Finance company must capitalize retailer payments tied to acquired contracts

Plain-English summary

A manufacturer's captive finance subsidiary bought retail financing contracts from independent brand retailers. In addition to each contract's principal amount, it paid three program payments that were separately paid but tracked to specific contracts. The taxpayer argued that the extra payments promoted product sales and should be deducted as advertising or marketing expenses. The agreements instead described the payments as compensation to retailers for the finance company's purchase of the contracts. The IRS distinguished separate interest-rate subvention payments that benefited product purchasers and rejected an attempt to recast the chosen transaction. Because the program payments acquired intangible debt instruments, they had to be capitalized under Section 263 rather than deducted currently.

Ruling snapshot

• Question: Are the three retailer-program payments deductible marketing expenses or costs to acquire intangible financing contracts?
• Outcome: Advice given: they are capitalized acquisition costs.
• Key authorities: IRC §§ 162 and 263; Treas. Reg. § 1.263(a)-4; INDOPCO v. Commissioner; Commissioner v. National Alfalfa Dehydrating & Milling Co.

Full text (IRS public release)

                   INTERNAL REVENUE SERVICE
         NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM



                                      Third Party Communication: None
                                      Date of Communication: Not Applicable

Number: 202121009
Release Date: 5/28/2021

Index (UIL) No.: 263.13-00
CASE-MIS No.: TAM-119227-20

LB:EC:SE:TT2:T1606

   Taxpayer's Name:                    ------------------------------------
   Taxpayer’s Address:                 -----------------------
                                       --------------------------
   Taxpayer's Identification No.:      ----------------
   Year(s) Involved:                   --------------------------------------------
   Date of Conference:                 ---------------------

LEGEND:

Taxpayer = ------------------------------------
Finance Company = ---------------------------------------------------
Brand 1 = ---------
Brand 2 = --------
Products = -----------
Add-On-Products and Services = ------------------------------------------------------------------
-----------------------------------------------------
Product Retailer = --------------------
Brand Retailer = ---------------------------------
Contract = --------------------------------------------
Agreement = --------------------------
Retailer Document = -----------------------------------------------------
Retailer Program = -----------------------------
Program 1 = ------------------------------------------------------------------
------------------------------------------------------------------
------
TAM-119227-20 2

Program 2 = ------------------------------
Program 3 = ---------------------------------------------
Other Payment 1 = ------------
Other Payment 2 = ----------------------
X = ---
Y = ---

ISSUE:

Whether the Program 1, Program 2, and Program 3 payments, in excess of the principal
amount of the Contract, Finance Company makes in connection with purchase of
Contract from Brand Retailer are capitalized costs paid to acquire an intangible asset or
currently deductible expenses.

CONCLUSION:

The Program 1, Program 2, and Program 3 Payments Finance Company makes to
Brand Retailer when it purchases Contract are capitalized costs paid to acquire an
intangible, not currently deductible expenses.

FACTS:

Taxpayer manufactures Brand 1 and Brand 2 Products. Finance Company is a captive
finance subsidiary of Taxpayer and a member of Taxpayer’s consolidated return group.
As part of its trade or business, Finance Company purchases Contract from
independent Brand Retailer which is not a member of Taxpayer’s consolidated group.
Once Finance Company purchases Contract from Brand Retailer, Finance Company
assumes all obligations for collecting payments on and administering Contract.

In a typical Product Retailer financing arrangement, Product Retailer and Product
purchaser enter into Contract, a single contract which includes both the sales and
financing agreements for Product. Product Retailer then submits the credit application
information it obtained from Product purchaser to one of several standardized
information platforms which compiles, with other credit information, a data file about
Contract. The data file is sent to competing finance companies which bid to purchase
Contract from Product Retailer. Product Retailer then selects a finance company -- in
general, the one offering the greatest compensation -- to which it will sell Contract.

Agreement between Finance Company and Brand Retailer and related documents,
such as Retailer Document, describe the terms and conditions of Finance Company’s
purchase of Contract. Under Agreement and Retailer Document, the purchase price of
Contract is its principal amount. LB&I and Taxpayer agree that Taxpayer capitalizes the
purchase price of Contract. Agreement also defines Finance Company’s Retailer
Program as the terms and conditions under which Finance Company agrees to pay
compensation to Brand Retailer for purchase of Contract. Retailer Program includes
Program 1 payment, as well as Other Payment 1 or Other Payment 2. Retailer Program
TAM-119227-20 3

payment is paid separately from the purchase price of Contract.

Under Program 1, if the minimum interest rate Finance Company requires to purchase
Contract (“buy rate”) is equal to or greater than the interest rate Brand Retailer
negotiates with Product purchaser (“retail rate”), Finance Company pays Brand Retailer
Other Payment 1 based on the amount financed. If the retail rate exceeds Finance
Company’s buy rate, Finance Company pays Brand Retailer the greater of Other
Payment 1 or X% - Y% of the difference between the retail rate and the buy rate.
Finance Company makes Program 1 payment at the end of the month in which Brand
Retailer sells Contract to Finance Company. Each Program 1 payment is tracked to a
specific Contract.

Under Program 2, Finance Company pays Other Payment 1 to Brand Retailer that sells
a target number of Contracts to Finance Company during a specific period. Finance
Company makes Program 2 payment to Brand Retailer quarterly. Each Program 2
payment is tracked to a specific Contract.

Finance Company makes Program 3 payment to Brand Retailer that finances its
wholesale new Product inventory through Finance Company (“Financing Brand
Retailer”). Finance Company pays Financing Brand Retailer a one-time Other Payment
1 for each Contract Financing Brand Retailer sells to Finance Company. Finance
Company makes Program 3 payment to Financing Brand Retailer each month for
Contract sold to Finance Company in the previous month. Each Program 3 payment is
tracked to a specific Contract.

It is common in Product industry for Product manufacturers, like Taxpayer, to offer
promotional below-market rate interest financing to Product purchasers to encourage
Product sales. Taxpayer represents the following facts regarding its below-market
interest rate program. Taxpayer authorizes Brand Retailer to enter Contract with Brand
1 purchaser and Brand 2 purchaser (collectively, “Brand Purchaser”) at below-market
interest rates. Finance Company purchases Contract from Brand Retailer for the
principal amount of Contract even though the fair market value of a below-market
interest rate Contract may be less than the principal amount of Contract. To reimburse
Finance Company for any difference between the principal amount of Contract and the
fair market value of the below-market interest rate Contract, Taxpayer pays an interest
rate subvention (subvention payment) to Finance Company. The subvention payment
shifts the cost of the below-market interest rate program from Finance Company to
Taxpayer. Taxpayer deducts subvention payment under § 162 as a sales and marketing
expense.

LAW AND ANALYSIS:

Section 162(a) of the Internal Revenue Code allows a current deduction for ordinary
and necessary expenses paid or incurred during the taxable year in carrying on any
trade or business.
TAM-119227-20 4

Section 263(a) provides, in part, that no deduction shall be allowed for any amount paid
out for new buildings or for permanent improvements or betterments made to increase
the value of any property or estate.
In Indopco, Inc. v. Commissioner, 503 U.S. 79, 112 S.Ct. 1039 (1992), the Supreme
Court noted:

   The notion that deductions are exceptions to the norm of capitalization
   finds support in various aspects of the Code. Deductions are specifically
   enumerated and thus are subject to disallowance in favor of capitalization.
   See §§ 161 and 261. Nondeductible capital expenditures, by contrast, are
   not exhaustively enumerated in the Code; rather than providing a
   ‘complete list of nondeductible expenditures,’ Lincoln Savings, 403 U.S.,
   at 358, 91 S.Ct., at 1901, § 263 serves as a general means of
   distinguishing capital expenditures from current expenses. See
   Commissioner v. Idaho Power Co., 418 U.S., at 16, 94 S.Ct., at 2766.

   Indopco, 503 U.S. at 84, 112 S.Ct. at 1043.

Section 1.263(a)-4 of the Income Tax Regulations provides rules requiring the
capitalization of costs associated with the acquisition or creation of an intangible.

Section 1.263(a)-4(b)(1)(i) requires a taxpayer to capitalize amounts paid to acquire an
intangible.

Section 1.263(a)-4(c)(1) provides that a taxpayer must capitalize amounts paid to
another party to acquire any intangible from that party in a purchase or similar
transaction. Section 1.263(a)-4(c)(1)(ii) lists a debt instrument as an example of an
intangible.

LB&I argues that, as described in Agreement, Financing Company agrees to make
Retailer Program payments to Brand Retailer to acquire Contract. Therefore, Taxpayer
must capitalize Retailer Program payments.

Taxpayer argues that the fair market value of Contract is its principal amount. Taxpayer
claims that Retailer Program payment Finance Company makes to Brand Retailer is a
separate payment in excess of the fair market value of Contract, deductible under § 162
as an advertising and promotional expense. To support this argument, Taxpayer
maintains that Retailer Program payment solidifies the relationships between and
among Taxpayer, Finance Company, Brand Retailer, and Brand Purchaser by
increasing (1) Taxpayer’s sales, and future sales, of Product to Brand Purchaser; (2)
Brand Retailer’s sales, and future sales, of Add-On Products and Services to Brand
Purchaser; (3) the number of Contracts Branch Retailer sell to Finance Company; and
(4) the number of Brand Financing Retailers who borrow from Finance Company to
purchase their wholesale new Product inventory. Taxpayer’s argument that it may
TAM-119227-20 5

deduct Finance Company’s Retailer Program payment is not supported by the terms of
Agreement.

Agreement specifically states that Retailer Program is Finance Company’s
compensation to Brand Retailer for the purchase of Contract. Retailer Program payment
includes Program 1 payment, as well as Other Payment 1 and Other Payment 2.
Finance Company’s Program 2 payment and Program 3 payment are Other Payment 1
and Other Payment 2 paid to compensate qualifying Brand Retailer for Contract
because Finance Company pays Other Payment 1 and Other Payment 2 only when it
purchases Contract and each payment is tracked to a specific Contract. Therefore, all
payments under Retailer Program are amounts paid to acquire Contract.

As additional support for its argument that Retailer Program payment is a deductible
sales and marketing expense, Taxpayer describes Retailer Program payment as
analogous to Taxpayer’s subvention payment. Taxpayer explains that, in both
circumstances, the difference between the principal amount of Contract and the fair
market value of Contract is attributable to Taxpayer’s promotion to sell Brand Product to
Brand Purchaser. Therefore, according to Taxpayer, the amount Finance Company
pays to acquire Contract is its principal amount but, like subvention payment, Retailer
Program payment is a deductible sales and marketing expense. We disagree with
Taxpayer’s argument that Retailer Program payment is a deductible sales and
marketing expense because it is similar to subvention payment. The structure and
economics of the Retail Program payment and the subvention payment are not the
same.

Finance Company pays the principal amount for Contract with a below-market interest
rate. Taxpayer’s subvention payment reimburses Finance Company for the difference
only pursuant to Taxpayer’s below-market interest rate promotion. Because Brand
Purchaser ultimately benefits from this arrangement, subvention payment resembles a
sales or marketing expense because it encourages the sale of Brand Product.

In contrast, under Agreement, Finance Company’s Retailer Program includes the
amount Finance Company agrees to pay as compensation to Brand Retailer for a
below-market, at-market, or above-market Contract. Retailer Program provides a direct
benefit to Brand Retailer. However, Retailer Program provides little, if any, benefit to
Brand Purchaser who is unlikely to know that Finance Company’s buy rate is less than
Contract rate Brand Purchaser negotiates with Brand Retailer.

For the reasons discussed, Finance Company’s payment pursuant to Retailer Program
is not analogous to subvention payment. However, even if the payments were similar,
the “actual transaction doctrine” precludes Taxpayer from asserting that the form of
Retailer Program payment reflects the substance of Finance Company’s purchase of
Contract but should be equated, for tax purposes, with Taxpayer’s subvention payment
-- an alternative form of the transaction which Taxpayer could have chosen, but did not
choose, to undertake. See Commissioner v. National Alfalfa Dehydrating & Mill & Co.,
TAM-119227-20 6

417 U.S. 134, 148-149 (1974) (“a transaction is to be given its tax effect in accord with
what actually occurred and not in accord with what might have occurred”).

Finance Company’s Retailer Program payment to Brand Retailer to purchase Contract
is an amount paid to acquire an intangible debt instrument. Therefore, under § 1.263(a)-
4(b)(1)(i) and § 1.263(a)-4(c)(1), Taxpayer must capitalize Retailer Program payment.

CAVEAT(S):

A copy of this technical advice memorandum is to be given to the taxpayer. Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.