«Taxpayer’s Name: Taxpayer’s Address: Taxpayer’s TIN: Tax Years: Conference was declined. LEGEND: Company = Date A = Tax Year B = x= ISSUES (1) ...»
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
INTERNAL REVENUE SERVICE
NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM
Conference was declined.
Company = Date A = Tax Year B = x=
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 § 1.475(c)-(1)(b)(4)(i) of the Income Tax Regulations without consent of the Commissioner and while under examination?
-2TAM-115030-98 (5) Assuming that Taxpayer could make the election under § 1.475(c)-(1)(b)(4)(i) of the regulations, how should Taxpayer's customer notes, transferred to Company, be valued by Taxpayer?
(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 § 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 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.
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%,
-3TAM-115030-98 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.
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.
Taxpayer received no distribution payments during the TaxYears in question.
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.
The customer note provided on its face that it was assigned to Company and future payments should be made to Company.
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.
-4TAM-115030-98 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.
Taxpayer effectively treated the transfers of customer notes to Company as sales for federal income tax purposes.
After May 15, 1997, and before September 10, 1997, Taxpayer made an election under § 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 § 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.
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.
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.
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.
-5TAM-115030-98 Taxpayer’s election to apply the mark to market accounting method of § 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 § 475.
LAW AND ANALYSIS
ISSUE 1 Are Taxpayer's transfers of customer notes to Company sales or financings?
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.
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.
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.").
-6TAM-115030-98 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-byfactor analysis is necessary to determine whether Taxpayer sold the customer notes.
-7TAM-115030-98 (1) Were the transfers treated as sales?
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.
-8TAM-115030-98 (2) Were Taxpayer’s customers notified of the transfer of the customer notes to Company?
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?
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?