If you guarantee a loan for a third party and have to make payments due to the guarantee, do you get to deduct the payment as a bad debt for tax purposes? The court addresses this in Baker Hughes, Inc. v. United States, No. 18-20585 (5th Cir. 2019) in the context of a payment made to a related party. This provides an opportunity to revisit the bad debt loss rules.
Facts & Procedural History
This case involves a Houston oil company, BJ Services Company (“BJ”). BJ is owned by Baker Hughes, which is the taxpayer in this case.
BJ conducted fracking services in Russia in 2006. It did so using a subsidiary entity formed in Russia. It entered into a three year service agreement for this work. The other party to the contract could terminate the contract if BJ’s subsidiary defaulted on the contract. BJ executed a guarantee for the work to be performed by its subsidiary.
BJ’s subsidiary did not default on the contract. But in 2006 and 2007, the Russian subsidiary incurred unexpected losses. BJ decided to stop working in Russia. It notified the parties to its contract of its intent to fulfill the duties through 2008, but that it would not renew the contract further.
The Russian Ministry of Finance sent BJ notice that its Russian subsidiary did not meet the capitalization requirements in Russia. The notice advised that the Russian tax authorities had the right to liquidate the company if the subsidiary did not increase its assets in Russia.
In response to the threat of liquidation, BJ transferred $52 million to its subsidiary. BJ estimated that these transfers saved it from incurring a $160 million loss.
BJ claimed the $52 million as a “bad debt expense” on its U.S. income tax return for 2008.
About Tax Losses for Bad Debts
The Code provides for bad debt losses. It merely says that a deduction is allowable for any debt which becomes worthless within the taxable year.
The regulations clarify that the deduction is only allowable for a bona fide debt. A bona fide debt is a debt which arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.
The regulations go on to say that a gift or contribution to capital is not considered to be a bona fide debt.
Bad Debts for Loan Guarantees
The regulations also address bad debts for loan guarantees.
It provides that taxpayers can deduct payments (of principal and interest) made on loans they guaranteed as part of their business. The regulations say that these payments are deducible as a bad debt.
To be deductible, there must be:
- An agreement entered into in the course of the taxpayer’s trade or business or a transaction for profit.
- An enforceable legal duty upon the taxpayer to make the payment (legal action need not have been brought against the taxpayer).
- The agreement had to be entered into before the obligation became worthless (or partially worthless in the case of an agreement entered into in the course of the taxpayer’s trade or business).
There are several court cases that address loan guarantees. As explained below, these cases allow bad debt deductions by assuming that the guarantor stepped into the original debtor’s shoes. This brings us back to this case.
Payments to a Subsidiary vs. to a Third Party
In this case, the court had to determine whether BJ sustained a bad debt that triggered a tax loss. BJ guaranteed its subsidiary’s services. BJ had $52 million and then it paid the $52 million to its subsidiary. Does that trigger a tax loss?
The taxpayer argued that it was entitled to a bad debt deduction for the payment it made as a guarantor of its subsidiary’s services. It reasoned that its U.S. business paid out the money and, thus, it must have a tax loss. There is some authority for this. But this authority involves payments made directly to unrelated third party creditors.
The IRS argued that a guarantor can only claim a bad debt deduction if the original obligor could have claimed the deduction if it had made payment. In this case, the subsidiary would not have been entitled to a deduction for a payment its parent company made to it. It would only be entitled to deduct a payment it made to a third party.
Put another way, according to the IRS, because the payment was not to a third party the subsidiary owed money to, there was no obligation for BJ that could trigger a bad debt deduction.
The trial and appeals courts agreed with the IRS:
The Supreme Court has analyzed the sorts of guarantor payments that are deductible as bad debts. See Putnam v. Comm’r,352 U.S. 82 (1956). There, the taxpayer made a payment to a creditor in discharge of the taxpayer’s obligation as guarantor of corporate notes of a debtor. Id. at 83. The Court reasoned that a performed guarantee to pay a debtor’s loan was a bad-debt deduction because upon paying the guarantee, the guarantor “step[ped] into the creditor’s shoes.” Id. at 85. When the guarantor was then unable to “recover from the debtor” the guaranteed and paid amount, the performed guarantee was functionally “a loss from the worthlessness of a debt.” Id. The taxpayer’s ability to claim the bad-debt deduction as a guarantor was the result of the existence of an underlying debt.
Thus, the appeals court concluded that payments made to subsidiaries do not trigger bad debt losses for tax purposes. If BJ had paid a third party on behalf of its subsidiary pursuant to a guarantee, it could have produced a bad debt for tax purposes.