Could a corporation avoid Virginia's related-party factoring-fee addback by asserting a valid securitization business purpose during its audit appeal?

Plain-English summary

Virginia upheld the related-party factoring-fee addbacks because the corporation had not used the statutory procedure for a valid-business-purpose exclusion. The corporation sold receivables to an affiliated entity and argued that the arrangement supported third-party financing and securitization.

The addback statute covered losses and expenses connected with related-party factoring. To seek discretionary business-purpose relief, the corporation first had to report the addition and pay the resulting tax, penalties, and interest. It could then petition with clear and convincing evidence and, if approved, file an amended return within one year of the Commissioner's response.

The corporation instead claimed a full exception on its original returns. Virginia therefore could not consider the exclusion in that posture. The ruling noted that a bankruptcy-remote receivables entity required by unrelated lenders could have a valid business purpose, so a timely petition following the correct procedure remained possible.

Virginia also rejected the claim that its audit omitted IRS changes. The audit used federal taxable income from the corporation's amended Virginia returns reflecting the Revenue Agent Report adjustments.

What this means for you

• Related-party factoring expenses fall within Virginia's intangible-expense addback rules.
• A potentially valid business purpose does not excuse the required claim procedure.
• Pay, petition, and document the transaction before filing the exclusion on an amended return.
• Reconcile IRS adjustments to both amended state returns and the state audit workpapers.

Common questions

Q: Did Virginia decide the securitization lacked a valid business purpose?
A: Not finally. It declined to consider the claim because the corporation had not followed the statutory procedure.

Q: Could the corporation still seek relief?
A: Potentially, if it complied within the limitations period and supplied the required evidence.

Q: Did the audit include the IRS adjustments?
A: Yes. It used federal taxable income from the amended Virginia returns.

Citations and references

• Va. Code §§ 58.1-302 and 58.1-402(B)(8)(a)-(b).
• Virginia Public Document 10-285 (December 22, 2010).

Subject

Audit report did reflect adjustments made by the Internal Revenue Service

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 11-174

Original ruling text

October 12, 2011

Re: § 58.1-1821 Application: Corporate Income Tax

Dear *:

This will reply to your letter in which you seek correction of the corporate income tax assessments issued to * (the "Taxpayer") for the taxable years ended September 30, 2005 through 2007. I apologize for the delay in responding to your appeal.

FACTS

For the taxable years at issue, the Taxpayer paid factoring fees to * (IHC). The Taxpayer filed Schedule 500AB with its 2004 through 2006 Virginia corporate income tax returns and claimed an exception for 100% of the factoring fees deducted on its federal income tax returns on the grounds that the sale of the receivables to IHC secured the receivables, and it had a valid business purpose other than the avoidance of tax.

On audit, the Department disallowed the amount claimed as an exception to the add back on the basis that the receivable sales (between the Taxpayer and IHC lacked a valid business purpose other than the avoidance of tax.

The Taxpayer contends its factoring transactions had a valid business purpose because they allowed IHC to obtain financing by selling an undivided percentage interest in the accounts receivable portfolio, thereby securitizing the receivables. In addition, the Taxpayer states the audit report did not reflect adjustments made by the Internal Revenue Service (IRS).

DETERMINATION

Add Back for Factoring Transactions

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 direct or 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.

Virginia Code § 58.1-302 specifically defines "intangible expenses and costs" to include losses related to or incurred in connection with factoring transactions.

Several exceptions to the add back requirement are detailed in Va. Code § 58.1-402 B 8 a. Based on the facts provided, it does not appear that the Taxpayer qualifies for any of these exceptions.

Valid Business Purpose

The Taxpayer contends it should be allowed to exclude the factoring fees from the add back requirement because the intercompany transactions were made at arm's length and had a valid business purpose other than the avoidance or reduction of tax.

Virginia Code § 58.1-402 A 8 b provides an exclusion for the add back when the intangible intercompany expenses were incurred through a valid business purpose other than the avoidance or reduction of tax. The statute establishes the specific procedures to follow to claim this exclusion.

In order to apply to the 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 Commissioner to consider evidence relating to any transactions between it and related members that resulted in its taxable income being increased. The 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.

If the Commissioner grants the application, the taxpayer may file an amended return that excludes the addition related to the specific transaction or transactions identified in the Commissioner's response. The amended return must be filed within one year of the Commissioner's response.

The Taxpayer's request was not made in accordance with the procedure for claiming the business purpose exclusion from the addition for intangible and interest expenses paid related entities pursuant to Va. Code § 58.1-402 B 8 b. As such, the Taxpayer's request to exclude the add back of the factoring fees on the basis that they were incurred for a valid business purpose cannot be considered.

Pursuant to Public Document (P.D.) 10-285 (12/22/2010), the sale of receivables to a wholly owned bankruptcy remote entity may have a valid business purpose if the bankruptcy remote entity facilitates the securitization of receivables and is required by unrelated third-party lenders. If the Taxpayer follows the procedures as prescribed under Va. Code § 58.1-402 B 8 b within the statute of limitations, the Department will consider whether to permit the Taxpayer to file amended returns to claim the valid business purpose exception. Until the Taxpayer complies with the statutory requirements, the assessments will be upheld.

RAR Adjustments

During March 2009, the IRS finalized audit adjustments against the Taxpayer for the 2004 and 2005 taxable years. The Taxpayer filed amended Virginia returns to reflect Revenue Agents Report (RAR) adjustments in August 2009.

The Taxpayer contends the auditor failed to include these adjustments in the Virginia audit report. A review of the audit reports, completed in October 2009, shows that the auditor used federal taxable income as reflected on the Taxpayer's amended Virginia returns. Thus, the audit reports do reflect the RAR adjustments.

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

Sincerely,

Craig M. Burns

Tax Commissioner

AR/1-4170182275.B