Rev. Rul. 54-43

Advice is requested relative to the Federal income tax consequences to a merchant of its transactions, under a `commitment agreement' with several banks, whereby it `sells' to them at the end of each monthly period at a `discount' its installment accounts receivable arising out of current sales of merchandise, instead of holding the accounts for collection for itself.

It the instant case, funds which the merchant had obtained from bank and other loans were insufficient to finance its rapidly increasing installment sales, and provisions of long-term loans outstanding prevented further borrowing. Therefore, it negotiated a `commitment agreement' with several banks, under which they agreed to `purchase,' at the end of each monthly period for 5 years, its installment accounts receivable offered for sale to them thereunder arising out of current sales of merchandise, provided and to the extent their aggregate holdings thereof will not exceed certain amounts. The accounts are payable in monthly or other installments and mature not more than 24 months from the date of delivery of the merchandise, title to which does not pass to the customers until full payment of their installment obligations.

The `purchase price' to be paid by the banks for such accounts shall be equal to the aggregate amount owing thereon by the merchandise customers, less `discount' at a certain percent per annum. The banks will pay 85 percent (referred to as the `purchase percentage') of such purchase price to the merchant on each monthly `settlement date' and the balance of 15 percent (referred to as the `deferred payment') thereof upon completion of payments owed by the merchandise customers on the sold accounts. If the merchant does not offer for sale to the banks such installment accounts equal to their aforesaid `purchase commitments,' it is required to pay to them quarterly a `commitment fee' computed at a certain fractional percent per annum on the average daily unused amount. The merchant may each month, on at least 30-days prior written notice to the banks, reduce their `purchase commitment.'

As agent for the banks, though without any special charge therefor, the merchant will retain physical possession of the installment paper sold by it to them, receive payments thereon from the merchandise customers, and on each monthly settlement date pay any net amount due to the banks. All such paper, and records pertaining thereto, will be appropriately identified as property of the banks. In the event of defaults by merchandise customers in their accounts `owned' by the banks, the merchant `may, at its option', on each monthly settlement date, `repurchase' such defaulted paper at the amount owing thereon by the merchandise customers, whereupon the banks will `reassign' it to the merchant `without recourse.' If the merchant does not exercise its option to repurchase such defaulted paper, the banks may forthwith cancel the entire `commitment agreement.' The merchant, however, is not obligated to repurchase such defaulted paper, nor does it have full liability therefor as debtor, endorser, or guarantor, but has liability, in effect as guarantor, only to the extent of the `deferred payment' of 15 percent of the purchase price of the sold accounts which the banks are not required to pay until completion of installment payments owed thereon by the merchandise customers. The merchant keeps its books on the accrual method of accounting, and has not elected to return income from its installment payment merchandise sales on the installment basis. Under its method of accounting, it includes in its gross income, upon consummation of an installment payment sale of merchandise, the amount of the selling price thereof, and any carrying charges, covered by the installment obligation received. Deductions, from gross income, on account of bad debts, are accomplished by the merchant through a reserve for bad debts.

Upon the basis of the foregoing, it is held that the transactions by the instant merchant with the banks under their `commitment agreement,' whereby it `sells' to them at the end of each monthly period at a `discount' its installment accounts receivable arising out of current sales of merchandise, instead of holding the accounts for collection for itself, constitute actual sales thereof and not loans thereon although entered into for financing purposes. This conclusion is supported by numerous decisions involving transactions under similar conditions and circumstances. See Della Nickoll, et al. v. Commissioner , Tax Court Memorandum Opinion entered September 11, 1951; Thomas Goggin & Bro. v. Commissioner , 45 B.T.A. 218; and decisions therein cited, including Lucius II. Elmer v. Commissioner , 65 Fed.(2d) 568, Ct. D. 759, C.B. XII-2, 172, and Alworth-Washburn Co. v. Helvering , 67 Fed.(2d) 694, Ct. D. 808, C.B. XIII-1, 208. Cf. Fraser-Smith Co. v. Commissioner , 14 T.C. 892; and I.T. 4072, C.B. 1952-1, 141. Such cases as Brewster Shirt Corp. v. Commissioner , 159 Fed.(2d) 227, Ct. D. 1724, C.B. 1949-2, 80; Central Station Signals, Inc. v. Commissioner , 10 T.C. 1015, affirmed, 174 Fed.(2d) 479; and Southeastern Finance Co. v. Commissioner , 4 T.C. 1069, affirmed, 153 Fed.(2d) 205 are clearly distinguishable, since therein there was positive unlimited liability on the part of the transferors of the accounts to repurchase or pay them in the event of default.

It is further held that the accounts sold by the instant merchant to the banks, under their `commitment agreement' which it negotiated with them for that purpose, were property held by it primarily for sale to customers in the ordinary course of its trade or business. Section 117(a)(1)(A) of the Internal Revenue Code, in defining `capital assets,' excludes therefrom `property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business.' It is recognized that installment accounts receivable constitute property. In Graham Mill & Elevator Co. v. Thomas , 152 Fed.(2d) 564, the collector of internal revenue was sustained in taking the position that losses from the sale by the petitioner in 1942 of notes and accounts receivable, along with the business of four branch establishments, at less than their face amounts, were not deductible in full as ordinary business losses under section 23(f) of the Internal Revenue Code but constituted losses from sales of `capital assets,' as defined in section 117(a)(1) of the Code, deductions for which were limited to the amount of gains during the taxable year from sales or exchanges of capital assets. In the instant case, however, the merchant sold forthwith, regularly, and in great numbers, its installment merchandise sales accounts receivable arising from current merchandise sales to certain banks as its customers therefore under a `commitment agreement' obtained from them for that purpose for a 5-year term. It is evident, therefor, that such accounts were held by the merchant primarily for sale to customers in the ordinary course of its trade or business within the purview of section 117(a)(1)(A), supra , rather than primarily as investments for collection for itself as the notes and accounts receivable customarily were held by the petitioner in the Graham Mill & Elevator Co. case, supra . On the other hand, the decision on Issue 2 in the Kanawha Valley Bank v. Commissioner , 4 T.C. 252, is well in point in the instant case. The Commissioner was sustained in taking the position, where a bank, following customary practice in its business regularly carried on, subscribed for allotments of Government securities with the intention of disposing of them even prior to their delivery and not to hold them as investments, that such securities so disposed of in 1940 and 1941 were not `capital assets' within the purview of section 117(a)(1) of the Internal Revenue Code, and the Court stated:

With respect to petitioner's transactions in disposing of government securities allotted to it by the United States Treasury, we think the facts clearly demonstrate that these securities were never held by petitioner as investments, but were acquired for sale in the regular course of its business. It appears that these transactions have long been carried on by petitioner and that it has several firms as its usual customers for such securities. The plan to sell was arranged prior to the acquisition of the securities, which were transferred on issuance direct to petitioner's customers. The sale being coincident with the acquisition, the bonds in question were not an investment in petitioner's hands. Respondent is sustained in his treatment of the gain on their sale as ordinary income.

Accordingly, losses from the sales by the instant merchant of current installment accounts receivable to the banks under their `commitment agreement,' consisting of the amount which the unpaid balances of the accounts sold exceeded the `purchase price' paid and payable therefor by the banks, are ordinary business losses deductible in full under section 23(f) of the Code.

Where the instant merchant, under its option in the `commitment agreement' with the banks, repurchases defaulted accounts at their unpaid balances, its basis of each repurchased account is its said repurchase price. Since such accounts, upon repurchase, again became part of the merchant's installment accounts receivable, they will be treated thereupon, for Federal income tax purposes, in the same manner as similar accounts which never were sold.

In the computation of additions to the merchant's reserve for bad debts, any installment accounts receivable which have been, or forthwith are to be, sold by it to the banks under their `commitment agreement' shall not be considered.

`Commitment fees' incurred by the merchant under the `commitment agreement,' being current charges for making business funds available to it on a standby basis and not for the use of funds, do not represent interest incurred but are deductible to it as ordinary and necessary business expenses under section 23(a)(1)(A) of the Code.