Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board
Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board Auto Dealerships - Audit Technique Guide - Uncle Fed's Tax*Board
To facilitate cash flow and to avoid collection responsibilities, the dealerships often transfer nonprime or sub-prime installment contracts to an unrelated finance company shortly after the deals are consummated for an up-front cash advance and the possibility of additional cash payments in the future. Dealerships may do business with several finance companies, and may have paid a fee and entered into a servicing agreement with each finance company prior to transacting business with it. Servicing agreements vary among finance companies, and one finance company may have a variety of programs, but the basic premise of most programs is the same. Upon transfer of the installment contract, the finance company pays the dealership an advance which may range from 50 to 75 percent of the contract, depending on the credit rating of a particular customer or the dealership’s aggregate pool of contracts. The advance can be based on the face amount of the contract without interest, or the total contract amount including interest. After paying the advance, the finance company collects the installment payments from the vehicle purchaser for a fixed percentage of each payment, often 20 percent. In addition, the finance company will be reimbursed for any out of pocket collection cost incurred. Only after recovering the fixed percentage fee, out of pocket collection costs, and the advance, will the finance company begin to pay the dealership for the remainder of the contract, known as the BACK-END DISTRIBUTION. To summarize, the finance companies apply the collections on the installment contracts in the following order: 1. To pay the fixed percentage collection fee 2. To reimburse out-of-pocket collection costs (e.g. repossessions related expenses) 3. To repay the advance from the finance company to the dealerships, and 4. To remit any remaining funds to the dealer (back-end distribution) Assuming a 20 percent fixed collection fee, and if the finance company has no out-of-pocket collection costs, the dealer has the potential through the advance plus back-end distributions to receive 80 percent of the installment contract (either the face amount of the contract or the face amount of the contract plus interest, depending on the servicing agreement). However, because of the order in which the collections are applied, dealers may not receive any back-end distributions because the collections received will be subject to a high default rate and may never exceed the sum of the 20 percent service fee, out-of-pocket costs, and the repayment of the outstanding advances. The chances of receiving back-end distribution are further diluted because the finance companies aggregate the installment contracts rather than carry them individually. For example, if a dealership transfers 20 non-prime or sub-prime contracts, the advances from the finance company for all 20 contracts will be aggregated, and only after collections are received that exceed the cumulative advances on all 20 contracts will any back-end distribution be made. Thus, as long as the finance company keeps issuing advances, the cumulative advance balance increases and the collections received may never be enough to cover this ever-increasing advance balance. To rectify this, some finance companies offer pool capping. Under this arrangement, the dealership may pays an additional fee to cap off one pool (or group) of contracts and to create a 19-15
new pool for additional, subsequent, contracts. Pool capping speeds up the time in which the dealer receives back-end distributions because it segregates a group of contracts, and collections received on those particular contracts are applied exclusively to those contracts. The collections on those contracts are not used to repay advances on contracts not in that pool. Once the advances on the contracts in that specific pool are repaid and the 20 percent collection fee and any out-of-pocket costs are covered, the dealership will begin to receive back-end distributions on those contracts. The same process would apply to all pools of the dealer that had been capped. The terms of pool capping arrangements must be carefully analyzed, however, since cross collateralization of pools may occur (payments made on contracts in one pool may be applied to another pool), diminishing the benefits of capping. Non-prime and sub-prime arrangements are continuously proliferating and permutating, so it is difficult to provide a "one-size fits all" description of these products. Agents should consider all the facts and circumstances pertinent to a particular servicing agreement when examining these issues. What Are the Issues? The discussions in this audit technique guide are directed toward dealership reporting. No conclusions should be made or inferred from this document about the treatment of these contracts by finance companies. There are several dealership issues associated with the tax reporting of non-prime and sub-prime contracts, including the following: Is the transfer of the contract from the dealership to the finance company a loan, an assignment, a sale or a pledge to collateralize a loan? • How should the cash advance be reported? • How should the payment of the fixed percentage collection fee be reported? • Are back-end distributions contingent payments? • When should the back-end distributions be reported? • How should the back-end distributions be valued? • How should interest be computed and reported? • How should enrollment fees and capping fees be reported? • Are adjustments to this issue changes in method of accounting? Income Tax Treatment Since inventory is a material income-producing factor, vehicle dealerships are required to use the accrual method of accounting. Often, however, dealers use the cash method to report the transfer of installment contracts to the finance company. They report only the customer down payment and the advance received from the finance company as current income. Back-end distributions are often reported in a later tax period, when received. The primary reasons these transactions are reported in this manner are because 1) they follow the actual cash flow, or economic reality, of the transactions, and 2) it is difficult to assign a value to money which the dealership does not know if, when or how much will be received. 19-16
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new pool for additional, subsequent, contracts. Pool capping speeds up the time in which the<br />
dealer receives back-end distributions because it segregates a group of contracts, and collections<br />
received on those particular contracts are applied exclusively to those contracts. The collections<br />
on those contracts are not used to repay advances on contracts not in that pool. Once the<br />
advances on the contracts in that specific pool are repaid and the 20 percent collection fee and any<br />
out-of-pocket costs are covered, the dealership will begin to receive back-end distributions on<br />
those contracts. The same process would apply to all pools of the dealer that had been capped.<br />
The terms of pool capping arrangements must be carefully analyzed, however, since cross<br />
collateralization of pools may occur (payments made on contracts in one pool may be applied to<br />
another pool), diminishing the benefits of capping.<br />
Non-prime and sub-prime arrangements are continuously proliferating and permutating, so it is<br />
difficult to provide a "one-size fits all" description of these products. Agents should consider all<br />
the facts and circumstances pertinent to a particular servicing agreement when examining these<br />
issues.<br />
What Are the Issues?<br />
The discussions in this audit technique guide are directed toward dealership reporting. No<br />
conclusions should be made or inferred from this document about the treatment of these contracts<br />
by finance companies.<br />
There are several dealership issues associated with the tax reporting of non-prime and sub-prime<br />
contracts, including the following:<br />
Is the transfer of the contract from the dealership to the finance company a loan, an assignment, a<br />
sale or a pledge to collateralize a loan?<br />
• How should the cash advance be reported?<br />
• How should the payment of the fixed percentage collection fee be reported?<br />
• Are back-end distributions contingent payments?<br />
• When should the back-end distributions be reported?<br />
• How should the back-end distributions be valued?<br />
• How should interest be computed and reported?<br />
• How should enrollment fees and capping fees be reported?<br />
• Are adjustments to this issue changes in method of accounting?<br />
Income Tax Treatment<br />
Since inventory is a material income-producing factor, vehicle dealerships are required to use the<br />
accrual method of accounting. Often, however, dealers use the cash method to report the transfer<br />
of installment contracts to the finance company. They report only the customer down payment<br />
and the advance received from the finance company as current income. Back-end distributions<br />
are often reported in a later tax period, when received. The primary reasons these transactions are<br />
reported in this manner are because 1) they follow the actual cash flow, or economic reality, of<br />
the transactions, and 2) it is difficult to assign a value to money which the dealership does not<br />
know if, when or how much will be received.<br />
19-16
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