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Department Disallows Indiana Taxpayer’s Claimed Factoring Fees

01.09.2014

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In Letter of Finding 02-20120612 (Dec. 2, 2013), the Indiana Department of Revenue (“Department”) held that a portion of an Indiana taxpayer’s (“Taxpayer”) claimed factoring fees must be disallowed because it artificially distorted Taxpayer’s Indiana income. Taxpayer paid factoring fees to a related entity, which was not included in Taxpayer’s Indiana income tax return. Taxpayer subcontracted its accounts receivable collection to the related entity by “factoring” its accounts receivables to the related entity. The Department added back to Taxpayer’s federal income the amount of factoring fees that Taxpayer paid to the related entity that exceeded the related entity’s expenses in providing the factoring services.

In its audit, Department noted that it could not find any business or operational advantage that Taxpayer could gain from factoring its receivables. Here, factoring did not provide Taxpayer with access to lower financing cost, which is the most common reason for using factoring operations. The Department surmised that the prime benefit of the factoring operation was to minimize Taxpayer’s state income tax exposure.  The Department cited IC § 6-3-2-2(1)(4) and IC § 6-3-2-2(m) in support of its adjustment, which states that the Department may make adjustments as necessary if a taxpayer’s income after allocation and apportionment does not accurately reflect its net income. Taxpayer challenged the adjustment, arguing that those statutes permit the Department to only adjust a taxpayer’s apportionment formula, not adjust its taxable income. Moreover, Taxpayer argued that the Department may only reallocate adjusted gross income in special circumstances not present here.

In the Letter of Finding, the Department noted that although a corporation is free to adopt whatever form it finds appropriate, that form must have a business function, and if the prime function of the corporate form is tax avoidance, a court may determine that it is a sham and disregard it. Furthermore, the Department found that it may depart from standard formulas for calculating adjusted gross income and use alternate methods so that a taxpayer’s income is fairly reflected and reported pursuant to IC § 6-3-2-2(1)(4) and IC §6-3-2-2(m).

The Department also rejected Taxpayer’s argument that reallocation could only be used in special circumstances. The Department took the position that although 45 IAC 3.1-1-62 provides that reallocation can be used in special circumstances, it does not limit its use only in special circumstances Thus, the Department may make a proposed assessment based on the best information available, and if the Department finds that the reported income does not accurately reflect a taxpayer’s income, it can use any other methods to compute the income.

Finally, Taxpayer argued that the income it originally reported accurately reflected its income because the related entity charged an arm’s length rate based on a transfer pricing study done under Internal Revenue Code Section 482.  The Department dispensed with this argument, however, stating that “a specific transaction’s arm’s-length status considered in isolation is not a factor that is relevant to the determination of whether or not the ‘substance’ of the taxpayer’s overall company structure, intercompany transactions, and consolidated group’s deductions fairly reflect a taxpayer’s consolidated group’s Indiana adjusted gross income.”  The Department therefore denied Taxpayer’s protest of the proposed assessment.

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