Factoring is a means of working capital financing frequently used by companies. As related parties may use factoring as a financing method, the transfer pricing aspects need to be considered to limit the potential risk of challenges by tax authorities and double taxation.
Definition of factoring
Factoring, also known as account receivable financing, is a means of working capital financing frequently used by companies across industries. Under a factoring agreement, a company sells or assigns its accounts receivable from the sale of goods or provision of services to a factor, typically at a discounted price, in exchange for cash in advance.
There are three parties directly involved in a factoring agreement: the factor who is a specialized financial intermediary that purchases accounts receivable at a discounted price, the seller who sells the receivable, and the debtor who has a financial liability to make a payment to the owner of the invoice.
Different types of factoring agreement
There are various means to categorize factoring agreements depending on their nature.
Recourse agreement vs. non-recourse agreement
This categorization is dependent on the person who bears the risk of default (e.g. for non-payment of obligations owing to the factor, false representations and warranties, breach of covenants and insolvency events). Under a recourse agreement, the seller bears the risk of default. Whereas under a non-recourse agreement, this risk is borne by the factor.
Notification factoring vs. non-notification factoring
This categorization is dependent on the amount of interactions between the factor and the debtor.
In a notification factoring, the factor is directly involved in the debt collections process and communicates with the debtor directly. The factor sends out notifications and verifications of invoices to the debtor. The debtor is required to collaborate with the factor in both processes.
In contrast, the interactions between the factor and the debtor is almost non-existent in a non-notification factoring. This saves the monitoring and verification process for the debtors – making it more user-friendly.
Different types of services of a factor
A factor may provide various types of services, for example:
- collect the seller’s accounts receivable from the debtor
- investigate the credit risk of the debtor; or
- assume the credit risk of the debtor;
Depending on the terms of the factoring agreement, there might be additional services provided by the factor, such as:
- Legal services
- Bookkeeping and reporting services;
- Advancing or financing services;
- Other administrative services
TP considerations for factoring
Several points have to be considered from a TP perspective when related parties use factoring as a financing method.