Transfer Pricing Insider
Volume 3, Issue 1
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A Model for Intercompany Factoring Arrangements
J. Harold McClure, Senior Manager
The debate over arm's-length discounts often amounts to the appropriate determination of what is a reasonable expected return to the assets of a factoring entity.
Companies can generate accounts receivable by selling goods to customers on credit. In some instances, the company may sell its accounts receivable to a factoring entity at a discount from the face value of the accounts receivable.1 Factoring entities:
- Provide cash in lieu of accounts receivable to the company.
- Are responsible in some instances for collecting the client's accounts receivable from customers and providing related bookkeeping and reporting services.
- Assume the credit risk of customers in nonrecourse factoring situations.
When the factoring entity and the company selling the accounts receivable are related parties, tax authorities may challenge whether the discount is consistent with the arm's-length standard. The IRS recently issued "Factoring of Receivables Audit Technique Guide," LMSB-04-0606-004, to assist examiners in determining whether a U.S. multinational has improperly shifted income abroad through the factoring of accounts receivable to foreign affiliates. The guide noted that a factoring arrangement between related parties may be abusive if the factoring fees are much higher than those charged to unrelated parties. The Canadian Revenue Agency (CRA) has also been scrutinizing intercompany factoring arrangements.2
The guide instructs IRS examiners to request certain information to determine if accounts receivable have been sold and to request a taxpayer's transfer pricing studies, including documentation. The guide also notes that the Preamble to the Regulations under Section 6050P (Returns relating to the cancellation of indebtedness by certain entities) describes a typical unrelated-party pricing of factoring transactions. The Preamble states that for typical transactions with unrelated parties, factoring fees are 0.35% of the face value of the accounts receivable if the factoring entity is not responsible for collection. This example appears to be based on a factor with recourse, as the implied annualized return is only 4.28%, assuming that this is a 30-day factor.3 The pricing of a nonrecourse factor would also have to consider the role played by assuming credit risk.
Intercompany factoring arrangements often have much higher discount rates. Exhibit 1 presents a set of third-party factoring arrangements once used in an Arthur Andersen transfer pricing memo to support a 4% discount. The observed discounts in the third-party factoring arrangements range from as low as 1% to as high as 5.4%, with a median discount of 4%. The Andersen memo also noted that the interquartile range was 3% to 4.5%. While the memo appears to suggest that these third-party transactions represent comparable uncontrolled transactions (CUTs) for the intercompany transaction, the CRA often rejects appeals to a CUT approach.
The first part of this article outlines a model for the determination of arm's-length discounts and discusses potential issues with the Andersen CUT approach. It then demonstrates that the debate over arm's-length discounts often amounts to the appropriate determination of what is a reasonable expected return to the assets of a factoring entity. The article proposes the use of the capital asset pricing model (CAPM). While CAPM does not support the belief among some tax authorities that a factoring entity deserves only a risk-free return, it also does not support the very high expected returns implicit in many intercompany factoring arrangements. The article concludes by discussing two intercompany factoring arrangements—one in FSA 200224003 and the agreement between Dell Marketing and Dell Receivables.
1 For prior coverage of factoring, see "Baker & McKenzie Transfer Pricing Annual Update," 19 JOIT 24 (June 2008); Rubinger, "'Management and Control'—Should Place of Formation Determine U.S. International Tax Consequences?," 18 JOIT 20 (October 2007).
2 Hollas, "Transfer Pricing," CA Magazine, June/July 2004, www.camagazine.com/2/1/5/5/4/index1.shtml.
3 (1.0035)12 = 1.04282. While the average interest rate on one-month Treasury notes from July 2001 to June 2008 was only 2.61%, those seven years had periods of very low interest rates. For the 20 years from July 1988 to June 2008, the average interest rate on three-month Treasury notes averaged 4.46%.
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