INSIGHT: Parent’s Contribution to ‘Troubled’ Subsidiary Not Deductible

Baker Hughes Inc. can’t deduct a $52 million contribution its predecessor, BJ Services Co., made to a troubled Russian subsidiary (BJ Russia). The company argued that the contribution should be treated as either a bad debt loss or a business expense

BJ Services conducted fracking services in Russia through BJ Russia. BJ Russia agreed to provide pressure pumping services in the Siberian oil fields to a joint venture between British Petroleum (BP) and a Russian company. The contract forged by BJ Services and the BP joint venture required BJ Services to execute a “performance guarantee.” If BJ Russia was unable to perform its obligations, BJ Services would be responsible to pick up the slack and perform those obligations or at the very least arrange for their performance.

BJ Russia sustained losses with respect to the contract. On Oct. 21, 2008, the Russian Ministry of Finance (RMF) sent a letter to BJ Russia advising the company it was in violation of the Civil Code of the Russian Federation and, therefore, “in danger of forced liquidation.” It was, under that Civil Code, woefully undercapitalized.

BJ Services chose to transfer funds from BJ Services to BJ Russia to ward off the threatened liquidation. BJ Services, for U.S. federal income tax purposes, claimed a deduction of $52 million, but that deduction was disallowed by the Internal Revenue Service. Baker Hughes, which acquired BJ Services in 2010, filed a refund complaint in the U.S. District Court for the Southern District of Texas in 2015. Baker Hughes claimed that the payment made by BJ Services was deductible as either a bad debt under tax code Section 166 or as an ordinary and necessary business expense under Section 162.

Contribution to Capital

A taxpayer, the court noted, is entitled to take as a deduction any debt which becomes worthless in that taxable year. See Section 166(a)(1). A contribution to capital cannot be considered a debt for purposes of Section 166. The question of whether the payment from BJ Services to “BJ Russia is deductible in the year made depends on whether the advances are debt (loans) or equity (contributions to capital),“ the court said.

In order for an advance of funds to be considered a debt a reasonable expectation of repayment must exist which does not depend solely on the success of the borrower’s business. The advances, here, were not debt, “but were more in the nature of equity. There was no certificate or note evidencing a loan, no provision for or expectation of repayment,” and no way for BJ Services to enforce repayment. In fact, the operative agreement stated that it was ”free financial aid“ and would not be paid back to BJ Services. “It was not a loan and did not create an indebtedness.”

Baker Hughes argued that the payment was made pursuant to a guarantee to perform because, if BJ Russia was liquidated, BJ Services would be liable for the damages caused by the breach. It is true that a guarantee payment qualifies for a bad debt deduction if “there was an enforceable legal duty upon the taxpayer to make the payment.” However, voluntary payments do not qualify.

The court acknowledged that BJ Services executed a performance guarantee with the BP joint venture to guarantee the work would be done. However, BJ Russia never failed to perform its obligations and the BP joint venture never looked to BJ Services “to satisfy any requirements under the performance guarantee. The event that triggered the payment was not a demand” by the BP joint venture to perform; it was the threatening notice emanating from the RMF. No money was paid to the BP joint venture, and no guaranteed debt or obligation was discharged by the payment. Nothing in the performance guarantee legally obligated BJ Services to give $52 million to BJ Russia. The payment neither extinguished BJ Services’ obligation to guarantee performance nor reduced the damages it would likely incur in the event of a default on the part of BJ Russia. In short, the court concluded, “this was not a payment…made by the taxpayer in discharge of the taxpayer’s obligation as a guarantor, because there was no discharge of any obligation.” The advance to BJ Russia did not create a debt, did not pay a debt, and was not a payment pursuant to a guarantee. Therefore, it follows that it was not deductible under Section 166(a) as a bad debt.

Preserving Reputation

Baker Hughes alternatively argued that the payment was deductible under Section162. The U.S. argued that BJ Services’ payment was neither an expense, nor was it ordinary.

As a general rule, the court observed, voluntary payments by a shareholder to his or her corporation to bolster its financial position are not deductible as a business expense.

Baker Hughes argued that the future benefits to BJ Services’ reputation and business operations (that would accrue from the avoidance of a forced liquidation of BJ Russia) did not preclude a current expense deduction. The company relied on a line of cases holding that, when one taxpayer pays the expenses of another taxpayer, the payment may be deductible under Section 162(a) if the taxpayer’s purpose is to “protect and promote” its own business interests such as reputation and goodwill. See Lohrke v. Commissioner. See also Revenue Ruling 73-226.

The government responded that the taxpayer’s expenditures (in order to be deductible) “must be linked to an underlying current expense of the other business.” Baker Hughes disputed that a deductible underlying expense is necessary to invoke the “Lohrke exception.” Yet, the court noted, “the authority most heavily relied upon by Baker Hughes, a 1995 technical advice memorandum (TAM 9522003), actually undermines its argument.” The free financial aid tendered to “BJ Russia was untethered to any actual expense of BJ Russia, deductible or not.” The “Lohrke exception” is inapplicable here. Citing Lohrke, courts have allowed deductions when the expenditures were made by a taxpayer to protect or promote his or her “own business, even though the transaction giving rise to expenditures originated with another person and would have been deductible by that other person if payment had been made” by him or her.

The transfer by BJ Services to BJ Russia, therefore, was neither a bad debt nor an ordinary and necessary expense of the taxpayer’s business. It follows, therefore, that the payment was not deductible by BJ Services. The government’s motion for summary judgment was granted and that of Baker Hughes was denied. See Baker Hughes, Inc. v. United States, No. 4:15-cv-02675, 2018 BL 215237 (S.D. Tex. 6/18/18).

Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.