IRS Technical Advice
Memorandum 9909003
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 the dealer was required to use the accrual method
of accounting.
Tax Analysts Document Number:Doc 1999-8683
Citations: TAM 199909003 (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 the dealer was required to use the accrual method of accounting.
The dealer, a calendar year, cash method individual,
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. 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 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 as an
auto dealer, the individual was required to be on an accrual method of
accounting.
====== FULL TEXT ======
Index Numbers: 61.03-00, 446.01-05, 1001.02-00
Release Date: 3/5/1999
Date: November 9, 1998
INTERNAL REVENUE SERVICE
NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM
Control Number: TAM-115028-98
[1] ISSUES
(1) Is Taxpayer required to use the accrual method to
account for the purchase and sale of used automobiles?
(2) Are Taxpayer's transfers of customer notes to
Company sales or financings?
(3) If the transfers described in ISSUE (2) are sales,
what are the amounts realized?
[2] CONCLUSIONS
(1) Taxpayer is required to use the accrual method to
account for the purchase and sale of used automobiles.
(2) Taxpayer's transfers of customer notes to Company
are sales.
(3) The amounts realized from sales of the customer
notes equal (a) the cash received for the customer note, plus (b) the fair
market value of Taxpayer's right to receive the distribution payments
created by the sale.
FACTS
[3] Taxpayer is an individual who files on the basis
of a calendar year using the cash receipts and disbursements method of
accounting. During Tax Year, Taxpayer sold used automobiles. Since most of
Taxpayer's customers were unable to arrange third-party financing (because
of perceived credit risk), Taxpayer accepted installment notes (customer
notes), secured by a lien on the automobile, as part of the consideration
for sales.
[4] To finance its own operations and avoid the
difficulties of servicing the customer notes, Taxpayer entered into a
"servicing agreement" with Company. Under the agreement,
Taxpayer paid Company a one-time, nonrefundable enrollment fee and agreed
to periodically submit customer notes for servicing, 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 the customer
notes. The advance payment was the lesser of 50 percent of the outstanding
principal balance of the customer note or 150 percent of the net down
payment made on the purchase of the financed automobile. A customer's
default did not obligate Taxpayer to return the advance payment or to
repurchase either the customer note or the financed automobile.
[5] Company determined the distribution payments by
pooling the customer notes transferred by Taxpayer and by applying
payments on the pool in the following order: (1) to pay Company's
collection costs (all of Company's out-of-pocket costs incurred in the
administration, servicing and collection of the customer notes), (2) to
pay Company's fee of 20 percent of the total payment (net of any
collection costs), and (3) to repay Company for all advance payments made
to Taxpayer. The reminder, if any, was payable to Taxpayer as distribution
payments.
[6] Taxpayer has stated that he never received and
does not expect to receive any distribution payments.
[7] Once Company agreed to service a customer note,
Taxpayer transferred the customer note, all files relating to the customer
note, and Taxpayer's security interest in the financed automobile. Company
was entitled to endorse Taxpayer's name on any payments made to Taxpayer
and any other instruments concerning the customer note and the financed
automobile. Taxpayer was obligated to ensure that the customer obtained
and maintained adequate automobile insurance.
[8] Company, in its discretion, could determine
whether there was a default on a customer note and could waive any late
payment, charge, or any other fee it was entitled to collect in the
ordinary course of servicing the customer note. Company agreed to use
reasonable efforts to collect all payments due under a customer note and
to repossess and sell or otherwise liquidate the financed automobile if a
default on the customer note occurred. Taxpayer agreed to indemnify
Company for any expenses and claims arising out of Company's
administration, servicing, and collection on the customer notes.
[9] Company had the right to terminate the servicing
agreement on 30 days written notice to Taxpayer. Company could terminate
immediately if for any two calendar quarters Taxpayer failed to place with
Company at least 15 qualifying customer notes or if Taxpayer
"defaulted." Taxpayer also had the right to terminate the
servicing agreement on 30 days written notice. If Company terminated the
agreement because of default or if Taxpayer terminated the agreement,
Taxpayer was obligated to pay Company its unreimbursed collection costs,
any outstanding advances, and a termination fee equal to 20 percent of the
outstanding amounts of the customer notes. If Company terminated the
agreement (other than for default) or if Taxpayer terminated the
agreement, Company would continue servicing and administering the customer
notes unless Taxpayer asked Company to stop.
[10] At the time they signed a customer note,
Taxpayer's customers were told that the customer note would be assigned
(without recourse) to Company. The assignment was stated on the face of
the customer notes.
[11] Taxpayer effectively treated the transfers of
customer notes to Company as sales for federal income tax purposes.
Taxpayer's treatment was consistent with a letter received from Company.
The letter was prepared for Company's use, including distribution to
dealers participating in Company's programs, and acknowledged that sale
treatment was a permissible characterization of the transfers.
OVERVIEW
[12] During Tax Year, 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.
[13] As a dealer in used automobiles, Taxpayer was
required to be on an accrual method of accounting. 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.
[14] 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 difference between Taxpayer's adjusted basis in the customer
note and Taxpayer's amount realized.
LAW AND ANALYSIS
ISSUE 1
[15] Is Taxpayer required to use an accrual method
to account for the purchase and sale of used automobiles?
[16] Section 446(a) of the Internal Revenue Code
provides that taxable income is computed under the method on the basis of
which the taxpayer regularly computes his income in keeping his books.
[17] Section 446(b) of the Code provides that if the
method of accounting used by the taxpayer does not clearly reflect income,
the computation of taxable income shall be made under such method as, in
the opinion of the Secretary, does clearly reflect income.
[18] Section 446(c) of the Code provides, in part,
that subject to section 446(a) and (b), a taxpayer may compute taxable
income under the cash method of accounting or an accrual method of
accounting.
[19] Section 1.446-1(a)(4)(i) of the Income Tax
Regulations provides that in all cases in which the production, purchase,
or sale of merchandise of any kind is an income producing factor,
merchandise on hand (including finished goods, work in progress, raw
materials, and supplies) at the beginning and end of the year shall be
taken into account in computing the taxable income of the year. (For rules
relating to computation of inventories, see sections 263A and 471 and the
regulations thereunder.)
[20] Section 1.446-1(c)(2)(i) of the regulations
provides that in any case in which it is necessary to use an inventory,
the accrual method of accounting must be used with regard to purchases and
sales unless otherwise authorized under section 1.446-1(c)(2)(ii).
[21] Section 1.446-1(c)(2)(ii) of the regulations
provides that the Commissioner may authorize a taxpayer to continue the
use of a method of accounting consistently used by the taxpayer, even
though not specifically authorized by the regulations, if, in the opinion
of the Commissioner, income is clearly reflected by the use of such
method.
[22] Section 471 of the Code provides that whenever in
the opinion of the Secretary the use of inventories is necessary in order
clearly to determine the income of any taxpayer, inventories shall be
taken by such taxpayer on such basis as the Secretary may prescribe as
conforming as nearly as may be to the best accounting practice in the
trade or business and as most clearly reflecting the income.
[23] Section 1.471-1 of the regulations provides that
in order to reflect taxable income correctly, inventories at the beginning
and end of each taxable year are necessary in every case in which the
production, purchase, or sale of merchandise is an income producing
factor. The inventory should include all finished or partly finished goods
and, in the case of raw materials and supplies, only those that have been
acquired for sale or that will physically become a part of merchandise
intended for sale.
[24] Under section 1.471-1 of the regulations,
inventories are necessary in every case in which the production, purchase,
or sale of merchandise is an income producing factor. See also section
1.446- 1(a)(4)(i). "Merchandise" for purposes of section 1.471-1
is property transferred to a customer.
[25] Taxpayer transferred used automobiles to its
customers, and the purchase and sale of such merchandise (used
automobiles) were income producing factors in Taxpayer's business. This
means that Taxpayer was required to maintain an inventory. Thus, Taxpayer
is required to use the accrual method to account for the purchase and sale
of used automobiles.
[26] A change from Taxpayer's current method of
accounting to the accrual method of accounting requires computing an
adjustment under section 481(a) of the Code. The entire section 481(a)
adjustment should be taken into account in the earliest year under
examination. Section 481(b) may limit the amount of tax arising from the
section 481(a) adjustment.
ISSUE 2
[27] Are Taxpayer's transfers of customer notes to
Company sales or financings?
[28] 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 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.
[29] 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
(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).
[30] 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 attending 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.").
[31] 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 have 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?
[32] The form of the agreement between Taxpayer and
Company is that of a servicing agreement and not a sales contract.
Taxpayer nevertheless treated the transfers of the customer notes as sales
for tax purposes. Further, in the letter sent to Taxpayer, Company
acknowledged that sale treatment was a permissible characterization of the
transfers.
(2) Were Taxpayer's customers notified of the
transfer of the customer notes to Company?
[33] Customers were told at the time they signed a
customer note that it would be assigned without recourse to Company. The
assignment was also stated on the note itself. 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?
[34] Company collected payments, serviced the customer
notes, and repossessed the financed automobile if a customer defaulted.
Although the servicing agreement states that Company was Taxpayer's
nominee for administrating, servicing and collecting on the customer
notes, in fact, 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 sole discretion to determine whether a
default had occurred and to elect to pursue remedies. 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?
[35] The payments Company received were the payments
that 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 fixed amount of a customer note, not on
Taxpayer's creditworthiness. This implies 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?
[36] The relationship between Taxpayer and Company had
none of the characteristics that are common in a lender-borrower
relationship. 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). That 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 to dispose of the
customer notes?
[37] The servicing agreement is silent about the power
of disposition. Taxpayer could dispose of the customer notes only by
reacquiring all of them from Company. To reacquire the customer notes,
Taxpayer had to terminate the servicing agreement and pay Company its
unreimbursed collection costs, any outstanding advances, and a termination
fee equal to 20 percent of the outstanding amounts of the customer notes.
If, however, 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). At the same time, Company's power to
dispose of the customer notes must have been restricted, since Taxpayer
had the right to reacquire them.
(7) Which party bore the credit risk on the
customer notes?
[38] By transferring the customer notes to Company,
Taxpayer eliminated almost all of his exposure to credit risk on the
customer notes. Aside from cancelling the servicing agreement or breaching
a representation or warranty, in the event of a customer's default,
Taxpayer had no obligation to repurchase either the customer note or the
financed vehicle, or return the advance payment. Further, Taxpayer fixed
his economic loss in the customer notes. After transferring a customer
note, Taxpayer's only risk of loss was a diminution in value of its right
to receive distribution payments. Company, on the other hand, was at risk
for recouping the advance payments it made to Taxpayer.
[39] It may be argued that Company's risk of loss was
insubstantial because (1) it advanced Taxpayer no more than 50 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.
[40] 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 of no more than 50 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.
[41] 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 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.
[42] 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 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.
[43] 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, the cost of reacquiring
the customer notes from Company effectively prevented Taxpayer from
profiting from any changes in market interest rates.
[44] For the foregoing reasons, we conclude that the
transfers of customer notes to Company are sales.
ISSUE 3
[45] What are the amounts realized on the sale of
the customer notes?
[46] 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.
[47] 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.
[48] Under the servicing 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 in the servicing agreement 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.
[49] 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.
[50] 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).
[51] Because the servicing 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 servicing 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).
[52] 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".
[53] 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).
[54] 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).
[55] The distribution payments called for in the
servicing 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.
[56] 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.
[57] 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).
[58] 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.
[59] 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.
[60] 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.
[61] 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 shall be included in the 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, 18485, 1934-1 C.B. 281.
[62] 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.
[63] 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.
[64] 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. 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.
[65] Accordingly, the amount realized by Taxpayer from
the sale 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 future distribution payments.
[66] 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 $5,900, a term of 36 months, an
interest rate of 18 percent per annum, and monthly payments of
approximately $213. Also assume that Company had no collection costs and
Taxpayer transferred only the one customer note. Company would be entitled
to receive its fee of 20 percent of each payment (approximately $43).
Company would also be entitled to the remaining $170 of any payment ($213
- $43 fee) until it recovered the advance payment of $2,950. Thus, Company
would be entitled to seventeen payments of $213, one payment of $103, and
eighteen payments of $43. Taxpayer would be entitled to receive, starting
in month eighteen, one payment of $110 and eighteen payments of $170.
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 46 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 still would be approximately 32 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 446 -- Methods of 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
accounting methods
gain or loss
Cross Reference:
Institutional Author:Internal
Revenue Service
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