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Corporation Argues Payment to Russian Subsidiary Is Deductible

NOV. 28, 2018

Baker Hughes Inc. v. United States

DATED NOV. 28, 2018
DOCUMENT ATTRIBUTES

Baker Hughes Inc. v. United States

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

In The United States Court Of Appeals
For The Fifth Circuit

FROM THE UNITED STATES DISTRICT COURT, SOUTHERN DISTRICT OF TEXAS
HOUSTON DIVISION
CIVIL ACTION NO. 4:15-CV-02675
HONORABLE STEPHEN WM. SMITH, PRESIDING

OPENING BRIEF FOR APPELLANT

Reagan M. Brown
Robert C. Morris
Stephen A. Kuntz
NORTON ROSE FULBRIGHT US LLP
1301 McKinney, Suite 5100
Houston, Texas 77010-3095
Telephone: (713) 651-5151
Telecopier: (713) 651-5246

Counsel for Plaintiff-Appellant Baker Hughes Incorporated

CERTIFICATE OF INTERESTED PARTIES

The undersigned counsel of record certifies that the following listed persons and entities have an interest in the outcome of this case as described in the fourth sentence of Fifth Circuit Local Rule 28.2.1. These representations are made so that the judges of this Court may evaluate possible disqualification or recusal.

Plaintiff-Appellant:

Baker Hughes Incorporated

After this lawsuit was filed, Baker Hughes Incorporated entered into a transaction with General Electric Company, and changed its name to Baker Hughes, a GE Company, LLC.

Attorneys for Plaintiff-Appellant:

Reagan M. Brown
Texas Bar No. 03162200
reagan.brown@nortonrosefulbright.com
Robert C. Morris
Texas Bar No. 24046484
robert.morris@nortonrosefulbright.com
Stephen A. Kuntz
Texas Bar No. 11762960
stephen.kuntz@nortonrosefulbright.com
Norton Rose Fulbright US LLP
1301 McKinney, Suite 5100
Houston, Texas 77010-3095
Telephone: (713) 651-5151
Telecopier: (713) 651-5246

Defendant-Appellee:

United States of America

Attorneys for Defendant-Appellee:

Mr. Jacob Earl Christensen
Utah Bar Card No. 10640
jacob.e.christensen@usdoj.gov
U.S. Department of Justice
Tax Division, Appellate Section
Post Office Box 502
Washington, DC 20044
Telephone: (202) 307-0878
Facsimile:(202) 514-9440

Mr. Cory Arthur Johnson
Illinois State Bar No. 6211233
cory.a.johnson@usdoj.gov
U.S. Department of Justice
Tax Division
Post Office Box 26
Washington, DC 20044
Telephone: (202) 307-3046
Facsimile:(202) 514-9440

Ms. Rika Valdman
New York State Bar No. 4956009
rika.valdman@usdoj.gov
U.S. Department of Justice
Tax Division
Post Office Box 683
Washington, DC 20044-0683
Telephone: (202) 514-6056
Facsimile:(202) 514-9440

REAGAN M. BROWN

STATEMENT REGARDING ORAL ARGUMENT

Although the tax principles that are dispositive of this case are long-settled, Plaintiff-Appellant Baker Hughes Incorporated (“Baker Hughes”) respectfully requests oral argument in order to assist the Court in understanding the errors made by the district court when it erroneously agreed with the decision of Defendant-Appellee United States of America (“Government”) to disallow deductions valued at tens of millions of dollars.


TABLE OF CONTENTS

CERTIFICATE OF INTERESTED PARTIES

STATEMENT REGARDING ORAL ARGUMENT

TABLE OF AUTHORITIES

INTRODUCTION

JURISDICTIONAL STATEMENT

STATEMENT OF THE ISSUES

STATEMENT OF THE CASE

I. STATEMENT OF FACTS

A. BJ Parent and BJ Russia

B. The BJ Group Sees an “Awesome Opportunity” In Russia

C. The TNK-BP Contract

D. BJ Parent's Performance Guarantee

E. The Russian Oil and Gas Market Unexpectedly Sours; BJ Parent Decides to Exit the Russian Market

F. The Russian Government Threatens to Liquidate BJ Russia Before Completion of the Contract

G. Compelled by the Performance Guarantee, BJ Parent Provides Free Financial Aid To Avoid the Catastrophic Financial and Reputational Losses BJ Parent Would Have Suffered if BJ Russia Had Been Liquidated

II. Proceedings and Order Below

SUMMARY OF ARGUMENT

STANDARD OF REVIEW

ARGUMENT

I. The FAA Payment Is Deductible As a Bad Debt Under Section 166

A. Losses Sustained By Guarantors Are Deductible As Bad Debts Under Section 166

B. The Government's Longstanding Position Is that a Payment Made Pursuant To a Guarantee Falls Within The Purview of Section 166 Regardless of Whether There Is a Repayment Obligation

C. The District Court Erred in Holding that the Government Correctly Disallowed the Bad Debt Deduction Because BJ Parent Did Not Have a Legal Right of Reimbursement From BJ Russia

D. The District Court Erred by Determining that the FFA Was a Voluntary Payment (i.e., a Capital Infusion)

E. The District Court Also Erred in Rejecting Application of Section 166 on the Basis that the FFA Was Provided Directly to BJ Russia and Not TNK-BP

II. Alternatively, the FFA Is Deductible As An Ordinary And Necessary Trade or Business Expense of BJ Parent Under Section 162

A. Payments Made By a Parent/Guarantor To Protect The Parent/Guarantor's Reputation Qualify For A Deduction Under Section 162

B. Section 162's Five Requirements Were Indisputably Met Here

1. BJ Parent “Paid or Incurred” the FFA During the Tax Year In Which It Claimed a Deduction

2. BJ Parent Paid the FFA “In Carrying on a Trade or Business”

3.The FFA Was An Expense of BJ Parent

a. The District Court Erred In Holding that the Payment Was a Recapitalization That Provided Benefits Beyond the End of the Tax Year

b.The District Court Misread Mills

4. The FFA Was An “Expense”

5. The FFA Was “Ordinary”

6. The FFA Was “Necessary”

C. The District Court Erred in Its Analysis of the IRS's National Office's Persuasive Technical Advice Memorandum

D. The District Court Erred in Relying on the Alleged Absence of BJ Parent's Right to Restrict BJ Russia's Use of the Funds as a Reason to Reject Application of Section 162

CONCLUSION

CERTIFICATE OF SERVICE

CERTIFICATE OF COMPLIANCE WITH TYPE-VOLUME LIMIT

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)

Andrew v. Commissioner, 54 T.C. 239 (1970)

Baker Hughes Incorporated v. United States, 313 F. Supp. 3d 804 (S.D. Tex. 2018)

Baum v. United States, 326 F. Supp. 32 (E.D. Wis. 1971)

Black Gold Energy Corp. v. Commissioner, 99 T.C. 482 (1992), aff'd, 33 F.3d 62 (10th Cir. 1994)

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

Bonynge v. Helvering, 117 F.2d 157 (2d Cir. 1941)

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

Canterbury Holdings, LLC v. Commissioner, 98 T.C.M. (CCH) 60 (2009)

Estate of Capell v. Commissioner, 36 T.C.M. (CCH) 1673 (1977)

Cepeda v. Commissioner, 66 T.C.M. 1032 (1993), aff'd on other issue without opinion, 56 F.3d 1384 (5th Cir. 1995)

Chicago Pneumatic Tool Co. v. Commissioner, 21 B.T.A. 569 (1930)

Commissioner v. Heininger, 320 U.S. 467 (1943)

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

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

Coulter Electronics, Inc. v. Commissioner, 59 T.C.M. (CCH) 350 (1990)

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

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

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

Foretravel, Inc. v. Commissioner, 70 T.C.M. (CCH) 1007 (1995)

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

Frazier v. Commissioner, 34 T.C.M. (CCH) 951 (1975)

Gillespie v. Commissioner, 54 T.C. 1025 (1970), aff'd 30 AFTR 2d 72-5574 (9th Cir. 1972)

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

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

Horne v. Commissioner, 523 F.2d. 1363 (9th Cir. 1975)

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

Kimbell v. United States, 371 F.3d 257 (5th Cir. 2004)

Kornauser v. United States, 276 U.S. 145

In re Lively, 717 F.3d 406 (5th Cir. 2013)

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), aff'd 424 F.2d 1368 (9th Cir. 1970)

Massey v. Commissioner, 43 T.C.M. (CCH) 1240 (1982)

McClendon v. United States, 892 F.3d 775 (5th Cir. 2018)

McCorkle v. Metropolitan Life Ins. Co., 757 F.3d 452 (5th Cir. 2014)

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

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

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

Pike v. Commissioner, 44 T.C. 787 (1965)

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

Roussel v. Commissioner, 37 T.C. 235 (1961)

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

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

Slappey Drive Indus. Park v. United States, 561 F.2d 572 (5th Cir. 1977)

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)

Thom v. Burnet, 55 F.2d 1039 (D.C. Cir. 1932)

U.S. Freightways Corp. v. Commissioner, 270 F.3d 1137 (7th Cir. 2001)

In re Vaughan v. Commissioner, 719 F.2d 196 (6th Cir. 1983)

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

Rules, Statutes and Codes

26 U.S.C. § 166(d)

28 U.S.C. § 1291

28 U.S.C. § 1346(a)(1)

Other Authorities

I.R.S. Tech. Adv. Mem. 200247004 (Nov. 22, 2002)

I.R.S. Tech. Adv. Mem. 9522003 (June 2, 1995)

Rev. Rul. 73-226, 1973-1 C.B. 62 (1973)

Rev. Rul. 76-203, 1976-1 C.B. 45 (1976)

Rev. Rul. 79-283, 1979-2 C.B. 80 (1979)

Treas. Reg. § 1.162-1(a)

Treas. Reg. § 1.166-9


INTRODUCTION

Plaintiff-Appellant Baker Hughes filed the underlying federal income tax refund lawsuit to recover $17,654,000 in federal income taxes, plus interest, after the Government disallowed Baker Hughes' deduction of $52 million in payments made by Baker Hughes' predecessor, BJ Services Company (“BJ Parent”), to one of its Russian subsidiaries (“BJ Russia”). BJ Parent made the payments pursuant to a contract it had with a joint venture controlled by the Russian Federation. Under that contract, BJ Parent guaranteed BJ Russia's performance of BJ Russia's contract to provide pressure pumping and other services to the Russian-controlled joint venture. BJ Parent made the payments after the Russian Federation threatened three times in writing to liquidate BJ Russia. The Government agrees those written threats were an effective demand on BJ Parent to perform on the guarantee. The payments were made after BJ Parent had decided to exit the Russian pressure pumping market, and had BJ Parent not made the payments, it would have sustained catastrophic financial losses and significant damage to its global reputation. By any measure, BJ Parent was compelled to make the payments.

Baker Hughes' claim for a refund is based on sections 1661 (allowing for bad debt deductions) and 162 (allowing for deductions of ordinary and necessary business expenses). Following cross-motions for summary judgment, the district court ruled in favor of the Government, holding that the payments at issue were a “voluntary” “capitalization” by a parent of its subsidiary and therefore not deductible by BJ Parent under either section 166 or section 162. Material errors were committed by the district court. This Court should reverse.

JURISDICTIONAL STATEMENT

The district court had jurisdiction under 28 U.S.C. § 1346(a)(1) and entered final judgment on June 19, 2018. ROA.2165 (R.E.3). Baker Hughes timely appealed on August 17, 2018. ROA.2166 (R.E.2). This Court has jurisdiction under 28 U.S.C. § 1291.

STATEMENT OF THE ISSUES

1. Whether the district court erred in granting the Government's motion for summary judgment on Baker Hughes' claim for a deduction under section 166 and in denying Baker Hughes' motion on the same issue.2

2. Whether the district court erred in granting the Government's motion for summary judgment on Baker Hughes' claim for a deduction under section 162 and in denying Baker Hughes' motion on the same issue.

STATEMENT OF THE CASE

I. STATEMENT OF FACTS

A. BJ Parent and BJ Russia

During the relevant period, BJ Parent was the common parent of a group of corporations and subsidiaries (“BJ Group”) that operated globally. ROA.2146 (R.E.4), 1291-1294, 1343-1344. The BJ Group was a leading worldwide provider of pressure pumping and oilfield services for the petroleum industry. ROA.1374-1375, 1297-1298. BJ Russia was the Russian affiliate of the BJ Group which operated and provided pressure pumping services (including hydraulic fracturing) in Russia. ROA.2146-2147 (R.E.4), 1295-1298, 1406-1407.

B. The BJ Group Sees an “Awesome Opportunity” In Russia

In 2006, Russian Federation President Vladimir Putin had given indications that Russia would join the global economy. Being among the first companies to participate in the development of Russia's oil fields presented an “awesome opportunity” for the BJ Group. ROA.1313-1314. The BJ Group had developed a type of high-tech pressure pumping technology and equipment that maximizes oil production and was not then being used in Russia. ROA.1697-1698, 1305-1306, 1313. Thus, the BJ Group believed BJ Russia was uniquely positioned to be successful in Russia, which would increase the BJ Group's profitability and further enhance its global reputation. ROA.1305-1306, 1313-1314.

C. The TNK-BP Contract

On August 1, 2006, BJ Russia signed a three-year contract with OJSC TNK-Management (“TNK-BP”) to provide pressure pumping (primarily hydraulic fracturing) services to TNK-BP (“Contract”). ROA.2147 (R.E.4). TNK-BP was a joint venture between British Petroleum (“BP”) and a Russian national oil company known as “TNK.” ROA.1296, 1407-1408. BJ Russia won the Contract “based upon the global reputation and the global capabilities of BJ [Parent].” ROA.1312.

Under the Contract, TNK-BP agreed to use BJ Russia's services for a stated minimum number of jobs over the Contract's three-year term at a fixed price. ROA.1300, 1698. TNK-BP could terminate the Contract if BJ Russia became bankrupt, if a liquidator was appointed for BJ Russia, or if BJ Russia defaulted on any of its contractual obligations. ROA.1477-1478. BJ Russia was further obligated to indemnify TNK-BP for any subcontractor liens. ROA.1482-1483.

D. BJ Parent's Performance Guarantee

TNK-BP's Invitation To Tender for the Contract required BJ Parent to guarantee that BJ Russia would perform the services required under the Contract, and to indemnify TNK-BP against any loss, damages, claims, costs and expenses resulting from a failure to perform or a breach of the Contract, which BJ Parent provided (“Performance Guarantee”). ROA.1307, 1309, 2147. BJ Parent routinely provided performance guarantees for its subsidiaries operating outside of North America. ROA. 1312, 1315, 1410-1411, 1698. BJ Parent provided two substantially similar letters for the Performance Guarantee: an initial letter dated January 19, 2006, and a second letter dated November 29, 2006. ROA.1308-1310, 1703-1704, 1706-1707.

BJ Parent guaranteed that BJ Russia “shall duly perform all its obligations contained in the Contract.” ROA.1703, 1706. If BJ Russia “shall in any respect fail to perform its obligations under the [TNK-BP] Contract or shall commit any breach thereof,” BJ Parent would “undertake, on simple demand by [TNK-BP], to perform or to take whatever steps may be necessary to achieve performance of said obligations under the Contract and shall indemnify and keep indemnified [TNK-BP] against any loss, damages, claims, costs and expenses which may be incurred by [TNK-BP] by reason of any such failure or breach on the part of [BJ Russia].” ROA.1383, 1703, 1706.

E. The Russian Oil and Gas Market Unexpectedly Sours; BJ Parent Decides to Exit the Russian Market

The “awesome opportunity” did not come to pass. Instead, the Contract proved to be a disaster. Not long after the Contract was executed, the competition for pressure pumping services in Russia intensified due to the entry of competitors with high-tech pressure pumping capabilities. The increased competition exerted downward pressure on the prices that BJ Russia could charge for its services. ROA.1305-1306, 1416-1417, 1698-1699. Higher costs for crude oil and labor (BJ Russia's primary costs of providing pressure pumping services) further hampered BJ Russia's ability to operate profitably. ROA.1699. The fixed prices BJ Russia had agreed to in the Contract turned out to be an albatross. Attempts to renegotiate those prices were unsuccessful. ROA.1306-1307, 1362-1363, 1699.

To make matters worse, BJ Russia had, at the request of TNK-BP, performed additional jobs outside the scope of the Contract and at prices that were as much as a 30% discount from the Contract price, increasing BJ Russia's already mounting losses. ROA.1363. BJ Russia had little choice but to accept these additional unprofitable jobs if it wanted to preserve its chances of obtaining larger, more lucrative jobs from TNK-BP — i.e., more than the minimum jobs stated in the Contract. ROA.1698-1699, 1302-1303, 1353-1354. The Contract was amended to compensate BJ Russia for these additional jobs (ROA.1699), but BJ Russia's hope that it would be rewarded with more lucrative jobs was dashed. Because BJ Russia's competitors were willing to perform pressure pumping services for TNK-BP at a price lower than the fixed price specified by the Contract, TNK-BP awarded BJ Russia's competitors the larger pressure pumping jobs while fulfilling its minimum job order commitment to BJ Russia with smaller, less lucrative jobs. ROA.1305-1307. By 2007, BJ Russia was hemorrhaging money. ROA.1304-1305.

BJ Parent had to stop the bleeding. Because of BJ Parent's Performance Guarantee, leaving Russia was not possible until BJ Russia's obligations under the Contract were satisfied. ROA.1699-1700. Nonetheless, BJ Russia began taking steps to end the relationship with TNK-BP, which included providing TNK-BP with formal, written notice in September 2008 that it would not renew the Contract following the fulfillment of its contractual obligations. ROA.1317, ROA.2073, ROA.2147.

F. The Russian Government Threatens to Liquidate BJ Russia Before Completion of the Contract

Approximately a month after BJ Russia informed TNK-BP that it would not renew the Contract, the Russian Ministry of Finance sent BJ Russia a letter dated October 21, 2008 (“Russian Demand Letter”).3 ROA.1721-1722, 1317, 2147. The Russian Ministry threatened to liquidate BJ Russia three separate times in the letter. ROA.1721-1722. The Russian Ministry warned that the Russian “tax authority has the right to claim the liquidation of the company through the court,” because BJ Russia's “net assets cost is less than the chartered capital minimum specified in article 26” of Russian Federal Law 208-FZ “On Joint Stock Companies.” ROA.1721-1722 (emphasis added). The Russian Ministry demanded BJ Russia provide by November 14, 2008, information regarding actions taken to improve its financial condition. ROA.1722.

BJ Parent and BJ Russia took seriously the Russian Demand Letter, as it put them between Scylla and Charybdis. ROA.1317-1319, 1367-1368. On one hand, the prospect of the Russian government taking control of BJ Russia, expropriating BJ Russia's equipment, and running BJ Russia with BJ Parent being left as the financial guarantor of a Russian-operated business under the Performance Guarantee was an abysmal and wholly unacceptable outcome to BJ Parent. ROA.1317-1319, 1413-1414. On the other hand, BJ Parent could not complete the Contract if BJ Russia was involuntarily liquidated by the Russian government, as BJ Russia was the only member of the BJ Group that had the equipment, people, and required licenses to do business in Russia. ROA.1367-1368.

G. Compelled by the Performance Guarantee, BJ Parent Provides Free Financial Aid To Avoid the Catastrophic Financial and Reputational Losses BJ Parent Would Have Suffered if BJ Russia Had Been Liquidated

The BJ Group discussed potential responses to the Russian Demand Letter with its Russian advisors and the Russian Ministry of Finance. ROA.1319. BJ Parent's Russian advisors informed BJ Parent that the “only mechanism . . . that would allow [BJ Parent] to keep control of [BJ Russia] and avoid the negative financial consequences of having the Russian government take control of [BJ Russia] and send [BJ Parent] a bill for [the] operations” was to provide “free financial aid” to BJ Russia under Russian law. ROA.1320, 1324-1325, 1329-1332, 1349 (emphasis added).

To avoid the catastrophic financial losses and reputational damages associated with a default by BJ Russia on the Contract, BJ Parent determined it had no choice but to provide the free financial aid. ROA1324-1325, ROA.1700.4 Thus, BJ Parent caused payments totaling $52 million in the form of “Free Financial Aid” (“FFA”) to be provided to BJ Russia via wire transfers in November and December of 2008, which was during the BJ Group's taxable year beginning October 1, 2008 and ending September 30, 2009. ROA.1724-1729, 1731-1733, 1356-1357, 1394.5 Importantly, there had been no discussion of putting $52 million into BJ Russia until after BJ Russia received the Russian Demand Letter, and the FFA would not have been made absent the Performance Guarantee. ROA.1324-1325, 1331-1332, 1367-1368, 1699-1700.

Had BJ Parent not provided the FFA, the Russian Ministry of Finance would have liquidated BJ Russia, and BJ Parent would have been responsible for all the associated costs of completing the work under the Contract. ROA.1703-1704, 1706-1707. The resulting financial damages to BJ Parent would have been at least $160 million. ROA.1700, 1336-1341, 1735-1736.The $160 million includes the payments BJ Parent would have been compelled to make to a third-party to complete BJ Russia's obligations under the Contract. ROA.1338-1339. In addition to the $160 million, BP Parent would have been exposed to contingent liabilities if a court-appointed agent started signing purchase orders and making decisions under the auspices of BJ Russia. ROA.1340. BJ Parent was concerned it would have been guarantors of those increased costs and activities under the Performance Guarantee. ROA.1340-1341. BJ Parent was also concerned members of the BJ Group would have been held liable under Russian labor law for substantial severance payments to over 300 BJ Russia employees. ROA.1339, 1735. Besides these catastrophic financial losses, BJ Group's reputation as a reliable service provider in the global market would have been severely damaged if BJ Russia defaulted. ROA.1369, 1700.

The Government acknowledges that a BJ Russia liquidation would have been disastrous for BJ Parent. The Government's damages estimate tops BJ Parent's estimate by $40 million. ROA.1768. (Government's expert testimony that BJ Parent's damages would have been $200 million if the assets used by BJ Russia were seized by the Russian government). The Government further agrees that if BJ Russia had been liquidated: (1) BJ Parent would not have been able to perform the services required by the Contract, (2) the Russian Federation would have seized control of BJ Russia and/or its assets, and (3) BJ Parent's business would have suffered reputational and economic damages. ROA.1753, 1756, 1757-1761, 1762, 1763-1764, 1768.

BJ Parent provided the FFA to BJ Russia without expectation of return, there was no obligation to return it, and at a time when BJ Russia could not have repaid it because of BJ Russia's precarious financial condition.6 ROA.1699-1701, 1320-1325, 1351-1352, 1372.

BJ Parent claimed a deduction on its tax return of $52,000,000, which was the amount of the FFA. ROA.2149 (R.E.4). As BJ Parent's Treasurer and Chief Tax Officer explained:

The payment was made pursuant to a performance guarantee that was entered into in the ordinary course of business. It's an ordinary and necessary activity of BJ Services Company. And it made the payment in order to extinguish that obligation in order to minimize the, the risk that BJ parent had, BJ Services Company had under its guarantee to BJ Russia. . . . our expectation was that that was a business expense that BJ Services Company incurred because of its guarantee of its Russian subsidiary.

ROA.1333-1334.7 The Government disallowed the deduction. ROA.2149 (R.E.4).

II. Proceedings and Order Below

On September 15, 2015, Baker Hughes filed its complaint seeking a judgment for a refund of the taxes it paid on the $52 million deduction disallowed by the Government. ROA.8. Baker Hughes claimed that the deduction should have been allowed under either section 166 (bad debt deduction) or 162 (ordinary business expense). ROA.8-20.

Thereafter, the parties filed cross motions for summary judgment on whether Baker Hughes was entitled to the refund based on each of those sections. ROA.2146 (R.E.4). The district court ruled in the Government's favor holding that neither section applied. ROA.2157, 2163 (R.E.4) (holding that Baker Hughes failed to meet its burden of showing its entitlement to the deduction).

Central to the district court's holding on section 166 was its determination that BJ Parent did not pay a debt of BJ Russia but made a capital contribution. ROA.2152-2153 (R.E.4). The district court also determined that while guarantee payments qualify for a bad debt deduction, the FFA was “voluntary.” ROA.2153-2154 (R.E.4). It also found the payment did not qualify for a bad debt deduction because BJ Parent had no right to expect repayment from BJ Russia (ROA.2156 (R.E.4)) and because the payment was made directly to BJ Russia and not to TNK-BP (ROA.2154 (R.E.4)). See also ROA.2157 (R.E.4) (concluding the FFA was not deductible under section 166 because it “did not create a debt, did not pay a debt, and was not a payment of a debt pursuant to a guarantee”).

In rejecting BJ Parent's argument that the payment was deductible under section 162, the district court held that the circumstances giving rise to the FFA “bear none of the hallmarks of an 'expense,'” reasoning that BJ Parent “chose” to provide the FFA. ROA.2159 (R.E.4). It further held that the expense was not “ordinary” (ROA.2157 (R.E.4)), although it did not explain the basis for that conclusion. The district court also again relied on the fact that BJ Russia was not obligated to return the funds nor was it restricted on the use of the FFA. ROA.2159 (R.E.4).

Once again, the district court concluded that the FFA was a capitalization of BJ Russia. ROA.2159-2160 (R.E.4). In so doing, the district court wrongly assumed that the FFA could only be treated as debt or equity, and failed to recognize a third alternative — an expense/deduction to BJ Parent and income to BJ Russia — which is the proper characterization in this case and precisely how the FAA was accounted for by BJ Parent and BJ Russia for both financial and tax accounting purposes. ROA.1894-1895, 1936, 1239. Finally, the district court reasoned that the expected benefits from the FFA were not to be realized solely or primarily in the same tax year as the FFA as another reason to find that the FFA did not fit within section 162. ROA.2160 (R.E.4). With respect to both sections 166 and 162, the district court found Baker Hughes' authorities inapposite or agreed with the Government's analysis of them. E.g., ROA.2155-2156, 2162-2163 (R.E.4).8

The district court issued a separate judgment. ROA.2165 (R.E.3).

SUMMARY OF ARGUMENT

The district court erred in holding that the FFA was not deductible by BJ Parent under either section 166 as a bad debt or under section 162 as an ordinary and necessary business expense of BJ Parent.

Section 166(a)

Section 166(a) provides that “[t]here shall be allowed as a deduction any debt which becomes worthless within the taxable year” and payments in discharge of a guarantee are deductible as bad debts. At the Government's urging, courts have repeatedly held that a “debt” exists between the guarantor and original debtor even if there is no legal repayment obligation (or in some cases an express prohibition on repayment). Because the value of the reimbursement right to the guarantor (if one even exists) is usually worthless at the time the payment is made, the “debt” to the guarantor is worthless.

The FFA clearly falls within the purview of section 166. There is no dispute that (1) BJ Russia had an obligation to perform on the Contract; (2) BJ Parent guaranteed that obligation; (3) the Russian Demand Letter was “effectively a demand” on the Performance Guarantee; (4) the FFA was made by BJ Parent pursuant to the Performance Guarantee; (5) had BJ Parent not made the FFA, BJ Parent would have sustained catastrophic financial and reputational losses; and (6) providing the FFA was the only means by which BJ Parent could perform its Performance Guarantee and avoid those losses. It is also undisputed that BJ Russia had no value at the time it received the FFA, was preordained to be shut down within the tax year, and had no expectation or hope that it could repay the FFA. The district court's holding that Baker Hughes failed to meet its burden of showing that the FFA was deductible under section 166 disregards undisputed facts and conflicts with myriad authorities.

Section 162

Section 162 allows taxpayers to deduct ordinary and necessary business expenses paid or incurred during the taxable year. In determining whether a payment of the type at issue here is deductible under section 162, the proper focus is on the motivations of the payor/shareholder (i.e., BJ Parent) for providing the funds; not on the use of the funds by the recipient (in this case, BJ Russia). Although the district court correctly found that BJ Parent provided the FFA “to avoid potential future losses” (ROA.2159 (R.E.4)) and so that “BJ Parent's own reputation and future business operations would not be damaged,” (ROA.2160 (R.E.4)), the district court took its first wrong turn by erroneously focusing on the effects and use of the FFA by BJ Russia. The district court took another wrong turn by misinterpreting a number of authorities and ignoring undisputed facts. For example, the district court failed to mention the important fact that BJ Parent had already made the decision to shut down BJ Russia before providing the FFA, and any “future operations” of BJ Russia were limited to the Contract, which was preordained to produce no profit and was completed in the same taxable year that the FFA was provided. The district court also overlooked that there was no benefit to BJ Russia from receiving the FFA, and any benefit to BJ Parent expired in the same year that the FFA was provided. Thus, the district court erred in holding that Baker Hughes failed to meet its burden of showing its entitlement to a deduction under section 162.

The district court erred in granting summary judgment to the Government. This Court should reverse the judgment and render judgment in Baker Hughes' favor. It can do so based on either or both section 166 or 162.

STANDARD OF REVIEW

This Court reviews issues of statutory interpretation and summary judgment de novo. Bombardier Aerospace Corp. v. United States, 831 F.3d 268, 272 (5th Cir. 2016) (citing In re Lively, 717 F.3d 406, 408 (5th Cir. 2013) (statutory interpretation); Kimbell v. United States, 371 F.3d 257, 260 (5th Cir. 2004) (summary judgment)); see also Frank Lyon Co. v. United States, 435 U.S. 561, 581 n.16 (1978) (when the underlying facts are not disputed, “[t]he general characterization of a transaction for tax purposes is a question of law.”). It also reviews judgments on cross-motions for summary judgment de novo. McCorkle v. Metropolitan Life Ins. Co., 757 F.3d 452, 456 (5th Cir. 2014). All evidence and inferences must be construed in the light most favorable to the non-moving party. Id.; see also McClendon v. United States, 892 F.3d 775, 781 (5th Cir. 2018).

ARGUMENT

I. The FAA Payment Is Deductible As a Bad Debt Under Section 166.

A. Losses Sustained By Guarantors Are Deductible As Bad Debts Under Section 166

Section 166(a) provides that “[t]here shall be allowed as a deduction any debt which becomes worthless within the taxable year.” “[P]ayments in discharge of a guaranty are normally to be treated as bad debt losses.” Martin v. Commissioner, 52 T.C. 140, 144 (1969), aff'd 424 F.2d 1368 (9th Cir. 1970) (emphasis in original); see also Black Gold Energy Corp. v. Commissioner, 99 T.C. 482 (1992), aff'd, 33 F.3d 62 (10th Cir. 1994) (guarantor's loss is a bad debt loss and is deductible under section 166).

The Supreme Court explained in Putnam v. Commissioner, 352 U.S. 82 (1956), that the common law doctrine of subrogation is the legal principle underlying a bad debt deduction under section 166 when a guarantor makes a payment pursuant to a guarantee. Id. at 85. Under this doctrine, when a guarantor makes a payment pursuant to a guarantee, there is an implied promise by the principal obligor to reimburse the guarantor for the payment. This implied promise is a “debt” for purposes of section 166 even if the guarantor has no right of repayment and the value of the reimbursement right to the guarantor (if one even exists) is usually worthless. Id.; see also Roussel v. Commissioner, 37 T.C. 235, 242 (1961) (“[a]t the time the guarantor is called upon to pay, the debtor presumably cannot pay and is many times insolvent, giving the guarantor little if any hope at that time of reimbursement.”).9

B. The Government's Longstanding Position Is that a Payment Made Pursuant To a Guarantee Falls Within The Purview of Section 166 Regardless of Whether There Is a Repayment Obligation

At the Government's insistence, courts have repeatedly held that a guarantor's losses are deductible under section 166 regardless of whether the guarantor had a legal right of repayment (or in some cases, a flat out prohibition on repayment). This makes sense, because “[t]o allow the tax result to turn on the presence or absence of this technical right of subrogation under state law would be to undermine the Putnam doctrine.” Gillespie v. Commissioner, 54 T.C. 1025, 1031 (1970), aff'd 30 AFTR 2d 72-5574 (9th Cir. 1972) (quoting Stratmore v. United States, 420 F.2d 461, 465 (3d Cir. 1970)). “No reason is advanced why Congress would have intended tax consequences to flow from the mere existence of a right of such doubtful economic significance.” Horne v. Commissioner, 523 F.2d. 1363, 1366 (9th Cir. 1975).

In re Vaughan v. Commissioner, 719 F.2d 196 (6th Cir. 1983), is another example of a court holding — at the Government's insistence — that a guarantor's losses are deductible under section 166 even though the guarantor had no legal right of repayment. In that case, the corporation's shareholder guaranteed the corporation's leases of restaurant sites. The business failed and the corporation's assets were liquidated and distributed during bankruptcy proceedings. The creditors then sued the shareholder on the guarantees, and the shareholder subsequently filed for a plan of arrangement under the bankruptcy laws. The plan expressly provided that the corporation at issue had no repayment obligation to the shareholder who had provided funds pursuant to the guarantee and the plan of arrangement expressly negated any such repayment obligation. Id. at 198.

Similar to the arguments made by the Government in this case (and adopted by the district court), the shareholder in In re Vaughan argued that the payments made pursuant to the guarantee cannot be deducted as a bad debt loss under section 166 because there were “no subrogation rights,” and therefore “no debt from the corporation to [the shareholder] ever arose to which §166(d) could be applied.” Id. The Sixth Circuit rejected this argument, holding that the “payments to the lessors represent payments to cover [the corporation's] corporate debt . . . [and] are deductible as nonbusiness bad debts pursuant to 26 U.S.C. § 166(d).” Id. at 199. “A preoccupation with the presence of subrogation rights has several undesirable consequences” and “[l]urking behind this formality is the fact that the payments were made in response to the lessors' demands for payment. The conclusion is inescapable that the payments were made essentially in satisfaction of obligations incurred on behalf of [the corporation].” Id. at 200.10

Likewise, in Stratmore v. United States, the taxpayers argued that because payments made pursuant to guarantees “were not subrogated to the creditors' rights, there was no 'debt' which could 'become worthless' in their hands . . . [and] [t]herefore . . . their loss . . . cannot be a bad debt under section 166.” 420 F.2d at 464. Although the government agreed that there was no right of subrogation, the government argued that the payments nonetheless should be characterized as “bad debts within section 166.” Id. The Third Circuit embraced the government's argument and determined “that taxpayers' payment pursuant to the guarantees was . . . a non-business bad debt under section 166(d).” Id. at 465.

In re Vaughan and Stratmore are not outliers. See, e.g., Horne, 523 F.2d at 1365-66 (rejecting taxpayer's contention “that without a remedy over against the corporation there is no 'debt' to render section 166 applicable . . . the availability of such a remedy against the borrower is likely to be a matter of academic interest only”); Black Gold Energy Corp., 99 T.C. at 487 (“[t]he courts held that, even without the existence of a technical right of subrogation, a guarantor's loss is in the nature of a bad debt loss, and, thus, is subject to the bad debt regime of section 166.”); Martin v. Commissioner, 52 T.C. at 146 (guarantor's loss was a bad debt loss even without the existence of an express subrogation right); Gillespie, 54 T.C. at 1031 (quoting Stratmore, 420 F.2d at 465) (“[i]n . . . the present case the claims against the debtors were at all relevant times no more collectible in the hands of the guarantors than in those of the original lender. To allow the tax result to turn on the presence or absence of this technical right of subrogation under state law would be to undermine the Putnam doctrine. . . . We hold that taxpayers' payment pursuant to the guarantees was . . . a non-business bad debt under section 166(d).”); Baum v. United States, 326 F. Supp. 32, 34 (E.D. Wis. 1971) (“a lack of subrogation is not a significant distinction”); Stoody v. Commissioner, 66 T.C. 710, 715 (1976), (rejecting argument that because “no debt arose in [taxpayer's] favor . . . his losses were not bad debt losses” under section 166; “The Ninth Circuit has held that subrogation is not an essential element in characterizing guarantor losses as bad debt losses” under section 166). The “outlier” decision is the one made by the district court in this case.

C. The District Court Erred in Holding that the Government Correctly Disallowed the Bad Debt Deduction Because BJ Parent Did Not Have a Legal Right of Reimbursement From BJ Russia

BJ Parent provided the FFA as a direct result of the Performance Guarantee at a time when BJ Russia had no hope of repaying the funds (i.e., any repayment obligation would be worthless). ROA.1324-1325, ROA.1699-1701,1372. As discussed above, the absence of a right of repayment is irrelevant to whether Baker Hughes is entitled to a bad debt deduction. The district court contravened these governing principles by focusing on whether BJ Parent had a legal right of reimbursement from BJ Russia for the FFA. See 2156 (R.E.4) (“BJ Parent had no right to expect repayment of the funds advanced”), ROA.2155 (R.E.4) (distinguishing Myers v. Commissioner, 42 T.C. 195 (1964) (discussed infra at 24), because “there was no contractual agreement between BJ Parent and BJ Russia requiring . . . repayment by BJ Russia”), ROA.2156 (R.E.4) (“the focus [of the cases allowing a bad debt deduction under section 166 for payments made by guarantors is] on whether payment under a performance guarantee created a debt that the payer had a legal right to be repaid” . . . [i]n 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.”), ROA.2157 (R.E.4) (“the advance to BJ Russia did not create a debt” and “is therefore not deductible under Section 166(a) as a bad debt.”). Because a right of repayment is not required for a guarantee payment to qualify as a deductible bad debt, however, the district court's decision to impose that requirement renders its judgment erroneous, and should be reversed.

D. The District Court Erred by Determining that the FFA Was a Voluntary Payment (i.e., a Capital Infusion)

The district court also committed legal error by holding that the FFA was not deductible under section 166 because “BJ Russia never failed to perform its obligations” and “[t]he event that triggered the payment was not a demand by TNK-BP or other creditors.” ROA.2154 (R.E.4). First, it is undisputed that the Russian Demand Letter was “effectively a demand” on the Performance Guarantee and the receipt of the letter triggered the payment. ROA.1872; see also ROA.1318, 1367-68. Furthermore, the Russian Federation controlled TNK-BP, and the Russian Demand Letter was issued by an agency of the Russian Federation immediately after BJ Russia informed TNK-BP that it would not be renewing the Contract. ROA.1317, 1721-1722. The timing of these facts is also not in dispute.

But even if the Russian Demand Letter were not a “demand” on the Performance Guarantee, it would not matter. Courts have appropriately refused to require taxpayers to be bystanders to their own financial Armageddon to qualify for a deduction under section 166 for payments made pursuant to performance guarantees.

For example, in Myers, Mr. and Mrs. Myers and their partnership guaranteed that Cortland Homes, Inc., a corporation in which the Myers' partnership owned stock, would complete the construction of residential properties (i.e., a guarantee for the performance of construction services). “Under the construction contract [the Myers' partnership], and therefore [the Myers], was obligated to furnish the necessary labor and materials and to complete the construction of the houses and improvements.” Myers, 42 T.C. at 207. At the time the guarantee was provided, the amount of money that would be required for Cortland Homes to complete the construction of the homes was unknown.

The costs of constructing the homes in Myers was badly underestimated due to engineering errors, a change in sewer requirements, a union strike, a depression in the loan market, and other unforeseen events. Cortland Homes ultimately completed the construction of the homes at a loss, but not without the Myers' partnership providing funds directly to Cortland Homes to complete the construction. Those funds could just have easily been styled as “Free Financial Aid,” as they were provided before Cortland Homes defaulted on its guaranteed construction contract, were made directly to the corporation at a time when it was financially distressed and hopelessly insolvent, were made without any expectation or hope of repayment, and the guarantor never sought to recover the funds. Id. at 205. Moreover, the guarantor-taxpayers in Myers were not in a position to file mechanics' liens with respect to the funds provided to the corporation, and in any event, filing mechanics' liens was not “a practical thing to do since it would have held up payment of 40 percent of the progress payments and have caused it greater loss.” Id. at 208 (emphasis added).

The Tax Court determined that these unrepaid funds were deductible under section 166 as bad debts when the taxpayer provided funds to the home builder corporation pursuant to the taxpayer's guarantee even though the home builder corporation had not defaulted on the underlying construction contract. Id. at 207.

Myers should have ended any argument that the bad debt deduction is unavailable if the taxpayer intervenes to prevent the worst from happening. The district court, however, dismissed Myers on the basis that “no debtor-creditor relationship was being created by” the FFA. ROA.2155 (R.E.4). That distinction is foreclosed by Putnam and its progeny.

Similarly in Andrew v. Commissioner, the Tax Court held that a guarantor-taxpayer was allowed a bad debt deduction for advances made to the customers of an operator of a livestock auction barn to cover the operator's business expenses even though the surety that issued a bond for the operator's business had not first paid the operator's customers. 54 T.C. 239, 245-47 (1970). “By paying the customers directly, [the guarantor] merely telescoped the transaction, and thereby avoided additional expenditures ('all demands, liability,' etc.) that would have arisen had the surety first been called upon to liquidate the customers' claims . . . [w]e find nothing in section 166(f) limiting its benefits only to those situations in which the charade is played to the end. A taxpayer is not required 'to throw good money after bad' or await 'the judgment of a court' in order to cause a 'sheriff to demonstrate a fact he already knows.'” Id. at 247 (citing Thom v. Burnet, 55 F.2d 1039, 1040 (D.C. Cir. 1932)); cf., Bonynge v. Helvering, 117 F.2d 157, 158 (2d Cir. 1941) (a taxpayer need not wait for a default before taking a bad debt deduction).

The irony of the district court's erroneous characterization of the FFA as “voluntary” is that if BJ Parent had waited to act until after BJ Russia was liquidated and defaulted on the Contract, Baker Hughes would have taken — and, presumably, been allowed — a much greater bad debt deduction than the deduction disallowed by the Government. According to the Government's own expert, liquidation of BJ Russia and the resulting default on the Contract would have caused BJ Parent to suffer financial losses of $200 million, plus reputational damages, which “certainly” would have been characterized as a “loss” if the “parade of horribles” had occurred. ROA. 1768-1769. The law does not require that BJ Parent stand by and wait until “the charade is played to the end” to qualify for a bad debt deduction. See e.g., Andrew, 54 T.C. at 247; Myers, 42 T.C. at 209-11 (taxpayer was entitled to a deduction under section 166 or section 162 for payments made pursuant to its guarantee even though there had been no default on the underlying contract).

Also erroneous was the district court's determination that the FFA was “more in the nature of equity” than debt. ROA.2153 (R.E.4) (“BJ Russia's undercapitalization also supports the conclusion this was an infusion of capital and not a loan that created a debt.”). It defies economic reality to construe the FFA as a kind of “capitalization.” Rational persons do not make voluntary capital contributions where there is no expectation or even hope that those contributions will result in a profitable or positive return from either BJ Russia or the Contract, or that any portion of the contribution will even be repaid. See, e.g., Slappey Drive Indus. Park v. United States, 561 F.2d 572, 581 (5th Cir. 1977) (“Contributors of capital undertake the risk because of the potential return, in the form of profits and enhanced value, on their underlying investment”).

The FFA was provided when BJ Russia's losses were preordained and inescapable; there was no objectively reasonable expectation that its losses could be avoided or materially mitigated. ROA.1322, ROA.1372. The FFA constituted a loss to BJ Parent in that such payments would not and did not contribute to the realization of any profit (to either BJ Russia, to BJ Parent or to the BJ Group), but only served to avoid even greater, catastrophic losses that BJ Parent and the BJ Group would have incurred but for the FFA.

Moreover, the FFA was not made to benefit BJ Russia, and it neither benefitted BJ Russia nor increased BJ Parent's net equity in BJ Russia. ROA.1013, ROA.1323-1325. The FFA was compelled by economic necessity because it was the “only mechanism” available to BJ Parent to mitigate its own loss of $160 million and severe reputational damage to the entire BJ Group. ROA.1324-25; see also ROA.1332 (the FFA was the “only path” available to BJ Parent).

E. The District Court Also Erred in Rejecting Application of Section 166 on the Basis that the FFA Was Provided Directly to BJ Russia and Not TNK-BP

In emphasizing that “[n]o money was paid to TNK-BP, and no guaranteed debt or obligation was discharged by the payment,” (ROA.2154 (R.E.4)), the district court erroneously disregarded the many decisions that routinely permit bad debt deductions when guarantors, such as BJ Parent, advanced money to a subsidiary, such as BJ Russia, so that the subsidiary could perform on a contract that the parent had guaranteed. See, e.g., Myers, 42 T.C. at 198-200 (bad debt deduction allowed for funds provided so a construction contract could be completed for which a performance guarantee had been provided); Massey v. Commissioner, 43 T.C.M. (CCH) 1240 (1982) (bad debt deduction allowed for taxpayer who provided funds directly to corporation because of guarantees); Estate of Capell v. Commissioner, 36 T.C.M. (CCH) 1673, 1681 (1977) (bad debt deduction allowed for taxpayer who guaranteed corporation's debts and later provided funds “primarily to avoid the possibility of default”); Foretravel, Inc. v. Commissioner, 70 T.C.M. (CCH) 1007 (1995) (bad debt deduction allowed for funds provided to a related party so that the related party could satisfy obligations the taxpayer had guaranteed).

In sum, because it is undisputed that BJ Parent provided the FFA pursuant to and as a direct result of its Performance Guarantee and to avoid the catastrophic losses that would have otherwise been incurred, the payment was compelled and not voluntary. That there was no expectation or ability of BJ Russia to repay is irrelevant under governing authority. The district court's holding that Baker Hughes failed to meet its burden of showing that the payment was deductible under section 166 and that the Government was entitled to summary judgment on Baker Hughes' claim is error and should be reversed.

II. Alternatively, the FFA Is Deductible As An Ordinary And Necessary Trade or Business Expense of BJ Parent Under Section 162

Section 162(a) provides in pertinent part, “[t]here shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. . . .” Payments are deducible under section 162 if they are: (1) paid or incurred during the taxable year, (2) for carrying on a trade or business, (3) an expense, (4) “ordinary,” and (5) “necessary.” Commissioner v. Lincoln Sav. & Loan Ass'n, 403 U.S. 345, 352-53 (1971). The FFA satisfies all of these requirements.11

A. Payments Made By a Parent/Guarantor To Protect The Parent/Guarantor's Reputation Qualify For A Deduction Under Section 162

Before demonstrating that the FFA met each of the five requirements under section 162, it is important to note that the focus of a deduction under section 162 is not on BJ Russia, but on BJ Parent. That is because, although shareholders are generally not permitted to deduct sums advanced to a corporation to meet that corporation's obligations, there is what the IRS National Office describes as the “well-established exception . . . [that] 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.” I.R.S. Tech. Adv. Mem. 9522003 at 9 (June 2, 1995) (emphasis added).Courts and the IRS National Office have repeatedly applied the “well-established exception” when — as here — the facts meet that exception.

Indeed, the long line of cases and IRS rulings applying the “well-established exception” focus on the motivation of the shareholder making the payment and whether that payment is ordinary and necessary to the shareholder's business:

The tests as established by all of these cases are that we must first ascertain the purpose or motive which cause the taxpayer to pay the obligations of the other person. Once we have identified that motive, we must then judge whether it is an ordinary and necessary expense of the individual's trade or business; that is, is it an appropriate expenditure for the furtherance or promotion of that trade or business? If so, the expense is deductible by the individual paying it.

Lohrke v. Commissioner, 48 T.C. 679, 688 (1967); see also Id. at 684-85 (“[a]s in the case of most general rules, an exception to this one has been developed. 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. . . .”) (emphasis added); see also e.g. Canterbury Holdings, LLC v. Commissioner, 98 T.C.M. (CCH) 60, 62 (2009) (“Canterbury understands [the general rule of section 162(a)], but invokes an exception. Section 162 permits deductibility of 'ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.' And there's nothing in the Code that bars a shareholder from deducting payments of his corporation's expenses, if those expenses are also ordinary and necessary to [the shareholder's] own trade or business.” (citing Lohrke, 48 T.C. at 688-89)) (emphasis in original); Gould v. Commissioner, 64 T.C. 132, 134-35 (1975) (“Ordinarily, a shareholder may not deduct a payment made on behalf of the corporation, but must treat it as a capital expenditure. However, such rule is not invariable; the payment may be deducted if it is an ordinary and necessary expense of a trade or business of the shareholder.”) (internal citations omitted); Rev. Rul. 73-226, 1973-1 C.B. 62 (1973) (“if the primary motive of the payer of another company's debt is to preserve its own good will and credit rating, rather than to help the debtor company continue in business, the payments are currently deductible” under section 162) (emphasis added); I.R.S. Tech. Adv. Mem. 9522003 (shareholder who provided funding to a troubled foreign subsidiary “to restore it to nominal solvency” under foreign regulatory capital requirements, which funding prevented involuntarily liquidation of the foreign subsidiary and protected shareholder's reputation, was entitled to a deduction under section 162).

BJ Parent's motives for providing the FFA, and the consequences for not doing so are not in dispute — to protect its own reputation and avoid the significant financial and reputational losses that BJ Parent would have suffered if BJ Russia did not complete the Contract. See e.g., ROA.1700. The FFA was not a capital investment in BJ Russia, as there was no expectation or hope that BJ Parent would ever earn a profitable return on the FFA or that any amount of the FFA would ever be returned to the BJ Parent. ROA.1333-1334. The district court wrongly assumed that the FFA could only be treated as debt or equity, and failed to recognize a third alternative — an expense/deduction to BJ Parent and income to BJ Russia — which is the proper characterization of the FFA in this case. BJ Russia was “defunct” and BJ Parent was “winding up the business.” ROA.1333-1334. BJ Russia ceased operations and shut down within the same tax year that the FFA was received. ROA.1700, 1731, 1733, 1751-1752, 1394.

Baker Hughes will now address the five requirements for a payment to qualify as a deduction under section 162.

B. Section 162's Five Requirements Were Indisputably Met Here

1. BJ Parent “Paid or Incurred” the FFA During the Tax Year In Which It Claimed a Deduction

BJ Parent “paid or incurred” the FFA in November and December of 2008, which was during the BJ Group's taxable year for which the deduction was claimed. ROA.1394, 1733, 1751-1752. Therefore, this requirement is satisfied.

2. BJ Parent Paid the FFA “In Carrying on a Trade or Business”

BJ Parent “made the $52 million payment in connection with its business” that included “operating subsidiaries in various parts of the world.” ROA.1765. The BJ Group was a leading worldwide provider of pressure pumping and oilfield services for the petroleum industry. ROA.1374-1375. An amount is paid or incurred in carrying on a trade or business if the amount is for an expenditure “directly connected with or pertaining to the taxpayer's trade or business.” Treas. Reg. § 1.162-1(a).

BJ Parent provided the FFA to fulfill its legal obligations under the Performance Guarantee and avoid the financial and reputational damage that would have resulted to BJ Parent if BJ Russia defaulted on the Contract. Without the FFA, BJ Russia would have been involuntarily liquidated by the Russian Federation and unable to perform the services required by the Contract. BJ Parent would have been liable for financial damages from these events in excess of $160 million (and suffered a loss of $200 million if the assets used by BJ Russia were seized by the Russian government) and suffered reputational damage. ROA.1700, 1753, 1756, 1757-1758, 1763-1764. Not surprisingly, the Government's expert conceded that the FFA was paid or incurred in carrying on BJ Parent's trade or business. ROA. 1756, 1757-1765.

3. The FFA Was An Expense of BJ Parent

The FFA was “a business expense that BJ [Parent] incurred because of its guarantee of its Russian subsidiary.” ROA.1334. Courts have repeatedly confirmed in analogous situations that payments by a parent to or on behalf of its subsidiary to protect the parent's reputation are deductible under section 162 where the subsidiary was in serious financial difficulty or its business was being wound down.

For example, in Coulter Electronics, Inc. v. Commissioner, 59 T.C.M. (CCH) 350 (1990), a U.S. parent corporation paid certain warranty expenses incurred by its Canadian subsidiary. The Tax Court allowed the parent to deduct these payments because the failure to make the payments would have adversely affected the parent's reputation for servicing its products after their sale. As the Tax Court explained:

[I]t is apparent that in the 16 years of its business life prior to 1974 petitioner had carefully built, nourished, and protected a reputation not only for manufacturing and selling good products but also for providing in the United States excellent service with respect to such products after their sale. It is equally apparent that due to the close proximity of the two markets, petitioner's reputation for such service in the United States would not only favorably affect the sale of its products in Canada but a failure by [subsidiary] to provide similar services in Canada would adversely affect petitioner's future sales in both Canada and the United States.

Coulter, 59 T.C.M. (CCH) at 367-68.

Similarly, in Lohrke, the Tax Court allowed a deduction to a taxpayer for payments pursuant to a guarantee of losses sustained by a customer of the taxpayer's majority-owned corporation. 48 T.C. at 684-89. The losses related to a synthetic fiber product manufactured by the corporation, and the taxpayer conducted a separate business of licensing the process to produce the synthetic fiber. The “guarantee” in Lohrke was provided by the taxpayer after his corporation experienced serious financial difficulties.The Tax Court held that because the corporation was in serious financial difficulty and was unable to compensate the customer itself, and because the taxpayer was reasonably concerned that his reputation in the industry and the future of his patented manufacturing process would be jeopardized if the corporation's customer was not compensated for the loss, the taxpayer was entitled to a current business expense deduction. Id.; see also Allen v. Commissioner, 283 F.2d 785, 790 (7th Cir. 1960) (shareholder's payment to corporation so that corporation could pay its creditors was deductible by shareholder when corporation was in serious financial difficulty and in the process of being liquidated; shareholder made payment to protect its own business reputation and credit standing and “[t]he condition of the corporation and its business belie any intention of making an investment in the corporation or its business”); Frazier v. Commissioner, 34 T.C.M. (CCH) 951, 963-64 (1975) (shareholder's payment on his failing corporation's loan pursuant to his guarantee of the loan was deductible and not an investment in his corporation; the court found that guarantees of corporate loans in the real estate construction industry are a common occurrence, and that the payment was necessary — “appropriate and helpful” — to protecting the reputation and credit standing of the shareholder's personal real estate business); Fishing Tackle Prods. Co. v. Commissioner, 27 T.C. 638, 643-44 (1957) (payments by a parent corporation to its subsidiary to reimburse the subsidiary for operating losses sustained in supplying special fishing rods to the parent's business were deductible as ordinary and necessary business expenses; expenditures made to “protect and promote” a taxpayer's business and which do not result in the acquisition of a capital asset are deductible); Scruggs-Vandervoort-Barney, Inc. v. Commissioner, 7 T.C. 779, 786-88 (1946) (payment by corporate retailer to depositors of a failed bank, which had been 97%-owned by the retailer, was deductible as an ordinary and necessary business expense even though the retailer was not obligated to make the payment); Lutz v. Commissioner, 282 F.2d 614 (5th Cir. 1960) (section 162 deduction allowed for shareholder of three corporations who assumed debts of those corporations and advanced funds to those corporations to allow them to meet their debts); Snow v. Commissioner, 31 T.C. 585, 591-93, 596 (1958) (payment by a law firm to reimburse the operating deficit of a savings and loan association, which had been organized by the law firm with the understanding that it would refer business to the law firm, was deductible); Myers, 42 T.C. at 206-11 (funds provided by shareholders to corporation to enable it to complete construction contracts that shareholders had guaranteed were deductible under section 162); I.R.S. Tech. Adv. Mem. 9522003 (shareholder who provided funding to a troubled foreign subsidiary “to restore it to nominal solvency” under foreign regulatory capital requirements, which funding prevented involuntarily liquidation of the foreign subsidiary and protected shareholder's reputation, was entitled to a deduction under section 162); Rev. Rul. 79-283, 1979-2 C.B. 80 (1979) (“Voluntary expenditures qualify as deductible ordinary and necessary business expenses when they are made either to prevent injury to the taxpayer's business, or to preserve and protect the goodwill of the business. . . .”).

a. The District Court Erred In Holding that the Payment Was a Recapitalization That Provided Benefits Beyond the End of the Tax Year

The district court's holding that the FFA was some sort of “recapitalization and reorganization” of BJ Russia that provided benefits “well beyond the tax year in which the payments were made” contradicts its own recitation of the facts and improperly focuses on BJ Russia's use of the FFA, rather than BJ Parent's purpose or motivation for providing those funds as required by the law. ROA.2160 (R.E.4). As the district court stated, the effect of the FFA to BJ Parent was that it “avoid[ed] potential future losses” and damage to its “own reputation and future business operations.” ROA.2160 (R.E.4), 2159 (R.E.4). Thus, the FFA was not made “for the purpose of changing the corporate structure for the benefit of future operations” of BJ Russia. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 89 (1992) (emphasis added).

All of the key events concerning BJ Parent's providing the FFA, BJ Russia's use of the FFA, and the effects on BJ Parent from providing the FFA took place before BJ Parent's tax year ended September 30, 2009. The FFA was provided in November and December of 2008, which was in the same tax year the Contract and Performance Guarantee expired (August 1, 2009). Upon expiration of the Contract, BJ Russia ceased business operations, began winding up its business, and “had no further revenue and incurred additional expenses in exiting the oilfield services market in Russia.” ROA.1700-1701. To the extent that BJ Russia continued in existence past the end of that taxable year, it was solely for the purpose of completing the “shutdown” of its business. ROA.1700-1701, 2035-2036. There simply was no realization of significant benefits beyond the taxable year in question. See, e.g., INDOPCO, Inc. v. Commissioner, 503 U.S. at 87.

b. The District Court Misread Mills

The district court also misread Mills Estate, Inc. v. Commissioner, 206 F.2d 244 (2d Cir. 1953), (ROA.2160 (R.E.4)), which addressed whether legal fees incurred by shareholders in connection with a reorganization “for the benefit of future operations” should either be capitalized or deducted as ordinary and necessary expenses. The legal fees at issue in Mills were paid pursuant to a corporate recapitalization to provide the corporation with “the capital structure it determined was best suited to carrying on that part of the business it was to continue.” Mills, 206 F.2d at 246 (emphasis added). The corporation in Mills was a going concern with the hope and expectation of future profits, and the shareholders had no plans to cease the corporation's business operations at the time the legal expenditures were incurred. That does not even remotely resemble the facts of this case.

BJ Parent's motivations for providing the FFA were not for the benefit of BJ Russia's future operations, but instead were made so that BJ Parent could “avoid potential future losses” and protect its “own reputation and future business operations.” ROA.2159-2160 (R.E.4). The FFA prevented the damage to BJ Parent's reputation that would have resulted from the involuntary liquidation of BJ Russia before the completion of the Contract. The shutdown and liquidation of BJ Russia were preordained to occur after the Contract was completed, which was in the same tax year that BJ Parent provided the FFA. BJ Parent did not realize any significant benefits after September 30, 2009 resulting from the FFA, as BJ Russia ceased operations. See U.S. Freightways Corp. v. Commissioner, 270 F.3d 1137, 1146 (7th Cir. 2001) (taxpayer entitled to section 162 deduction for payments of license fees, permit fees, and insurance premiums even though taxpayer received benefits after the end of the tax year when payments were made because external agencies and companies not affiliated with taxpayer controlled the time when the licenses, permits, and policies had to be renewed); I.R.S. Tech. Adv. Mem. 200247004 (Nov. 22, 2002) (the IRS's “position is that expenditures made primarily to protect or preserve an established business are currently deductible, even if a secondary result of such expenditures for protection and preservation result in long term benefits.”). Hence, there was no sort of “recapitalization” or “reorganization” for the benefit of future operations as was the case with the corporation at issue in Mills. 206 F.2d at 246.

4. The FFA Was An “Expense”

The FFA was provided “[i]n response to a letter from the Russian Ministry of Finance threatening liquidation because of undercapitalization” and would not have been provided absent that letter. ROA.2159 (R.E.4). BJ Parent did not provide the FFA to create a new business, but instead to facilitate the winding down of an existing business (BJ Russia) and its orderly exit from the Russian market and to protect the existing business reputation and credit of BJ Parent. ROA.1317-1319, 1329-1332, 1369, 1700. As a result, the FFA is an “expense” under section 162. See Allen, 283 F.2d at 790-91 (explaining the difference between payments made to establish or purchase goodwill or business standing (not deductible) and payments made to protect an existing business reputation and credit (deductible)); Briarcliff Candy Corp. v. Commissioner, 475 F.2d 775, 787 (2d Cir. 1973) (citing Allen and Lutz in holding that expenditures for the protection of an existing investment or the continuation of an existing business or the preservation of existing income from loss or diminution were ordinary and necessary expenses within the meaning of section 162 and not capital in nature); A.E. Staley Mfg. Co. v. Commissioner, 119 F.3d 482, 491-92 (7th Cir. 1997) (the bulk of $12.5 million paid by the taxpayer to investment bankers in connection with defense of hostile takeover offer was deductible).

5. The FFA Was “Ordinary”

The FFA was an “ordinary” expense for BJ Parent, a company in the global oil and gas services business. The principal function of the term “ordinary” is “to clarify the distinction, often difficult, 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). “Ordinary” means “normal, usual, or customary.” Lincoln Savings, 403 U.S. at 353 (quoting Deputy v. Du Pont, 308 U.S. 488, 495 (1940)).

An expenditure need not be frequent to be ordinary, and expenditures that “may happen once in a lifetime” still constitute ordinary expenses.Welch v. Helvering, 290 U.S. 111, 114 (1933). As the Supreme Court in Welch observed:

A lawsuit affecting the safety of a business may happen once in a lifetime. The counsel fees may be so heavy that repetition is unlikely. None the less, the expense is an ordinary one because we know from experience that payments for such a purpose, whether the amount is large or small, are the common and accepted means of defense against attack. Cf. Kornauser v. United States, 276 U.S. 145 . . . The situation is unique in the life of the individual affected, but not in the life of the group, the community, of which he is a part.

Id.

Like other multinational corporations in the oil and gas services industry, BJ Parent was required to provide performance guarantees on behalf of its subsidiaries that operated outside of North America, and routinely did so. ROA.1311-1315, 1410-1411. The FFA was provided pursuant to the Performance Guarantee, which was given as part of BJ Parent's ordinary international business practices. ROA.1754. (BJ Parent had entered into similar service guarantees on behalf of other foreign subsidiaries).

6. The FFA Was “Necessary”

The FFA was “necessary” to protect BJ Parent's global reputation. The term “necessary” imposes only the minimal requirement that the expense be “appropriate and helpful” to the taxpayer's business. Tellier, 383 U.S. at 689; Commissioner v. Heininger, 320 U.S. 467, 471 (1943); see also Cepeda v. Commissioner, 66 T.C.M. 1032, 1037 (1993), aff'd on other issue without opinion, 56 F.3d 1384 (5th Cir. 1995) (medical clinic allowed a section 162 deduction for payments made to related corporation to cover its operating deficits; “It is 'necessary' if the expenditure was motivated by the intent that it would result in a business benefit.”). Indeed, the Supreme Court has held that courts should be “slow to override” a taxpayer's judgment that expenditures were appropriate and helpful to its business. Welch, 290 U.S. at 113.

The Contract provided BJ Parent a platform to demonstrate its recently developed pressure pumping equipment and technology in the Russian market, which could open new markets worldwide for its sophisticated pressure pumping equipment and services. ROA.1305-1306, 1313-1314. BJ Russia would not have been awarded the Contract absent the Performance Guarantee. ROA.1307-1309, 1378. Thus, the Performance Guarantee was “appropriate and helpful” to BJ Parent's business.

The FFA was also appropriate and helpful to BJ Parent's business, because it preserved BJ Parent's business reputation and financial position. ROA.1700. See Lutz, 282 F.2d at 618-21 (shareholder assumed debts of three corporations and provided funds to allow them to meet their debts for the purposes of protecting his personal business reputation and credit and his license); Scruggs-Vandervoort-Barney, Inc., 7 T.C. at 787 (finding voluntary payment to a failed bank was an ordinary and necessary business expense of parent to protect its business reputation rather than acquire a new business). BJ Parent could not wind down BJ Russia and exit the Russian market unless the legal obligations under the Contract were satisfied. ROA.1699. See Chicago Pneumatic Tool Co. v. Commissioner, 21 B.T.A. 569, 574, 575 (1930) (parent's subsidiaries were in financial difficulty and “headed for bankruptcy,” and parent expended the funds as a “business necessity” to maintain foreign outlets for its products; any benefits to the subsidiaries were “merely incidental”).

This is not a case where BJ Parent made some voluntary payment out of the goodness of its heart. See, e.g., Lutz, 282 F.2d at 618 (“Certainly Lutz was not paying out these large sums of money without legal obligation, or to satisfy neighborly amenities, or to heighten his reputation for generosity and opulence.”). Without the FFA, the Russian authorities would have liquidated BJ Russia, thereby triggering the Performance Guarantee, expropriating the BJ Group's equipment and technology, and forcing a default on the Contract with financial damages to BJ Parent estimated to exceed $160 million. ROA.1700, 1721-1722, 1735-1736, 1317-1319, 1336-1340, 1365, 1367-1369.

The Government's expert readily acknowledged that the FFA was necessary for BJ Russia to complete the Contract and protect BJ Parent's business, as the following events would have occurred if BJ Russia had been liquidated: (1) BJ Russia would not have been able to perform on the Contract; (2) the Russian government could have seized control of BJ Russia and/or its assets; (3) BJ Parent would have been liable for damages from these events in excess of $160 million (and suffered a loss of $200 million if the assets used by BJ Russia were seized by the Russian government); and (4) BJ Parent's business would have suffered reputational and economic damage. ROA.1753, 1756, 1757-1761, 1762, 1763-1764, 1768. The FFA, however, prevented these dire events from occurring. ROA.1756, 1757-1761, 1762, 1763-1764, 1765. There is no dispute that the FFA was “necessary.”

C. The District Court Erred in Its Analysis of the IRS's National Office's Persuasive Technical Advice Memorandum

Litigants frequently tout the proverbial “white horse” case that they claim applies directly to the position they assert in a lawsuit. Usually that turns out not to be the case. Not so here. The IRS National Office's Technical Advice Memorandum 9522003, issued June 2, 1995 (“TAM”), involved facts virtually identical to those in this case, as demonstrated by the following chart:

TAM12

Baker Hughes’ Claim Under Section 162

Taxpayer — shareholder and parent of a Foreign Subsidiary

Taxpayer — Baker Hughes, successor to BJ Parent, shareholder and parent of a foreign subsidiary (BJ Russia)

Foreign Subsidiary in financial difficulty

BJ Russia — liabilities substantially in excess of assets

Foreign Regulatory Authority determined that Taxpayer’s Foreign Subsidiary required additional funds in excess of its capital funds to continue operations

Russian Finance Ministry threatened to liquidate BJ Russia because BJ Russia’s net assets cost was less than the chartered capital minimum specified by Russian law

Taxpayer-Parent discouraged by Foreign Subsidiary’s future business prospects and determined that Foreign Subsidiary’s operations should be wound down

BJ Parent determined that downward economic pressures in Russia necessitated winding down BJ Russia’s operations and exit from Russia

Taxpayer-Parent could not wind down Foreign Subsidiary’s operation because it was technically insolvent under the foreign law governing the Foreign Subsidiary

BJ Parent could not wind down BJ Russia’s operations and exit the Russian market because BJ Russia’s technical insolvency under Russia law — if not resolved — would result in BJ Russia’s liquidation, which would have caused BJ Russia to be in breach of its contract with TNK-BP, thereby subjecting BJ Parent to catastrophic losses

Taxpayer-Parent desired to avoid an unorderly liquidation of Foreign Subsidiary because Taxpayer-Parent believed it would suffer substantial damage to its goodwill and reputation within the business community if it permitted Foreign Subsidiary to fail without its creditors being satisfied in full.

BJ Parent desired to avoid liquidation of BJ Russia because BJ Parent believed it would suffer substantial damage to its goodwill and reputation in the business community if BJ Russia was liquidated and defaulted on its obligations to TNKBP

Taxpayer-Parent notified Foreign Regulatory Authority that it intended to wind up business affairs of Foreign Subsidiary and could voluntarily provide the financial support necessary to meet Foreign Subsidiary’s financial obligations

BJ Russia notified TNK-BP that it would exit the Russian market after fulfilling its obligations under the Contract, and notified the Russian Finance Ministry that the chartered capital requirement would be met with the FFA from BJ Parent

Taxpayer-Parent voluntarily remitted funds to the Foreign Subsidiary to restore the Foreign Subsidiary to nominal solvency under the foreign law governing the Foreign Subsidiary

BJ Parent provided FFA to BJ Russia to restore BJ Russia to nominal solvency under Russian law

Foreign Subsidiary could not repay the funds advanced by Taxpayer-Parent

BJ Russia could not repay the FFA to BJ Parent

Taxpayer-Parent waived any right to repayment of the funds

BJ Parent agreed contractually that BJ Russia had no obligation to repay the FFA

Taxpayer-Parent sought a deduction for funds advanced under section 162

Baker Hughes seeks a deduction for the FFA under section 162

After analyzing the facts described above relating to the Taxpayer-Parent, the IRS National Office — relying on numerous cases and IRS National Office rulings cited and discussed herein — determined that the Taxpayer-Parent/Shareholder was entitled to a deduction under section 162 because the payments it made to its Foreign Subsidiary were “made to extinguish another taxpayer's liability [and] to protect and promote the payor's own goodwill.” TAM at 9. The IRS National Office properly concluded that the funds advanced by the Taxpayer-Parent to its foreign subsidiary were ordinary and necessary business expenses deductible under section 162, and not a capital contribution. Id.

And while the IRS National Office's Technical Advice Memorandum is not binding precedent, it absolutely has the “power to persuade,” and certainly “reveal(s) the interpretation put upon” section 162 “by the agency charged with the responsibility of administering the revenue laws.” See Skidmore v. Swift & Co., 323 U.S. 134, 140 (1944); Hanover Bank v. Commissioner, 369 U.S. 672, 686 (1962). Never was this more true than in this case, where the facts surrounding BJ Parent's FFA to BJ Russia are so remarkably similar to those involving the Taxpayer-Parent/Shareholder and its Foreign Subsidiary in the TAM.

The district court erroneously sought to distinguish the TAM by reasoning that the “factual circumstances described in [the TAM] are materially different” from those in this case because the aid provided by the shareholder in the TAM “was not intended to facilitate continued operations of the subsidiary, but rather to wind up those operations in a more orderly fashion.” ROA.2162 (R.E.4). “Materially different”? The district court's reasoning ignores the true facts in this case. See supra at 48-49.

As Baker Hughes has established supra, BJ Parent decided to exit the Russian pressure pumping market, but could not immediately do so because of the Contract and Performance Guarantee. The FFA was provided only after the Russian Federation made a demand on the Performance Guarantee, and BJ Parent made the only decision it could make — to cut its losses and provide the minimum amount of funding necessary to complete the Contract and mitigate the reputational and financial damages (more than three times the amount of the FFA) that BJ Parent indisputably would have suffered if BJ Russia had defaulted on the Contract. BJ Russia ceased operations within eight months after receiving the FFA, which was in the same tax year. The FFA was certainly not provided to “continue business operations.” Instead, like the aid provided to the foreign corporation in TAM, the FFA was made to “wind up [BJ Russia's] operations in a more orderly fashion.”

D. The District Court Erred in Relying on the Alleged Absence of BJ Parent's Right to Restrict BJ Russia's Use of the Funds as a Reason to Reject Application of Section 162

The district court also found that the FFA was not deductible under section 162 because the FFA agreement did not restrict BJ Russia's use of the funds. See ROA.2163 (R.E.4). (“The free financial aid provided by BJ Parent was untethered to any actual expense of BJ Russia” and “unconditional”). This ignores reality and elevates form over substance. The reality is that BJ Russia, as a subsidiary of BJ Parent, was subservient to the will of the management of BJ Parent. Given the purpose and intended effect of the FFA, BJ Russia was as a practical matter restricted as to how those funds would be used.

It is undisputed that the FFA worked as intended — to avoid the catastrophic financial and reputational losses that would have occurred absent the FFA. Thus, the mere fact that the FFA documents do not say “X amount of the funds will pay Y expenses of BJ Russia” does not and cannot disqualify the FFA from being deductible under section 162 when, as here, courts and the IRS have recognized the right of a deduction when the payment would preserve the taxpayer's business reputation. See, e.g., Allen, 283 F.2d at 789-91 (deduction allowed under section 162 for advances to corporation used to pay corporation's creditors to preserve taxpayer's business reputation and credit standing); Pike v. Commissioner, 44 T.C. 787, 799 (1965) (taxpayer-shareholder's payment to corporation of profit from taxpayer's sale of stock was deductible under section 162 because taxpayer reasonably believed his reputation in the insurance industry would be damaged if he failed to make the payment; “No more is required for petitioner's payment to Cardinal to be deductible as an ordinary and necessary business expense under Section 162(a)”); TAM (parent corporation entitled to a deduction under section 162 for funds provided to its foreign banking subsidiary in financial difficulty so that subsidiary could satisfy its depositors and creditors, and parent corporation-shareholder could avoid damage to its goodwill and business reputation that would have occurred if subsidiary had failed).

The TAM is particularly telling because nowhere in that TAM does the IRS National Office attempt to segregate (or even mention) the funds that were used to repay the Foreign Subsidiary's depositors (payments clearly were not deductible by the Foreign Subsidiary under section 162 because bank deposits are loans and repayments of loans are not deductible) from the funds used by the Foreign Subsidiary to pay other creditors (which may or may not have been deductible by the foreign subsidiary under section 162 depending on the underlying nature of those expenses). An analysis of the Foreign Subsidiary's use of the funds and the underlying nature of the payments made by the Foreign Subsidiary from the financial support provided by the Taxpayer-Parent/Shareholder was not relevant, because the proper focus under section 162 is on the motivation of the Taxpayer-Parent/Shareholder providing the funds. See also Lutz, 282 F.2d at 615 n.2, 619 (rejecting the IRS's characterization of a shareholder's payments as capital expenditures; shareholder allowed an ordinary and necessary business expense deduction for payments he made to creditors of his three corporations); Allen, 283 F.2d at 790-91 (major shareholder who voluntarily provided funds to a corporation for the purpose of paying the corporation's general creditors allowed section 162 deduction because the funds were provided “to protect the reputation and credit standing” of the shareholder's other business operation); Rev. Rul. 73-226, 1973-1 C.B. 62 (1973) (parent corporation engaged in banking business allowed deduction under section 162 for payments to depositors and creditors of its insolvent foreign banking subsidiary to protect the parent corporation's business reputation and goodwill); Dunn & McCarthy, Inc. v. Commissioner, 139 F.2d 242, 243-44 (2d Cir. 1943) (corporation allowed deduction under section 162 for payments to its salesmen in satisfaction of loans that they had made to its president who had died insolvent “for the purpose of conserving the good will of salesmen and of customers”); Pepper v. Commissioner, 36 T.C. 886, 890-91 (1961) (law firm solicited lenders for its client and had done the legal work on the loans; when the law firm learned that the client's business was fraudulent and that the client had defaulted on the loans, the law firm paid off the lenders to protect the law firm's business and was allowed a deduction for the amounts paid); Frazier v. Commissioner, 34 T.C.M. (CCH) at 963-65 (shareholder who made payment to a third-party lender with respect to his failing corporation's loan to protect the reputation and credit standing of the shareholder's business was allowed deduction); Scruggs-Vandervoort-Barney, Inc. v. Commissioner, 7 T.C. 779, 781-82, 785-88 (1946) (deduction allowed where corporation had been the principal shareholder of a failed bank and paid the claims of the depositors of the failed bank to preserve and protect the corporation's business); see also Rev. Rul. 76-203, 1976-1 C.B. 45 (1976) (citing and discussing various authorities regarding payments to or for the other person's creditors, lenders or depositors).

CONCLUSION

For the reasons stated above, Baker Hughes respectfully requests that the Court reverse the district court's judgment and render judgment in Baker Hughes' favor that it is entitled to a refund of $17,654,000 in federal income taxes, plus interest. It further asks for all other relief to which it may be justly entitled.

Respectfully submitted,

NORTON ROSE FULBRIGHT US LLP

By: Reagan M. Brown
Texas Bar No. 03162200
reagan.brown@nortonrosefulbright.com
Robert C. Morris
Texas Bar No. 24046484
robert.morris@nortonrosefulbright.com
Stephen A. Kuntz
Texas Bar No. 11762960
stephen.kuntz@nortonrosefulbright.com
1301 McKinney, Suite 5100
Houston, Texas 77010-3095
Telephone: (713) 651-5151
Telecopier: (713) 651-5246
Counsel for Plaintiff-Appellant

FOOTNOTES

1 Unless otherwise indicated, all “section” references are to the Internal Revenue Code, Title 26 of the United States Code (26 U.S.C. § __), and all references to “Treas. Reg. § __” are to the Treasury Regulations set forth in Title 26 of the Code of Federal Regulations (26 C.F.R. § __), as amended and in effect for the tax years in issue.

2 See ROA.2146 n.3 (district court's agreement to treat Baker Hughes' response to the Government's motion for summary judgment on section 166 as Baker Hughes' own motion).

3 It is undisputed that although the Russian Demand Letter was to BJ Russia, it was “effectively a demand” that BJ Parent perform on the Performance Guarantee. ROA.1872; see also ROA.1318, 1367-1368.

4 Moreover, BJ Parent understood that the general manager of BJ Russia had personal liability for BJ Russia's actions or failures. ROA.537. BJ Parent “was not going to throw him under the bus or leave him out to dry in Russia.” ROA.537.

5 The amount of the FFA was determined in conjunction with BJ Russia's advisors, and was the “minimum amount” needed so that BJ Russia could complete the Contract. ROA.1323-1330.

6 As discussed infra, one of the key reasons the district court rejected Baker Hughes' claim to be entitled to bad debt deduction was the absence of a repayment obligation by BJ Russia. ROA.2155-2157 (R.E.4). But a repayment obligation is not required under governing law.

7 Consistent with the tax treatment, the FFA was treated as an expense for financial accounting purposes by BJ Parent and as other income — not a capital contribution — by BJ Russia. ROA.1894-1895, 1936, 1239.

8 The decision is reported at Baker Hughes Incorporated v. United States, 313 F. Supp. 3d 804 (S.D. Tex. 2018).

9 Treas. Reg. § 1.166-9 provides that a taxpayer is eligible for a bad debt deduction when a payment is made pursuant to a guarantee so long as (1) the guarantee was entered into in the course of the taxpayer's trade or business or a transaction for profit; (2) there was an enforceable legal duty upon the taxpayer to make the payment (except that legal action need not have been brought against the taxpayer); (3) the guarantee was entered into before the obligation became worthless (“an agreement is considered entered into before the obligation became worthless . . . if there was reasonable expectation on the part of the taxpayer at the time the agreement was entered into that the taxpayer would not be called upon to pay the debt”), and (4) the guarantor receives reasonable compensation (which includes if the guarantee was entered into in accordance with normal business practices or for a good faith business purpose). Here, there is no dispute that (1) the Performance Guarantee was entered into in BJ Parent's ordinary course of business, (2) the Performance Guarantee was enforceable under Russian law, (3) BJ Parent reasonably believed that it would not be called upon to act on the Performance Guarantee, and (4) the Performance Guarantee was entered into in accordance with BJ Parent's normal business practices and for a good faith business purpose. See e.g., ROA.1311-1314, 1412, 1380-1381. The Government argued in its summary judgment briefings that BJ Parent was not entitled to a bad debt deduction because BJ Russia's obligation to perform services for TNK-BP was not a “bona fide debt” under the regulations because it was not a formal loan or promissory note. ROA.72-84. The district court did not reference this argument in its memorandum, and in any event, the Government was wrong. See e.g., Myers v. Commissioner, 42 T.C. 195. (1964).

10 The Sixth Circuit also determined that the shareholder's “guaranties constituted indirect loans of [the shareholder's] personal financial resources to [the corporation]. Therefore, [the shareholder] was 'providing the corporation with financing' as contemplated in Putnam and Stratmore.Id. at 199 (emphasis added).

11 The only two requirements the Government challenged were that the FFA was not (1)“an expense,” and (2) “ordinary.” See ROA.2157 (R.E.4) (“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.'”). For completeness, Baker Hughes will address each requirement under section 162.

12 The facts relating to the TAM are set forth in ROA.1899-1915.

END FOOTNOTES

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