses and costs were deductible or deducted in computing federal taxable income for Virginia purposes.
The Code also provides several exceptions to the general rule that an addback is required. One exception relevant to TAX's assessment of the Taxpayer states:
-
- This addition shall not be required for any portion of the intangible expenses and costs if one of the following applies: (1) The corresponding item of income received by the related member is subject to a tax based on or measured by net income or capital imposed by Virginia, another state, or a foreign government that has entered into a comprehensive tax treaty with the United States government. (Emphasis added.)
In Public Document (P.D.) 07-153 (10/2/2007), TAX determined that parsing the statutory language of Va. Code § 58.1-402(B)(8)(a) demonstrates that the exception is not all inclusive. When considering this statute in its totality, it is clear that the exception does not apply to the gross amount of payments made to an affiliate merely because the gross amount is shown on another state's tax return. Rather, the exception is limited to the portion of a taxpayer's factoring expenses paid to its affiliate that correspond to the portion of the affiliate's income subjected to tax in other states, as evidenced by the apportionment percentages shown on the affiliate's tax returns filed with other states.
The auditor reduced the factoring expenses addback exception to the portion of the Taxpayer's factoring expenses paid to the affiliate that correspond to the portion of the affiliate's income subjected to tax in other states. The Taxpayer has not provided any additional information to dispute the auditor's adjustment based on the amount of income subject to tax in other states. Accordingly, the Taxpayer does not qualify for a full deduction of its factoring expenses under Va. Code § 58.1-402(B)(8)(a).
Valid Business Purpose
The Taxpayer contends that it should be allowed to exclude the addition from the addback requirement because the intercompany transactions had a valid business purpose other than the avoidance or reduction of tax.
Virginia Code § 58.1-402(B)(8)(b) outlines very specific procedures a taxpayer must follow in order to claim this exception. To apply to the Tax Commissioner for relief based upon the existence of a valid business purpose, a taxpayer must file its Virginia income tax return reporting the addition in accordance with the statute and remit all taxes, penalties, and interest due for the taxable year. A taxpayer may then petition the Tax Commissioner to consider evidence relating to any transactions between the corporation and related members that resulted in its taxable income being increased. The Tax Commissioner may permit the taxpayer to file an amended return if the application demonstrates by clear and convincing evidence that the transactions resulting in such increase in taxable income had a valid business purpose other than the avoidance or reduction of the tax.
The Taxpayer has followed the procedures required under Va. Code § 58.1-402(B)(8)(b) for taxable year 2005. Accordingly, the question now before TAX is whether the Taxpayer has demonstrated by clear and convincing evidence that the intercompany transactions resulting in the increase in taxable income had a valid business purpose other than the avoidance or reduction of tax due.
The Taxpayer has demonstrated by clear and convincing evidence that the transactions between Parent and LLC have the valid business purpose of obtaining favorable financing terms. Specifically, the Taxpayer has presented evidence that it created a bankruptcy-remote entity to facilitate the securitizing of its receivables and that, in fact, it was required to do so by the Lender. The Taxpayer also demonstrated that the Lender's terms were more favorable than other financial institutions and that cost savings accrued as a result of the agreement. Given this evidence, it is clear that the creation of bankruptcy-remote entities had the valid business purpose of obtaining more favorable financing.
Because the Taxpayer demonstrated that the sale of receivables to a wholly-owned bankruptcy-remote entity had the valid business purpose of obtaining favorable financing, the Taxpayer is permitted to file an amended return excluding the addition related to the sale of receivables from Parent to LLC.
Pursuant to Va. Code § 58.1-402(B)(8)(b), the amended return must be filed within one year of the Commissioner's response. Therefore, Parent must file an amended return within one year from the date of this ruling.
Virginia Code § 58.1-402(B)(8)(b) gives the Tax Commissioner the authority to permit the corporation to continue deducting the related intangible expenses and costs in subsequent tax years without submitting a petition each year. Accordingly, the Taxpayer is hereby granted the valid business purpose exemption for subsequent taxable years without being required to submit a petition each year, provided there is no substantial change in the facts surrounding the arrangement.
CONCLUSION
Based on the foregoing, the Taxpayer has demonstrated that it qualifies for the valid business purpose exception to the addback statute. Accordingly, the Taxpayer will be permitted to file an amended return to claim the deduction for related intangible expenses and costs. Furthermore, the Taxpayer will be permitted to claim the valid business purpose exemption for receivables sold to LLC in subsequent tax years without submitting additional petitions, provided there is no substantial change in the facts surrounding the taxable arrangement.
The Code of Virginia sections and public documents cited are available online at www.tax.virginia.gov in the Tax Policy Library section of the TAX website. If you have additional questions, please contact ***** in the Office of Tax Policy, Policy Development Division, at *****.
-
-
-
-
-
-
-
- Sincerely,
-
-
-
-
-
-
-
-
-
-
-
-
-
- Craig M. Burns
Tax Commissioner
- Craig M. Burns
-
-
-
-
-
-
PD/1-3249443211
Rulings of the Tax Commissioner