Could a corporate group deduct factoring losses from receivables sold to a related bankruptcy-remote entity?

Plain-English summary

Virginia allowed the corporate group to deduct its factoring discount losses because the related-party receivables structure had a proven third-party financing purpose. The operating subsidiaries sold receivables at independently determined fair market value—97% of face value—to a bankruptcy-remote special-purpose corporation.

The first lender required receivables to be isolated from the parent and operating companies so outside creditors could not reach them in a bankruptcy. The special-purpose entity then sold an interest in the receivables to bank conduits, while the operating companies continued collection under a servicing arrangement.

A second group of lenders imposed a revolving-credit covenant that restricted which entities could be consolidated parties. The special-purpose company's voting ownership and board-appointment structure was designed so neither the parent nor the third-party owner controlled more than half the board, allowing the structure to comply with that covenant.

Virginia normally required an add-back for related-member intangible expenses and factoring losses. But the group followed the required process: it filed and paid based on the add-back, then petitioned for the valid-business-purpose exception. The lender documents and entity structure proved by clear and convincing evidence that the transactions were designed to obtain financing, not avoid Virginia tax.

The group could file an amended 2008 return within one year of the ruling and amended returns for other open years with the same facts. It could also continue using the exception in later years without filing a new petition annually, provided there was no substantial change in the arrangement.

What this means for you

• A related-party receivables sale can qualify for Virginia's valid-business-purpose exception when unrelated lenders genuinely require the structure.
• Follow the statutory sequence: report and pay the add-back first, then petition with clear and convincing evidence.
• Preserve loan agreements, securitization requirements, pricing support, corporate documents, ownership rights, board controls, and servicing terms.
• Continuing relief depends on stable facts; monitor changes in lenders, ownership, pricing, entity powers, and transaction flow.
• Amended-return deadlines run from the Commissioner's response.

Common questions

Q: Why was the bankruptcy-remote entity necessary?
A: Lender 1 required receivables to remain available as collateral even if the parent or operating subsidiaries entered bankruptcy.

Q: Why was its ownership split?
A: The revolving-credit covenant required it not to be a consolidated subsidiary, so voting ownership and board rights were divided with a third party.

Q: Did the taxpayers follow the petition procedure?
A: Yes. They included and paid the add-back before seeking the exception.

Q: Was relief limited to 2008?
A: No. Virginia also allowed open prior years and later years with materially unchanged facts, subject to the stated filing deadlines.

Citations and references

• Va. Code § 58.1-402 B 8 a and b.
• Virginia Public Documents 10-285 and 10-286, discussed for comparable bankruptcy-remote financing structures.

Subject

Add-back of loss realized on factoring transactions

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 13-195

Original ruling text

October 23, 2013

Re: Ruling Request: Add-back of loss realized on factoring transactions

Dear *:

This is in response to your letter requesting the exclusion of factoring discount losses on accounts receivable which were previously included in computing Virginia taxable income as an addition under Va. Code § 58.1-402(B)(8)(a). I apologize for the delay in responding to your request.

FACTS

*, , , , , , , , ("Taxpayers") are engaged in business within the Commonwealth and file a Virginia corporate income tax return on a combined basis. The Taxpayers are subsidiaries of *** ("Parent").

Parent and Taxpayers entered into an asset securitization agreement with a third party lender ("Lender 1") in order to obtain financing. Under the agreement, the accounts receivable of the operating subsidiaries of Parent were used as security for the financing.

Creation of the Bankruptcy-Remote Corporation

Lender 1 required that the securitized accounts receivable be placed into a bankruptcy-remote, qualified special purpose entity. This requirement ensured that if the Parent or Taxpayers went bankrupt, then outside creditors could not lay claims on the receivables. In order to satisfy this requirement, pursuant to a Receivables Purchase Agreement, Taxpayers sold all of their accounts receivable to a bankruptcy-remote, qualified special purpose entity, * ("Bankruptcy-Remote Corporation"). The accounts receivable were sold at an independently determined fair market value (discounted to 97% of face value). Bankruptcy-Remote Corporation is owned by Parent and ("Third Party Owner") and is incorporated in ** ("State B").

To further isolate the accounts receivable from the reach of outside creditors, Bankruptcy-Remote Corporation sold an undivided variable percentage ownership interest in the receivables to two bank conduits ("Purchasers"). Bankruptcy-Remote Corporation receives cash through the funding proceeds from Purchasers. As a part of the Receivables Purchase Agreement, Bankruptcy-Remote Corporation and the Purchasers entered into a servicing arrangement with the Taxpayers. Under this arrangement, the Taxpayers collect the receivables for 0.50% of the outstanding balance of the accounts receivable purchased by Bankruptcy-Remote Corporation. Also, under the Receivables Purchase Agreement,

Bankruptcy-Remote Corporation pays the Purchasers' conduit fees.

Bankruptcy-Remote Corporation retains the ineligible receivables and a subordinated or retained interest in the pool of receivables. In the event of termination or liquidation,

Bankruptcy-Remote Corporation has no obligation to the Purchasers to protect them from credit losses. Bankruptcy-Remote Corporation is only exposed to losses to the extent of its subordinated interest in the pool of receivables.

Bankruptcy-Remote Corporation had to meet a number of requirements in order to be considered a bankruptcy-remote entity. Among those requirements, Bankruptcy-Remote Corporation had to be engaged in a single business activity, be restricted on how funds are used and have title to the property (accounts receivable) on its books. Bankruptcy-Remote Corporation's purpose is limited by its Certificate of Incorporation and it cannot engage in other business pursuits or incur other third party obligations. That is designed to make it a remote possibility that Bankruptcy-Remote Corporation could enter into bankruptcy.

Ownership Structure of the Bankruptcy-Remote Corporation

Parent's primary source of funding was through a revolving credit agreement ("Revolver") with a group of third-party banks ("Lender 2"). There was a provision within the Revolver covenant which did not allow consolidated parties to be restricted with respect to how they pay funds. However, qualified special purpose entities restrict the payment of funds in order to obtain their bankruptcy-remote status. Bankruptcy-Remote Corporation was restricted with respect to how it paid funds because it was only allowed to use funds to repay Purchasers and to purchase accounts receivable from the Participants. Therefore, in order to meet the requirements of the Revolver, Bankruptcy-Remote Corporation was structured so that it would not be considered a consolidated party.

In the Revolver, a consolidated party is defined as a subsidiary of the Parent or of the Participants. The Revolver defines a subsidiary as a corporation in which Parent or the Participants own 50% of the voting common stock and can name more than 50% of the board of directors.

Bankruptcy-Remote Corporation has four directors and two classes of common stock. There are two shares of Class A voting, common stock. Parent owns one share and the Third Party Owner owns the other. The Class B stock is non-voting and Parent owns each of those shares. Further, Class A owners may appoint one director for each 25% share of stock that they hold. Because Parent and the Third Party Owner each own 50% of the voting stock, they may each appoint two directors. However, neither Parent nor Third Party Owner may appoint more than 50% of the board of directors. Therefore, Bankruptcy-Remote Corporation is not a subsidiary or a consolidated party of the Parent and does not breach the covenants of the Revolver. Upon the formation of Bankruptcy-Remote Corporation, the ownership was structured in order to fit within the requirements of the Revolver.

The Taxpayers contend that they have demonstrated that their intercompany transactions have a valid business purpose. Therefore, the Taxpayers contend that their factoring discount losses should be excluded from the add-back requirement of Va. Code § 58.1-402(B)(8)(a) under the valid business purpose exception in Va. Code § 58.1-402(B)(8)(b).

DETERMINATION

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 related members to the extent 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 add-back is required. The exception relevant to the Department of Taxation's ("the Department's") assessment of the Taxpayers is the valid business purpose exception. Virginia Code § 58.1- 402(B)(8)(b) sets forth the requirements that a taxpayer must meet in order to claim the valid business purpose exception. First, a taxpayer must file the related income tax return for the taxable year and remit all taxes, penalties and interest due for that taxable year. This also requires the taxpayer to include the amount of any intangible expenses and costs added-back to federal taxable income pursuant to Va. Code § 58.1-402(B)(8)(a). The taxpayer may then petition the Tax Commissioner to consider evidence relating to the transaction or transactions between the corporation and related members that resulted in the corporation's taxable income being increased. If the taxpayer's application demonstrates to the Tax Commissioner's sole satisfaction, by clear and convincing evidence, that the transaction or transactions between the corporation and related members resulting in an increase in taxable income under Va. Code § 58.1-402(B)(8)(a) had a valid business purpose other than the avoidance or reduction of the tax due, then the Tax Commissioner shall permit the corporation to file an amended return.

The Taxpayers have followed the procedures required under Va. Code § 58.1- 402(B)(8)(b) for the 2008 taxable year. Accordingly, the question now before the Department of Taxation is whether the Taxpayers have demonstrated by clear and convincing evidence that the intercompany transactions resulting in an addition to taxable income had a valid business purpose other than the avoidance or reduction of the tax due.

In Public Documents (P.D.) 10-285 (12/22/2010) and 10-286 (12/22/2010), the Department analyzed whether the taxpayers qualified for the valid business purpose exception. In both of these rulings, the taxpayers sold receivables to wholly owned bankruptcy-remote entities because they were required to do so in order to obtain financing. The taxpayer in P.D. 10-285 failed to follow the procedure required to petition for the valid business purpose exception and the Department did not consider their valid business purpose exception request. However, the Department stated that the taxpayer appeared to have a valid business purpose other than the avoidance or reduction of tax. In P.D. 10-286 the taxpayer did fulfill the procedural requirements necessary to petition the Commissioner for the valid business purpose exception and the Department determined that the taxpayer had the valid business purpose of obtaining favorable financing. Therefore, the taxpayer was allowed to claim the valid business purpose exception.

In the present case, the Taxpayers have demonstrated by clear and convincing evidence that the transactions between the Taxpayers and Bankruptcy-Remote Corporation have the valid business purpose of obtaining financing from third party lenders. First, the Taxpayers have presented evidence that the Bankruptcy-Remote Corporation was created in order to securitize its receivables. The Taxpayers have shown that it was required by Lender 1 to sell its accounts receivable to the Bankruptcy-Remote Corporation in order to obtain financing. This arrangement ensures that the receivables will be available to pay Lender 1 if the Parent or Taxpayers liquidate. Further, the Taxpayers have presented evidence which shows that the ownership structure of the Bankruptcy-Remote Corporation was arranged in order to meet the provisions of the Revolver. This structure was required in order for the Parent to continue to obtain financing from Lender 2.

Because the Taxpayers demonstrated that the sale of its receivables to Bankruptcy-Remote Corporation had the valid business purpose of obtaining financing, the Taxpayers are permitted to file an amended return excluding the addition of factoring discount losses generated by the sale of receivables from the Taxpayers to the Bankruptcy-Remote Corporation.

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, the Taxpayers 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 Taxpayers are 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. The Taxpayers are also granted permission to file amended returns to claim the valid business purpose exemption for any open taxable years in which the facts surrounding the arrangement are the same.

CONCLUSION

Based on the foregoing, the Taxpayers have demonstrated that they qualify for the valid business purpose exception to the add-back statute. Accordingly, the Taxpayers will be permitted to file an amended return to claim the deduction for factoring discount losses. Furthermore, the Taxpayers will be permitted to claim the valid business purpose exemption for receivables sold to Bankruptcy-Remote Corporation 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 Laws, Rules & Decisions section of the Department's website. If you have additional questions, please contact * in the Office of Tax Policy, Policy Development Division, at ***.

Sincerely,

Craig M. Burns

Tax Commissioner

CMB/mth