IRS Technical Advice
Memorandum 9840001
Transfers of Notes From Car Dealer to Loan Servicing
Company Are Sales
The Service has ruled in technical advice that
transfers of customer notes from a used car dealer to a loan servicing
company are sales.
Tax Analysts Document Number: Doc 98-29581
Citations: LTR 9840001 (October 2, 1998)
SUMMARY ======
The Service has ruled in technical advice that
transfers of customer notes from a used car dealer to a loan servicing
company are sales. It also ruled that (1) the amount the dealer realized
on the sale of the notes equals the cash received from the company, plus
the fair market value of its right to receive monthly payments; and (2)
the one-time fee the dealer paid to the company qualifies as a capital
expenditure under section 263A and an intangible under section 197 that is
amortizable over 15 years.
The car dealer is an accrual method corporation owned
by one shareholder. For customers who can't obtain third-party financing,
the dealer accepts notes that are secured by a lien on the cars sold.
To finance its operations, the dealer entered into an
agreement with a loan servicing company. Under the terms of the agreement,
the dealer paid the company a one-time, nonrefundable fee and agreed to
sell the company some of its customer notes periodically. If the company
accepted a note, it made an advance payment to the dealer and agreed to
make monthly payments based on its collections on the notes. After company
accepted the note, the dealer transferred the note and its security
interest in the car to the company.
Once the company accepted the note, it had the
discretion to determine whether a customer defaulted. Similarly, it could
waive any late payment, charge, or any other fee that it was entitled to
collect while servicing the note.
The Service ruled that the dealer's transfers of the
notes to the company were sales. In reaching that conclusion, it noted
that (1) the dealer treated the transfer as a sale for tax purposes; (2)
the company held itself out as the owner of the notes by pledging them as
security for its own indebtedness; (3) the dealer told customers at the
time they signed the note that the note would be assigned without recourse
to company; (4) the company handled all the notes' servicing; (5) the
relationship between the dealer and the company didn't resemble a
lender-borrower relationship; (6) the company could dispose of the notes
and bore the credit risk on them; and (7) the company's potential for gain
on the notes was greater than the dealer's.
Having concluded the transfers were sales, the Service
also ruled that the amount the dealer realized on the sale of the notes
equaled the cash received from the company, plus the fair market value of
its right to receive monthly payments. It noted, however, that the dealer
wouldn't have to include the amount of future payments in the amount
realized on the sale because the poor creditworthiness of the dealer's
customers made the likelihood of future payments doubtful.
In terms of characterizing the one-time fee, the
Service ruled that it qualified as a capital expenditure under section
263A and an intangible under section 197 that is amortizable over 15
years. In reaching those conclusions, it noted that (1) the one-time fee
afforded the dealer the long-term benefit of being able to sell customer
notes indefinitely to the company; and (2) the dealer agreement was a
contractual relationship for the future acquisition of services in the
dealer's ordinary course of business.
FULL TEXT ======
Date: April 10, 1998
TAM-108124-97
[1] ISSUES
(1) Are Taxpayer's transfers of customer notes to
Company sales or financings?
(2) If the transfers described in ISSUE (2) are sales,
what are the amounts realized?
(3) How is Taxpayer required to treat the
nonrefundable enrollment fee paid to Company?
[2] CONCLUSIONS
(1) Taxpayer's transfers of customer notes to Company
are sales.
(2) 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.
(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.
FACTS
[3] Taxpayer is incorporated in State and files on the
basis of a calendar year using an overall accrual method of accounting. A
is the sole shareholder of Taxpayer. During Tax Year, Taxpayer sold used
automobiles. For qualifying customers who 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 to divest itself
of the customer notes, Taxpayer entered into a "dealer
agreement" with Company. Under the dealer agreement, /1/ Taxpayer
paid Company a one- time, nonrefundable enrollment fee of $x and agreed to
periodically sell Company a minimum number of customer notes. 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. /2/ A customer's default did not
obligate Taxpayer to return the advance payment or to repurchase either
the customer note or the financed automobile. Company advised dealers to
require a 25 percent down payment so that between the customer's down
payment and Company's advance payment the dealer would likely earn a
profit on the sale of the automobile whether or not the dealer received
distribution payments.
[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 co[s]ts 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 any collection
costs), and (3) to repay Company for all advance payments made to
Taxpayer. The remainder, if any, was payable to Taxpayer as distribution
payments. Taxpayer's right to distribution payments was subordinated to
Company's obligation to repay its senior indebtedness, which was defined
as Company's indebtedness secured by the customer notes.
[6] In Tax Year, Taxpayer did not receive any
distribution payments, and as of Date, Taxpayer had received only 2.8
percent of the total principal of all customer notes transferred to
Company in distribution payments.
[7] Once Company accepted a customer note, there was a
"transfer, sale and assignment" of the customer note and
Taxpayer's security interest in the financed automobile. Company received
all files relating to the customer note and 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 that it was entitled to collect in the
ordinary course of servicing the customer note. Company agreed to use
reasonable efforts to collect all payments under the customer note and to
repossess and sell or otherwise liquidate the financed automobile if a
default on the customer note had occurred.
[9] Both Taxpayer and Company had the right to
terminate the dealer agreement on 30 days notice to the other party. /3/
Company could also terminate the dealer agreement without notice if (1)
Taxpayer "defaulted," (2) Taxpayer did not sell at least 10
customer notes to Company within the first six months of the agreement, or
(3) Taxpayer did not sell at least 15 customer notes to Company each
calendar quarter. On termination of the dealer agreement, Taxpayer
generally had no obligation to repurchase any customer notes that it had
sold to Company, and Company remained obligated to make distribution
payments for customer notes that it had bought from Taxpayer. If Taxpayer
had not sold the required number of customer notes within the first six
months of the agreement, Company could terminate the agreement and require
Taxpayer to repurchase all of the sold customer notes. Also, if Taxpayer
misrepresented any information regarding a sold customer note, Company
could require Taxpayer to repurchase the customer note.
[10] Taxpayer's customers were told at the time they
signed a customer note that it would be assigned without recourse to
Company. The assignment was stated on the face of the customer notes.
[11] Company pledged the customer notes as security
for its own indebtedness and later transferred the customer notes to a
wholly- owned business trust to securitize the customer notes.
[12] After Company initiated bankruptcy proceedings,
Taxpayer filed an unsecured, nonpriority claim against Company. Taxpayer
described its basis for claim as having " [s]old notes . . . at
partial [a]dvance [sic] balance to be paid as notes paid out."
[13] Taxpayer treated the transfer of the customer
notes as sales. For federal income tax purposes, Taxpayer treated only the
advance payment received from Company as Taxpayer's amount realized from
the sale of the customer note. Taxpayer's adjusted basis in a customer
note equaled the outstanding principal balance of the customer note.
Accordingly, Taxpayer calculated its loss from the sale of a customer note
as the difference between the advance payment and its adjusted basis in
the customer note. Taxpayer's tax treatment of the transaction was
consistent with the tax treatment recommended by Company, which was
contained in two memorandums sent by Company to dealers participating in
its program.
OVERVIEW
[14] 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.
[15] 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.
[16] 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
[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 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.").
[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 dealer agreement states that Company will
purchase the customer notes from Taxpayer. For tax and non-tax purposes,
Taxpayer treated the transactions as sales of the customer notes. For
non-tax purposes, Company held itself out as the owner of the customer
notes -- Company pledged the customer notes as security for its own
indebtedness and later transferred the customer-notes to a wholly- owned
business trust to securitize the customer notes.
(2) Were Taxpayer's customers notified of the transfer
of the
customer notes to Company?
[23] Customers were told at the time they signed a
customer note that it would be assigned without recourse 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 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?
[25] 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?
[26] 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?
[27] Company had the power of disposition. Once
Company accepted a customer note, there was a "transfer, sale and
assignment" of the customer note and of Taxpayer's security interest
in the financed vehicle to Company. Taxpayer also gave company the powers
of attorney necessary for Company to exercise its rights and duties
concerning the customer note. The dealer agreement did not restrict
Company's right to dispose of the transferred customer notes. In fact,
Company pledged the customer notes as security for its indebtedness to a
different party. Company later contributed the contracts to a wholly-owned
business trust that sold notes that were secured by the customer notes to
institutional investors in private placements. Cf. Town & Country Food
Co., 51 T.C. at 1057 (finance company could acquire and dispose of
installment notes only if dealer defaulted on its indebtedness).
[28] Taxpayer, on the other hand, could not sell the
customer notes after they were transferred to Company. Taxpayer did not
have possession of the customer notes or the affiliated files. Taxpayer
had neither the right to substitute different customer notes for the ones
transferred to Company, nor the right to reacquire the 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 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 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 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.
[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 of no more than 50 percent of
their face amounts and permitted Company to retain substantial fees on ail
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 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. /4/ 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.
/5/ 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, /6/ 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". In general, section 1.483-4 establishes
the treatment of contingent payments by reference to section 1.1275-4.
Section 1.1275-4, which was issued simultaneously with section 1.483-4,
addresses the taxation of contingent payment debt instruments.
[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 chose 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," 1 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 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 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, 184-85, 1934-1 C.B. 281.
[53] In Commissioner v. Hansen, 36O U.S. 446 (1959),
1959-2 C.B. 460, /7/ 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. 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.
Accordingly, Taxpayer should not include the amount of future distribution
payments in the amount realized on the sale of the customer notes.
ISSUE 3
[56] 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?
[57] 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).
[58] 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.
[59] 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.
[60] 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. DuPont,
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 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.
[61] 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.
[62] 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).
[63] 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.
[64] 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.
[65] 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.
[66] 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 term 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.
[67] 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.
[68] 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.
[69] 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.
[70] 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.
[71] A copy of this technical advice memorandum is to
be given to Taxpayer. Section 6110(j)(3) of the Code provides that it may
not be used or cited as precedent.
FOOTNOTES
/1/ The original agreement was superseded by later
dealer agreements.
/2/ Under the second dealer agreement, the advance
payment was an amount that was agreed upon by Company and Taxpayer, but in
no event would it be more than 50 percent of the outstanding principal
balance of the customer note.
/3/ Under the second dealer agreement, Taxpayer could
terminate by giving Company notice of 10 days.
/4/ 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 and
Taxpayer transferred only the one customer note. 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.
/5/ 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.
/6/ 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.
/7/ 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 1001 -- Gain or Loss
Geographic Identifier: United
States
Subject Area: Corporate taxation
Accounting periods and methods
Index Terms: gain or loss
Cross Reference:
Institutional Author: Internal Revenue Service
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