• Balazs Karancsi, Expert |

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.

Factoring service agreement

Related parties should have a written factoring service agreement detailing the type of services the factor provides. It should also reflect the division of responsibilities, rights and obligations, assumption of risks and pricing arrangements.

Pricing arrangements

The pricing arrangement should take account of the actual functions performed, risks assumed and assets of the parties, substantiated by a transfer pricing study demonstrating what third-parties would typically do in a comparable situation. More specifically, several factors are relevant for considerations in the context of factoring:

  • Firstly, the servicing costs of the factor should be reflected in the pricing policy. This cost may include administrative, legal, bookkeeping and dunning expenses. 
  • Secondly, the pricing of the discount should reflect the risk profile of the factor, the seller and the debtor(s). E.g.: who undertakes the risk of default or dilutions which may occur as a result of rebates or chargebacks? Are the account receivables secured? 
  • Thirdly, the financing cost borne by the factor for providing the seller with upfront cash should be considered. 
  • Furthermore, the discount rate for the account receivables should contain a profit margin that reflects returns on the costs/expenses of the factor. This profit margin is typically expected in an arm’s length transaction. 

Treasury Considerations for internal factoring

The sale or transfer of intercompany or external accounts receivables and payables can also be used to manage FX transactions on behalf of the subsidiaries. In this case, the factor (or “Re-Invoicing Center”) that is usually the same entity as the Inhouse Bank or Corporate Treasury centralizes all invoices that are not in the functional currency of a specific subsidiary. 

The advantage is that the Re-Invoicing Center can economize on the increased FX volumes exchanged in the market and hence achieve more beneficial exchange rates. Additionally, subsidiaries only have to deal with transactions in their functional currency and do not require additional FX bank accounts.

For intercompany invoices, the settlement can even be processed via internal clearing accounts (i.e. “Inhouse Bank Accounts”) and thus completely avoid the detour via external bank accounts. That way, the Re-Invoicing Center has full transparency on all FX transactions within the company and can centralize the FX management and even use these insights for cash flow planning and FX hedging.

What should you do?

To limit the possible challenges and the corresponding risks, taxpayers should 

  • account for all type of intercompany financing arrangements, including factoring,
  • ensure that the transaction is properly documented, i.e. an intercompany agreement is in place and a transfer pricing study is concluded to support the applicable prices, and
  • check that the transfer pricing analysis considers the type of the factoring agreement, the parties’ risk profiles and the auxiliary services that may additionally be provided by the factor.