IRS Technical Advice
Memorandum 9909002
Auto Dealer's Transfers of Customer Paper Were Sales
The Service has ruled in technical advice that an auto
dealer's transfers of customer notes to a finance company were sales
and that an enrollment fee the dealer paid to participate in the
finance company program was a capital expenditure amortizable over
15 years.
Tax Analysts Document Number: Doc 1999-8682 (22 original pages)
Citations: TAM 199909002 (November 9, 1998)
====== SUMMARY ======
The Service has ruled in technical advice that an auto
dealer's transfers of customer notes to a finance company were sales and
that an enrollment fee the dealer paid to participate in the finance
company program was a capital expenditure amortizable over 15 years. The
Service also ruled that the dealer was eligible to elect mark-to- market
accounting, but could not mark customer notes to market after they were
sold to the finance company.
The dealer, a calendar year, accrual method
corporation, sold used automobiles for cash and installment notes secured
by liens on the cars. To finance its operations and dispose of the
customer notes, the dealer transferred the notes to a finance company. The
dealer paid the company a one-time, nonrefundable enrollment fee and an
annual maintenance fee. When the finance company accepted customer paper
from the dealer, it made an advance payment to the dealer and agreed to
make monthly distribution payments conditioned on the company's
collections of all customer notes. The finance company received title to
the customer notes and the dealer's security interests in the financed
automobiles.
The dealer elected mark-to-market accounting after May
15, 1997, and before September 10, 1997, for an open year that ended
before December 24, 1996, and all later years. The dealer also filed a
Form 3115 for the change.
The Service ruled that the dealer's transfers of
customer notes to the finance company were sales and that the amount the
dealer realized from the sale of customer notes was the cash received plus
the fair market value of the dealer's right to receive the distribution
payments created by the sale. Further, the Service concluded that the
enrollment fee the dealer paid was a capital expenditure and an intangible
amortizable over 15 years.
The Service also ruled that because the dealer was
eligible to make a mark-to-market election and made the election in a
timely manner, the election was effective. Customer notes, however, should
not be marked to market after the dealer sold the notes. Further, said the
IRS, the dealer's right to distribution payments should not be marked to
market.
====== FULL TEXT ======
Index Numbers: 61.03-00, 263.13-06, 162.05-00,
197.00-00, 475.00-00,
1001.02-00
Release Date: 3/5/1999
Date: * * *
INTERNAL REVENUE SERVICE
NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM
TAM-115030-98
[1] ISSUES
(1) Are Taxpayer's transfers of customer notes to
Company sales or financings?
(2) If the transfers described in ISSUE (1) are sales,
what are the amounts realized?
(3) How is Taxpayer required to treat the
nonrefundable enrollment fee paid to Company?
(4) Did Taxpayer make an unauthorized change of
accounting method by making an election under section
1.475(c)-(1)(b)(4)(i) of the Income Tax Regulations without consent of the
Commissioner and while under examination?
(5) Assuming that Taxpayer could make the election
under section 1.475(c)-(1)(b)(4)(i) of the regulations, how should
Taxpayer's customer notes, transferred to Company, be valued by Taxpayer?
[2] CONCLUSIONS
(1) Taxpayer's transfers of customer notes to Company
are sales.
(2) The amount realized from a sale of the customer
notes equals (a) the cash received for the customer notes plus (b) the
fair market value of Taxpayer's right to receive the distribution payments
created by the sale.
(3) The enrollment fee is a capital expenditure under
section 263 of the Internal Revenue Code and is an intangible under
section 197 that is amortizable over 15 years.
(4) Since Taxpayer was eligible to make an election
under section 1.475(c)-1(b)(4)(i) of the regulations and made such
election in a timely manner, such election was effective.
(5) Customer notes should not be marked to market by
Taxpayer after having been sold to Company. Taxpayer's right to
distribution payments also should not be marked to market.
FACTS
[3] Taxpayer is a corporation that files on the basis
of a calendar year using an overall accrual method of accounting. During
Tax Years, Taxpayer sold used automobiles. Since many of Taxpayer's
customers were unable to arrange third party financing (because of
perceived credit risk), Taxpayer accepted installment notes secured by a
lien on the automobile (customer notes) as part of the consideration for
sales.
[4] To finance its own operations and divest itself of
the customer notes, Taxpayer entered into an agreement, dated as of Date
A, with Company. Under the agreement, Taxpayer paid Company a one- time,
nonrefundable enrollment fee of $x and, was required to pay an annual
maintenance fee equal to one-sixth of $x in each subsequent year. As a
consequence, Taxpayer had the right to periodically submit customer notes
for financing, administration, and collection. If Company accepted a
customer note, it made an advance payment to Taxpayer and agreed to make
distribution payments which were monthly payments conditioned on Company's
collections on all customer notes. The amount of the advance payment was
equal to the product of the face amount of the customer note and a
percentage that ranged from 100% to 50%, depending on Company's assessment
of the customer's credit rating. During Tax Years, advance payments
equalled on average approximately 60% of the face amount of the customer
note. Taxpayer was not required to return the advance payment due to a
default on the customer note.
[5] Company determined the distribution payments by
pooling all of the customer notes transferred by Taxpayer and by applying
payments on the pool in the following order: (1) to pay Company's
collection costs and insurance premiums for coverage of the financed
vehicle; (2) to pay Company a "collection fee" equal to 20% of
the monthly receipts; and (3) to repay Company for all advance payments
made to Taxpayer by Company plus interest charged at a rate equal to prime
less 3%. The remainder, if any, was payable to Taxpayer as distribution
payments.
[6] Taxpayer received no distribution payments during
the Tax Years in question.
[7] Under the agreement, once Company agreed to
service a customer note, it was entitled to receive title to the note and
Taxpayer's security interest in the financed automobile. Company was also
entitled to endorse Taxpayer's name on any payments made to Taxpayer and
any other instruments concerning the customer note and the financed
automobile. Company had sole and exclusive discretion to collect upon the
customer notes but agreed to use reasonable efforts to collect all
payments due including repossession and liquidation of the financed
automobile if a default on the customer note had occurred.
[8] The customer note provided on its face that it was
assigned to Company and future payments should be made to Company.
[9] Company had the right to terminate the agreement
with respect to future acceptance of customer notes at any time on 30 days
written notice to Taxpayer; Company would continue to service the customer
notes already accepted. Company could also terminate the agreement upon
the occurrence of certain events of default (i.e., Taxpayer makes certain
misrepresentations, Taxpayer declares bankruptcy, or Taxpayer fails to
purchase or return upon request certain vehicles it is selling on behalf
of Company). If the agreement were terminated due to the occurrence of an
event of default or because Taxpayer chose to terminate the agreement,
Taxpayer would be required to repay to Company the outstanding balance on
the advance payments, any unreimbursed collection costs, and 20% of the
outstanding balance of the customer notes and, in turn, Company would
reassign the customer notes to Taxpayer.
[10] The agreement also placed certain additional
restrictions on Taxpayer. Taxpayer could not assign its rights under the
Agreement to third parties. Taxpayer made a variety of representations
including that it had and would remain duly qualified to carry on its
business and had all necessary licenses and that any documents delivered
to Company would be free of false or misleading statements and bear
genuine signatures. In addition, Taxpayer was obligated to insure that the
customer obtained adequate automobile insurance.
[11] Taxpayer effectively treated the transfers of
customer notes to Company as sales for federal income tax purposes.
[12] After May 15, 1997, and before September 10,
1997, Taxpayer made an election under section 1.475(c)-(1)(b)(4)(i) for
tax year B (an open year for which a tax return had previously been filed
but which ended on or before December 24, 1996) and all subsequent tax
years by filing the appropriate statement with an amended tax return for
tax year B. This election was made while Taxpayer was under examination
for that year and without the consent of the District Director. The
election was not made during a "window period" as described in
sections 6.01(2) or 6.01(3) of Rev. Proc. 97-27, 1997-21 I.R.B. 10. If
valid, the election had the effect of changing Taxpayer's accounting
method to reflect the application of the mark- to-market accounting method
of section 475(a). Taxpayer also filed a Form 3115 with respect to such
change of accounting method with the Service by October 31, 1997 but did
not provide a copy of the Form 3115 to the examining agent.
OVERVIEW
[13] During Tax Years, Taxpayer sold used automobiles
in exchange for cash and customer notes. Taxpayer then sold the customer
notes to Company for cash plus the right to receive distribution payments.
[14] On the sale of an automobile, Taxpayer's amount
realized was the cash received plus the issue price of any customer note
received, which (assuming adequate stated interest) was the face amount of
the customer note.
[15] On the sale of a customer note, Taxpayer's amount
realized was the cash received from Company (the advance payment) plus the
fair market value of Taxpayer's right to receive the distribution
payments. Thus, Taxpayer realized a loss on the sale of a customer note
equal to the excess of Taxpayer's adjusted basis in the customer note over
Taxpayer's amount realized.
[16] Taxpayer's election to apply the mark to market
accounting method of section 475 to its securities was effective. However,
Taxpayer could not mark to market customer notes once they had been sold.
The Taxpayer's right to distribution payments also did not constitute
securities that could be marked to market under section 475.
LAW AND ANALYSIS
ISSUE 1
[17] Are Taxpayer's transfers of customer notes to
Company sales or financings?
[18] Taxpayer transferred customer notes to Company in
exchange for advance payments and contractual rights to distribution
payments. The question is whether Taxpayer sold the customer notes or
whether Taxpayer borrowed the advance payment from Company using the
customer notes as collateral. If the transactions were sales, then
Taxpayer must recognize any gain or loss for federal income tax purposes
under section 1001 of the Internal Revenue Code. Alternatively, if the
transactions were secured financings, then Taxpayer does not include the
borrowed amounts in gross income. United States v. Centennial Savings Bank
FSB, 499 U.S. 573, 582 (1991), 1991-2 C.B. 30.
[19] In general, federal income tax consequences are
governed by the substance of a transaction determined by the intentions of
the parties to the transaction, the underlying economics, and all other
relevant facts and circumstances. Gregory v. Helvering, 293 U.S. 465, 470
(1935), XIV-1 C.B. 193. The label the parties affix to a transaction does
not determine its character. Helvering v. Lazarus & Co., 308 U.S. 252,
255 (1939), 1939-2 C.B. 208; Mapco Inc. v. United States, 556 F.2d 1107,
1110 (Ct. Cl. 1977).
[20] The term "sale" is given its ordinary
meaning and is generally defined as a transfer of the ownership of
property for money or for a promise to pay money. Commissioner v. Brown,
380 U.S. 563, 570-71 (1965), 1965-2 C.B. 282. Whether a transaction is a
sale or a financing arrangement is a question of fact, which must be
ascertained from the intent of the parties as evidenced by the written
agreements read in light of the surrounding facts and circumstances.
Haggard v. Commissioner, 24 T.C. 1124, 1129 (1955), aff'd, 241 F.2d 288
(9th Cir. 1956). But see Farley Realty Co. v. Commissioner, 279 F.2d 701,
705 (2d Cir. 1960) ("[T]he parties) bona fide intentions may be
ignored if the relationship the parties have created does not coincide
with their intentions.").
[21] A transaction is a sale if the benefits and
burdens of ownership have passed to the purported purchaser. Highland
Farms, Inc. v. Commissioner, 106 T.C. 237, 253 (1996); Grodt & McKay
Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981). In cases
involving transfers of debt instruments, the courts have considered the
following factors to be relevant in determining whether the benefits and
burdens of ownership passed: (1) whether the transaction was treated as a
sale, see United Surgical Steel Co., Inc. v. Commissioner, 54 T.C. 1215,
1229-30, 1231 (1970), acq., 1971-2 C.B. 3; (2) whether the obligors on the
notes (the transferor's customers) were notified of the transfer of the
notes, id.; (3) which party serviced the notes, id.; Town & Country
Food Co., Inc. v. Commissioner, 51 T.C. 1049, 1057 (1969), acq., 1969-2
C.B. xxv; (4) whether payments to the transferee corresponded to
collections on the notes, United Surgical Steel Co., 54 T.C. at 1229-30,
1231; Town & Country Food Co., 51 T.C. at 1057; (5) whether the
transferee imposed restrictions on the operations of the transferor that
are consistent with a lender-borrower relationship, United Surgical Steel
Co., 54 T.C. at 1230; Yancey Bros. Co. v. United States, 319 F. Supp. 441,
446 (N.D. Ga. 1970); (6) which party had the power of disposition,
American Nat'l Bank of Austin v. United States, 421 F.2d 442, 452 (5th
Cir. 1970), cert. denied, 400 U.S. 819 (1970); Rev. Rul. 82-144, 1982-2
C.B. 34; (7) which party bore the credit risk, Union Planters Nat'l Bank
of Memphis v. United States, 426 F.2d 115, 118 (6th Cir. 1970), cert.
denied, 400 U.S. 827 (1970); Elmer v. Commissioner, 65 F.2d 568, 569 (2d
Cir. 1933) aff'g 22 B.T.A. 224 (1931); Rev. Rul. 82-144; and (8) which
party had the potential for gain, United Surgical Steel Co., 54 T.C. at
1229; Town & Country Food Co., 51 T.C. at 1057; Rev. Rul. 82-144. No
one factor is dispositive of the issue of whether a sale has taken place.
The facts and circumstances determine the importance of each factor. Thus,
a factor-by-factor analysis is necessary to determine whether Taxpayer
sold the customer notes.
(1) Were the transfers treated as sales?
[22] The agreement states that Taxpayer may submit to
Company customer notes for "financing, administration and collection.
. . ." Thus, on its face, the agreement appears to view the
transactions as financings rather than sales. However, Taxpayer did report
the advance payments as income which is consistent with viewing the
transactions as sales for tax purposes.
(2) Were Taxpayer's customers notified of the
transfer of the customer notes to Company?
[23] The customer notes indicated on their face that
they would be assigned to Company. See, e.g., United Surgical Steel Co.,
54 T.C. at 1229-30, 1231 (customers' lack of notice of assignment was a
factor supporting financing treatment).
(3) Which party handled collections and serviced
the customer notes?
[24] Company collected payments, serviced the customer
notes and repossessed the financed automobile if a customer defaulted.
Company was not acting as Taxpayer's agent. Taxpayer did not exercise any
control over Company. Aside from agreeing to use reasonable efforts,
Company had the sole and exclusive discretion to manage the customer
notes. Compare United Surgical Steel Co., 54 T.C. at 1229- 30, 1231, and
Town & Country Food Co., 51 T.C. at 1057 (taxpayers collected payments
and serviced installment notes) with Elmer, 65 F.2d at 570 (taxpayer did
not collect payments on installment notes). See also Mapco, 556 F.2d at
1111.
(4) Did payments to Company correspond to
collections on the customer notes?
[25] The payments Company received were the payments
Company collected on the customer notes. Taxpayer had no obligation to
make payments to Company. Company received payments only if and when it
collected amounts on the customer notes. Compare United Surgical Steel
Co., 54 T.C. at 1230, and Town & Country Food Co., 51 T.C. at 1057
(lenders looked to taxpayers for repayment, not payments on pledged
installment notes) with Branham v. Commissioner, 51 T.C. 175, 180 (1968)
(taxpayer's payments to purported lender were exactly the same in amount
and timing as payments on underlying installment notes). Furthermore, an
advance payment was based on a percentage of the face amount of a customer
note transferred by Taxpayer, which suggests that Taxpayer sold the
customer notes. Cf. United Surgical Steel Co., 54 T.C. at 1231 (taxpayer
did not borrow maximum amount allowable under agreement); Yancey Bros.
Co., 319 F. Supp. at 446 (taxpayer had access to additional funds without
providing additional collateral).
(5) Did Company impose restrictions on the
operations of Taxpayer that are consistent with a lender-borrower
relationship?
[26] The relationship between Taxpayer and Company had
none of the characteristics that are common in a lender-borrower
relationship. Other than requiring that Taxpayer remain duly qualified to
carry on its business and obtain necessary licenses, Company imposed no
restrictions on the operations of Taxpayer. For example, Company did not
require Taxpayer to maintain a specified ratio of assets to liabilities or
current assets to current liabilities. Company did not receive the right
to review Taxpayer's books and records. Company received only the right to
documents that were necessary for Company to exercise its rights and
duties concerning the transferred customer notes. Since Company imposed no
restrictions on Taxpayer's operations, Company is less like a lender and
more like a purchaser of the customer notes. See, e.g., United Surgical
Steel Co., 54 T.C. at 1230 (bank's imposition of restrictions on
operations of taxpayer was a factor showing lender- borrower
relationship). This conclusion is further supported by Company's failure
to require Taxpayer to maintain a minimum amount of collateral. see, e.g.,
Union Planters Nat'l Bank of Memphis, 426 F.2d at 118, (purported seller
required to make margin account payments); Yancey Bros. Co., 319 F. Supp.
at 446 (taxpayer obligated to maintain ratio of collateral to debt of not
less than 105 percent).
(6) Which party had the power of disposition?
[27] Company had the power of disposition. The
agreement contemplates that, following Company's acceptance of a
receivable, title to the customer note and the security interest in the
financed vehicle would be assigned to Company. The agreement did not
restrict Company's right to dispose of the transferred customer notes. Cf.
Town & Country Food Co., 51 T.C. at 1057 (finance company could
acquire and dispose of installment notes only if the dealer defaulted on
its indebtedness).
[28] Taxpayer, on the other hand, no longer had title
to the customer notes, and so could not transfer the customer notes.
Further, the agreement expressly forbids Taxpayer assigning its rights
under the agreement to third parties so Taxpayer could not assign any
contractual rights it might have in the customer notes (e.g. its right to
distribution payments) to a third party absent Finance Company's waiver of
the restriction on assignment. Taxpayer had neither the right to
substitute different customer notes for customer notes transferred to
Company, nor the right to reacquire customer notes (unless by terminating
the agreement and reacquiring all customer notes). If Company were a
lender, then it would be reasonable to expect Taxpayer to have the ability
to substitute collateral of equal value to secure the outstanding loan.
Cf. American Nat'l Bank of Austin, 421 F.2d at 452 (purported seller could
dispose of the securities without prior approval from purported buyer).
(7) Which party bore the credit risk on the
customer notes?
[29] By transferring the customer notes to Company,
Taxpayer eliminated almost all of its exposure to credit risk on the
customer notes. Aside from cancelling the agreement or allowing an event
of default to occur, in the event of a customer's default, Taxpayer had no
obligation to repurchase either the customer note or the financed vehicle,
or to return the advance payment. Further, Taxpayer fixed its economic
loss in the customer notes. After transferring a customer note, the only
loss Taxpayer could realize was a diminution in value of its right to
receive distribution payments. Company, on the other hand, was at risk for
the advance payments it made to Taxpayer.
[30] It may be argued that Company's risk of loss was
insubstantial because (1) it advanced Taxpayer an average of about 60
percent of the face amount of each customer note, and (2) the distribution
payments were based on the entire pool of customer notes, which meant that
Taxpayer's right to payments was subordinated to Company's right.
[31] This argument assumes that the fair market value
of the customer notes equaled their face amounts. The evidence, however,
is to the contrary. Between a customer's down payment and the advance
payment from Company, Taxpayer generally profited on the sale of an
automobile. Given the value of the automobiles sold, the credit quality of
the customers, and statutory limits on interest charged in consumer credit
sales, it is reasonable to conclude that the face amounts of the customer
notes exceeded their fair market values. See, e.g., Hercules Motor Corp.
v. Commissioner, 40 B.T.A. 999, 1000 (1939) (taxpayer inflated sales price
to account for buyer's uncertain credit status). Taxpayer transferred
customer notes to Company for cash payments averaging about 60 percent of
their face amounts and permitted Company to retain substantial fees on all
collections. Taxpayer would not have agreed to these conditions unless the
fair market value of the customer notes was less than their face amounts.
Accordingly, we are unwilling to conclude that Company's risk of loss was
insubstantial.
(8) The potential for gain on the customer notes.
[32] Company's potential for gain on the customer
notes was greater than Taxpayer's. Company gave Taxpayer cash, namely, the
advance payments when Taxpayer transferred customer notes to Company.
Company's right to recover those advance payments plus a small
"interest charge" and payment for its collection costs and fees
was limited to its collections on the customer notes. Company's profits,
therefore, depended on the timing and amount of the collections rather
than on any interest charged to Taxpayer while the advance payments were
outstanding. Consequently, the greater the collections on the customer
notes, the greater Company's rate of return on the advance payments made
to Taxpayer. /1/ In addition, Company stood to gain more than Taxpayer if
customers defaulted at a rate lower than expected.
[33] In cases addressing transfers of debt instruments
or other rights to future payments, courts have pointed to a fixed rate of
return on the loaned amount as evidence that the transactions were
financings. E.g., Mapco, 556 F.2d at 1111-12; Union Planters Nat'l Bank of
Memphis, 426 F.2d at 118; American Nat'l Bank of Austin, 421 F.2d at 452;
United Surgical Steel Co., 54 T.C. at 1229. A debt instrument can provide
for a variable rate of return and even contingent payments. E.g., sections
1.1275-4 and 1.1275-5 of the Income Tax Regulations; Rev. Rul. 83-51,
1983-1 C.B. 48. Nevertheless, to be a financing there must be a
debtor-creditor relationship between Company and Taxpayer. Since Company's
economic return was based solely on the performance of the customer notes
rather than on its relationship with Taxpayer, Company was more like an
owner of the customer notes than a creditor of Taxpayer.
[34] After transferring the customer notes, Taxpayer
had little potential to realize gain on the customer notes. Only after
Company recouped its out-of-pocket costs, its fees, and all of the advance
payments would Taxpayer receive any distribution payments. While Taxpayer
had the potential for some benefit if the pool of customer notes had a low
default rate, that potential benefit does not in itself make Taxpayer the
owner of the customer notes. See Commissioner v. Brown, 380 U.S. 573
(1965); Rev. Rul. 83-51, 1983-1 C.B. 48. Further, Taxpayer could not
realize any economic benefit of changes in market interest rates by
disposing of the customer notes.
[35] For the foregoing reasons, we conclude that
Taxpayer sold the customer notes to Company.
ISSUE 2
[36] What are the amounts realized on the sale of
the customer notes?
[37] Under section 1001(b) of the Code and section
1.1001-1(a) of the regulations, the amount realized from the sale of
property is the money received plus the fair market value of any other
property received. The fair market value of property is a question of
fact, but only in rare and extraordinary cases will property be considered
to have no fair market value.
[38] In return for the customer notes, Taxpayer
received advance payments and the right to distribution payments. The
advance payments are clearly "money received" under section
1001(b) of the Code. The amount realized attributable to Taxpayer's right
to receive the distribution payments must be determined.
[39] Under the dealer agreement, Taxpayer's receipt of
distribution payments depended on Company's ability to collect on the
customer notes and Company's cost of making those collections.
Distribution payments were determined under a complex formula. No amount
or time of payment was specified for any particular customer note or any
group of customer notes. Payment, if any, was deferred until an indefinite
time in the future. Moreover, there was no provision for interest
regardless of when Taxpayer might receive any distribution payments.
[40] The deferred nature of the distribution payments
and the absence of any stated interest implicates section 483 of the Code.
/2/ Section 483 generally applies to payments under a contract for the
sale of property if the contract provides for one or more payments due
more than 1 year after the date of sale, and the contract does not provide
for adequate stated interest. For purposes of section 483, a sale is any
transaction treated as a sale for tax purposes (such as Taxpayer's
transaction with Company) and property includes debt instruments (such as
the customer notes). Section 1.483-1(a)(2) of the regulations.
[41] Section 483 of the Code is intended to ensure
that a minimum portion of the payments under a sales contract is treated
as interest. H. Conf. Rep No. 215, 97th. Cong. 1st Sess. 281 (1981),
1981-2 C.B. 525. In other words, if a sales contract provides for deferred
payments but not adequate stated interest, section 483 recharacterizes a
portion of the deferred payments as interest for tax purposes. Thus,
unstated interest is not treated as part of the amount realized from the
sale or exchange of property (in the case of the seller), and is not
included in the purchaser's basis in the property acquired in the sale or
exchange. Section 1.483-1(a)(2) of the regulations. See sections
1.1001-1(g) and 1.1012-1(g).
[42] Because the dealer agreement calls for deferred
payments but no interest, some portion of the distribution payments must
be characterized as interest under section 483 of the Code. This, in turn,
reduces the amount realized under section 1001 attributable to those
payments. Had the dealer agreement called for a single $100,000 payment
due three years after sale of a pool of customer notes, fixing the amount
realized would be relatively simple. It would involve nothing more than
calculating the present value of the $100,000 on the date of sale. This,
however, is not the case. The conditional nature of the distribution
payments raises additional questions under section 483(f).
[43] Section 483(f) of the Code authorizes the
Secretary to issue regulations applying section 483 to any contract for
the sale or exchange of property under which the liability for, or the
amount or due date of, a payment cannot be determined at the time of the
sale or exchange. Section 1.483-4 of the regulations, /3/ which was issued
under the authority of section 483(f), contains rules applying section 483
in the case of a sales contract that calls for one or more
"contingent payments".
[44] In general, section 1.483-4 of the regulations
establishes the treatment of contingent payments by reference to section
1.1275- 4, which was issued simultaneously with section 1.483-4 and
addresses the taxation of contingent payment debt instruments.
Specifically, section 1.483-4(a) states that interest under the sales
contract is generally computed and accounted for using rules similar to
those that would apply if the contract were a debt instrument subject to
section 1.1275-4(c). Thus, each contingent payment under the contract is
characterized as principal and interest under rules similar to those in
section 1.1275-4(c)(4).
[45] Neither section 1.483-4 nor section 1.1275-4 of
the regulations define the term "contingent payments."
Nevertheless, the statutory basis for the section 1.483-4 regulations is
section 483(f), and section 483(f) pertains to payments which "the
liability for, or the amount or due date of," cannot be determined at
the time of the sale or exchange. Payments are not contingent payments,
however, merely because of a contingency that is remote or incidental at
the time of the sale or exchange. See section 1.1275-4(a)(5).
[46] The distribution payments called for in the
dealer agreement are contingent payments under section 483 of the Code and
section 1.483-4 of the regulations. At the time Taxpayer sold a customer
note, Company's liability for, and the amount and timing of any
distribution payments could not be reasonably determined. Company's
liability to make distribution payments depended on its ability to collect
on the customer notes and its collection costs. In this case, these
contingencies were neither remote nor incidental. Nor were they
predictable.
[47] At the time of sale, both Taxpayer and Company
understood that customers' defaults and Company's collection costs would
reduce the amounts left for distributions to Taxpayer. As discussed above,
the face of the customer notes generally exceeded the value of the
underlying collateral. Given that fact, together with the high credit risk
of Taxpayers' customers, Company would fail to collect the entire
principal amount of a significant but uncertain number of customer notes.
Company would also have significant but uncertain collection costs. Thus,
reductions due to default and collection costs would be significant, and
because of the formula for determining the distribution payments, could
reasonably be expected to leave Taxpayer with minimal, if any,
distribution payments. For these reasons, and in light of other unique
circumstances, Company's liability for, and the amount and timing of those
payments to Taxpayer could not be determined at the time of the sale of
the customer notes.
[48] Because the distribution payments are contingent
payments under section 1.483-4 of the regulations, each payment must be
accounted for using rules similar to those contained in section
1.1275-4(c)(4).
[49] Under section 1.1275-4(c)(4) of the regulations,
the portion of a contingent payment treated as interest is includible in
gross income by the holder and deductible from gross income by the issuer
in the year in which the payment is made. A contingent payment is
characterized by section 1.1275-4(c)(4)(ii) as a payment of principal in
an amount equal to the present value of the payment, determined by
discounting the payment at the test rate from the date the payment is made
to the issue date.
[50] Under section 1.1275-4(c)(5)(iii) of the
regulations, the holder's basis in the contingent payments under a
contract is reduced by any principal payments (as characterized by section
1.1275- 4(c)(4)(ii)) received by the holder. If the holder's basis in the
contingent payments is reduced to zero, any additional principal payments
(as characterized by section 1.1275-4(c)(4)(ii)) are treated as gain from
the sale or exchange of the contract.
[51] Section 1.1001-1(g)(2)(ii) of the regulations
provides the rule for determining the amount realized attributable to a
debt instrument subject to section 1.1275-4(c)(4) or section 1.483-4.
Under section 1.1001-1(g)(2)(ii), the amount realized attributable to
contingent payments is their fair market value. Since the distribution
payments are contingent payments for purposes of section 483 of the Code,
the amount realized attributable to the distribution payments is the fair
market value of the distribution payments. Thus, the amounts realized from
the sales of the customer notes equal (a) the cash received plus (b) the
fair market value of Taxpayer's right to receive the distribution
payments.
[52] The conclusions reached on this issue are
consistent with section 451 of the Code. Section 451(a) provides that the
amount of any item of gross income for the taxable year in which received
by the taxpayer, unless, under the method of accounting used in computing
taxable income, such amount is to be properly accounted for as of a
different period. Section 1.451-1(a) of the regulations provides that,
under an accrual method of accounting, income is includible in gross
income when all the events have occurred that fix the right to receive the
income and the amount of the income can be determined with reasonable
accuracy. See also section 1.446- 1(c)(1)(ii)(A). Thus, it is the right to
receive and not the actual receipt that determines inclusion. Spring City
Foundry Co. v. Commissioner, 292 U.S. 182, 184-85, 1934-1 C.B. 281.
[53] In Commissioner v. Hansen, 360 U.S. 446 (1959),
1959-2 C.B. 460, /4/ the Supreme Court addressed the issue of whether
accrual method taxpayers have a fixed right to receive income even though
payment is withheld. The taxpayers were two automobile dealers and a
trailer dealer who accepted installment notes from their customers. Each
dealer sold their notes to a finance company for a price determined by a
fixed formula. The finance company paid 95 to 97 percent of the formula
price in cash and held the remainder in reserve. The reserve served as
security for payment of the dealers obligation to repurchase a note that
went into default. If the accumulated reserve exceeded a designated
percentage of the unpaid principal balances of the notes, the finance
companies paid the excess to the dealer.
[54] The Supreme Court held that the dealers had to
currently include in income the amounts withheld in reserve. Even though
the dealers' actual receipt of the reserve amounts was subject to their
contingent liabilities to the finance companies, the Court concluded that
the dealers had received a fixed right to the reserve amounts. Id. at 463.
Only one of two things could happen to the reserve amounts -- either the
amounts would be paid to the dealers or would be used to satisfy the
dealers guaranty obligations to the finance companies. Id. at 465-66. As
the dealers effectively received the entire amount of the reserves in all
events, the right to the receive the reserves was not conditional but
absolute at the time they were withheld and the dealers had to include the
reserves in income at that time. Id.
[55] Under the particular facts and circumstances of
the instant case, Taxpayer does not have a fixed right to distribution
payments at the time Taxpayer sells a customer note. Taxpayer's case is
distinguishable from Hansen. Taxpayer's customers had poor credit and the
customer notes were of poor quality. Because of the poor creditworthiness
of the customers, Company's collection costs were uncertain and sometimes
significant. Company was obligated to pay distribution payments to
Taxpayer only if it collected enough from the customers to recover (1) all
its collection costs on the transferred customer notes; (2) its 20%
servicing fee on the customer notes; and (3) any outstanding advances on
the customer notes plus an interest charge. Under these circumstances,
there was reasonable doubt that any future distribution payments would be
made to Taxpayer. In light of these facts and circumstances, which were
not present in Hansen, Taxpayer's right to distribution payments were
contingent upon future events that were uncertain at the time the notes
were sold to Company.
[56] Accordingly, the amounts realized by Taxpayer
from the sales of the customer notes does not necessarily include the full
amount of future distribution payments. Rather, the amount realized is
equal to (a) the cash received plus (b) the fair market value of
Taxpayer's right to receive the distribution payments.
ISSUE 3
[57] How is Taxpayer required to treat the
nonrefundable enrollment fee paid to Company? Is the fee a capital
expenditure under section 263 of the Code or currently deductible under
section 162? If the fee is a capital expenditure, is it a section 197
intangible?
[58] Section 161 of the Code provides that, in
computing taxable income there are allowed as deductions the items
specified in part VI (which contains section 162), subject to the
exceptions provided in part IX (which contains section 263).
[59] Section 162(a) of the Code allows a deduction for
all of the ordinary and necessary expenses paid or incurred during the
taxable year in carrying on any trade or business.
[60] Section 263(a) of the Code prohibits a deduction
for any amount paid out for new buildings or for permanent improvements or
betterments made to increase the value of any property or estate.
[61] The determination of whether an expenditure is
capital or ordinary must be based on a careful examination of the
particular facts and circumstances of each situation. Deputy v. du Pont,
308 U.S. 488, 496 (1940), 1940-1 C.B. 118, 121. An expenditure incurred in
a taxpayer's business may qualify as ordinary and necessary under section
162 of the Code if it is appropriate and helpful in carrying on that
business, is commonly and frequently incurred in the type of business
conducted by the taxpayer, and is not a capital expenditure under section
263. Commissioner v. Tellier, 383 U.S, 687, 689 (1966), 1966-1 C.B. 32,
33; Deputy v. du Pont, 308 U.S. at 495, 1940-1 C.B. at 121; Welch v.
Helvering, 290 U.S. 111, 113 (1933), 1933-2 C.B. 112, 113. Under section
161, if a cost is a capital expenditure, the capitalization rules of
section 263 take precedence over the deduction rules of section 162.
Commissioner v. Idaho Power Co., 418 U.S. 1, 17 (1974), 1974-2 C.B. 85,
90. Thus, a capital expenditure cannot be deducted under section 162,
regardless of whether it is ordinary and necessary in carrying on a trade
or business.
[62] In determining whether a cost is a capital
expenditure, the Supreme Court in INDOPCO, Inc. v. Commissioner, 503 U.S.
79 (1992), noted that a taxpayer's realization of benefits beyond the year
in which the expenditure is incurred is undeniably important in
determining whether the appropriate tax treatment is a current deduction
or a capital expenditure. 503 U.S. at 87, citing United States v.
Mississippi Chemical Corp., 405 U.S. 298, 310 (1972), 1972-1 C.B. 229,
232-33 (expense that "is of value in more than one taxable year"
is a nondeductible capital expenditure). Initiation fees payable to an
organization, the services of which benefit the taxpayer's business beyond
the taxable year, are nondeductible capital expenditures. Harmon v.
Commissioner, 72 T.C. 362, 367-68 (1979); Wells-Lee v. Commissioner, 360
F.2d 665 (8th Cir. 1966); Iowa-Des Moines Nat'l Bank v. Commissioner, 68
T.C. 872 (1977), aff'd on other grounds, 592 F.2d 433 (8th Cir. 1979);
Webb v. Commissioner, 55 T.C. 743 (1971); Rev. Rul. 77-534, 1977-2 C.B.50.
[63] Another factor that is considered is whether the
fee is nonrecurring. The distinction between recurring and nonrecurring
expenditures provides a crude but serviceable demarcation between
deductible expenses and capital expenditures. Encyclopedia Britannica Inc.
v. Commissioner, 685 F.2d 212, 216-17 (7th Cir. 1982); Central Texas
Savings & Loan Assoc. v. United States, 731 F.2d 1181, 1183 (5th Cir.
1984); Rev. Rul. 80-3, 1980-1 C.B. 145; Rev. Rul. 70-171, 1970-1 C.B. 55.
In Central Texas Savings & Loan, the court held that fees paid to
obtain permits to open new branch offices were capital expenditures:
[T]he permit was a one-time payment
that gave the taxpayer the
right to operate for an indefinite
period of time. The benefit
secured by the permit clearly
extended beyond the year in which
the fee payment was made.
Furthermore, the fact that the fee
payment was made only once supports
the proposition that the
outlay was a capital asset, rather
than an annual expense.
731 F.2d at 1183. Accord Grace
Nat'l Bank of New York v.
Commissioner, 15 T.C. 563, 565
(1950) (holding that admission fee was
capital expenditure because not
recurring and benefits of fee not
limited to taxable year in which
paid or incurred).
[64] The enrollment fee at issue is similar to an
initiation or admission fee. By making a one-time payment, Taxpayer was
able to sell customer notes indefinitely to Company. Company's purchase of
the customer notes provided long-term benefits to Taxpayer's business by
eliminating the need to carry and service high-risk customer notes. This
in turn freed up Taxpayer's cash flow, enhanced its ability to maintain a
greater automobile inventory, and increased turnover. The benefits to
Taxpayer were significant and extended substantially beyond the taxable
year. Accordingly, the enrollment fee is a capital expenditure under
section 263 of the Code and may not be currently deducted under section
162.
[65] Section 197(a) of the Code provides that a
taxpayer is entitled to an amortization deduction for any amortizable
section 197 intangible. The amortization is ratable over a 15-year period.
[66] Under section 197(c)(1) of the Code, an
"amortizable section 197 intangible" is any section 197
intangible acquired by the taxpayer after August 10, 1993 and held in
connection with the conduct of a trade or business.
[67] Under section 197(d)(1) of the Code, a
"section 197 intangible" includes any supplier-based intangible.
The term "supplier-based intangible" (defined in section
197(d)(3)) means any value resulting from the future acquisition of goods
and services pursuant to relationships (contractual or otherwise) in the
ordinary course of business with suppliers of goods or services to be used
or sold by the taxpayer.
[68] Section 197(e)(4)(D)(i) of the Code allows, to
the extent provided in regulations, for an exception from inclusion as a
section 197 intangible any interest under a contract if such right has a
fixed duration of less than 15 years.
[69] The dealer agreement with Company provides
Taxpayer with a program for financing its automobile sales. The dealer
agreement is a contractual relationship for the future acquisition of
services in the ordinary course of business for Taxpayer. Thus, the dealer
agreement meets the definition of a supplier-based intangible under
section 197(d) of the Code.
[70] The dealer agreement does not have a fixed
duration of less than 15 years, therefore the exception from inclusion
under section 197 of the Code does not apply. Taxpayer entered into the
dealer agreement after the August 10, 1993, effective date of section 197.
Therefore, the dealer agreement meets the requirements of section 197(c)
and the nonrefundable enrollment fee is amortizable as a section 197
intangible.
[71] The adjusted basis of the dealer agreement is
amortizable ratably over a 15-year period beginning with the month in
which the contract was entered into. As Taxpayer deducted the fee in the
year paid rather than capitalizing, an adjustment under section 481 of the
Code is necessary to recover the improper deduction.
ISSUE 4
[72] Did Taxpayer make an unauthorized change of
accounting method by making an election under section 1.475(c)-1(b)(4)(i)
of the regulations without consent of the Commissioner and while under
examination?
[73] Section 1.475(c)-1(b)(4) of the regulations
exempts a taxpayer from the application of section 475 of the Code if the
taxpayer would not be a "dealer in securities" within the
meaning of section 475 but for its purchases of "customer
paper." Customer paper with respect to a person is defined to mean a
debt instrument if --
(i) The person's principal activity
is selling nonfinancial goods or
providing nonfinancial services;
(ii) The debt instrument was issued
by a purchaser of the goods or
services at the time of the
purchase of those goods or services in
order to finance the purchase; and
(iii) At all times since the debt
instrument was issued, it has been
held either by the person selling
those goods or services or by a
corporation that is a member of the
same consolidated group as that
person. Section 1.475(c)-1(b)(2).
[74] Under section 1.475(c)-1(b)(4)(i) of the
regulations, a taxpayer may elect to waive the "customer paper"
exemption. Although section 1.475(c)-1(b) became effective on December 24,
1996, the waiver may be elected for a year ending on or before December
24, 1996, by attaching a statement to an amended tax return filed prior to
October 31, 1997. An election under section 1.475(c)-1(b)(4)(i) is deemed
also to be an election to waive the exemption from application of section
475(a) provided by section 1.475(c)-1(c) for taxpayers with negligible
sales of securities. See Rev. Rul. 97-39, 1997-39 I.R.B. 4, Holding 18.
[75] In general, making the election under section
1.475(c)- 1(b)(4)(i) of the regulations requires a taxpayer to change its
method of accounting. Ordinarily, a taxpayer cannot change its method of
accounting absent the Commissioner's permission. Section 446(e). Rev.
Proc. 97-27, 1997-1 C.B. 680, governs changes of accounting methods
applied for after May 15, 1997. Rev. Proc. 97-27, at sections 4.01, 13.01.
Rev. Proc. 97-27, however, does not apply to taxpayers under examination
other than those that request a change of accounting method with the
consent of the district director or in certain "window periods".
Id. at section 6.01. In addition, Rev. Proc. 97-27 does not apply to
changes of accounting method subject to automatic consent procedures such
as Rev. Proc 97-43. Id. at section 4.02(1).
[76] Rev. Proc. 97-43, 1997-39 I.R.B. 12, provides a
method by which a taxpayer can secure the automatic consent of the
Commissioner to change its method of accounting to reflect the application
of section 475 of the Code as a result of making the election provided by
section 1.475(c)-1(b)(4)(i) of the regulations. To secure automatic
consent, the taxpayer must make the election by attaching the statement
required by section 1.475-1(b)(4)(i) to a tax return or amended tax
return, as applicable. Rev. Proc. 97-43 at section 4.02. In addition, the
taxpayer must file a Form 3115 (and certain supplemental material) with
the main office of the Service and, subject to certain limited exceptions,
with the tax return or amended tax return that makes the election. Id. at
sections 4.05, 4.07. If the taxpayer is under examination with respect to
the year of change, a copy of the Form 3115 must also be provided to the
examining agent. Id. at section 4.06(1). The effective date for Rev. Proc.
97-43 is September 10, 1997, although the effective date for section
1.475(c)- 1(b) is December 24, 1996. T.D. 8700, 1997-1 C.B. 108; Rev.
Proc. 97- 43 at section 6.
[77] Taxpayer's primary activity is the sale of used
cars. The customer notes are issued by the purchasers of the used cars in
order to finance their purchase. The customer notes are held by Taxpayer
upon issuance. Therefore, the customer notes are customer paper with
respect to Taxpayer. Taxpayer was therefore subject to the "customer
paper" exemption and could waive the exemption by making an election
under section 1.475(c)-1(b)(4)(i). If an election out of the negligible
sales exemption of section 1.475(c)-1(c) had been necessary for Taxpayer
to have become subject to the application of the mark-to-market accounting
method of section 475(a) of the Code, the election under section
1.475(c)-1(b)(4)(i) would be deemed also to be an election out of the
application of section 1.475(c)-1(c).
[78] Electing the waiver provided by section 1.475(c)-
1(b)(4)(i) of the regulations may require changing an accounting method.
However, the section is, on its face, comprehensive and does not refer to
an obligation to obtain consent of the Commissioner in order to elect the
waiver. This suggests that automatic consent to a resultant change in
accounting method was contemplated. This is consistent with Rev. Proc.
97-43 which imposed certain requirements for taxpayers to obtain such
automatic consent.
[79] Taxpayer did not file a copy of the Form 3115
with the Taxpayer's examining agent and, therefore, failed to comply with
the requirements of section 4.06(1) of Rev. Proc. 97-43. However, since
Taxpayer's election predated the effective date of Rev. Proc. 97-43, Rev.
Proc. 97-43 should not be read to impose requirements on Taxpayer
additional to those imposed by 1.475(c)-1(b)(4)(i).
[80] Rev. Proc. 97-27 does not apply to changes of
accounting method subject to automatic consent procedures. Therefore, Rev.
Proc. 97-27 does not apply in this case.
[81] Taxpayer was eligible to make an election under
1.475(c)- 1(b)(4)(i) of the regulations. Taxpayer made such election in
conformity with the regulation prior to October 31, 1997, so such election
could apply to tax year B, which was an open tax year ending on or before
December 24, 1996. Taxpayer's election predated the effective date of Rev.
Proc. 97-43. Taxpayer's election is an automatic change of accounting
method, and is therefore not subject to Rev. Proc. 97-27.
ISSUE 5
Assuming that Taxpayer could make the election under
section 1.475(c)-1(b)(4)(i) of the regulations, how would Taxpayer's
customer notes, transferred to the Company, be valued by Taxpayer?
[82] A taxpayer that is subject to section 475 of the
Code (whether by election or otherwise) is required to apply the mark-to-
market accounting method of section 475(a) to any "security"
held by the taxpayer other than one described in section 475(b)(1) that is
timely identified as provided by section 475(b)(2) or that is deemed
identified as described in Holding 15 of Revenue Ruling 97-39. A security
is defined to include stock, partnership or beneficial interests in widely
held or publicly traded partnerships or trusts, notes, bonds, debentures,
or other evidence of indebtedness, swaps, an interest in or any derivative
financial instrument in any of the above-described securities, and a
position which is a hedge with respect to an instrument described above.
Section 475(c)(2).
[83] Because the customer notes received by Taxpayer
are "customer paper" as defined by section 1.475(c)-1(b)(2) of
the regulations, they are securities for the purposes of section 475 of
the Code. Therefore, customer notes held by Taxpayer, other than those
identified or deemed identified as described in section 475(b)(1), would
be marked to market by Taxpayer in accordance with section 475(a). Of
course, customer notes not held by Taxpayer because of a sale to a third
party would not be marked to market by Taxpayer. The customer notes sold
to Company, therefore, could not be marked to market by Taxpayer after
their sale.
[84] When Taxpayer transfers a customer note to
Company, it receives a right to distribution payments. Such rights could
be marked to market by Taxpayer if they constituted a "security"
for the purposes of section 475 of the Code. However, the right to
distribution payments does not fit within any of the definitions of a
security under section 475(c)(2). Therefore, the right to distribution
payments can not be marked to market by Taxpayer.
[85] A copy of this technical advice memorandum is to
be given to Taxpayer. Section 6110(k)(3) of the Code provides that it may
not be used or cited as precedent.
FOOTNOTES
/1/ An example may help illustrate why Company's rate
of return on its investment (the advance payments) depended solely on the
performance of the customer notes. Assume Taxpayer transferred to Company
a customer note with a face amount of $3,600, a term of 22 months, an
interest rate of 21.82 percent per annum, and monthly payments of
approximately $200. Also assume that Company had no collection costs,
Taxpayer transferred only the one customer note and that Company did not
receive interest on the advance payment. Company would be entitled to
receive its fee of 20 percent of each payment (approximately $40). Company
would also be entitled to the remaining $160 of any payment ($200 - $40
fee) until it recovered the advance payment of $1,800. Thus, Company would
be entitled to eleven payments of $200, one payment of $80, and ten
payments of $40. Taxpayer would be entitled to receive, starting in month
twelve, one payment of $120 and ten payments of $160.
Company's rate of return on the advance payment made
to Taxpayer increases as more payments are collected on the customer note.
If Company were to collect all payments, then Company's yield to maturity
would be approximately 68 percent per annum, compounded annually. If
Company were to collect enough payments for it to recoup its collection
costs, its 20 percent fee, and its advance payment, then Company's yield
to maturity would be approximately 48 percent. And if Company were to
collect only one-half of the payments, then its yield to maturity still
would be approximately 42 percent. As the example shows, the more payments
Company collects, the greater Company's rate of return on its advance
payment to Taxpayer.
/2/ The deferred receipt of the distribution payments
superficially resembles the deferred receipt of payment in Commissioner v.
Hansen, 360 U.S. 446 (1959), 1959-2 C.B. 460. Nevertheless, as discussed
later, under the facts and circumstances, Taxpayer had no fixed right to
receive the distribution payments at the time Taxpayer sold the customer
notes.
/3/ Section 1.483-4 applies to sales or exchanges that
occur on or after August 13, 1996. For a sale or exchange that occurred
before August 13, 1996, a taxpayer may use any reasonable method to
account for the contingent payments, including a method that would have
been required under the proposed regulations when the sale or exchange
occurred. See T.D. 8674, 1996-2 C.B. 84, 89.
/4/ Section 483 was not applicable in Hansen. Section
483 was added to the Code by the Revenue Act of 1964, Pub. L. No. 88-272,
section 224, 78 Stat. 19, 77-79 (1964), and applies to sellers of ordinary
income property as a result of the Tax Reform Act of 1984, Pub. L. No.
98-369, 98 Stat. 678, 98th Cong. 2d Sess. (1984).
END OF FOOTNOTES
______________________________________________________________________________
Code Section: SECTION 61 -- GROSS INCOME
DEFINED; Section 263 -- Capital Expenditures; Section 475 --
Mark-to-Market Accounting; Section 1001 -- Gain or Loss
Geographic Identifier: United
States
Subject Area: Accounting periods and methods
Financial instruments tax issues
Index Terms: gross income, completed sale
capital expenditures
accounting methods, mark-to-market
gain or loss
Cross Reference:
Institutional Author: Internal Revenue Service
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