I factored my accounts receivable to a related entity, which then sold interests in them to unrelated investors to fund my operations -- can I exclude the factoring costs from Virginia's intercompany intangible expense add-back?

Plain-English summary

A corporation factored its accounts receivable to a related entity ("IHC") for the taxable years ended September 2010 through 2012. IHC then securitized those receivables and sold an undivided percentage interest to unrelated investors under receivables purchase agreements, generating funding for the corporation's operations. The corporation claimed a full exception to Virginia's related-party intangible expense add-back for its factoring costs; the Department disallowed the exception on audit, finding the arrangement between the corporation and IHC lacked a valid business purpose beyond avoiding tax.

The add-back, and what it takes to escape it. Virginia generally requires corporations to add back intangible expenses and costs (including factoring-transaction losses, per Va. Code § 58.1-302) paid to a related member, if those amounts were deducted for federal purposes -- regardless of whether the transactions were at arm's length or had genuine economic substance (Va. Code § 58.1-402 B 8 a). To avoid the add-back, a taxpayer must fit one of the statute's specific exceptions.

Why the unrelated member exception failed. This exception applies when the related member derives at least a third of its revenue from LICENSING intangible property to unrelated parties on comparable terms (§ 58.1-402 B 8 a 2). IHC did deal exclusively with unrelated investors -- but as the BUYER of the receivables, not as a licensor of intangible property. Selling a percentage interest in purchased receivables isn't licensing intangibles, so the exception's core requirement wasn't met.

Why the third party expense exception failed. This exception requires (i) the related member paid the relevant amount, during the same year, to someone who isn't a related member, AND (ii) the transaction with the related member didn't have tax avoidance as its principal purpose (§ 58.1-402 B 8 a 3). The Department found the first prong contemplates using the related member as a CONDUIT to pass the taxpayer's own intangibles through to an unrelated party -- here, the corporation instead used the receivables as COLLATERAL to secure financing from the outside investors, a fundamentally different arrangement. On the second prong, the corporation argued its principal purpose was financing, not tax avoidance -- but the Department noted it could have arranged similar or identical financing directly with the same investors WITHOUT first routing the receivables through IHC, undercutting that explanation.

Why the valid business purpose route was never actually available. The corporation also argued IHC was a legitimate bankruptcy-remote securitization vehicle, which can sometimes support a valid-business-purpose exception (P.D. 10-285). But Va. Code § 58.1-402 B 8 b sets out a specific, mandatory PROCEDURE for this exception: the taxpayer must first file its return reporting the add-back and pay all resulting tax, penalties, and interest, and only THEN petition the Commissioner with clear and convincing evidence of a valid business purpose -- if granted, an amended return excluding the add-back must be filed within one year of the Commissioner's response. The corporation never followed this procedure, so its business-purpose argument couldn't be considered on the merits at all.

Outcome. Having failed both substantive exceptions and never having used the required procedure for the business-purpose route, the corporation's add-back was upheld in full, with an updated bill (including accrued interest) due within 30 days.

What this means for you

Corporations factoring receivables to a related entity that then sells interests to unrelated investors

Selling receivables to unrelated third parties through a related intermediary doesn't automatically satisfy either the "unrelated member" or "third party expense" exceptions -- both have specific structural requirements (licensing revenue, or a genuine pass-through of your own intangibles) that a collateralized-financing arrangement may not meet.

Anyone planning to argue a related-party transaction had a valid business purpose other than tax avoidance

This exception has a mandatory sequence: file your return WITH the add-back and pay the tax first, then petition the Commissioner separately with clear and convincing evidence -- raising the argument for the first time in a correction appeal, after the fact, does not satisfy the statute and forfeits the exception entirely.

Corporations that could have obtained similar financing directly, without a related intermediary

If you route a transaction through a related entity when you could have made essentially the same arrangement directly with the unrelated counterparty, expect the Department to treat that routing as evidence against a non-tax-avoidance business purpose.

Common questions

Q: We factor receivables to a related company that resells interests to outside investors -- does that qualify for the "unrelated member" exception since the investors are unrelated?
A: Not necessarily. That exception requires the related member to be LICENSING intangible property to unrelated parties, not merely buying and reselling receivables interests -- a different kind of transaction.

Q: We want to argue our related-party transaction had a valid business purpose (like bankruptcy-remote securitization) rather than tax avoidance -- can we raise that on a correction appeal after already being assessed?
A: Not under this procedure. The valid business purpose exception requires filing your return with the add-back and paying the tax first, then separately petitioning the Commissioner with clear and convincing evidence -- raising it for the first time on appeal doesn't satisfy the statute.

Q: Could we have avoided this add-back by financing directly with the outside investors instead of routing through our related entity?
A: Possibly relevant either way -- but here, the fact that similar direct financing appeared to be available undercut the taxpayer's argument that the related-party routing had a genuine non-tax business purpose.

Citations and references

Statutes:

• Va. Code § 58.1-402 B 8 a -- intangible expense add-back requirement for related-member transactions
• Va. Code § 58.1-402 B 8 a 2 -- unrelated member exception, requiring the related member to derive at least 1/3 of revenue from licensing intangibles to unrelated parties on comparable terms
• Va. Code § 58.1-402 B 8 a 3 -- third party expense exception, requiring both a pass-through payment to an unrelated party and no principal tax-avoidance purpose
• Va. Code § 58.1-402 B 8 b -- valid business purpose exception; requires filing and paying first, then petitioning the Commissioner for permission to amend
• Va. Code § 58.1-302 -- intangible expenses and costs include factoring-transaction losses

Prior rulings the Department relied on (described here, not linked): P.D. 10-285 (12/22/2010) -- a sale of receivables to a wholly owned bankruptcy-remote entity may have a valid business purpose where it facilitates securitization required by unrelated third-party lenders, but only through the statutory petition procedure.

Source

• Landing page: Virginia Laws, Rules & Decisions
• Ruling: P.D. 24-31

Original ruling text

March 21, 2024

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, 2010 through 2012. I apologize for the delay in responding to your letter.

FACTS

For the taxable years at issue, the Taxpayer engaged in the factoring of accounts receivable with a related entity, * (IHC). IHC, then securitized the receivable assets and sold an undivided percentage interest to unrelated parties (Purchasers) through receivables purchase agreements. The Taxpayer filed Schedule 500AB (Schedule of Related Entity Add Backs and Exceptions) with its 2009 through 2011 Virginia corporate income tax returns and claimed an exception for 100% to the Intangible Income and Expense Exception for the factoring costs deducted on its federal income tax returns.

Under 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 filed an application for correction contending its factoring transactions meet the unrelated member and third-party expense exceptions to the add-back. The Taxpayer further asserts that its transfer of receivables to IHC was at arm’s length transaction rates and was a primary strategy for funding operations of the Taxpayer, and, thus, had a valid business purpose other than the avoidance of tax.

DETERMINATION

Add-back for Factoring Transactions

Pursuant to Virginia Code § 58.1-402 B 8 a, an addition is required, to the extent excluded from federal taxable income, for:

[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.

Virginia Code § 58.1-302 specifically defines “intangible expenses and costs” to include losses related to or incurred in connection with factoring transactions. For purposes of this addition, intangible expenses and costs must be included regardless of whether the transactions were conducted at arm’s length or the entities at issue had sufficient economic substance. In order to be eligible to be excluded from the addition, such costs or expenses must meet one of the exceptions enumerated under Virginia Code § 58.1-402 B 8.

Unrelated Member Exception

The Taxpayer argues that the factoring transactions with IHC meet the exception under Virginia Code § 58.1-402 B 8 a 2 because the transactions were conducted at arm’s length. The unrelated member exception to the add-back requirement states:

This addition shall not be required for any portion of the intangible expenses and costs if one of the following applies: . . . (2) The related member derives at least one-third of its gross revenues from the licensing of intangible property to parties who are not related members, and the transaction giving rise to the expenses and costs between the corporation and the related member was made at rates and terms comparable to the rates and terms of agreements that the related member has entered into with parties who are not related members for the licensing of intangible property.

Under the exception, the related member must be deriving gross revenues from both the corporation required to make the addition and members that are not related. In this case, the IHC engaged in the selling of an undivided percentage interest of securitized accounts receivable exclusively to unrelated parties. However, because IHC was the purchaser of the accounts receivable from the Taxpayer rather than the seller, IHC was not generating revenue from the intercompany transactions in the same manner as from the unrelated third parties.

Furthermore, the exception specifically identifies related parties that derive revenue from licensing intangible property. IHC was not licensing intangible property to an unrelated third party. Rather it was selling a percentage interest in the Taxpayer’s account receivables to the unrelated party. Because IHC was not licensing intangibles, the Taxpayer would not be eligible for this exception.

Third Party Expense Exception

In addition, the Taxpayer believes the transactions meet the requirements for the exception under Virginia Code § 58.1-402 B 8 a 3. The third party expense exception provides an exception to the add-back to the extent:

The corporation can establish to the satisfaction of the Tax Commissioner that the intangible expenses and costs meet both of the following: (i) the related member during the same taxable year directly or indirectly paid, accrued or incurred such portion to a person who is not a related member, and (ii) the transaction giving rise to the intangible expenses and costs between the corporation and the related member did not have as a principal purpose the avoidance of any portion of the tax . . .

In order for this exception to apply, a corporation must satisfy both provisions of the exception. The first prong of the exception requires that a taxpayer transfer its intangibles to an unrelated third party by using the related member as a conduit. In this case, the Taxpayer is not transferring its intangibles to the Purchasers through IHC. Rather, it is using the intangibles as collateral in order to secure funding from the unrelated party. As such, the first provision of the exception was not met.

The second provision of the third party expense exception that requires that the transaction creating the intangible expense between a taxpayer and their related entity not be made for the principal purpose of tax avoidance. The Taxpayer argues that the primary purpose of the intercompany transactions was to use the receivables as collateral to secure financing. However, the Taxpayer could have made similar, if not identical, agreements with the Purchasers without first transferring the receivables to IHC.

Valid Business Purpose

The Taxpayer also contends that it should be allowed to exclude the factoring fees from the add-back requirement because IHC was created as a bankruptcy remote entity. 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. Virginia Code § 58.1-402 B 8 b 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. An amended return reflecting acceptance of a valid business purpose application 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 Virginia 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.

CONCLUSION

Based on the foregoing, the Taxpayer does not meet either the third party expense exception or the unrelated member exception. In addition, it has not followed the proper procedure in order to demonstrate a valid business purpose. As such, the auditor’s adjustments are correct, and the assessments are upheld. A revised bill, with interest accrued to date, will be sent to the Taxpayer. No additional interest will accrue provided the outstanding balance is paid within 30 days from the date of the revised bill.

The Code of Virginia sections and public document cited are available on-line at www.tax.virginia.gov in the Laws, Rules & Decisions section of the Department’s website. If you have any questions regarding this ruling, you may contact * in the Office of Tax Policy, Appeals and Rulings, at (804) ***.

Sincerely,

Craig M. Burns

Tax Commissioner

AR/554.B

Related Documents

10-285

17-223