Payments not deductible under bad debt or ordinary expense rules
Financial support provided to a subsidiary corporation generally does not give rise to an immediate tax deduction, as illustrated by Baker Hughes Inc. v. United States, Docket No. 4:15-CV-2675 (S.D. Tex., June 18, 2018). In that case, a United States District Court denied a U.S. parent company’s tax deduction claims with respect to funding provided to its Russian subsidiary. The taxpayer presented two arguments in support of its claimed deduction, and the court disagreed with both.
The Russian subsidiary provided fracking services to oil companies. It entered into a three year, multimillion dollar contract to provide water pumping services in Siberian oil fields. The U.S. parent company (which indirectly owned 100% of the Russian subsidiary) provided a performance guarantee of the contract. If the Russian subsidiary could not perform the contracted-for services, the US parent would be obligated to perform them.
The contract was not profitable as originally expected. The Russian subsidiary suffered losses, and became insufficiently capitalized under Russian law. The U.S. parent company provided $52 million of funding to the Russian subsidiary (indirectly, though a Cypriot holding company that directly owned the Russian subsidiary’s shares). It provided the funding to avoid various undesirable potential consequences, including avoiding the potential need to provide services under the contract’s performance guarantee.
No bad debt deductions
Baker Hughes’ first argument in support of the claimed deduction was that it should be allowed a bad debt deduction. Bad debt deductions generally are available where a taxpayer makes a payment with respect to its guarantee of another taxpayer’s debt, in addition to situations where a debt held by a taxpayer becomes worthless.
Examining the situation at hand, the court first noted that the $52 million of funding did not give rise to a debt obligation of the Russian company for U.S. tax purposes. The Russian subsidiary had no repayment obligation at all with respect to the funding. Accordingly, the $52 million transfer did not result in a debt that could become worthless.
The court next considered whether payment of the $52 million should be considered a payment on a guarantee deductible under Reg. section 1.166-9. That regulation provides that payments made in discharge of part or all of the taxpayer’s obligation as a guarantor generally give rise to a bad debt deduction. The court’s decision was that the payment was not deductible under this rule, for two reasons.
First, the U.S. parent company had no enforceable legal duty to make the payment. The court held that without that legal duty, no deduction would be permitted. Second, even if the U.S. parent’s performance guarantee under the contract was considered to give rise to a duty to make the $52 million funding payment, the payment did not discharge the U.S. parent from its guarantee obligation under the contract. No performance had yet been required under the performance guarantee. That guarantee obligation remained in place after the $52 million payment and was not discharged. Since there was no discharge of the guarantee obligation, the court held that Reg. section 1.166-9 could not apply to permit a bad debt deduction.
No deduction as ordinary and necessary business expense
Baker Hughes’ second argument in support of the claimed deduction was that the $52 million payment represented an ordinary business expense because of (a) the U.S. parent’s obligations under the contractual performance guarantee and (b) the potentially serious business consequences that a contractual default by the Russian subsidiary would have had.
However, the court held that no business expense deduction was available to the U.S. parent company, for two reasons. First, the payment was voluntarily made by a shareholder to a corporation to improve the financial position of the corporation. This sort of payment is treated, under case law and regulations, as a contribution to the corporation’s capital that is not deductible when paid but instead added to the shareholder’s tax basis in its stock.
Second, a business expense deduction is only permitted if the expense involved is ordinary and necessary for the taxpayer’s own business. Here, the U.S. parent company was under no obligation to make the payment, but chose to do so to avoid potential future losses. The payment enabled the Russian subsidiary to continue operations and complete the contract. The funds were used to repay debt of the Russian subsidiary owed to another subsidiary of the U.S. parent company. Under these facts, the court concluded that no expense of the U.S. parent’s business was involved.
A parent company’s funding of its subsidiary is an expenditure that typically does not give rise to an immediate tax deduction for the parent. In the Baker Hughes case, the District Court held for this nondeductible result notwithstanding the fact that the parent company had guaranteed the subsidiary’s performance on a contract to provide services to a customer. Companies considering claiming U.S. federal income tax deductions for funding provided for expenditure by a subsidiary should obtain appropriate tax advice and may benefit from taking note of the Baker Hughes decision and the authorities it cites.