Could a Virginia corporation net a related entity's bad debts and cash discounts against its factoring-expense add-back?

Plain-English summary

Virginia upheld the full factoring-expense add-back. The corporation's disregarded LLC sold accounts receivable at a discount to a related entity. On its Virginia returns, the corporation reduced the factoring add-back by bad debts and cash discounts that the related entity incurred. The Department restored the full amount.

Virginia's definition of intangible expenses and costs expressly included losses connected with factoring transactions. The Department found no stated exception that allowed the taxpayer to net the related entity's costs against that add-back.

A valid business purpose could potentially support relief, but the statute required a separate sequence: report the addition, pay all tax, penalty, and interest, and then petition the Tax Commissioner with clear and convincing evidence. If approved, the taxpayer could file an amended return within one year of the response. The taxpayer had not followed that procedure, so the Department could not consider the claim in this appeal.

The determination left open the possibility of a timely later application. It noted that a receivables transfer to a wholly owned bankruptcy-remote entity may have a valid business purpose when needed for third-party securitization, but no exception was granted here.

What this means for you

• Virginia's related-party factoring add-back is not automatically reduced by operating costs borne by the related entity.
• Review the statutory exceptions before netting any related-party expense.
• A valid-business-purpose argument has a prescribed filing-and-payment process; raising the merits without following that process may be insufficient.
• Preserve lender requirements, securitization documents, arm's-length evidence, and the business reasons for using the related entity.

Common questions

Q: Did Virginia accept the bad debts and cash discounts as a reduction?
A: No. The Department found no applicable exception permitting that netting.

Q: Was an arm's-length or business-purpose argument impossible?
A: Not necessarily, but it had to be presented through the statutory application procedure after reporting and paying the add-back.

Q: Could the taxpayer still seek relief?
A: The determination said the Department would consider a compliant application filed within the statute of limitations.

Q: What happened to the assessments?
A: They were upheld until the taxpayer complied with the statutory requirements.

Citations and references

• Va. Code §§ 58.1-1821, 58.1-302, and 58.1-402 B 8 a and b.
• Virginia Public Document 10-285, discussed for bankruptcy-remote receivables entities and valid business purpose.

Subject

Bad debts and cash discounts incurred by LLC; Net factoring expenses

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 13-211

Original ruling text

November 12, 2013

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 December 31, 2008 and 2009. I apologize for the delay in responding to your appeal.

FACTS

The Taxpayer was the sole owner of a single member limited liability company, * (OLLC), which was treated as a disregarded entity for federal income tax purposes. OLLC sold accounts receivables at a discount to *** (IHC). The Taxpayer filed Schedule 500AB with its 2008 and 2009 Virginia corporate income tax returns and added back the factoring expense net of bad debts and cash discounts incurred by IHC.

On audit, the Department adjusted the add-back to include the full amount of the factoring expense on the basis that there is no exception for the reduction reported by the Taxpayer. On appeal, the Taxpayer contends that because the bad debts and cash discounts were legitimate expenses incurred by IHC, such expenses were not intangible expenses and costs required to be added-back.

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 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.

The Taxpayer contends it should be allowed to net factoring expenses against certain costs incurred by IHC in determining the amount of the required add-back because the intercompany transactions were made at arm's length and IHC incurred legitimate costs that should have been incurred by the Taxpayer.

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 Department 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 it and related members that resulted in its taxable income being increased. The Department 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 Department grants the application, the taxpayer may file an amended return that excludes the addition related to the specific transaction or transactions identified in the Department's response. The amended return must be filed within one year of the Department'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 for the 2008 and 2009 taxable years will be upheld.

Revised bills, with interest accrued to date, will be sent to the Taxpayer. No additional interest will accrue provided the outstanding balance in paid within 30 days from the date of the revised bills.

The Code of Virginia sections and public document 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/1-5139598761.B