Recently Released IRS Guidance Offers Opportunity to Accelerate Losses Inherent in Accounts Receivable

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1 ALBANY AMSTERDAM ATLANTA BOCA RATON BOSTON CHICAGO DALLAS DELAWARE DENVER FORT LAUDERDALE HOUSTON LAS VEGAS LOS ANGELES MIAMI NEW JERSEY NEW YORK ORANGE COUNTY ORLANDO PHILADELPHIA PHOENIX SACRAMENTO SILICON VALLEY TALLAHASSEE TOKYO TYSONS CORNER WASHINGTON, D.C. WEST PALM BEACH ZURICH Strategic Alliances with Independent Law Firms* Recently Released IRS Guidance Offers Opportunity to Accelerate Losses Inherent in Accounts Receivable BRUSSELS LONDON MILAN ROME TOKYO GREENBERG TRAURIG, LLP ATTORNEYS AT LAW

2 Prior to a statutory change in 1998, many sellers of nonfinancial goods and services effectively were able to claim a current tax deduction for an amount equal to the reserves that they posted against their accounts receivable. The ability to claim this deduction arose from the application of the mark-to-market rules to the accounts receivable. All that changed in 1998, when Congress carved out accounts receivable from the definition of securities that were eligible to be accounted for under the mark-to-market accounting rules. A recently-released Internal Revenue Service Technical Advice Memorandum ( TAM ) offers sellers of nonfinancial goods and services the opportunity to structure a transaction that provides an efficient mechanism to claim a current deduction, equivalent to the deduction that would have been available under the mark-to-market rules, for reasonable reserves against their accounts receivable. TAM recites that the taxpayer, engaged in manufacturing and selling of various products, formed a domestic subsidiary ( X ) and contributed cash and its customer service department to X. X formed a foreign subsidiary ( Y ) and contributed the cash to Y. Then X and Y formed another domestic subsidiary ( S ), with X contributing the customer service department to S and Y contributing the cash to S. (In this way, the customer service department never passed through the non-u.s. subsidiary.) The interposition of a foreign subsidiary was necessary to prevent the taxpayer and S from being members of the same consolidated group of corporations, which was critical for reasons discussed below in more detail. Diagrammatically, the new operating structure looked as follows: Parent Goods & Services Receivable Customers Sale Of Accounts Receivable X (US) Y (Non-US) S (US) Customer Service Department Upon the sales of goods to customers, the Parent included the full face amount of the customer accounts receivable in the amount realized and, hence, gross income. The Parent then immediately sold the accounts receivable to S for their fair market value, which was less than the face amount. The sale to S resulted in the ordinary loss to the Parent equal to the difference between the face value and the fair market value of the accounts receivable. The net result was that the taxpayer included in income only the fair market value of the accounts receivable

3 Unless the Parent sold the accounts receivable to S, it would have had to include in income the face value of accounts receivable and recognize any losses later. Thus, the sale of accounts receivable resulted in the acceleration of a tax deduction for the reserve for doubtful accounts. On audit, the examination team proposed to defer all or a portion of the losses that resulted from the sale. In TAM , the IRS National Office upheld this strategy. The TAM explores three potential challenges to the transaction: (1) the anti-avoidance rules disallowing losses on sales or exchanges between related parties (Section 267 of the Internal Revenue Code of 1986, as amended (the Code )); (2) the intercompany transaction anti-avoidance rules; and (3) the closed and completed transaction rules disallowing losses. Application of the Rules Disallowing Losses Incurred on Sales or Exchanges Between Related Parties Losses on certain sales or exchanges of property between related parties are disallowed under Code 267. If this rule applies, instead of deducting losses on sales or exchanges between members of the controlled group currently, taxpayers are required to defer such losses until the property is transferred outside the controlled group or until such other time as prescribed in regulations. These rules, however, contain a so-called factoring exception. The factoring exception provides that the general loss disallowance rules do not apply in the case of sales of receivables to controlled group members. The taxpayer took the advantage of this exception. In order for the factoring exception to be applicable, four conditions must be met: (1) The seller must acquire the accounts receivable from a sale to a nonmember at a gain; (2) The seller and the buyer must be members of the same controlled group (but not the same consolidated group for this reason, the interposition of Y, a foreign company, was necessary); (3) The seller s sale of the accounts receivable to the buyer must be for fair market value; and (4) The seller s loss that is permitted to be taken into account cannot exceed the gain recognized on the underlying sale. All these requirements were met under the facts presented in the TAM, and the factoring exception applied, allowing the taxpayer to take the current loss. It should be noted that the examination team did not challenge the taxpayer s business purpose for factoring the receivables. In this regard, the IRS also noted that the fact that S received the customer service department including personnel to service the receivables supported the substance of the sale. In addition, the taxpayer asserted, and presumably offered evidence to show, that the restructuring offered cost savings, and facilitated using the receivables in securitization transactions

4 Application of the Intercompany Transactions Anti-Avoidance Rules The examination team also argued that losses should be disallowed under the consolidated return intercompany transaction anti-avoidance rules. These rules state that if a transaction is engaged in or structured with a principal purpose to avoid application of the intercompany transaction rules, adjustments must be made to carry out the purposes of those rules. The examination team argued that the interposition of Y, a foreign subsidiary, should not have been respected because it took the taxpayer out of the application of the intercompany rules. If Y was not interposed or Y were a domestic company, the deferral regime prescribed by the intercompany transactions rules would apply, disallowing current losses. However, the IRS held that the transaction in question should not be subject to the adjustments prescribed by the intercompany transaction anti-avoidance rules because those anti-avoidance rules were not intended to reach this type of factoring transactions. Closed and Completed Transaction Rules Disallowing Losses A deduction for any loss will not be sustained unless the loss is: (1) a bona fide loss; (2) evidenced by a closed and completed transaction; (3) fixed by identifiable events; and (4) with certain exceptions, sustained in the year claimed. A loss is not sustained if the taxpayer has a reasonable prospect of recovery. The examination team took a position that there was no sustained loss because the transaction was not a closed and completed transaction. The IRS concluded in the TAM, however, that the transaction was a closed and completed one because upon the sale of the accounts receivable, all rights arising from the contracts between the taxpayer and the customers (with the exception of the right to returned goods * ) passed permanently to S. The benefits and burdens of ownership passed to S upon the sale. The fact that certain contingent rights in the accounts receivable were retained by the taxpayer did not prevent the transaction from being completed and closed. Summary The facts and analysis of TAM offer an extraordinary opportunity to accelerate losses on accounts receivable. Interested persons are advised to structure these transactions in a conservative manner to ensure that the transactions have economic substance and will be respected for U.S. tax purposes. Members of the Greenberg Traurig Tax and Corporate departments have extensive experience in working with internal corporate reorganizations and can assist persons interested in pursuing transactions similar to the one addressed in TAM * The IRS also noted that under the facts of the TAM, the taxpayer sold to S only a portion of the rights in the accounts receivable (primarily, the right to be paid in cash), while retaining others (primarily, the right to the return of goods if sales are cancelled). Therefore, it was appropriate and necessary to make an equitable allocation of basis based on the relative fair market value of the rights transferred and the rights retained, an allocation that would reduce the amount of loss on the sale of the accounts receivable

5 This Alert was written by Mark Leeds and Artem Fokin in the New York office. Please contact Mr. Leeds at , Mr. Fokin at or your Greenberg Traurig liaison, if you have any questions regarding the subject matter of this GT Alert. Albany Amsterdam Atlanta Boca Raton Boston Chicago Dallas Delaware Denver Fort Lauderdale Houston Las Vegas Los Angeles Miami New Jersey New York Orange County Orlando Philadelphia Phoenix Sacramento Silicon Valley Tallahassee Tokyo Tysons Corner Washington, D.C West Palm Beach Zurich This Greenberg Traurig ALERT is issued for informational purposes only and is not intended to be construed or used as general legal advice. The hiring of a lawyer is an important decision. Before you decide, ask for written information about the lawyer s legal qualifications and experience. Greenberg Traurig is a trade name of Greenberg Traurig, LLP and Greenberg Traurig, P.A Greenberg Traurig, LLP. All rights reserved. *Greenberg Traurig has entered into Strategic Alliances with the following independent law firms, where Greenberg Traurig attorneys are available for consultation by appointment only: Olswang in London and Brussels, Studio Santa Maria in Milan and Rome, and the Hayabusa Kokusai Law Offices in Tokyo. Greenberg Traurig is not responsible for any legal or other services rendered by attorneys employed by the Strategic Alliance firms

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