Baker Hughes Incorporated v. UNITED STATES OF AMERICA
Filing
56
MEMORANDUM AND ORDER granting 29 MOTION for Summary Judgment and 43 MOTION for Summary Judgment , and denying 44 MOTION for Partial Summary Judgment (Signed by Magistrate Judge Stephen Wm Smith) Parties notified.(jmarchand, 4)
United States District Court
Southern District of Texas
ENTERED
IN THE UNITED STATES DISTRICT COURT
FOR THE SOUHERN DISTRICT OF TEXAS
HOUSTON DIVISION
BAKER HUGHES INCORPORATED
Plaintiff,
vs.
UNITED STATES OF AMERICA,
Defendant.
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§
§
§
§
June 18, 2018
David J. Bradley, Clerk
Civil Action No. 4:15-CV-2675
MEMORANDUM AND ORDER
This is a dispute over a disallowed income tax deduction. Although the parties to
this litigation are an American company and the U.S. Government (for taxes collected on
its behalf by the Internal Revenue Service), the facts giving rise to the claim involve a
Russian subsidiary company and the Russian Ministry of Finance. Pending before the
court are the parties’ cross motions for summary judgment seeking a determination
whether a payment made by a U.S. parent company, through a Cypriot entity, to a
Russian subsidiary is deductible either as a bad debt (Dkts. 29 & 31 1 ) or as an ordinary
and necessary business expense (Dkts. 43 & 44).
BACKGROUND
The following facts are largely undisputed.2 During the relevant time period, BJ
Services Company (“BJ Parent”) was the parent company of an affiliated group of
corporations and subsidiaries throughout the world. Through a series of foreign and
domestic holding companies, BJ Parent conducted fracking services in Russia through a
1
At oral hearing on February 23, 2018, Plaintiff Baker Hughes Incorporated requested leave to file a formal motion for
summary judgment on its bad debt claim. Because a separate motion would only restate the same arguments Baker
Hughes made in response to defendant’s motion, the Court denied plaintiff’s request noting, instead, it would consider
plaintiff’s response (Dkt. 31) as its motion.
2
Except where noted, the parties agree on the facts relevant to the issues raised in this matter. The disagreement
between the parties is over the legal effect of those facts.
Russian subsidiary, ZAO Samotlor Fracmaster Services (“BJ Russia”). (Dkt. 29-2, 21-4).
Plaintiff, Baker Hughes Incorporated, is the successor to BJ Parent.
In August 2006, BJ Russia contracted with OJSC TNK-Management (“TNK-BP”),
a joint venture between a Russian company and British Petroleum. (Dkt. 44, p. 5). Under
the contract, BJ Russia agreed to provide pressure pumping services to TNK-BP in the
Siberian oil fields. (Id.). The agreement guaranteed a minimum number of jobs for BJ
Russia over the three years of the contract at a fixed rate, and was valued at
approximately $44 million. (Id. at p. 6; depo of Brett Wells, Dkt 44-3, p. 14). The
contract required BJ Parent to extend a “performance guarantee:” if BJ Russia was unable
to perform all of its obligations under the contract, BJ Parent would, upon demand by
TNK-BP, be responsible to perform or to take whatever steps necessary to perform, as
well as be liable for any losses, damages, or expenses caused by BJ Russia’s failure to
complete the contract. (Dkt. 29-6).
The contract was not as profitable as BJ Russia had forecast, and it sustained net
losses in 2006 and 2007. (Dkt. 44, p. 9). In September 2008, BJ Russia informed TNKBP that it would not renew the contract and would exit the Russian market at the
conclusion of the contract in 2009. (Dkt. 44, p. 9; depo. of Brett Wells, Dkt. 44-3, p. 32).
On October 21, 2008, the Russian Ministry of Finance sent a letter to BJ Russia advising
the company it was in violation of articles 90 and 99 of the Civil Code of the Russian
Federation and in danger of forced liquidation. (Dkt. 44-14). Those provisions require a
joint stock company to maintain “net assets” in an amount at least equal to the company’s
2
chartered capital. (Dkt. 44-14). A company may reduce its chartered capital to match the
level of its net assets, but the Civil Code sets a minimum level for chartered capital. If, at
the end of year, the net assets fall below that minimum level, the company must be
liquidated. (Dkt. 44-14).
The Ministry of Finance informed BJ Russia that, by its calculations, the
company’s net assets cost for 2006 was -228,277,00 Rubles, and -570,683,000 Rubles for
2007. Since the net assets cost were below the chartered capital minimum,3 the Russian
tax authority had the right to liquidate the company through the courts, a point it repeated
three times in the letter. (Dkt. 44-14). The company was given until November 14, 2008
to “improve [the company’s] financial performance and increase the net assets.” (Dkt. 4414). BJ Parent considered this to be a credible threat, and analyzed the ramifications if BJ
Russia was liquidated. (Dkt. 44, p. 10-11). It believed that if BJ Russia was liquidated,
TNK-BP would force BJ Parent to finish the contract pursuant to the Performance
Guarantee, and BJ Parent would have to pay a third party to complete the work. (Dkt 44,
11-12). BJ Parent estimated its potential exposure exceeded $160 million, and worried
about the potential damage to its reputation if one of its subsidiaries defaulted. (Dkts. 44,
p. 12; 44-18).
On November 13, 2008, BJ Russia assured the Ministry of Finance that it was
“taking steps to improve the financial and economic activities of the company and to
increase the net assets in 2008.” (Dkt. 29-9). After considering the options available in the
3
There is no evidence of the minimum chartered capital amount. However, since BJ Russia’s net asset costs were
negative, it is evident the net assets were less than the minimum chartered capital, whatever the amount.
3
limited time given, BJ Parent chose to transfer funds from BJ Parent to BJ Russia under
article 251(11) of the Tax Code of the Russian Federation, Federal law No. 117-FZ. (Dkt.
43-2). That provision allows a majority shareholder to transfer assets to a company
without tax consequences for the receiving company. (Dkt. 43-2, 8-9). To comply with
the statute, it was necessary to change the ownership structure of BJ Russia from two
owners with equal shares of stock to a single majority shareholder. (Dkt. 43, p. 6). BJ
Holding (Russia) Limited sold 1,050 shares of BJ Russia stock to a Cypriot entity,
Samotlor Holding Limited, making Samotlor the majority shareholder of BJ Russia. (Dkt
43-2).
Samotlor then signed an agreement to provide “Free Financial Aid” in the amount
of $52 million to BJ Russia. (Dkt 44-15). The funds would be transferred by BJ Parent,
on behalf of Samotlor, by December 31, 2008. (Dkt. 44-15). It was agreed that the “stated
cash assets shall be used by the Company to execute its activities as stipulated by the
Company’s Charter” and that Samotlor “confirms hereby that its financial assistance is
free and that it does not expect the company to return the funds to the shareholder.” (Id.).
BJ Parent then made a series of transfers in amounts between $2,000.00 and $6,000.00 to
BJ Russia.4 (Dkt. 44-16). BJ Parent (now Baker Hughes Incorporated) claimed a
deduction on its tax return of $52 million, but that deduction was disallowed by the IRS.
Baker Hughes now seeks a refund of $17,654,000 in federal income taxes it paid on the
$52 million, plus interest. Baker Hughes contends the payment is deductible as a bad debt
4
The money was transferred in smaller increments because of a concern that a lump sum transfer of $52 million
might be held up by the bank. (Depo. of Brett W ells, Dkt. 44-3, p. 42).
4
under Section 166 of the Tax Code, or as an ordinary and necessary trade or business
expense under Section 162. See 26 U.S.C. §§ 162 and 166.
ANALYSIS
Summary judgment is appropriate if no genuine issues of material fact exist, and
the moving party is entitled to judgment as a matter of law. F ED. R. C IV. P. 56(c). The
party moving for summary judgment has the initial burden to prove there are no genuine
issues of material fact for trial. Provident Life & Accident Ins. Co. v. Goel, 274 F.3d 984,
991 (5th Cir. 2001). Dispute about a material fact is genuine if the evidence could lead a
reasonable jury to find for the nonmoving party. In re Segerstrom, 247 F.3d 218, 223 (5th
Cir. 2001). “An issue is material if its resolution could affect the outcome of the action.”
Terrebonne Parish Sch. Bd. v. Columbia Gulf Transmission Co., 290 F.3d 303, 310 (5th
Cir. 2002).
If the movant meets this burden, “the nonmovant must go beyond the pleadings
and designate specific facts showing that there is a genuine issue for trial.” Littlefield v.
Forney Indep. Sch. Dist., 268 F.3d 275, 282 (5th Cir. 2001) (quoting Tubacex, Inc. v. M/V
Risan, 45 F.3d 951, 954 (5th Cir. 1995)). If the evidence presented to rebut the summary
judgment is not significantly probative, summary judgment should be granted. Anderson
v. Liberty Lobby, Inc., 477 U.S. 242, 249-50 (1986). In determining whether a genuine
issue of material fact exists, the court views the evidence and draws inferences in the light
most favorable to the nonmoving party. Id. at 255. Where, as here, the evidentiary facts
are not disputed, a court may grant summary judgment if trial would not enhance its
5
ability to draw inferences and conclusions. Nunez v. Superior Oil Co., 572 F.2d 1119,
1124 (5th Cir. 1978).
1. Section 166 – Bad Debt
Baker Hughes contends the $52 million payment to BJ Russia is deductible under
Section 166(a), which applies to “any debt which becomes worthless within the taxable
year.” 26 U.S.C. § 166(a) (1). It argues that courts have defined the term “debt” broadly,
and have allowed payments that were made to discharge a guarantee to be deducted as
bad debt losses. Baker Hughes further insists that Treasury Regulation § 1.166-9 allows it
to deduct this payment because “a payment of principal or interest made . . . by the
taxpayer in discharge of part or all of the taxpayer’s obligation as a guarantor . . . is
treated as a business debt becoming worthless in the taxable year in which the payment is
made.” Id. Baker Hughes argues that it made the payment to discharge its obligation to
guarantee performance on the BJ Russia contract, and therefore satisfies this regulation.
Baker Hughes’ argument proceeds as follows:
1) The Russian Ministry was threatening to liquidate BJ Russia because it did not
have sufficient capital;
2) Liquidation of BJ Russia would have caused it to default on the contract with
TNK-BP);
3) That default would have made TNK-BP a judgment-creditor and BJ Russia a
judgment-debtor;
4) BJ Russia would have been obligated to pay TNK-BP a fixed and determinable
sum of money potentially in excess of $160 million;
6
5) BJ Parent guaranteed BJ Russia’s performance, creating a creditor-debtor
relationship between them and making BJ Parent liable for BJ Russia’s debts;
and
6) The payment to BJ Russia satisfies the debt created by BJ Parent’s performance
guarantee, and BJ Russia’s inability to repay renders it a bad debt under IRC §
166.
Baker Hughes’ arguments conflate two questions: 1) did BJ Parent pay a debt
owed by BJ Russia to TNK-BP because it guaranteed that obligation; or 2) did the
transfer of money by BJ Parent (through the shareholder company) to BJ Russia create a
debt owed by BJ Russia to BJ Parent. The answer to both these questions is no.
A taxpayer is entitled to take as a deduction any debt which becomes worthless in
that taxable year. 26 U.S.C. § 166(a)(1). The Treasury regulations clearly state that a
contribution to capital cannot be considered a debt for purposes of 26 U.S.C. §166. 26
C.F.R. § 1.166–1(c) (1983). The question of whether the payment from BJ Parent to BJ
Russia is deductible in the year made “depends on whether the advances are debt (loans)
or equity (contributions to capital).” Stinnett’s Pontiac Service, Inc. v. Commissioner of
Internal Revenue, 730 F.2d 634, 638 (11th Cir. 1984). “Articulating the essential
difference between the two types of arrangement that Congress treated so differently is no
easy task. Generally, shareholders place their money ‘at the risk of the business’ while
lenders seek a more reliable return.” Slappey Drive Ind. Park v. United States, 561 F.2d
572, 581 (5th Cir. 1977). In order for an advance of funds to be considered a debt rather
than equity, the courts have stressed that a reasonable expectation of repayment must
7
exist which does not depend solely on the success of the borrower’s business. American
Processing and Sales Co. v. United States, 371 F.2d 842, 856 (Ct.Cl. 1967).5
It is clear that the advances to BJ Russia were not debts, but were more in the
nature of equity. There was no certificate or note evidencing a loan, no provision for or
expectation of repayment of principal or interest, and no way to enforce repayment.
Instead, the operative agreement stated clearly and succinctly that it was “free financial
aid” and would not be paid back to BJ Parent or to Samotlor. (Dkt. 44-15). The intent of
the parties was clear: it was not a loan and did not create an indebtedness. In fact, it could
not be a loan because further indebtedness for BJ Russia would not have solved the net
assets and capitalization problems identified by the Russian Ministry of Finance. (Depo.
of Ronald Pinto, Dkt. 44-4, p. 11) (it could not be a loan “because that would increase our
liabilities which would make them shut us down.”). BJ Russia’s undercapitalization also
supports the conclusion this was an infusion of capital and not a loan that created a debt.
Baker Hughes next argues that the payment was made pursuant to a guarantee to
perform because if BJ Russia was liquidated, BJ Parent would be liable for the damages
caused by the breach. It is true that a guaranty payment qualifies for a bad debt deduction
if “[t]here was an enforceable legal duty upon the taxpayer to make the payment.”
Herrera v. Commissioner of Internal Revenue, 544 F. App’x 592, 595 (5th Cir. 2013)
5
The Fifth Circuit has identified at least thirteen factors relevant to deciding whether an advance is debt or equity:
(1) the names given to the certificates evidencing the indebtedness; (2) the presence or absence of a fixed maturity
date; (3) the source of payments; (4) the right to enforce payment of principal and interest; (5) participation in
management flowing as a result; (6) the status of the contribution in relation to regular corporate creditors; (7) the
intent of the parties; (8) ‘thin’ or adequate capitalization; (9) identity of interest between creditor and stockholder;
(10) source of interest payments; (11) the ability of the corporation to obtain loans from outside lending institutions;
(12) the extent to which the advance was used to acquire capital assets; and (13) the failure of the debtor to repay on
the due date or to seek a postponement. Estate of Mixon v. United States, 464 F.2d 394, 402 (5th Cir. 1972); see also
In re Lothian Oil, Inc., 650 F.3d 539, 542 (5th Cir. 2011) (noting an “11 factor test” consisting of factors 1-11).
8
(quoting Treas. Reg. § 1.166–9(d) (2)). However, voluntary payments do not qualify. See
Treas. Reg. § 1.166–1(c) (“A gift . . . shall not be considered a debt for purposes of
section 166.”); see also Piggy Bank Stations, Inc. v. Commissioner of Internal Revenue,
755 F.2d 450, 452–53 (5th Cir. 1985).
Baker Hughes points to several cases in which bad debt deductions were allowed
for payments made pursuant to guarantees of obligations. (Dkt. 31, p. 21). Those cases
are not persuasive. It is true that BJ Parent executed a performance obligation with TNKBP to guarantee the work would be done. However, BJ Russia never failed to perform its
obligations, and TNK-BP never looked to BJ Parent to satisfy any requirements under the
performance guarantee. (Depo. of Ronald Pinto, Dkt. 44-4, p. 46). The event that
triggered the payment was not a demand by TNK-BP or other creditors of BJ Russia to
perform, instead it was the notice from the Russian Ministry of Finance that BJ Russia
was undercapitalized and at risk of being liquidated. No money was paid to TNK-BP, and
no guaranteed debt or obligation was discharged by the payment.6 Nothing in the
performance guarantee legally obligated BJ Parent to give $52 million to BJ Russia, it
was only required to perform on the contract if BJ Russia could not. After the money was
transferred to BJ Russia, both BJ Parent and BJ Russia had the same obligations under the
performance guarantee that existed before the transfer. The payment neither extinguished,
in whole or in part, BJ Parent’s obligation to guarantee performance, nor reduced the
6
Although it is not entirely clear from the record, it appears the funds were used, at least in part, to pay some
outstanding loans, at least one of which was to another subsidiary of BJ Parent. There is no evidence or contention
that these loans were guaranteed by BJ Parent. However, by paying down that debt, BJ Russia reduced its liabilities
and increased its net assets. (See depo. of Brett W ells, Dkt. 44-3, p. 50) (discussing the use of the $52 million to pay
down liabilities).
9
damages it would pay in the event of a default. It also did not impact BJ Russia’s
obligations to perform; it merely reduced the risk that BJ Russia would be unable to
perform due to liquidation for violation of Russian legal capitalization requirements. In
short, this was not “a payment of principal or interest made . . . by the taxpayer in
discharge of part or all of the taxpayer’s obligation as a guarantor,” because there was no
discharge of any obligation.
Plaintiff relies heavily on the case of Myers v. Commissioner of Internal Revenue,
42 T.C. 195 (1964) to argue that an advance of money pursuant to a performance
guarantee that allows the receiving company to complete a construction project is a debt
that is deductible under Section 162. Myers is inapplicable to these facts. The court in
Myers found that the taxpayer:
made such advances as were necessary to complete the construction and to
sell the houses free and clear of labor, mechanic’s and materialmen’s liens.
Upon doing so a debtor-creditor relations was created under the
construction contract between Cortland Homes and Myers Bros . . . even
though Courtland Homes might not be able to meet its obligation to
reimburse the partnership. . . . In this connection it is to be noted
(notwithstanding the respondent’s contentions on brief to the contrary) that
the parties have in effect stipulated that the amount of the advances here in
question represented debts owing to Myers Bros. by Cortland Homes . . . .
Id. at 208 (emphasis added). Here, by contrast, there was no contractual agreement
between BJ Parent and BJ Russia requiring such a payment to BJ Russia or repayment by
BJ Russia.7 The terms of the payments stressed that no debtor-creditor relationship was
being created because it was “free financial aid.” In Myers, Cortland Homes, had it
7
The payment was made to avoid being called to perform on the performance guarantee between BJ Parent and
TNK-BP. (Depo. of Brett W ells, Dkt. 44-3, p. 37) (“W e took steps to prevent there being a default underneath that
contract.”).
10
continued to exist, owed a debt to Myers Bros. in the amount of the advances that had
been made. Here, because this was “free financial aid,” BJ Russia owed no such debt to
BJ Parent.
The other cases cited by Baker Hughes to support this contention are similarly
distinguishable. In each instance, the focus was on whether payment under a performance
guarantee created a debt that the payer had a legal right to be repaid. Gillespie v. Comm’r,
54 T.C. 1025, 1031 (1970) aff’d. by unpublished order 72-2 U.S. T.C. 9742 (9th Cir.
1972) (“At the outset it must be recognized that as a result of the discharge of the
debenture [there] arose an obligation running from Gillespie Equipment Inc., to the
petitioners.”); Justice Steel, Inc. et al. v. Commissioner, 41 T.C. 209 (1980) (company
that indemnified its directors for personal guarantees made on behalf of other companies
had paid a constructive dividend to them when there was no expectation of repayment);
Matter of Vaughan, 21 B.R. 695 (E.D. Ky. 1982) aff’d 719 F.2d 196 (6th Cir. 1983)
(“The Court views the guaranty agreements as an indirect loan . . .”); compare with Field
& Co. v. Comm’r, 33 T.C.M. 115 (1974) (advances to insolvent company with no
expectation of being repaid and no provision for insurance was a capital contribution and
not a debt). In each instance, when the payment of the guarantee gave the payer a right to
be repaid, it was a debt; when the payer had no right to be repaid, it was a capital
contribution. As has been noted, BJ Parent had no right to expect repayment of the funds
advanced.
11
In summary, the advance to BJ Russia did not create a debt, did not pay a debt, and
was not a payment of a debt pursuant to a guarantee. It is therefore not deductible under
Section 166(a) as a bad debt.
2.
Section 162(a) – Ordinary and Necessary Expense
Baker Hughes argues, in the alternative, that the payment was deductible as an
ordinary and necessary business expense under 26 U.S.C. § 162(a). That section of the
Internal Revenue Code allows the deduction of “all the ordinary and necessary business
expenses paid or incurred during the taxable year in carrying on any trade or business.”
26 U.S.C. § 162(a). Baker Hughes contends that the free financial aid was an ordinary
business expense to BJ Parent, because it fulfilled its legal obligations under the
Performance Guarantee and avoided serious business consequences if its subsidiary had
defaulted on the TNK-BP Contract. Among those consequences were BJ Parent’s
exposure to financial damages in excess of $160 million, including the loss of assets and
equipment of BJ Russia, as well as severe damage to BJ Parent’s reputation as a reliable
service provider in the global market. (Dkt. 44, pp. 13-18).
The United States contends that, as a matter of law, BJ Parent’s contribution of
free financial aid to its subsidiary was neither an “expense,” nor was it “ordinary.” The
court agrees, for reasons explained below.
As a general rule, voluntary payments by a shareholder to his corporation in order
“to bolster its financial position” are not deductible as a business expense or loss.
12
Schleppy v. Commissioner, 601 F.2d 196, 197 (5th Cir. 1979), citing Deputy v. DuPont,
308 U.S. 488 (1940) and Interstate Transit Lines v. Commissioner, 319 U.S. 590 (1943).
It is settled that a shareholder’s voluntary contribution to the capital of the
corporation has no immediate tax consequences. 26 U.S.C. § 263; 26 CFR §
263(a)-2(f) (1986). Instead, the shareholder is entitled to increase the basis
of his shares by the amount of his basis in the property transferred to the
corporation. 26 U.S.C. § 1016(a)(1). When the shareholder later disposes of
his shares, his contribution is reflected as a smaller taxable gain or a larger
deductible loss. This rule applies not only to transfers of cash or tangible
property, but also to a shareholder’s forgiveness of a debt owed to him by
the corporation. . . . The rules governing contributions to capital reflect the
general principle that a shareholder may not claim an immediate loss for
outlays made to benefit the corporation.
Commissioner v. Fink, 483 U.S. 89, 94 (1987). This principle is also set out in the
regulations:
Amounts assessed and paid under an agreement between bondholders or
shareholders of a corporation to be used in a reorganization of the
corporation or voluntary contributions by shareholders to the capital of the
corporation for any corporate purpose. Such amounts are capital
investments and are not deductible.
Treas. Reg. § 1.263(a)-2(f) (1986).
In determining whether the appropriate tax treatment of an expenditure is
immediate deduction or capitalization, “a taxpayer’s realization of benefits beyond the
year in which the expenditure is incurred is undeniably important.” INDOPCO, Inc. v.
Commissioner, 503 U.S. 79, 87 (1992) (citing Central Texas Savings & Loan Assn. v.
United States, 731 F.2d 1181, 1183 (5th Cir. 1984) (“While the period of the benefits may
not be controlling in all cases, it nonetheless remains a prominent, if not predominant,
characteristic of a capital item.”)).
13
Moreover, to qualify for deduction, the expense involved must be ordinary and
necessary for the taxpayer’s own business. As a general rule, a taxpayer may not deduct
the expenses of another. See Welch v. Helvering, 290 U.S. 111, 114 (1933) (“Men do at
times pay the debts of others without legal obligation or the lighter obligation imposed by
the usages of trade or by neighborly amenities, but they do not do so ordinarily.”); Deputy
v. Commissioner, 308 U.S. 488, 495 (1940) (“[T]he fact that a particular expense would
be an ordinary or common one in the course of one business and so deductible under [§
162(a)] does not necessarily make it such in connection with another business.”).
As the government correctly observes, the circumstances giving rise to BJ Parent’s
free financial aid to its subsidiary bear none of the hallmarks of an ‘expense.’ BJ Parent
was under no obligation to make this payment to BJ Russia but chose to do so to avoid
potential future losses. In response to a letter from the Russian Ministry of Finance
threatening liquidation because of undercapitalization, BJ Parent decided to alter the stock
ownership of BJ Russia and have the new majority shareholder (Samotlor) transfer free
cash to BJ Russia. There was no obligation to return the funds, and BJ Russia was not
restricted in how it could use them. BJ Russia then decided to use the money to pay down
an existing loan to BJ International, another subsidiary of BJ Parent. As a result, BJ
Russia recapitalized its balance sheet, reducing its liabilities and increasing its net equity,
thereby eliminating the net asset problem identified by Russian authorities. BJ Russia was
thereby enabled to continue operations and complete the contract. Under these
circumstances, the transfer of funds under the Free Financial Aid Agreement fits squarely
14
within the capitalization principle explained in Fink and specified in Treasury Regulation
§ 1.263(a)-2(f).
The Second Circuit reached a similar conclusion on analogous facts in Mills Estate
v. Comm’r, 206 F.2d 244 (2d Cir. 1953). A New York law required a certain level of net
assets before a corporation could make a corporate distribution. In order to undertake the
transactions necessary to satisfy the net asset test, the taxpayer paid legal fees. The court
ruled that legal fees incurred in the recapitalization effort were not deductible as ordinary
and necessary business expenses. Given the non-deductibility of transactional costs
associated with recapitalization, it is hard to fathom how a different result could be
reached when (as here) the disbursement at issue is the recapitalization itself.
To be sure, BJ Parent did receive other benefits as a result of the recapitalization
and reorganization effected by the Free Financial Aid Agreement. By helping BJ Russia
avoid liquidation and finish the TNK-BP contract, BJ Parent assured not only that BJ
Russia’s valuable proprietary equipment and technology would be recovered, but also that
BJ Parent’s own reputation and future business operations would not be damaged. But
these expected benefits were not realized solely, or even primarily, in the 2008-09 tax
year. Instead, like any normal capital expenditure, these benefits to the taxpayer were
expected to (and presumably did in fact) continue into the future, well beyond the tax year
in which the payments were made.
Baker Hughes argues that the future benefits to BJ Parent’s reputation and business
operations do not preclude a current expense deduction here. It relies upon a line of cases
15
holding that, when one taxpayer pays the expenses of another, the payment may be
deductible under § 162(a) if the taxpayer’s purpose is to protect or promote its own
business interests such as reputation and goodwill. See Hood v. Commissioner, 115 T.C.
172, 180–181 (2000); Lohrke v. Commissioner, 48 T.C. 679 (1967). This is a recognized
exception to the general rule that a taxpayer may not deduct the expenses of another. As
the Tax Court observed in Lohrke:
In a number of cases, the courts have allowed deductions when the
expenditures were made by a taxpayer to protect or promote his own
business, even though the transaction giving rise to the expenditures
originated with another person and would have been deductible by that
person if payment had been made by him.
48 T.C. at 684-85.
The Government responds that, even under the Lohrke exception, the taxpayer’s
expenditure must be linked to an underlying current expense of the other business. In
Lohrke, for example, the taxpayer sent a check to a third party customer to compensate
for losses resulting from defective products sold by the taxpayer’s corporation. Id. at 683.
The other court cases cited by Baker Hughes reveal the same pattern—the expenditure at
issue was earmarked to pay an obligation or extinguish a liability owed to a third party.
See Lutz v. Commissioner, 282 F.2d 614, 615 (5th Cir. 1960) (individual taxpayer sought
deductions for “amounts he paid and debts he assumed with respect to creditors of [] three
corporations.”); Allen v. Commissioner, 283 F.2d 785, 790 (7th Cir. 1960) (amounts paid
“for the purpose of providing payment in full to [the corporation’s] general creditors.”);
Dunn & McCarthy v. Commissioner, 139 F.2d 242, 243 (2d Cir. 1943) (corporate
16
taxpayer repaid loans made by company salesmen to its deceased president); Pepper v.
Commissioner, 36 T.C. 886, 887 (1961) (taxpayer directly repaid third-party creditors
$65,750); Scruggs-Vandervoort-Barney, Inc.v. Commissioner, 7 T.C. 779 (1946)
(taxpayer reimbursed third-party bank depositors $240,888.31).
In reply, Baker Hughes disputes that a deductible underlying expense is necessary
to invoke the Lohrke exception. It points to cases allowing a § 162 deduction for
payments made by a shareholder to repay his corporation’s debt to a third-party lender,
even though the underlying loan was not a deductible expense of the corporation. See e.g.,
Frazier v. Commissioner, 34 T.C.M. (CCH) (1975). Yet the authority most heavily relied
upon by Baker Hughes, a 1995 IRS Technical Advice Memorandum (No. 9522003),
actually undermines its argument. The TAM restates the Lohrke exception in a manner
fully consistent with the Government’s position:
A well-established exception to this general rule, however, permits
taxpayers to claim a deduction for a payment made to extinguish another
taxpayer’s liability where the payment was made to protect and promote the
payor’s own goodwill and is otherwise an ordinary and necessary business
expense. Lohrke v. Commissioner, 48 T.C. 679 (1967).
Dkt. 48-1, at 10. (emphasis added).8
8
An IRS Technical Advice Memorandum is not binding precedent. See Bombardier Aerospace Corp. v.
United States, 831 F.3d 268, 282 (5th Cir. 2016) (citing 26 U.S.C. § 6110(k) (3)). Even if it were, the
factual circumstances described in the TAM No. 9522003 are materially different. A parent company had
provided funding to pay debts owed by its subsidiary to non-shareholder creditors, in order that the
subsidiary could be dissolved; the applicable law would not permit dissolution until all debts were paid.
The TAM expressly noted that the payment was not intended to facilitate continued operations of the
subsidiary, but rather to wind up those operations in a more orderly fashion. Dkt. 48-1 at 10. Here, BJ
Parent was not providing funding so that BJ Russia might be shut down; to the contrary, it was infusing
BJ Russia with sufficient additional capital to satisfy Russian regulations and continue business
operations. See Lidgerwood Mfg. Co. v. Commissioner, 22 T.C. 1152 (1954) (corporate debt cancelled in
order to facilitate continued operations held capital contribution).
17
Whether the Lohrke exception requires an underlying deductible expense, as
opposed to a loan or some other type of non-deductible obligation to a third party, is
apparently an unsettled question, but one that need not be reached here. The free financial
aid provided by BJ Parent was untethered to any actual expense of BJ Russia, deductible
or not. Given the unconditional nature of the aid, BJ Russia’s decision to use some of the
funds to pay down an intra-corporate loan is simply immaterial to the analysis. For these
reasons, the Lohrke exception is inapplicable here.
CONCLUSION
As the Supreme Court reminded in INDOPCO, Inc. v. Commissioner, income tax
deductions are strictly construed because they are a “a matter of legislative grace.” 503
U.S. at 84. When distinguishing capital expenditures from current expenses, the Code
makes clear that “deductions are exceptions to the norm of capitalization,” and so the
burden of clearly showing entitlement to the deduction is on the taxpayer. Id. at 84;
Interstate Transit Lines v. Comm’r, 319 U.S. 590, 593 (1943). Based on the summary
judgment record, Baker Hughes cannot carry that burden here.
The court concludes, as a matter of law, that the $52 million transfer from BJ
Parent to BJ Russia is not a bad debt deductible under 26 U.S.C. § 166; nor is it an
ordinary and necessary expense of the taxpayer’s business deductible under 26 U.S.C. §
162(a). Accordingly, Baker Hughes’ motions for summary judgment (Dkt. 31, Dkt. 44)
are DENIED, and the Government’s motions for summary judgment (Dkt. 29, Dkt 43)
are GRANTED.
18
A separate final judgment will be issued.
Signed at Houston, Texas on June 18, 2018.
19
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