The U.S. Court of Appeals for the Fifth Circuit recently affirmed the ruling of a federal district court that a corporation was not entitled to a tax deduction for a payment of $52 million to its foreign subsidiary. Our previous Alert, discussing the district court ruling.
In Baker Hughes, Inc. v. United States, No. 18-20585 (5th Cir. Nov. 21, 2019), the Court of Appeals rejected the U.S. parent company’s two alternative arguments for a tax deduction. The ruling outlines some of the parameters of two Code provisions governing deductions—sections 162 and 166.
The taxpayer’s Russian subsidiary provided fracking services to oil companies. It entered into a three year, multimillion-dollar contract to provide pumping services in Siberian oil fields. The U.S. parent company, which indirectly owned 100% of the Russian subsidiary, provided a performance guarantee on the contract. If the Russian subsidiary could not perform the contracted-for services, the U.S. parent would be obligated to perform them under its performance guarantee.
The contract was not profitable as originally expected. The Russian subsidiary suffered losses, became insufficiently capitalized and was in danger of liquidation by the Russian government. The U.S. parent company responded by funding the Russian subsidiary with $52 million (indirectly, through a holding company), primarily to enable the subsidiary to comply with Russian law.
No bad debt deduction
The company’s first argument in support of the claimed deduction was that it should be allowed a bad debt deduction. Bad debt deductions generally can be taken where a debt held by a taxpayer becomes worthless. Additionally, under Reg. section 1.166-9, a bad debt deduction generally can be taken where a taxpayer makes a payment with respect to its guarantee of another taxpayer’s debt.
On appeal, the parties agreed that the general criteria for a bad debt deduction—worthlessness of preexisting debt—were not met, as the subsidiary never had an obligation to repay the $52 million to its parent. The company instead argued that the payment of the $52 million should be considered a payment on a guarantee, deductible under Reg. section 1.166-9. Although the payment did not revolve around any underlying debt obligation, the company argued that such an obligation is not necessary for the parent to take a deduction; the parent’s guarantee on the subsidiary’s performance on the contract to provide services sufficed. The court rejected this argument, noting that that Reg. section 1.166-9 and court cases addressing it involved guarantees on bona fide debt. The facts in the Baker Hughes case, in contrast, did not involve any underlying debt.
No deduction as an ordinary business expense
The company’s second argument in support of the claimed deduction was that the $52 million payment represented an ordinary business expense. Under section 162, to qualify as a deductible ordinary business expense, an item must be paid or incurred during the taxable year in carrying on a trade or business, and it must be an expense that is both ordinary and necessary.
However, the court held that no business expense deduction was available to the parent, for two reasons. First, the ‘ordinary’ and ‘necessary’ components are not met where one taxpayer pays to satisfy the obligation of another taxpayer, even where the second taxpayer is a subsidiary of the first.
Second, a voluntary payment made by a corporation’s shareholder to benefit the corporation’s financial position generally is a capital contribution and not a business expense. The taxpayer had argued, however, that its purpose in making the payments was not to benefit its subsidiary, but rather to protect or promote the parent company’s own business interests. Although the Tax Court had sanctioned such an approach in several cases, the court rejected this argument in this case. The $52 million paid to the subsidiary was not only unrelated to any specific expense of the U.S. parent, it was also unrelated to any specific expense of the subsidiary. Under section 162, there must be an underlying ‘expense’ to support an ordinary and necessary business expense deduction, and here there was none.
Tax deductions for bad debts or business expenses are available only under limited circumstances for a company that funds another related company – such as a parent corporation funding its subsidiary. Companies considering the tax treatment of funding provided to (or on behalf of) a subsidiary or other affiliate should take note of the Baker Hughes decision and the authorities it cites, and should obtain appropriate tax advice.