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For the first time, the IRS rules on the income earned when factoring receivables.
Robert Willens, CFO.com | US
September 23, 2011
In a letter ruling issued in August, the Internal Revenue Service found that income from factoring receivables is not Subpart F income. It was the first time the IRS ever ruled on the character of income earned when a company sells its invoices at a discount to a third party.
That's important because Subpart F income, a kind of income earned by a controlled foreign corporation, is taxed to its U.S. shareholders at the time it's earned. Score a victory for corporations seeking to avoid generating Subpart F income — and getting taxed on it.
(A U.S. shareholder of a foreign corporation is defined as a U.S. person who owns 10% or more of the total combined voting power of all classes of stock entitled to vote. A controlled foreign corporation is defined as a foreign corporation in which more than 50% of the total combined voting power of all classes of its stock or more than 50% of the total value of its stock is owned by U.S. shareholders on any day during the taxable year of the foreign corporation.)
In the case at hand, the U.S.-based corporate taxpayer, which we'll call TP, owns Supplier Co., a product supplier based in another country. Supplier's contracts provide for payment at contractually based milestones. Upon reaching a milestone, Supplier sends an invoice to the customer, creating a receivable. To speed up the receipt of cash, Supplier often factors its receivables. This factoring is generally done with a related party.
Supplier, a controlled foreign corporation, owns FirstCo, a disregarded entity of Supplier for U.S. tax purposes. (A disregarded entity is one that's separate from the parent but chooses to be disregarded as separate from the business owner for federal tax purposes.) FirstCo factors Supplier's receivables. At the time of TP's query, this factoring program has no U.S. tax consequences because of FirstCo's U.S. tax status as a disregarded entity wholly owned by Supplier. For regulatory reasons, however, the factoring transactions would become recognized as transactions between Supplier and the entity to which FirstCo's business or stock is transferred.
The factoring transaction is properly treated for U.S. income-tax purposes as a sale of receivables, rather than a borrowing. In its August ruling, the IRS held that any income derived by Supplier from factoring its receivables would not constitute Subpart F income.
The only kind of Subpart F income that the factoring of its receivables would potentially produce is a gain from the sale or exchange of property that does not give rise to any income. Did the factoring of receivables by Supplier convert into any income? The answer is no, according to the IRS.
Any accelerated income received by Supplier as a result of factoring receivables is a substitute for the income it would have collected under the relevant contracts and should retain the same non-Subpart F character, according to the ruling. Further, any income that Supplier may recognize from factoring receivables not previously included in income represents an acceleration of income from the underlying contracts and does not arise from the sale or exchange of property within the meaning.
Thus, TP wasn't required to report any share of such income because the income was not Subpart F income. That's a substantial victory for the owners of controlled foreign corporations that want to factor their accounts receivable merely to speed up payments.
Robert Willens, founder and principal of Robert Willens LLC, writes a tax column for CFO.com.