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:: Factoring of Receivables Audit Techniques Guide
LMSB-04-0606-004
Factoring of
Receivables Audit Techniques Guide
June 2006
NOTE: This
guide is current through the publication
date. Since changes may have occurred after
the publication date that would affect the
accuracy of this document, no guarantees are
made concerning the technical accuracy after
the publication date.
Overview
Companies generate accounts
receivable by selling goods or services to
their customers on credit. Many companies
who extend credit to their customers sell
their accounts receivable to a factor. A
factor is a specialized financial
intermediary who purchases accounts
receivable at a discount. Under a factoring
agreement a company sells or assigns its
accounts receivable to a factor in exchange
for a cash advance. The factor typically
charges interest on the advance plus a
commission. The price paid for the
receivables is discounted from their face
amount to take into account the likelihood
of uncollectibility of some of the
receivables.
Factoring is a technique
used by companies to manage their accounts
receivable and provide financing. Typically
companies that have access to sources of
financing that is less expensive than
factoring would not use factoring as source
of credit.
A factor may provide any of
the following services:
-
Investigation of
the credit risk of customers of the
client;
-
Assumption of the
credit risk of customers;
-
Collection of the
client’s accounts receivable from
customers;
-
Bookkeeping and
reporting services related to
accounts receivable;
-
Provision of
expertise related to disputes,
returns and adjustments;
-
Advancing or
financing.
There are numerous types of
factoring arrangements. Some of the basic
types vary the treatment of credit risk
assumption and customer or debtor
notification. When the factoring agreement
involves the purchase of accounts receivable
where the factor bears the risk of a
customer or debtor failing to pay the client
for reason of financial inability it is a
non-recourse or without-recourse agreement.
In the situation where the client must bear
the risk of nonpayment due to financial
inability, the agreement is a recourse
agreement. In many instances, factoring
agreements provide for accounts to be
purchased on both a recourse and
non-recourse basis depending on the credit
worthiness of the customers or the debtors.
Compliance Focus
A strategy has been
identified in which multinational
corporations use the factoring of accounts
receivable among related parties. The goal
of this strategy is to avoid U.S. taxation
by shifting income offshore and to
significantly reduce remaining U.S. income
by deducting expenses related to the same
income.
Typical Fact
Pattern:
A U.S. subsidiary
(“Taxpayer”) of a foreign parent earns sales
income and books accounts receivable. The
Taxpayer then factors (sells at a discount)
the accounts receivable to a brother-sister
foreign affiliate. The Taxpayer pays the
foreign factor the following fees: a
discount; administration fees; commissions;
and interest.
The Taxpayer deducts these
fees or may net them against gross
receipts. However, the foreign factor does
not perform any of the typical services of a
factor, including collection of the
Taxpayer’s accounts receivable. Instead,
the Taxpayer agrees to continue doing all or
most of its own collection work on its
accounts receivable. In some cases,
factoring arrangements involve the use of a
domestic (U.S. based) factor instead of a
factor located offshore. In cases involving
a domestic factor, some audit steps and
issues discussed below may not apply. If
the transaction is between two domestic
entities it may be structured for state tax
purposes and has no federal tax effect. In
addition, in some cases, the Taxpayer and
factor may be engaged in a financing
arrangement involving securitizing the
accounts receivable.
General Audit Steps
Although U.S. taxpayers are
taxed on their worldwide income, the income
of foreign subsidiaries of U.S. taxpayers is
generally deferred from taxation in the
U.S. Consequently, the existence of a
factoring arrangement may not be readily
identified on the face of a return.
Therefore, at a minimum the following audit
steps should be utilized:
-
Submit a specific
IDR to determine if any accounts
receivable were sold. If yes, were
they sold to:
-
Review the tax
return balance sheet to determine if
the accounts receivable reflected
thereon are reasonable for the size
and type of business.
-
Perform a
comparative analysis of the balance
sheets for the current and
at least 5 prior tax years,
noting any significant reduction in
accounts receivable.
-
Review the tax
preparation workpapers for large
debits to income.
-
Review and
analyze Form 5472 and the
audited financial statements of both
the domestic entity and the related
foreign entity for any footnotes
reflecting the sales and/or
securitization of the accounts
receivable. Request that the
foreign entity provide this
information in English.
Note whether this analysis
demonstrates income shifting from
the domestic entity to the foreign
entity. Also note whether there is
evidence that the foreign entity was
conducting a trade or business
within the United States.
The following facts
should be determined during the audit
through IDRs or functional analysis and by
requesting documentary substantiation where
appropriate.
The Factor
-
Name and location
of the factor;
-
Relationship of the
factor to the taxpayer;
-
The name and
location of a common parent of the
factor and the taxpayer;
-
Whether the
taxpayer and the factor are part of
a consolidated group;
-
Whether the factor
is a Controlled Foreign Corporation
(CFC);
-
The name of any
promoter/advisor or accounting firm
involved in structuring the
taxpayer’s factoring arrangement.
The Factoring
Arrangement
The factoring arrangement
is usually set forth in a Factoring
Agreement between the factor and the
taxpayer. Obtain a description of the terms
of the factoring arrangement including if
applicable the following:
-
The names of the
parties that entered into the
Factoring Agreement;
-
The date the
Factoring Agreement was signed;
-
The services the
factor agreed to provide;
-
The services the
factor contracted back to the
taxpayer;
-
The fees the
taxpayer charged the factor for
performing the services contracted
back to the taxpayer;
-
The discount and
fees charged by the factor for:
-
The date the
taxpayer was required to transfer
accounts receivable to the factor;
-
The date the factor
had until to accept or deny the
factored accounts receivable;
-
Whether the sale of
the receivables to the factor was
recourse or non-recourse;
-
The reasons the
taxpayer provided for entering into
the factoring arrangement;
-
Whether the
taxpayer ever entered a factoring
arrangement before;
-
Whether it is a
common practice in the taxpayer’s
industry to factor receivables;
-
If a related entity
is utilized to perform factoring,
explain the source of the funding
used by this entity to acquire the
accounts receivable.
Securitization
If the factoring
arrangement involves the securitization of
factored accounts receivable then obtain a
description of the securitization process
including:
-
The purpose for
securitizing the accounts
receivable;
-
The names and
location of all entities involved in
the securitization process;
-
The relationship
between the parties involved in the
securitization arrangement;
-
Whether any of the
entities involved in securitizing
the accounts receivable were a
Special Purpose Vehicle (SPV);
-
The fees charged by
the parties involved in securitizing
the accounts receivable;
-
A description of
how the accounts receivable were
securitized, including the flow of
funds;
-
Whether the sale of
the receivables to the factor was
recourse or non-recourse;
-
Whether the
taxpayer ever securitized its
accounts receivable before;
-
Whether it is a
common practice in the taxpayer’s
industry to securitize accounts
receivable;
-
If a related entity
is utilized to perform
securitization, explain the source
of the funding used by this entity
to acquire the accounts receivable.
Tax Return
-
Indicate where on
the tax return the expenses from the
factoring arrangements are
deducted. Identify if the factoring
fees are netted against other items
such as sales. Also, indicate if
the factoring deductions are
reflected as book/tax difference on
Schedule M.
-
Provide all tax
preparation workpapers related to
the factoring/securitization
arrangement.
Financial
Statements
Indicate if and how the
factoring arrangements are presented on the
taxpayer’s financial statements. Compare
the treatment of how the factoring
arrangements are presented on the financial
statements with the presentation on the tax
returns.
Transfer Pricing
Studies
Taxpayers engaged in
transactions with related parties are
required to establish an appropriate
transfer price in accordance with prescribed
methodologies. Analysis and evaluation of
the appropriate price is what is known as a
Transfer Pricing Study.
To obtain a copy of any and
all Transfer Pricing Studies, prepare a
separate IDR consisting of the following two
paragraphs:
Please provide
within 30 days of this request any
principal documentation outlined in Treas.
Reg. Section 1.6662-6(d) (2) (iii) (B) that
has been prepared to support your transfer
pricing methodologies for all years under
examination. This information would
generally be provided in the form of a
study; however all principal documentation
outlined under the Code and associated
Treasury Regulation which was prepared for
the years under examination, regardless of
form, is requested. This documentation
should include all internal and/or external
studies.
It should be so noted that
any documentation prepared by the taxpayer
pursuant to Section 6662(e) must be in
existence when the return was filed in order
to meet the documentation requirement. In
addition, if this documentation is not
provided within 30 days of
this request, and if there are significant
adjustments to your transfer price as
determined under IRC Section 482, a penalty
may be applicable under IRC Section 6662(e)
or (h).
Functional Analysis
When determining the
appropriate amount of factoring fee charged
between related parties, it may be necessary
to perform a functional analysis to
determine the actual services performed; the
entity which performed the services; and,
any compensation charged for these services.
A functional analysis
prepared with respect to factoring
arrangements should include, but not be
limited to, the following:
-
Identity of the
factor and its geographic location.
-
Identity of the
legal form (partnership,
corporation, LLC, etc) of the factor
-
Identity of the tax
form (partnership, corporation,
disregarded entity) of the factor.
-
Identity of the
functions performed by the factor;
and, if appropriate, the functions
which the factor contracts to be
performed on its behalf.
-
Identity of the
number, names and location of any
employees of the factor.
-
Identity of duties
specifically performed by each
employee.
-
Identity of who
performs the factoring functions.
-
Explanation, in
detail, of any transfer pricing
methodology used in determining how
a related entity reimbursed the
taxpayer for services provided (i.e.
servicing rights).
-
Explanation, in
detail, of any risks assumed with
regard to the factored receivables
and the entity assuming such risks.
-
Analysis, in
detail, of the amounts attributable
to these risks, to be supported by
appropriate workpapers.
Bad Debt History
Determine the bad debt
history of the taxpayer’s accounts
receivable for the years under exam and if
possible the past 3 to 5 years. Calculate
the percentage of receivables written off as
bad debts for each of the years. Identify
the first time that the taxpayer entered
into a factoring arrangement and indicate
the reasons the taxpayer provided for
entering into such an arrangement.
Dates the
Receivables Were Collected and Transferred
The legal analysis of
factoring arrangements may require
identifying the dates and amounts of
receivables transferred to the factor.
Accordingly, for all the factored
receivables determine:
-
The dates and the
amounts of the accounts receivable
the taxpayer transferred to the
factor.
-
The dates the
taxpayer received collection on the
accounts receivable; and
-
The dates the
factor had until to accept or deny
the transferred accounts receivable.
Prior History on
Sale of Accounts Receivable/Repeal of
Mark-To-Market Treatment under Section
475/Tax Avoidance
Obtain answers to the
following questions:
-
Prior to July 1998,
did the taxpayer utilize Section 475
to mark-to-market its accounts
receivable?
-
Did the taxpayer
start or complete setting up
transactions involving the “sale” of
its accounts receivable to related
corporations after July, 1998?
-
Were any of these
corporations created or acquired
around or after July, 1998 to carry
out this sale of accounts
receivable?
-
Were any of these
types of transactions set up and
promoted/marketed by any of the
accounting firms or other
promoters/advisors?
-
Were any of the
valuation services (for the accounts
receivable) provided by the same
accounting firm which marketed the
transaction? Who provided the
valuation services?
Other
-
Obtain a copy of
the Accounting Manual; Standard
Operating Procedures and/or Flow
Charts which describe the corporate
factoring/securitization policies
and/or procedures.
-
Obtain all legal,
accounting, financial, and economic
opinions and memoranda secured by or
on behalf of the taxpayer in
connection with this transaction.
-
Determine whether a
Tax Contingency reserve was
established for any transactions.
-
Obtain copies of
any communications, brochures,
memoranda or other materials
received from or sent to the
Taxpayer or its representatives
describing the factoring
arrangement.
Treas. Reg. section
6050P
Treas. Reg. section 6050P
contains final regulations to the
information reporting requirement under
section 6050P of the Internal Revenue Code
for discharges of indebtedness. The
preamble of the Treas. Reg. section 6050P
regulations, describe typical unrelated
party pricing of factoring transactions and
provide an example demonstrating how a bona
fide unrelated party factoring transaction
is often priced. The preamble states that
factoring between unrelated parties
ordinarily involves a factor who performs
the following functions:
-
Initial credit
investigation;
-
Selective
assumption of the risk of loss
(sometimes referred to as
guaranteeing credit);
-
On-going credit
monitoring of the client’s
customers, collection and
bookkeeping.
The preamble states that
for typical transactions with
unrelated parties factoring fees
range between 0.35 percent of the face value
of the accounts receivable (if the client
retains the collection function) and 0.70
percent of the face value (if the factor
undertakes the collection function).
Accordingly, it may be
indicative that a factoring arrangement
between related parties is abusive if the
factoring fees are much higher than the
typical factoring fees charged for unrelated
parties. This type of analysis should be
made in determining whether a section 482
adjustment is warranted.
Typical Issues:
Potential issues include,
but are not limited to:
-
Were there deemed
dividends from the U.S. taxpayer to
its foreign parent in the amount of
collected accounts receivable
transferred to the foreign factor;
and, were withholding taxes due on
the dividends paid to a foreign
recipient?
-
Have the
arm’s-length principles under
section 482 been applied with
respect to the sale of accounts
receivable to a related party?
-
Did the foreign
factor’s factoring activities
generate income from a trade or
business within the United States?
-
Should losses
between the related parties in the
factoring transaction be adjusted
under Section 267?
-
Was the factor a
controlled foreign corporation
(“CFC”) conducting intercompany
transactions with the Taxpayer
pursuant to Treas. Reg. 1502?
-
Should losses from
the factoring transaction be
disallowed under Section 269 because
the factor was acquired or created
to evade or avoid income tax?
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