No Bad Debt Deduction for Payment Properly Characterized as Capital Contribution

(Parker Tax Publishing December 2019)

The Fifth Circuit affirmed a district court's denial of a bad debt deduction for a $52 million payment a parent company made to its Russian subsidiary in order to comply with Russian regulatory requirements because the payment was a properly characterized as a nondeductible capital contribution. The Fifth Circuit also rejected the taxpayer's argument that the payment was deductible as an ordinary and necessary business expense because it found that the payment was not tied to any actual expense of the subsidiary. Baker Hughes, Inc. v. U.S., 2019 PTC 456 (5th Cir. 2019).

Background

Baker Hughes, Inc., is the successor in interest to BJ Services Company (BJ Parent), which conducted fracking services in Russia through a Russian subsidiary (BJ Russia). In 2006, BJ Russia entered into a three-year contract with TNK-BP, a joint venture between two oil companies, to provide fracking services in Siberia. TNK-BP could terminate the contract if BJ Russia became bankrupt, if a liquidator was appointed for BJ Russia, or if BJ Russia defaulted on its contractual obligations. During the three-year term of the contract, BJ Russia did not default, and TNK-BP never claimed it had. As a condition of BJ Russia's bidding on the contract, TNK-BP required BJ Parent to provide a guarantee that BJ Parent would perform or ensure the performance of the fracking services that TNK-BP asked BJ Russia to provide.

BJ Russia sustained unanticipated losses on the contract in 2006 and 2007. Nevertheless, it was critical that BJ Russia not breach its contract. In September 2008, BJ Russia informed TNK-BP of its intention not to renew the contract; it would exit the Russian market after BJ Russia fulfilled its contractual obligations. In 2008, the Russian Ministry of Finance informed BJ Russia that it was in violation of a Russia law that required companies to maintain net assets in an amount at least equal to the company's chartered capital. The Ministry explained that if a company's net assets are less than the minimum level for chartered capital at the end of the financial year, then the company was subject to liquidation by the Russian taxing authority.

BJ Parent transferred $52 million to BJ Russia in order to increase BJ Russia's net assets and end the risk of liquidation. The transfer of funds was made as Free Financial Aid (FFA) under the Russian Tax Code. A finance manager of BJ Parent described FFA as "just giving money with no repayment obligation, ever." Had BJ Parent failed to prevent BJ Russia's liquidation, BJ Parent estimated that its losses would have been at least $160 million. To be eligible for a tax exemption under Russian law, the FFA had to be given on behalf of BJ Russia's majority shareholder. BJ Russia and its majority shareholder, also a subsidiary of BJ Parent, entered into an agreement whereby BJ Parent would transfer funds in the form of FFA to BJ Russia on behalf of the majority shareholder. The parties agreed that BJ Russia had no obligation to repay BJ Parent. The FFA was characterized in a BJ Russia shareholder meeting as a "free capital contribution" from BJ Parent to BJ Russia. BJ Russia used at least part of the $52 million to partially repay a loan from another BJ Parent subsidiary.

BJ Parent deducted the $52 million FFA provided to BJ Russia as a bad debt expense under Code Sec. 166 on its tax return for 2008. The IRS determined that the payment was a capital contribution and disallowed the deduction. Baker Hughes, as BJ Parent's successor in interest, filed a lawsuit in a district court seeking a refund $17.8 million. Baker Hughes argued that it was entitled to a bad deduction for the payment to BJ Russia and asserted an additional claim that the FFA was deductible as an ordinary and necessary business expense under Code Sec. 162. The district court granted summary judgment in the government's favor, and Baker Hughes appealed to the Fifth Circuit.

Under Reg. Sec. 1.166-9, a payment that discharges a taxpayer's obligation as a guarantor may qualify for a bad debt deduction when the taxpayer has an enforceable legal duty to make the payment. However, Reg. Sec. 1.166-1(c) provides that a voluntary gift or capital contribution is not a debt for purposes of Code Sec. 166. Generally, a payment by one taxpayer for the obligation of another taxpayer is not deductible as an ordinary and necessary business expense under Code Sec. 162. However, in Lohrke v. Comm'r, 48 T.C. 679 (1967), the Tax Court recognized an exception where (1) the taxpayer's purpose is to protect or promote the taxpayer's own business interests, and (2) all other Code Sec. 162 requirements are met.

Baker Hughes acknowledged that BJ Russia had no obligation to repay the $52 million to BJ Parent. Nonetheless, it argued that the payment fulfilled BJ Parent's guarantee obligation and therefore was deductible under Reg. Sec. 1.166-9. Baker Hughes argued that the letter from the Russian Ministry of Finance was effectively a demand on BJ Parent's performance guarantee that triggered the payment. Baker Hughes further argued that the payment was not a capital contribution because BJ Parent had no expectation of recovery and, instead, the payment was deductible as an ordinary and necessary business expense under Lohrke.

Fifth Circuit's Analysis

The Fifth Circuit affirmed the district court's decision and held that BJ Parent's $52 million payment was not deductible either as a bad debt or as an ordinary and necessary business expense.

The Fifth Circuit found no authority holding that a bad debt deduction applies to a guarantor's payment on a guarantee that does not create a debtor-creditor relationship with the party whose original obligation is extinguished. According to the court, Reg. Sec. 1.166-9(a) applies when a taxpayer's payments discharge the taxpayer's obligation as a guarantor, meaning a guarantor can claim a bad debt deduction only if the creditor could have claimed such a deduction were it not for the guarantor's payment of the underlying debt. In the court's view, BJ Parent's payment imposed no obligation on BJ Russia. The court found that there was no debt at all, good or bad. BJ Russia never failed to perform its contractual obligations with TNK-BP, and TNK-BP never called on BJ Parent to carry out its obligations as guarantor. As a result, the court concluded that there was no bad debt to support Baker Hughes' claim for a bad debt deduction. Rather, the court concluded that the payment was a contribution to capital, as it was described by BJ Parent itself.

The court also held that the $52 million payment was not deductible as an ordinary and necessary business expense because it was a capital contribution, which under Reg. Sec. 1.263(a)-2(f) as in effect in 2008, was considered a nondeductible capital investment. The court reasoned that BJ Russia used the payment to reduce debt and recapitalize its balance sheet through reducing its liabilities and increasing its net equity. In the court's view, the same result would have occurred had BJ Russia kept the funds and not paid down its debt. The court also concluded that the Lohrke exception did not apply because the deduction under Code Sec. 162 requires an underlying expense, and BJ Parent's payment was not an expense of BJ Parent nor was it provided to pay any expense of BJ Russia.

For a discussion of business bad debts versus nonbusiness bad debts, see Parker Tax ¶98,425. For a discussion of ordinary and necessary trade or business expenses, see Parker Tax ¶90,101.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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