Government Argues Payment to Russian Subsidiary Wasn’t Deductible

BAKER HUGHES, INCORPORATED,
Plaintiff-Appellant
v.
UNITED STATES OF AMERICA,
Defendant-Appellee

IN THE UNITED STATES COURT OF APPEALS
FOR THE FIFTH CIRCUIT

On appeal from the United States District Court
for the Southern District of Texas
(Case No. 4:15-cv-02675)

BRIEF FOR THE APPELLEE

RICHARD E. ZUCKERMAN
Principal Deputy
Assistant Attorney General

TRAVIS A. GREAVES
Deputy Assistant Attorney General

GILBERT S. ROTHENBERG (202) 514-3361
RICHARD FARBER (202) 514-2959
JACOB CHRISTENSEN (202) 307-0878
Attorneys
Tax Division
Department of Justice
POST OFFICE BOX 502
Washington, D.C. 20044

Of Counsel:
RYAN K. PATRICK
United States Attorney

STATEMENT REGARDING ORAL ARGUMENT

Counsel for the United States believe that oral argument would be helpful in assisting the Court to determine the important tax issues presented by this appeal.

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TABLE OF CONTENTS

Statement regarding oral argument

Table of contents

Table of authorities

Statement of the issue

Statement of the case

Summary of argument

Argument

Conclusion

Certificate of service

Certificate of compliance

TABLE OF AUTHORITIES

Cases:

A.E. Staley Mfg. Co. v. Commissioner, 119 F.3d 482 (7th Cir. 1997)

Allen v. Commissioner, 283 F.2d 785 (7th Cir. 1960)

Anderson v. Liberty Lobby, Inc., 477 U.S. 242 (1986)

Black Gold Energy v. Commissioner, 99 T.C. 482 (1992)

Bombardier Aerospace Corp. v. United States, 831 F.3d 268 (5th Cir. 2016)

Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775 (2d Cir. 1973)

Brown v. United States, 890 F.2d 1329 (5th Cir. 1989)

Burgess v. United States, 553 U.S. 124 (2008)

Central Texas Savings & Loan Ass'n v. United States, 731 F.2d 1181 (5th Cir. 1984)

Commissioner v. Fink, 483 U.S. 89 (1987)

Commissioner v. Idaho Power Co., 418 U.S. 1 (1974)

Commissioner v. Lincoln Savings & Loan Ass'n, 403 U.S. 345 (1971)

Commissioner v. Tellier, 383 U.S. 687 (1966)

Commissioner v. Tufts, 461 U.S. 300 (1983)

Coulter Electronics, Inc. v. Commissioner, T.C. Memo. 1990-186 (1990)

Deputy v. Du Pont, 308 U.S. 488 (1940)

Dunn & McCarthy v. Commissioner, 139 F.2d 242 (2d Cir. 1943)

Eskimo Pie Corp. v. Commissioner, 4 T.C. 669 (1945)

Field & Co. v. Commissioner, T.C. Memo. 1974-25 (1974)

Fishing Tackle Prods. Co. v. Commissioner, 27 T.C. 638 (1957)

Ford Motor Co. v. Texas Department of Transportation, 264 F.3d 493 (5th Cir. 2001)

Frank Lyon Co. v. United States, 435 U.S. 561 (1978)

Frazier v. Commissioner, T.C. Memo. 1975-220 (1975)

Gillespie v. Commissioner, 54 T.C. 1025 (1970)

Gould v. Commissioner, 64 T.C. 132 (1975)

Hanover Bank v. Commissioner, 369 U.S. 672 (1962)

Horne v. Commissioner, 59 T.C. 319 (1972)

Howard Hughes Co., LLC v. Commissioner, 805 F.3d 175 (5th Cir. 2015)

Ihrig v. Commissioner, 26 T.C. 73 (1956)

In re Vaughan, 21 B.R. 695 (E.D. Ky. 1982)

INDOPCO, Inc. v. Commissioner, 503 U.S. 79 (1992)

Interstate Transit Lines v. Commissioner, 319 U.S. 590 (1943)

Justice Steel, Inc. v. Commissioner, T.C. Memo. 1980-466 (1980)

Lessinger v. Commissioner, 872 F.2d 519 (2d Cir. 1989)

Lidgerwood Mfg. Co. v. Commissioner, 22 T.C. 1152 (1954)

Lohrke v. Commissioner, 48 T.C. 679 (1967)

Lutz v. Commissioner, 282 F.2d 614 (5th Cir. 1960)

Martin v. Commissioner, 52 T.C. 140 (1969)

Mills Estate v. Commissioner, 206 F.2d 244 (2d Cir. 1953)

Myers v. Commissioner, 42 T.C. 195 (1964)

Newark Morning Ledger Co. v. United States, 539 F.2d 929 (3d Cir. 1976)

Pepper v. Commissioner, 36 T.C. 886 (1961)

Piggy Bank Stations, Inc. v. Commissioner, 755 F.2d 450 (5th Cir. 1985)

Putnam v. Commissioner, 352 U.S. 82 (1956)

Sackstein v. Commissioner, 14 T.C. 566 (1950)

Schleppy v. Commissioner, 601 F.2d 196 (5th Cir. 1979)

Scruggs-Vandervoort-Barney, Inc. v. Commissioner, 7 T.C. 779 (1946)

Sheline v. Dun & Bradstreet Corp., 948 F.2d 174 (5th Cir. 1991)

Skidmore v. Swift & Co., 323 U.S. 134 (1944)

Snow v. Commissioner, 31 T.C. 585 (1958)

Stoody v. Commissioner, 66 T.C. 710 (1976)

Stratmore v. United States, 420 F.2d 461 (3d Cir. 1970)

Welch v. Helvering, 290 U.S. 111 (1933)

Woodward v. Commissioner, 397 U.S. 572 (1970)

Wortham Machinery Co. v. United States, 521 F.2d 160 (10th Cir. 1975)

Zimmerman v. United States, 318 F.2d 611 (9th Cir. 1963)

Statutes:

Internal Revenue Code (26 U.S.C.):

Tax Reform Act of 1976, Pub. L. No. 94-455, § 1201, 90 Stat. 1520 (1976)

Regulations:

Treasury Regulations (26 C.F.R.):

25 Fed. Reg. 11402 (Nov. 26, 1960)

44 Fed. Reg. 68463 (Nov. 29, 1979)

Other Authorities:

Bittker, Emory & Streng, Federal Income Taxation of Corporations & Shareholders: Forms, § 2.02[5] (Oct. 2018)

Fed. R. Civ. P. 33(b)(3)

Fed. R. Civ. P. 56(a)

H.R. Conf. Rep. No. 94-1515 (1976)

H.R. Rep. No. 94-658 (1975)

Revenue Ruling 73-226, 1973-1 C.B. 62 (1973)

Technical Advice Memorandum 9522003 (1995)

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STATEMENT OF THE ISSUE

Whether the District Court correctly held that Baker Hughes was not entitled to an income tax deduction under either § 162 or § 166 of the Internal Revenue Code for the transfer of $52 million in cash, in the form of “free financial aid,” to a Russian subsidiary in order to bring the subsidiary into compliance with the capitalization requirements of Russian law.

STATEMENT OF THE CASE

A. BJ Parent and BJ Russia

Baker Hughes is the successor by merger of BJ Services Company (“BJ Parent”). ROA.10. During the relevant time period, BJ Parent was the common parent company of an affiliated group of foreign and domestic companies, and it was the indirect owner of ZAO Samotlor Fracmaster Services (“BJ Russia”), a Russian subsidiary that conducted oil and gas pressure pumping (fracking) services in Russia. ROA.11, 90, 1085-1087.

B. BJ Russia's agreement to provide fracking services to TNK-BP and BJ Parent's performance guarantee

In August 2006, BJ Russia contracted with a Russian oil company, TNK-BP, to provide fracking services in Siberian oil fields. ROA.92-361. The contract was to last for a period of three years, during which time BJ Russia agreed to provide fracking services pursuant to work orders issued by TNK-BP. ROA.95, 105-106, 182.

For BJ Russia to bid on the contract, TNK-BP required BJ Russia's parent company, BJ Parent, to guarantee performance of the services to be rendered. ROA.385. BJ Parent provided an initial guarantee letter, dated January 19, 2006, that was included with BJ Russia's bid. ROA.393-394. After the contract was signed, BJ Parent provided a substantially similar guarantee letter, dated November 29, 2006. ROA.390-391; see also ROA.1308-1310. BJ Parent's guarantee provided, in relevant part:

ROA.390 (all caps omitted).

Thus, BJ Parent guaranteed that BJ Russia would perform the fracking services that TNK-BP asked BJ Russia to provide and that, if BJ Russia failed to perform, BJ Parent would take steps to ensure performance of those services. ROA.390. During the 3-year term of the contract, however, BJ Russia never defaulted under the contract, nor did TNK-BP ever claim that BJ Russia defaulted. ROA.410. BJ Parent, accordingly, was never called upon by TNK-BP to take any action pursuant to its performance guarantee. ROA.410.

According to Baker Hughes, the TNK-BP contract nevertheless turned out not to be profitable, and BJ Russia allegedly informed TNK-BP in September 2008 that it did not intend to renew the contract upon its expiration in August 2009. Br. 6-7.

C. The Russian Ministry of Finance's determination that BJ Russia was undercapitalized

In a letter dated October 21, 2008, the Russian Ministry of Finance notified BJ Russia that it was not in compliance with Articles 90 and 99 of the Civil Code of the Russian Federation. ROA.1721-1722. Those provisions require a joint stock company to maintain “net assets” in an amount at least equal to the company's chartered capital. A company may reduce its chartered capital to match the level of its net assets, but the Civil Code establishes a minimum level for chartered capital. ROA.1721. The letter explained that, if a company's net assets are less than the minimum level for chartered capital at the end of the financial year, then the company is subject to liquidation by the Russian taxing authority. ROA.1721-1722.

In its October 21 letter, the Russian Ministry of Finance informed BJ Russia that, based on its calculations, BJ Russia's net assets for 2006 and 2007 — which it computed to be less than zero for both years (-228,277,000 Rubles and -570,683,000 Rubles, respectively) — were less than the chartered capital minimum.¹ ROA.1721-1722. The Russian Ministry informed BJ Russia that, based on its determination, “the taxing authority ha[d] the right to claim the liquidation of the company through the court.” ROA.1722. The letter suggested that BJ Russia take action to improve its “business activity,” and it further required BJ Russia to inform the Russian Ministry, by November 14, 2008, of the actions it had taken “to improve [its] financial performance and increase the net assets in 2008.” ROA.1722.²

On November 13, 2008, BJ Russia responded to the Russian Ministry's letter, stating that it was “taking steps to improve the financial and economic activities of the company and to increase the net assets in 2008.” ROA.430. BJ Russia did not tell the Russian Ministry what steps it was taking to do so in its response letter, and there apparently was no other written communication between BJ Russia and the Russian Ministry of Finance concerning the matter. ROA.405-409, 1319.

D. BJ Parent's contribution of “free financial aid” to increase BJ Russia's net assets

BJ Parent ultimately decided to address BJ Russia's undercapitalization problem by transferring $52 million in cash to BJ Russia in the form of “free financial aid,” pursuant to Article 251.1(11) of the Tax Code of the Russian Federation. ROA.459. Article 251.1(11) provides an exemption from Russian profit tax for assets received “without consideration” by a Russian organization from its majority shareholder.³ ROA.459, 1161-1163. BJ Parent believed that giving free financial aid under this provision would be the most tax efficient way to provide BJ Russia with the additional capital it needed to satisfy the net-asset requirement of Russian law. See ROA.1058-1059, 1115 (email exchange with tax counsel: “The most tax efficient way in Russia for this capital to be provided is in the form of 'free financial aid,' that is, the shareholders just give money to the Russian affiliate with no repayment obligation, ever.”).

Prior to this time, BJ Russia had been directly owned by two equal shareholders, BJ Holdings (Russia) Ltd. and Samotlor Holdings Ltd. (“Samotlor”), also subsidiaries of BJ Parent, each of which owned 4,050 shares of BJ Russia stock. ROA.90, 451, 1086-1087. Therefore, for the free financial aid to qualify for the Russian tax exemption under Article 251.1(11), BJ Russia's ownership structure had to be changed to include a single majority shareholder on behalf of which the aid could be transferred to BJ Russia. ROA.1034-1035, 1090-1091. The steps for providing the free financial aid to BJ Russia were outlined in a BJ Russia stockholder meeting, in a document titled “Russia: Free Capital Contribution.” ROA.451, 441-451. As reflected in the diagram, the first step was to “[i]ncrease Samotlor Holdings Ltd.'s interest in [BJ Russia],” after which BJ Parent would make a “free capital contribution” to BJ Russia on behalf of Samotlor — the new majority shareholder. ROA.451 (emphasis added).

On November 24, 2008, in accordance with the plan, BJ Holdings (Russia) Ltd. sold 1,050 shares of its BJ Russia stock to Samotlor, making Samotlor the majority shareholder of BJ Russia. ROA.1102-1113. This restructuring of the ownership of BJ Russia was done to allow Samotlor to transfer the free financial aid to BJ Russia in its capacity as BJ Russia's majority shareholder. ROA.1034-1035, 1057-1058, 1090-1091.

Subsequently, on November 26, 2008, BJ Russia and Samotlor executed an “Agreement on provision of Free Financial Aid.” ROA.432-437. Under the agreement, Samotlor, in its capacity as majority shareholder of BJ Russia, agreed to transfer $52 million in cash to BJ Russia as “free financial aid.” ROA.433; see also ROA.1034-1035, 1057-1058, 1090-1091. The funds would be transferred by BJ Parent directly to BJ Russia, on behalf of Samotlor, by December 31, 2008. ROA.433. The agreement provided that the funds “shall be used by the Company [BJ Russia] to execute its activities as stipulated by the Company's Charter.” ROA.433. The agreement further made clear that the financial aid was free and that there was no obligation to return the funds:

The Shareholder [Samotlor] confirms hereby that its financial assistance is free and that it does not expect the Company [BJ Russia] to return the funds to the Shareholder.

ROA.433. Baker Hughes concedes in its brief that “there was no obligation to return” the funds. Br. 11. Baker Hughes also admits, in its responses to interrogatories, that the funds “could be used at BJ Russia's discretion.” ROA.459-460, 463.

In November and December 2008, BJ Parent transferred a total of $52 million in cash to BJ Russia, on behalf of Samotlor, as free financial aid. ROA.465, 467. BJ Russia then used the money to pay down an existing intercompany loan from BJ Services International (SARL), another subsidiary of BJ Parent. ROA.90, 1028-1030. The infusion of $52 million in free cash had the effect of increasing BJ Russia's net assets, thereby resolving its undercapitalization problem that had been identified by the Russian Ministry of Finance. ROA.1023, 1064-1067; see also ROA.469-470 (BJ Russia's balance sheet for 2008 reflecting a positive closing balance for “equity” in the amount of 213,840,000 Rubles). The free financial aid thus enabled BJ Russia to avoid liquidation of its assets by the Russian authorities and continue its work under the TNK-BP contract. ROA.17 (¶ 40); ROA.1700 (¶ 9).

E. BJ Parent's claim for refund

BJ Parent claimed a tax deduction for the $52 million in free financial aid provided to BJ Russia as a “bad debt expense” on its income tax return for the 2008 fiscal year. ROA.1236, 1239. The Internal Revenue Service disallowed the deduction in its entirety, based on its determination that BJ Parent “failed to establish that the $52,000,000 transaction with [BJ Russia] qualifies as a bad debt or guaranteed debt under I.R.C. § 166 and the regulations thereunder.” ROA.791. The IRS further determined that no deduction is allowed because “the payment, allegedly made in satisfaction of a guarantee, is in fact a capital contribution” that may not be deducted under any provision of the Internal Revenue Code. ROA.791.

F. The proceedings in the District Court

Baker Hughes, as BJ Parent's successor, then filed this action in the District Court, seeking a federal income tax refund for the 2008 year in the amount of $17,654,000, plus interest. ROA.8-20. The complaint asserted that BJ Parent was entitled to a tax deduction under Internal Revenue Code (I.R.C.) (26 U.S.C.) § 166 for a “debt” that became “worthless” during the 2008 taxable year. ROA.8. The United States filed a motion for summary judgment, contending that Baker Hughes had failed to identify any debt that would entitle it to a deduction under § 166 and that the Government was entitled to judgment as a matter of law. ROA.72-84.

After the Government filed its motion for summary judgment, the District Court permitted Baker Hughes to assert an alternative claim for a deduction that was not raised in its complaint — i.e., that the $52 million in free financial aid was a deductible trade-or-business expense under I.R.C. § 162. ROA.971-973. After conducting additional discovery, the parties filed cross-motions for summary judgment with respect to the § 162 claim, ROA.975-999, 1251-1279, and the District Court permitted Baker Hughes to treat its response to the Government's initial motion as its own cross-motion for summary judgment with respect to the bad debt claim under § 166 as well, ROA.2146 n.1.

The District Court granted the United States' motion for summary judgment and denied Baker Hughes' cross-motion with respect to both claims. ROA.2146-2164. The District Court held that Baker Hughes was not entitled to a deduction for the free financial aid under § 166 because the aid “did not create a debt, did not pay a debt, and was not a payment of a debt pursuant to a guarantee.” ROA.2151-2157. The District Court also rejected Baker Hughes' claim under § 162, concluding that the free financial aid was neither an “expense,” nor an “ordinary” one, but was instead a nondeductible contribution to the capital of BJ Russia on behalf of its shareholder. ROA.2157-2163.

SUMMARY OF ARGUMENT

The District Court correctly held that Baker Hughes (successor to BJ Parent) was not entitled to a deduction, as a matter of law, for the $52 million in free financial aid it provided to a subsidiary, BJ Russia, on behalf of BJ Russia's direct shareholder, Samotlor, in order to bring BJ Russia into compliance with the capitalization requirements of Russian law. Rather, as the District Court and the Commissioner concluded, the free financial aid was a nondeductible contribution to the capital of BJ Russia by its shareholder that has no immediate tax consequences. Samotlor, however, is entitled to increase its basis in its shares in BJ Russia by $52 million, and the tax benefits resulting from the contribution will be realized later, in the form of a smaller taxable gain or a larger deductible loss upon the disposition of those shares or the liquidation of BJ Russia.

1. The District Court correctly determined that Baker Hughes was not entitled as a matter of law to a trade-or-business expense deduction under § 162 for the free financial aid it provided to its Russian subsidiary. Deductions under § 162 (and § 166) are subject to the provisions of § 263 that preclude a deduction for capital expenditures, including contributions to the capital of a corporation. It is settled that a shareholder's voluntary contribution to the capital of his corporation has no immediate tax consequences and that, as a general rule, a shareholder may not claim a deduction for outlays made to benefit his corporation. No exception to this general rule applies here. The free financial aid in this case was a nondeductible contribution to the capital of BJ Russia.

The free financial aid does not qualify for a deduction under § 162 in any event because it was neither an “expense,” nor was it “ordinary,” which are necessary elements for a deduction. The free financial aid was untethered to any actual “expense” that was paid or incurred by BJ Parent; BJ Russia was simply given $52 million in unrestricted cash that was added to its capital and that BJ Russia could retain or use at its own discretion. Because there was no underlying expense, Baker Hughes' reliance on the Lohrke line of cases is misplaced. Furthermore, the free financial aid was not an “ordinary” expense, but was rather a capital expenditure, because it provided future benefits to BJ Parent that extended well beyond the tax year in which the free financial aid was provided.

2. The District Court also correctly held that Baker Hughes was not entitled as a matter of law to a bad debt deduction under § 166. First, the District Court correctly concluded that BJ Parent's provision of the free financial aid to BJ Russia was not a loan and, hence, did not create a “debt” owed by BJ Russia to BJ Parent. The free-financial-aid agreement expressly stated in this regard that the aid was free and that there was no expectation of repayment. Baker Hughes does not challenge this aspect of the District Court's ruling on appeal.

Second, the District Court also correctly concluded that Baker Hughes was not entitled to a deduction for the free financial aid in its capacity as guarantor of the TNK-BP contract. Under § 166, a taxpayer who makes a payment in discharge of its obligation as a guarantor of a debt may claim a bad debt deduction to the extent it is unable to recover its payment from the debtor. BJ Parent, however, was not a guarantor of any bona fide “debt” for purposes of § 166. The TNK-BP contract for which BJ Parent provided a performance guarantee was an executory contract for the performance of fracking services by BJ Russia; it did not involve any underlying debt obligation at all. Thus, BJ Parent's provision of free financial aid to BJ Russia did not satisfy any debt related to its performance guaranty or otherwise, as required for a deduction under § 166. Nor did it discharge BJ Parent's contingent liability as guarantor while the TNK-BP contract remained ongoing.

The District Court's grant of summary judgment in favor of the United States was correct and should be affirmed.

ARGUMENT
The District Court correctly held that Baker Hughes was not entitled to a deduction, as a matter of law, for the $52 million in free financial aid provided to BJ Russia on behalf of BJ Russia's direct shareholder (Samotlor) in order to bring BJ Russia into compliance with the capitalization requirements of Russian law

Standard of review

This Court reviews a grant of summary judgment de novo, applying the same standard prescribed for use by the district court. Ford Motor Co. v. Texas Department of Transportation, 264 F.3d 493, 498 (5th Cir. 2001). On review of the district court's rulings on cross-motions for summary judgment, each party's motion is reviewed independently, applying that same standard. Id.

A. Introduction

The dispute in this case is not whether Baker Hughes may claim tax benefits from the transfer of $52 million in free financial aid to BJ Russia. Rather, the parties' dispute is about when, and in what form, the resulting tax benefits are properly allowable under the Internal Revenue Code. Baker Hughes argues that it is entitled to a current deduction for the free financial aid for its 2008 tax year, either as a trade-or-business expense under I.R.C. § 162 or as a bad debt expense under I.R.C. § 166. The District Court correctly held, however, that the free financial aid was not deductible in 2008 under either § 162 or § 166.

Instead, as the District Court (and the Commissioner) concluded, the free financial aid provided by BJ Parent on behalf of BJ Russia's majority shareholder, Samotlor, was a nondeductible contribution to the capital of BJ Russia that has no immediate tax consequences.⁴ In this situation, the shareholder — Samotlor — is entitled to increase its basis in its shares in BJ Russia by $52 million, and the tax benefits resulting from the contribution will be realized later, in the form of a smaller taxable gain or a larger deductible loss upon the disposition of those shares or the liquidation of BJ Russia. Commissioner v. Fink, 483 U.S. 89, 94 (1987); Woodward v. Commissioner, 397 U.S. 572, 574-575 (1970).

The District Court's grant of summary judgment in favor of the United States was correct and should be affirmed.

B. The summary judgment standard

Summary judgment is proper if “there is no genuine dispute as to any material fact and the movant is entitled to judgment as a matter of law.” Fed. R. Civ. P. 56(a). A fact is material if it “might affect the outcome of the suit under the governing law,” and a dispute is genuine “if the evidence is such that a reasonable jury could return a verdict for the nonmoving party.” Anderson v. Liberty Lobby, Inc., 477 U.S. 242, 248 (1986).

Baker Hughes bore the burden below to prove that it was entitled to a refund, such that it was required to prove that the Commissioner's determination of a tax deficiency, which is presumed to be correct, was erroneous and that it was entitled to a deduction for its $52 million payment. Welch v. Helvering, 290 U.S. 111, 115 (1933); Brown v. United States, 890 F.2d 1329, 1334 (5th Cir. 1989). Summary judgment is appropriate where the material facts are not in dispute and the only questions before the court are issues of law. E.g., Sheline v. Dun & Bradstreet Corp., 948 F.2d 174, 176 (5th Cir. 1991); Brown, 890 F.2d at 1334. The proper characterization of a transaction for tax purposes and questions of statutory interpretation are issues of law. Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16 (1978); Howard Hughes Co., LLC v. Commissioner, 805 F.3d 175, 180 (5th Cir. 2015).

C. Baker Hughes is not entitled to a deduction for the free financial aid as a trade-or-business expense under § 162

The Supreme Court has emphasized the general principle that “deductions are exceptions to the norm of capitalization.” INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). An income tax deduction, moreover, is “a matter of legislative grace,” and “the burden of clearly showing the right to the claimed deduction is on the taxpayer.” INDOPCO, 503 U.S. at 84.

Section 162 allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” I.R.C. § 162(a). To qualify as an allowable deduction under § 162, an item must “(1) be 'paid or incurred during the taxable year,' (2) be for 'carrying on any trade or business,' (3) be an 'expense,' (4) be a 'necessary' expense, and (5) be an 'ordinary' expense.” Commissioner v. Lincoln Savings & Loan Ass'n, 403 U.S. 345, 352 (1971). The allowance of any deduction under § 162 (or § 166), however, is “subject to the exceptions provided in part IX” of Subchapter B, Subtitle A of the Code, including § 263, which precludes any deduction for “capital expenditures.” I.R.C. § 161; see also I.R.C. § 261. Under this “priority-ordering directive” of the Code, Commissioner v. Idaho Power Co., 418 U.S. 1, 17 (1974), an item that is a “capital expenditure” under § 263 is not deductible, even if it would otherwise qualify for a deduction under § 162 (or § 166). Id.

The undisputed facts establish that the free financial aid provided by BJ Parent to BJ Russia on behalf of its shareholder, Samotlor, does not qualify for a deduction under § 162, not only because it does not meet the underlying requirements for a deduction under § 162, but also because the free financial aid was a capital contribution for which a deduction is precluded by § 263. In this regard, the District Court correctly concluded that the free financial aid was neither an “expense,” nor was it “ordinary,” but was instead a contribution to the capital of BJ Russia on behalf of its shareholder, Samotlor. ROA.2157-2163.

1. A shareholder's transfer of free cash to its corporation is a contribution to capital that does not give rise to an immediate deduction

The governing principles of taxation that control this case were articulated by the Supreme Court in Commissioner v. Fink, 483 U.S. at 94:

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 C.F.R. § 1.263(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. See 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. 26 C.F.R. § 1.61-12(a) (1986). Such transfers are treated as contributions to capital even if the other shareholders make proportionately smaller contributions, or no contribution at all. See, e.g., Sackstein v. Commissioner, 14 T.C. 566, 569 (1950). 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. Deputy v. Du Pont, 308 U.S. 488, 60 S.Ct. 363, 84 L.Ed. 616 (1940); Eskimo Pie Corp. v. Commissioner, 4 T.C. 669, 676 (1945), aff'd, 153 F.2d 301 (CA3 1946).

Thus, as this Court has recognized, cash given by a shareholder to his corporation “in order to bolster its financial position” does not entitle the shareholder to a deduction. 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)). “In such a situation, the amounts paid are added to the basis of the stock in the stockholder's hands.” Id.

This settled tax treatment of outlays made by a shareholder to benefit a corporation is dictated by the Internal Revenue Code. Section 263 expressly precludes a deduction for “capital expenditures” — that is, for “any amount paid out for new buildings or for permanent improvements or betterments made to increase the value of any property or estate.” I.R.C. § 263(a)(1). The Treasury Regulations in effect during the year at issue further provide that “voluntary contributions by shareholders to the capital of the corporation for any corporate purpose” are regarded as “capital investments and are not deductible.” Treas. Reg. (26 C.F.R.) § 1.263(a)-2(f) (2008). Instead, a shareholder's contribution to the capital of his corporation produces an increase in the basis of his shares in an amount equal to his basis in the property transferred. I.R.C. § 1016(a)(1). By virtue of this adjustment to basis, the taxpayer will eventually recover his investment for tax purposes when he disposes of his shares, in the form of a smaller taxable gain or a larger deductible loss.

The term “capital contribution” does not presuppose on the shareholder's part a donative intent, in the sense that there must be no business motive for making it. To the contrary, the Court in Fink identified benefits to the shareholders in that case who had surrendered a portion of their shares back to the corporation, which included “to protect or increase the value of their investment in the corporation,” yet the Court still held that the transaction was a capital contribution. 483 U.S. at 97. As the Court there stated, “payments made by a stockholder of a corporation for the purpose of protecting his interest therein must be regarded as an additional cost of his stock, and so cannot be deducted immediately.” Id. at 100 (quoting Eskimo Pie Corp. v. Commissioner, 4 T.C. 669, 676 (1945)); see also Ihrig v. Commissioner, 26 T.C. 73, 76 (1956).

The corollary of the principle that capital contributions are not immediately deductible by the shareholder is that such contributions are not taxable as income to the corporation. I.R.C. § 118(a). This tax treatment of capital contributions under the Code is similar to that provided by Article 251.1(11) of the Russian tax law, which similarly excludes from the tax base of a Russian organization the assets received without consideration from a majority shareholder, and which was invoked by BJ Russia here to avoid having to pay Russian profit tax on its receipt of the free financial aid in this case. ROA.459.

2. The free financial aid was a nondeductible contribution to the capital of BJ Russia by its shareholder

The rule articulated in Fink applies here. As noted, under the applicable regulations, “voluntary contributions by shareholders to the capital of the corporation for any corporate purpose” are regarded as “capital investments and are not deductible.” Treas. Reg. § 1.263(a)-2(f) (2008).

Here, during the 3-year term of the TNK-BP contract, there were no defaults by BJ Russia, and BJ Parent was never called upon to take any action with respect to its performance guarantee. ROA.410. Rather, in response to a letter from the Russian Ministry of Finance threatening the liquidation of BJ Russia because of its undercapitalization, BJ Parent chose to alter the stock ownership of BJ Russia and have its new majority shareholder, Samotlor, contribute free cash to BJ Russia in its capacity as the majority shareholder. ROA.1034-1035, 1057-1058, 1090-1091. BJ Parent chose this form for the transaction so that the free financial aid would qualify for the exemption from Russian profit tax under Article 251.1(11), which required that the financial aid be transferred “without consideration” by the majority shareholder. See footnote 3, supra at p. 7. Baker Hughes admitted, in its responses to interrogatories made under oath, that BJ Russia had no obligation to return the funds and was not restricted in how it could use the funds:

[T]he Funding Payments were not issued in exchange for stock, there was no obligation to return them, they could be used at BJ Russia's discretion, and they were exempt from Russian profit tax.

ROA.459-460, 463. The free financial aid agreement also expressly provided that the aid was “free” and that there was no expectation of repayment. ROA.433. BJ Russia then chose to use the money to pay down an outstanding intercompany loan to another subsidiary of BJ Parent.

As a result of these transactions, BJ Russia's ownership structure changed, its liabilities decreased, and its net assets increased, thereby resolving the undercapitalization problem that had been identified by the Russian authorities. ROA.1023, 1032-1033, 1064-1067. According to Baker Hughes' own allegations in the complaint, the free financial aid thus allowed BJ Russia to avoid the liquidation of its assets and continue its business operations into the future — at least until its work under the TNK-BP contract was completed nearly a year later (in August 2009):

The Funding Payments allowed BJ Russia to complete the [T]NK-BP Contract by preventing an involuntary liquidation of BJ Russia by the Russian government. BJ Parent could not have completed the TNK-BP Contract itself because BJ Russia was the only member of the BJ Group licensed to do business in Russia.

ROA.17 (¶ 40); see also ROA.1700 (¶ 9). Notably, Baker Hughes alleges that BJ Russia was the only member of the BJ Group that could perform the work required under the TNK-BP contract. Id.

There can be no real dispute that the transfer of $52 million in free cash to BJ Russia by its shareholder to satisfy BJ Russia's capitalization requirements under Russian law is a permissible “corporate purpose” covered by the broad scope of Treasury Regulation § 1.263(a)-2(f). Baker Hughes itself has stated repeatedly that the free financial aid was necessary “to strengthen [BJ Russia's] balance sheet to conform to the requirements under Russian Federal Law.” ROA.624, 662. And Samotlor's own resolution approving the free financial aid similarly stated that the aid was given “to strengthen the financial basis” of BJ Russia. ROA.439. According to Baker Hughes, the free financial aid enabled BJ Russia to avoid the liquidation of its assets by the Russian tax authorities and continue to operate in Russia — also a permissible “corporate purpose” under the regulation.

On these facts, which are not in dispute, the District Court correctly concluded that the free financial aid “fits squarely within the capitalization principle explained in Fink and specified in Treasury Regulation § 1.263(a)-2(f).” ROA.2159-2160. The free financial aid was given “in order to bolster [BJ Russia's] financial position,” Schleppy, 601 F.2d at 197, and bring BJ Russia into compliance with Russian capitalization requirements, thereby enabling BJ Russia to keep its assets and continue its business operations. As such, the free financial aid was a capital contribution that must be added to the basis of Samotlor's shares in BJ Russia. Indeed, BJ Russia itself referred to the free financial aid as a “capital contribution” in its own internal documentation of the transaction. ROA.451.⁵

As the District Court noted (ROA.2160), the Second Circuit reached a similar conclusion on analogous facts in Mills Estate v. Commissioner, 206 F.2d 244 (2d Cir. 1953). In that case, a New York law imposed a net asset test requiring that a corporation have a certain level of assets in order to make a corporate distribution to its shareholders. The corporation incurred legal fees in carrying out the transactions necessary to satisfy the net asset test, which included the surrender of shares back to the corporation in order to reduce the number and authorized amount of outstanding shares of capital stock. The court held that the legal fees incurred in this “recapitalization” effort to achieve an “altered corporate structure” were “capital in nature” and were not deductible trade-or-business expenses. 206 F.2d at 246; accord INDOPCO, 503 U.S. at 89 (“Courts long have recognized that expenses . . . incurred for the purpose of changing the corporate structure for the benefit of future operations are not ordinary and necessary business expenses.”) (quotation omitted). Given that transactional costs associated with recapitalization are not deductible, the same conclusion is inescapable where, as here, the disbursement at issue is the additional capital itself.

Baker Hughes argues (Br. 39-41) that the District Court's reliance on Mills was misplaced because the free financial aid was not provided “for the benefit of future operations” of BJ Russia. That argument, however, is contradicted by Baker Hughes' own allegations in the complaint that the free financial aid allowed BJ Russia to avoid liquidation and continue its business operations until its work under the TNK-BP contract was completed (nearly a year later). ROA.17 (¶ 40); see also ROA.1700 (¶ 9). Moreover, according to Baker Hughes, BJ Russia was the only member of the BJ Group that could perform the work required under the contract. Id. Thus, Baker Hughes' own allegations establish that the free financial aid was given to enable BJ Russia to continue its business operations under the TNK-BP contract because there was no other company that could perform the work. The Second Circuit's decision in Mills thus strongly supports the District Court's conclusion in this case that the free financial aid was a nondeductible capital contribution.

3. The Lohrke exception relied on by Baker Hughes is inapplicable

In seeking to avoid the proper treatment of the $52 million payment as a capital contribution, Baker Hughes invokes some inapposite cases that, notwithstanding the general rule that a shareholder is not entitled to a deduction for outlays made to benefit his corporation, have in some situations permitted taxpayers to deduct expenditures made to pay an expense of another taxpayer. Br. 30-32. In Lohrke v. Commissioner, 48 T.C. 679, 684-685 (1967), the Tax Court observed:

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.

Cf. Welch, 290 U.S. at 114 (“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.”). Baker Hughes argues that the District Court “wrongly assumed” that the free financial aid could “only be treated as debt or equity” and “failed to recognize [this] third alternative” — i.e., as a deductible “expense” by BJ Parent. Br. 33. In fact, however, the District Court specifically addressed — and correctly rejected — Baker Hughes' reliance on the Lohrke exception. ROA.2160-2163.

a. Baker Hughes' reliance on the Lohrke exception fails because, as the District Court explained (ROA.2163), the free financial aid was untethered to any actual “expense,” which is a necessary element for a deduction under § 162. I.R.C. § 162(a); Lincoln Savings & Loan Ass'n, 403 U.S. at 352. Here, where BJ Russia was given free cash that it could retain or use at its discretion, the necessary element of an underlying “expense” that was “paid or incurred” is missing. I.R.C. § 162(a).

The cases and other materials that Baker Hughes itself relies upon demonstrate the requirement that there be an actual underlying “expense,” as well as Baker Hughes' failure to meet it. The taxpayer in Lohrke, for instance, sent a check to a third-party customer to compensate it for losses resulting from defective products sold by the taxpayer's corporation. 48 T.C. at 683. There was an underlying expense in that case that was paid by the shareholder on behalf of his corporation. Similarly, in Lutz v. Commissioner, 282 F.2d 614, 615 (5th Cir. 1960), the taxpayer was allowed deductions for “amounts he paid and debts he assumed with respect to creditors” of three controlled corporations. Again, there were underlying expenses in that case as well, which the shareholder paid on behalf of his corporations. An examination of nearly all the other cases that Baker Hughes cites (Br. 31-32, 35-37, 52) reveals the same pattern.⁶ The common element in all these cases is that, although a shareholder or parent corporation may have been allowed a deduction, there was always an underlying expense to support it — i.e., a currently deductible liability to a third party that was extinguished or paid by the expenditure in question. This requirement — that a currently deductible liability to a third party be extinguished or paid by the expenditure in question — is supported by the Lohrke court's own description of the exception, which describes the “expenditure” as one arising from a “transaction” that “originated with another person” and that “would have been deductible by that person if payment had been made by him.” 48 T.C. at 684-685.⁷

But a similar extinguishment of a liability to a third party is missing in this case. BJ Russia was simply given $52 million in unrestricted cash that was added to its capital; there was no actual “expense” that was paid or incurred by anyone. As the District Court correctly observed, the free financial aid was “untethered to any actual expense of BJ Russia[.]” ROA.2163. In the absence of an underlying “expense,” Baker Hughes' claim under § 162 must fail.

Moreover, BJ Russia's discretionary, subsequent use of the funds to pay the intercompany loan from BJ Services International cannot supply the missing “expense.” First, Baker Hughes admitted in its responses to interrogatories made under oath that the funds “could be used at BJ Russia's discretion.” ROA.459-460, 463; see Fed. R. Civ. P. 33(b)(3).⁸ The District Court thus correctly concluded that, because of the unconditional nature of the free financial aid, BJ Russia's subsequent use of the funds to pay down an intercompany loan is “immaterial to the [Lohrke] analysis.” ROA.2163. In this regard, BJ Russia's undercapitalization problem would have been equally resolved if BJ Russia had simply kept the funds in its bank account instead of using them to pay the loan. BJ Russia's unilateral decision to use the funds to pay a loan cannot serve to transform BJ Parent's nondeductible capital contribution into a deductible expenditure.

BJ Russia's use of the funds to pay the intercompany loan is immaterial for the additional reason that BJ Russia was a “disregarded” foreign entity of BJ Services International, which supplied the loan. ROA.11 (¶¶ 12-13), 1086-1087, 1240 (lines 1.a. and 3.a.). “A loan from an owner to a disregarded entity is ignored (being merely a transfer inside the entity)” for U.S. income tax purposes. Bittker, Emory & Streng, Federal Income Taxation of Corporations & Shareholders: Forms, § 2.02[5], 2004 WL 1943443 (Oct. 2018). As a result, the loan from BJ Services International to BJ Russia is ignored for U.S. income tax purposes, see Treas. Reg. §§ 301.7701-2(a), 301.7701-3(a), and BJ Russia's discretionary use of the funds to pay the loan is of no consequence for this additional reason.

b. The other cases that Baker Hughes cites (Br. 36, 37, 41) are also distinguishable. In each of the cases A.E. Staley Mfg. Co. v. Commissioner, 119 F.3d 482 (7th Cir. 1997); Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775 (2d Cir. 1973); Myers v. Commissioner, 42 T.C. 195 (1964); and Snow v. Commissioner, 31 T.C. 585 (1958), the expenditure in question was a payment of the taxpayer's own expense and was not even made on behalf of another taxpayer. Thus, the general rule precluding a shareholder from deducting outlays made to benefit his corporation, Fink, 483 U.S. at 94 — which controls this case — was not even implicated in those cases.⁹

Similarly, the case of Fishing Tackle Prods. Co. v. Commissioner, 27 T.C. 638 (1957), is also distinguishable because, unlike this case, it too involved an actual underlying expense. In Fishing, a corporate taxpayer that was engaged in the distribution of sport fishing equipment organized a subsidiary corporation for the purpose of manufacturing patented fishing rods. The subsidiary produced the rods for sale exclusively to the taxpayer at a price established by the taxpayer, based on the estimated manufacturing costs. Id. at 641-642. The subsidiary incurred operating losses, however, because the taxpayer had underestimated the manufacturing costs, so the taxpayer reimbursed the subsidiary for the operating losses after correcting its estimate of the subsidiary's manufacturing costs. Id. at 642. In allowing the taxpayer a deduction under § 162 for its reimbursement payments, the court stated that, “[i]n effect, the reimbursement was merely an adjustment of the price of the rods sold to” the subsidiary, id. at 644, that is, an actual additional expense of the taxpayer. The court further noted, in concluding that the payments were not capital expenditures, that the subsidiary (unlike BJ Russia in this case) was not “inadequately capitalized.” Id.

None of these cases supports Baker Hughes' argument that it is entitled to a deduction under § 162 for BJ Parent's contribution of free cash to BJ Russia, on behalf of its shareholder, because BJ Russia was undercapitalized in violation of Russian law.

c. The non-precedential Technical Advice Memorandum (“TAM”) 9522003, on which Baker Hughes most heavily relies (Br. 45-49), also demonstrates the legal flaws in its argument. First, the Code expressly prohibits such written determinations from being “used or cited as precedent,” I.R.C. § 6110(k)(3), a prohibition that is restated in the TAM itself. Accordingly, Baker Hughes' claim (Br. 48) that the TAM should be accorded Skidmore deference (see Skidmore v. Swift & Co., 323 U.S. 134 (1944)) is entirely misconceived. A primary reason for the prohibition on the use or citation of TAMs as precedent is that such written determinations are not subject to an adequately high level of review within the IRS or the Department of the Treasury before their issuance. See H.R. Rep. No. 94-658, at 322-23 (1975). Thus, contrary to Baker Hughes' assertions, the TAM does not represent the views of the “IRS National Office” or the “interpretation put upon” § 162 “by the agency charged with the responsibility of administering the revenue laws.” Br. 48. Both cases that Baker Hughes cites in claiming otherwise, Skidomore, supra, and Hanover Bank v. Commissioner, 369 U.S. 672 (1962), predate the statutory prohibition in § 6110(k)(3), which was added to the Code in 1976. Pub. L. No. 94-455, § 1201(a) and (e), 90 Stat. 1520 (1976) (originally codified as § 6110(j)(3)). This Court should follow the current law. See Bombardier Aerospace Corp. v. United States, 831 F.3d 268, 282 (5th Cir. 2016) (TAM is “not precedential” and “not bind[ing]”).

In any event, the TAM is consistent with the Government's argument that an actual expense is required for the Lohrke exception to apply. The taxpayer in the TAM was permitted a deduction for providing funding for the payment of debts owed by its subsidiary to third-party creditors. As discussed above, the free financial aid in this case was untethered to any actual expense of BJ Russia, and a similar resulting extinguishment of a liability to a third party is missing here.

In addition, the TAM is distinguishable because the payment there in issue was not intended to facilitate continued operations of the subsidiary, but rather to wind up those operations in an orderly fashion. Here, in contrast, as Baker Hughes itself alleged in its complaint, BJ Parent provided free cash to BJ Russia on behalf of its shareholder to satisfy Russian capitalization requirements and enable BJ Russia to continue its business operations under the TNK-BP contract, which was not due to expire until almost a year after the payments were made. ROA.17 (¶ 40); see also ROA.1700 (¶ 9). The District Court correctly rejected Baker Hughes' reliance on the TAM for these reasons. ROA.2162. See Lidgerwood Mfg. Co. v. Commissioner, 22 T.C. 1152 (1954) (corporate debt cancelled in order to facilitate continued business operations held capital contribution).

d. Finally, Baker Hughes argues that, in applying the Lohrke exception, the Court must focus on the motivation of BJ Parent for providing the free financial aid. Br. 31-33. But, as demonstrated above, because the essential requirement of an actual “expense” under § 162 is missing here, Baker Hughes is not entitled to a deduction under § 162 regardless of BJ Parent's alleged motive for providing the free financial aid.

4. Baker Hughes' own allegations that the free financial aid provided future benefits to BJ Parent confirm that the aid must be capitalized

Even putting aside Baker Hughes' failure to identify an actual expense, Baker Hughes' own allegations confirm that the free financial aid must be capitalized because it provided long-term benefits to BJ Parent and, hence, was not an “ordinary” expense in any event. I.R.C. § 162(a).

For the Lohrke exception to apply, the expense in question must still be an “ordinary” expense that is currently deductible, as opposed to a “capital expenditure” under § 263. Newark Morning Ledger Co. v. United States, 539 F.2d 929, 934 n.5 (3d Cir. 1976); I.R.C. §§ 161, 261. “The principal function of the term 'ordinary' in § 162(a) is to clarify the distinction . . . between those expenses that are currently deductible and those that are in the nature of capital expenditures[.]” Commissioner v. Tellier, 383 U.S. 687, 689 (1966).

Baker Hughes rests its claim for a deduction under § 162 on its contentions that the free-financial-aid transaction was “necessary” to “protect BJ Parent's global reputation,” Br. 43, enabled it to recover its valuable and proprietary equipment and technology (because the liquidation of BJ Russia was avoided), Br. 34, and was made “in connection with [BJ Parent's] business” of “operating subsidiaries in various parts of the world,” Br. 33. Baker Hughes made these same allegations in its complaint. ROA.16-17 (¶¶ 39-41). Indeed, Baker Hughes alleges in its complaint that BJ Parent entered the Russian market to “showcase” its new equipment and technology:

BJ Parent also believed that the Russian oil and gas market was a good platform for BJ Parent to showcase some of its recently developed pressure pumping equipment and technology. BJ Parent believed that successful use of its equipment and technology in Russia would promote its worldwide business by opening up new markets for the use of its sophisticated pressure pumping equipment and services.

ROA.11-12.

Now, however, in trying to avoid the necessary conclusion that the aid must be capitalized, Baker Hughes argues that, because BJ Russia's significant operations allegedly ended on August 1, 2009 (at the end of the TNK-BP contract), the aid should not be capitalized. Br. 38-39. That blatant attempt to shift back and forth between BJ Parent and BJ Russia to demonstrate error in the District Court's decision is unavailing. One entity cannot be used to test whether the “necessary” and “trade or business” elements of § 162 are satisfied, and then a different one to determine if the alleged expenditure must be capitalized.

As the Supreme Court held in INDOPCO, it is the “taxpayer's realization of benefits beyond the year in which the expenditure is incurred” that is relevant for determining whether an expenditure is capital. 503 U.S. at 87 (emphasis added). Here, BJ Parent is the taxpayer and is the company that Baker Hughes itself alleges was intended to reap the benefits of showcasing its technology in Russia and that reaped the benefits of its subsidiary completing the contract, which, among other things, ensured that BJ Parent would recover its valuable and proprietary equipment and technology. Recovery of the equipment and technology alone plainly would have provided an enormous benefit to BJ Parent far beyond the tax year at issue. See ROA.2090-2094 (equipment photos); ROA.12 (¶ 18). It is beside the point that BJ Russia completed the TNK-BP contract in August 2009 and then allegedly began to wind down business. What is determinative is that, according to Baker Hughes' own allegations, BJ Parent realized reputational and other benefits from its provision of aid to BJ Russia that were not limited in duration to the tax year at issue or to the length of the TNK-BP contract.

The District Court thus properly concluded that the benefits to BJ Parent from the free-financial-aid transaction “were expected to (and presumably did in fact) continue into the future, well beyond the tax year in which the payments were made.” ROA.2160. See INDOPCO, 503 U.S. at 87; Central Texas Savings & Loan Ass'n 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.”). For these reasons, the free financial aid was also not an “ordinary” expense under § 162, but, rather, was a nondeductible capital expenditure.

* * *

In sum, none of the cases or other materials cited by Baker Hughes supports its argument that it is entitled to a deduction under § 162 for BJ Parent's contribution of free, unrestricted cash to BJ Russia, on behalf of its shareholder, Samotlor, in order to provide additional capital to BJ Russia and bring it into compliance with Russian capitalization requirements.

D. Baker Hughes is not entitled to a deduction for the free financial aid as a bad debt expense under § 166

Subject to the prohibitions of, inter alia, § 263 (precluding deductions for capital expenditures), § 166 allows a deduction for “any debt which becomes worthless within the taxable year.” I.R.C. §§ 166(a)(1), 161, 261. The District Court correctly held that Baker Hughes was not entitled as a matter of law to a deduction under § 166 because the free-financial-aid transaction “did not create a debt, did not pay a debt, and was not a payment of a debt pursuant to a guarantee.” ROA.2157.

We note that Baker Hughes does not challenge in its brief on appeal the District Court's determination that the free financial aid provided to BJ Russia was not a loan to BJ Russia and, hence, created no indebtedness running from BJ Russia to BJ Parent. ROA.2153. The free-financial-aid agreement expressly stated in this regard that it was freely given and that there was no expectation of repayment. ROA.433. Indeed, as the District Court pointed out, the free financial aid could not have been intended as a loan because further indebtedness on the part of BJ Russia would not have resolved the undercapitalization cited by the Russian Ministry of Finance and, therefore, would have served no purpose if it gave rise to a debt owing by BJ Russia. ROA.2153; see also ROA.1352 (deposition testimony of BJ Russia's controller confirming the free financial aid was not a “loan” “because that would increase our liabilities which would make them shut us down”).

Instead, Baker Hughes contends, as it did in the District Court, that the free financial aid was provided in connection with BJ Parent's performance guarantee of the TNK-BP contract and is, therefore, deductible by it in its capacity as a guarantor under § 166, even though BJ Parent did not guarantee any debt and its payment of the free financial aid did not create any indebtedness owed to BJ Parent. As demonstrated below, and as the District Court correctly concluded, Baker Hughes' claim in this regard fails as a matter of law on multiple independent grounds.

1. BJ Parent was not the guarantor of any bona fide “debt” for purposes of § 166, and its provision of aid to BJ Russia did not create or satisfy any debt related to its performance guaranty or otherwise

Baker Hughes' bad debt claim as a guarantor fails, first and foremost, because BJ Parent was not the guarantor of any bona fide “debt” for purposes of § 166, and its provision of aid to BJ Russia did not create or satisfy any debt related to its performance guarantee or otherwise. Consequently, BJ Parent did not incur any bad debt loss in connection with its status as a guarantor of BJ Russia's performance under its contract. The TNK-BP contract for which BJ Parent provided the guarantee was an executory contract for the performance of fracking services by BJ Russia; it did not create a bona fide debt obligation on the part of BJ Russia or BJ Parent as required for a deduction under § 166 and the applicable regulations. The District Court correctly rejected Baker Hughes' untenable position that it is somehow entitled to a bad debt deduction notwithstanding that there was no debt involved in this case at all.

a. “To be deductible under § 166(a), the debt must be bona fide.” Piggy Bank Stations, Inc. v. Commissioner, 755 F.2d 450, 452 (5th Cir. 1985) (citing Treasury Regulation § 1.166-1(c)); accord Wortham Machinery Co. v. United States, 521 F.2d 160, 164 (10th Cir. 1975); Zimmerman v. United States, 318 F.2d 611, 612 (9th Cir. 1963). Originally promulgated in 1960, Treasury Regulation § 1.166-1(c) provides that “[o]nly a bona fide debt qualifies for purposes of section 166.” 25 Fed. Reg. 11402, 11529-30 (Nov. 26, 1960); Treas. Reg. § 1.166-1(c). The regulation defines a “bona fide debt” as “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.”¹⁰ Id.

In 1979, the Treasury Department promulgated Treasury Regulation § 1.166-9, providing that a taxpayer who makes a payment in discharge of its obligation as a guarantor of an underlying debt may claim a bad debt deduction to the extent it is unable to recover its payment from the debtor. 44 Fed. Reg. 68463, 68464-65 (Nov. 29, 1979); Treas. Reg. § 1.166-9. That regulation provides (emphases added):

(a) Payment treated as worthless business debt. This paragraph applies to taxpayers who, after December 31, 1975, enter into an agreement in the course of their trade or business to act as (or in a manner essentially equivalent to) a guarantor, endorser, or indemnitor of (or other secondary obligor upon) a debt obligation. Subject to the provisions of paragraphs (c), (d), and (e) of this section, a payment of principal or interest made during a taxable year beginning after December 31, 1975, by the taxpayer in discharge of part or all of the taxpayer's obligation as a guarantor, endorser, or indemnitor is treated as a business debt becoming worthless in the taxable year in which the payment is made or in the taxable year described in paragraph (e)(2) of this section. . . .

Treas. Reg. § 1.166-9(a).

The import of these regulations is clear: only bona fide debts qualify for deductions under § 166, and a guarantor is eligible for a deduction under § 166 only if the guarantee relates to a bona fide debt. Treas. Reg. §§ 1.166-1(c), 1.166-9(a). Hence, a guarantor gets a bad debt deduction only where the underlying creditor otherwise could have claimed a bad debt deduction but for the guarantor's payment of the debt. See H.R. Rep. No. 94-658, at 176 (report relating to 1976 amendment of § 166, noting that “when a taxpayer has a loss arising from the guaranty of a loan, he is to receive the same treatment as where he has a loss from a loan which he makes directly.”); H.R. Conf. Rep. No. 94-1515, at 440 (1976). That makes perfect sense because, if the guarantor pays the debtor's unpaid debt to the creditor, and is thus the one left with a loss in the place of the creditor, then the guarantor should receive the same treatment as if he had made the loan directly and suffered the loss. See Putnam v. Commissioner, 352 U.S. 82, 85 (1956) (“[U]pon the payment by the guarantor of the debt, the debtor's obligation to the creditor becomes an obligation to the guarantor . . . by subrogation, the result of the shift of the original debt from the creditor to the guarantor who steps into the creditor's shoes.”).

Here, however, BJ Parent was not a guarantor of any bona fide debt — i.e., “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.” Treas. Reg. § 1.166-1(c). BJ Parent's guarantee was instead with respect to the performance of BJ Russia's contract to provide fracking services for TNK-BP in Siberian oil fields. ROA.92-361. The TNK-BP contract plainly did not create a “debtor-creditor relationship” between BJ Russia and TNK-BP based on “a valid and enforceable obligation to pay a fixed or determinable sum of money.” Thus, TNK-BP (if it were subject to U.S. tax) would not have been entitled to a bad debt deduction if BJ Russia had failed to perform fracking services under the contract. Rather, it would have had a claim for damages against BJ Russia for breach of contract. That is far different than the claim a lender has against a borrower who fails to repay its loan. Similarly, a failure by BJ Parent to honor its performance guarantee of the TNK-BP contract might give rise to a damages claim for breach of contract, but not to a debt.¹¹

b. Baker Hughes sought to avoid this clear result below by attempting to draw some significance from the fact that Treasury Regulation § 1.166-9(a) employs the term “debt obligation,” and not the term “bona fide debt.” According to Baker Hughes, the term “debt obligation” in § 1.166-9(a) has a different, and purportedly broader, meaning than the term “bona fide debt” that is defined in § 1.166-1(c). This argument, which Baker Hughes also hints at in its brief, Br. 18 n.9, is baseless.

The record shows that BJ Parent, through a wholly-owned subsidiary, made a capital contribution to BJ Russia because BJ Russia was undercapitalized under Russian law and faced liquidation by the Russian authorities if its capital was not increased. As demonstrated above, it is undisputed that BJ Parent's provision of additional capital to BJ Russia did not give rise to any indebtedness running from BJ Russia to BJ Parent. It is also undisputed that BJ Parent was never called upon to make a payment pursuant to its guarantee of BJ Russia's contract obligations, as BJ Russia fully performed all of its obligations in this regard. It follows, therefore, that BJ Parent did not discharge any “debt obligation” whatsoever in connection with the transaction and, consequently, had no bad debt loss deductible under § 166. (See discussion infra at pp. 55-58.) Thus, Baker Hughes' attempt to distinguish “debt obligation” from “bona fide debt” would be pointless even if such a distinction existed. As shown below, however, the distinction Baker Hughes attempts to draw is little more than a figment of its imagination.

Section 166 allows a deduction for a “debt” that becomes worthless in the taxable year. I.R.C. § 166(a)(1). As noted, Treasury Regulation § 1.166-1(c) provides that the only type of “debt” that qualifies under § 166 is one that is “bona fide”: “Only a bona fide debt qualifies for purposes of section 166.” Treas. Reg. § 1.166-1(c) (emphasis added). The regulation thus defines — and qualifies — the term “debt,” as that term is used in the statute. Therefore, to qualify as a “debt” under § 166, the debt in question must be a “bona fide” one; that is, a debt that “arises from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money.” Treas. Reg. § 1.166-1(c); Piggy Bank Stations, 755 F.2d at 452. There is no language limiting the requirement of a bona fide debt to some subset of debts under § 166 that does not include guarantors.

As noted, § 1.166-9 was promulgated in 1979, well after § 1.166-1(c) was promulgated in 1960. In promulgating § 1.166-9, there was no need to again define the term “debt” appearing therein because the definition of “debt” for “purposes of section 166” already existed in § 1.166-1(c) and had been in use for many years.¹² Thus, the term “debt obligation” in § 1.166-9 refers to a bona fide debt obligation, as defined in § 1.166-1(c). To conclude otherwise, as Baker Hughes advocates, would contradict the very reason that guarantors may claim a bad debt loss.

As the Tax Court explained in Black Gold Energy v. Commissioner, 99 T.C. 482, 486 (1992), a guarantor gets a bad debt deduction not because of his payment to the original creditor, “but on account of the debtor's inability to reimburse him” as the one who steps into the shoes of the original creditor. In other words, once the guarantor makes a payment, the loss that entitles him to a bad debt deduction is the debtor's inability to pay the original debt now owed to the guarantor. Therefore, the term “debt” cannot have different meanings in § 1.166-1 and § 1.166-9 because there is only one unpaid debt for which either the original creditor or the guarantor may get a deduction under § 166. The debt guaranteed in § 1.166-9 must be the same one that would qualify under § 1.166-1 with respect to the original creditor, because it is that debt to which the guarantor becomes subrogated as successor and allows the guarantor, instead of the original creditor, to claim a bad debt deduction. Putnam, 352 U.S. at 85, 88-89. A contrary holding would lead to the nonsensical result of allowing bad debt deductions under § 166 to guarantors of transactions for which the original creditor would not be entitled to a bad debt deduction.

For these reasons, only guarantors of bona fide debts are eligible for a deduction under § 166, and Baker Hughes plainly fails that test here, as we have demonstrated.

2. At all events, the free financial aid was not made “in discharge of part or all of” BJ Parent's obligation as guarantor of the TNK-BP contract

As demonstrated above, Baker Hughes' claim fails because BJ Parent was not a guarantor of any bona fide debt, and the free financial aid itself also was plainly not a loan and did not give rise to any indebtedness. But Baker Hughes' claim fails for the additional, independent reason that BJ Parent's provision of the free financial aid to BJ Russia (through Samotlor) was not “in discharge of part or all of [BJ Parent's] obligation as a guarantor,” as the regulation requires in order to claim a bad debt deduction. Treas. Reg. § 1.166-9(a). Further, to qualify for a deduction, there also must have been “an enforceable legal duty upon the taxpayer to make the payment.” Treas. Reg. § 1.166-9(d)(2). Voluntary payments do not qualify. Treas. Reg. § 1.166-1(c) (“A gift or contribution to capital shall not be considered a debt for purposes of section 166.”).

The District Court correctly concluded that neither of these requirements is satisfied here. ROA.2153-2155. Although BJ Parent guaranteed the performance of BJ Russia under the TNK-BP contract, BJ Russia never defaulted under the contract, and, as a result, BJ Parent was never called upon to make any payment with respect to its performance guarantee. ROA.410. The event that triggered BJ Parent's payment of the free financial aid was not, as Baker Hughes incorrectly claims (Br. 23), a “demand” by TNK-BP that BJ Parent perform under its guarantee. Rather, it was a letter from the Russian Ministry of Finance addressed to BJ Russia, notifying BJ Russia that it was not in compliance with Russian capitalization requirements and, therefore, was in danger of liquidation by the Russian tax authorities. ROA.1721-1722. Indeed, the Russian Ministry's letter did not even mention BJ Parent, TNK-BP, or the TNK-BP contract, let alone BJ Parent's performance guarantee under the contract.¹³

In response to the letter, BJ Parent chose to provide additional capital to BJ Russia, in the form of free financial aid, in order to satisfy Russian capitalization requirements and avoid the liquidation of BJ Russia so that it could continue its business operations and complete the TNK-BP contract. The free financial aid was never paid to TNK-BP, either by BJ Parent or by BJ Russia, and, therefore, could not have been paid in satisfaction of any debt owed to TNK-BP under the contract. Moreover, BJ Parent's obligation as a guarantor was unaffected by the payment of the free financial aid. Indeed, had BJ Russia defaulted on its contract obligations after receipt of the aid, BJ Parent would have been liable under its guaranty to the same extent it would have been had the payment never been made. Because there was no discharge of any obligation, the free financial aid was not paid “in discharge of part or all of” BJ Parent's obligation as a guarantor, as required for a bad debt deduction. Treas. Reg. § 1.166-9(a).

3. Baker Hughes' remaining arguments are unavailing

a. Baker Hughes mischaracterizes the District Court's opinion

Baker Hughes argues that a guarantor is entitled to a deduction under § 166 “regardless of whether the guarantor had a legal right of repayment,” and that the District Court erroneously denied its claim because it did not have a “legal right of reimbursement.” Br. 19-23. Contrary to Baker Hughes' contention, however, the District Court did not hold that only a guarantor with subrogation rights may claim a deduction under § 166. Baker Hughes' argument mischaracterizes both the District Court's opinion and the law. In fact, the District Court's opinion was properly focused on the absence of both an underlying bona fide debt that was guaranteed by BJ Parent and any other debt owed to BJ Parent that was not paid.

The District Court's analysis on pages 10-11 of its opinion (ROA.2155-2156), with which Baker Hughes takes issue, see Br. 22-23, focused on the critical distinction between cases that involve a bona fide debt entitling a guarantor to a deduction under § 166, on the one hand, and cases — including the instant case — that do not. The District Court first compared this case with Myers, 42 T.C. 195, noting that there was a “debtor-creditor relationship” in that case and that the amount of the advances in question represented “debts” owed to the taxpayers, ROA.2155, which are requirements for a bona fide debt under Treas. Reg. § 1.166-1(c). By contrast, the District Court explained, the terms of the free financial aid in this case stressed that “no debtor-creditor relationship was being created” and that, unlike in Myers, “BJ Russia owed no . . . debt to BJ Parent.” ROA.2155-2156. The District Court's analysis in this regard was fully consistent with the applicable regulations requiring that debts be bona fide to qualify for a deduction under § 166. Treas. Reg. § 1.166-1(c).

The District Court went on (page 11 of its opinion, ROA.2156) to draw the same crucial distinction between the other cases relied on by Baker Hughes. In this part of its opinion, the District Court distinguished cases involving a bona fide debt obligation from cases in which the courts disallowed a bad debt deduction for a voluntary payment because — as was the case here — there was “no expectation of repayment.” ROA.2156; see Field & Co. v. Commissioner, T.C. Memo. 1974-25 (1974) (advances by corporate taxpayer to subsidiary were not loans, but capital contributions, since there was no expectation of repayment); Justice Steel, Inc. v. Commissioner, T.C. Memo. 1980-466, n.5 (1980) (“A bona fide debt is required. Voluntary payment without obligation or expectation of repayment fails to establish the requisite debt.”) (citations omitted). Again, the District Court's analysis was consistent with the applicable regulation providing that “[a] gift or contribution to capital shall not be considered a debt for purposes of section 166.” Treas. Reg. § 1.166-1(c). The District Court properly distinguished this case from those cases that involved a payment precipitated by the guarantee of a bona fide debt obligation.

Baker Hughes' argument (Br. 28-29) that the District Court erred in denying its claim under § 166 on the ground that “no money was paid to TNK-BP, and no guaranteed debt or obligation was discharged by the payment,” ROA.2154, is also misconceived. The point of the District Court's analysis was that the free financial aid was not paid by BJ Parent “in discharge of part or all of [BJ Parent's] obligation as a guarantor” of a bona fide debt obligation, as the regulations require. Treas. Reg. § 1.166-9(a).

b. The cases Baker Hughes cites regarding subrogation confirm that a bona fide debt is required

Finally, the cases that Baker Hughes cites (Br. 19-23) regarding subrogation simply confirm that a bona fide debt is required, and that a guarantor is entitled to a deduction under § 166 only when payment is made in discharge of the guarantor's obligation as a guarantor of a bona fide debt obligation.

In Myers, supra, for example, the taxpayers made advances to pay for construction costs for which they were legally entitled by contract to be repaid by their corporation, but the corporation became insolvent and failed to repay them. 42 T.C. at 208, 210. The court found that a “debtor-creditor relationship was created, under the construction contract, between” the corporation and the taxpayers, and the parties “stipulated” that “the amount of the advances” paid by the taxpayers “represented debts” owed to them by their corporation. Id. at 208. Thus, Myers involved a bona fide debt under the regulation. See Treas. Reg. § 1.166-1(c). In stark contrast, the parties to the free-financial-aid agreement in this case agreed it was not a debt. ROA.433.

Similarly, in both Gillespie v. Commissioner, 54 T.C. 1025 (1970), and In re Vaughan, 21 B.R. 695 (E.D. Ky. 1982), aff'd 719 F.2d 196 (6th Cir. 1983), the taxpayers guaranteed a lease or rental agreement. When the lessees defaulted, creating a fixed and determinable debt for rent owed, see Treas. Reg. § 1.166-1(e), the taxpayers paid the unpaid rent in discharge of their obligation as guarantors, and the debt owed them as guarantors then became worthless because it was uncollectible. These cases again confirm that the guarantee of a bona fide debt is a threshold requirement for a guarantor to claim a bad debt deduction — in these cases, a fixed and determinable amount of accrued, unpaid rent owed to the lessor. The other cases Baker Hughes cites (Br. 19-23) also involved bona fide debts that were either owed to or guaranteed by the taxpayer, unlike this case.¹⁴

* * *

In none of the cases cited by Baker Hughes has a court allowed a shareholder to deduct, as a bad debt or otherwise, a capital contribution. That is hardly surprising given that the Internal Revenue Code and the regulations thereunder expressly prohibit the deduction of capital contributions. That BJ Parent had valid business reasons for making its capital contribution to BJ Russia does not transform its capital contribution into a tax deductible expenditure. Fink, 483 U.S. at 97, 100; Eskimo Pie Corp., 4 T.C. at 676; Ihrig, 26 T.C. at 76; see supra at p. 23. Shareholders make capital contributions to bolster their corporations and thereby benefit themselves. That a shareholder makes a capital contribution to provide his corporation with sufficient funds to stay in business does not render the contribution tax deductible. That is essentially what BJ Parent did, and there is no reason to allow it a tax deduction not available to any other shareholder who makes a capital contribution.

CONCLUSION

The judgment of the District Court was correct and should be affirmed.

Respectfully submitted,

RICHARD E. ZUCKERMAN
Principal Deputy
Assistant Attorney General

TRAVIS A. GREAVES
Deputy Assistant Attorney General

GILBERT S. ROTHENBERG (202) 514-3361
RICHARD FARBER (202) 514-2959
JACOB EARL CHRISTENSEN (202) 307-0878
Attorneys
Tax Division
Department of Justice
POST OFFICE BOX 502
Washington, D.C. 20044

Of Counsel:
RYAN K. PATRICK
United States Attorney

JANUARY 2019