from the United States District Court for the Southern
District of Texas
SOUTHWICK, WILLETT, and OLDHAM, Circuit Judges.
H. SOUTHWICK, CIRCUIT JUDGE.
dispute over an income tax deduction, the taxpayer appeals
the decision of the district court that a $52 million payment
from its predecessor in interest to the predecessor's
subsidiary was not a bad debt under 26 U.S.C. § 166 or
an ordinary and necessary business expense under 26 U.S.C.
§ 162. Therefore, no income tax deduction was allowed
for the payment. We AFFIRM.
AND PROCEDURAL BACKGROUND During the relevant time period, BJ
Services Company, which the parties have referred to as
"BJ Parent" and so shall we, conducted fracking
services in Russia. It operated through a Russian subsidiary,
ZAO Samotlor Fracmaster Services, which also has an agreed
shortform, "BJ Russia." The plaintiff Baker Hughes
is the successor in interest to BJ Parent. In 2006, BJ Russia
entered into a three-year contract with OJSC TNK-Management
("TNK-BP"), a joint venture between Russian
National Oil company TNK and British Petroleum, to provide
fracking services in Siberia. TNK-BP could terminate this
contract if BJ Russia became bankrupt, if a liquidator was
appointed for BJ Russia, or if BJ Russia defaulted on its
contractual obligations. During the three-year term of the
contract, BJ Russia did not default, and TNK-BP never claimed
condition of BJ Russia's bidding on this contract, TNK-BP
required BJ Parent to provide a guarantee that BJ Parent
would perform or ensure the performance of the fracking
services that TNK-BP asked BJ Russia to provide. The final
version of this guarantee in part provided:
1.We [BJ Parent] guarantee that [BJ Russia] shall duly
perform all its obligations contained in the Contract.
2. If [BJ Russia] shall in any respect fail to perform its
obligations under the Contract or shall commit any breach
thereof, we 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 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 sustained unanticipated losses on the contract in 2006
and 2007. BJ Russia decided to exit the Russian market.
Nevertheless, it was critical that BJ Russia not breach its
contract. In September 2008, BJ Russia informed TNK-BP of its
intention not to renew the contract; it would exit the
Russian market after BJ Russia fulfilled its contractual
letter dated October 21, 2008, the Russian Ministry of
Finance informed BJ Russia that it was not in compliance with
Articles 90 and 99 of the Civil Code of the Russian
Federation. Those provisions require a joint stock company,
such as BJ Russia, 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 Russian Law establishes a minimum level for
chartered capital. The Ministry 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. In the letter, the Ministry provided calculations
showing that BJ Russia's net assets were less than the
chartered capital minimum for both 2006 and 2007. Based on
these calculations, the Ministry determined that the Russian
"tax authority ha[d] the right to claim the
liquidation of the company through the court."
(underlining in original). The Ministry required BJ Russia to
provide by November 14, 2008, information regarding actions
taken to "improve [its] financial performance and
increase the net assets in 2008."
Russia responded to the Ministry in a letter dated November
13, 2008. In this letter BJ Russia stated that it "was
taking steps to improve the financial and economic activities
of the company and to increase the net assets in 2008"
but did not specify what these steps were. The issue in this
case is how to classify, for tax purposes, BJ Parent's
actions in response to the Ministry's letter.
Parent made wire transfers totaling $52 million to BJ Russia.
The transfer caused BJ Russia's net assets to be greater
than its chartered capital, and the transfer ended the risk
of liquidation. This transfer of funds was made as "Free
Financial Aid" ("FFA") under a provision of
the Tax Code of the Russian Federation. The finance manager
of BJ Parent's non-United States affiliates described FFA
as "just giv[ing] money . . . with no repayment
obligation, ever." Under the Russian Tax Code, assets
received by an organization from its majority shareholder
without consideration are exempt from a profit tax. According
to an email exchange between the BJ Parent finance manager
and BJ Parent tax counsel, BJ Parent considered a transfer of
funds via FFA as the most "tax efficient" way to
provide BJ Russia with the capital needed to satisfy the
net-asset requirements of Russian law. Had BJ Parent failed
to prevent BJ Russia's liquidation, BJ Parent estimates
that its losses would have been at least $160 million.
eligible for the tax exemption under Russian law, the FFA had
to be given on behalf of BJ Russia's majority
shareholder. BJ Russia and its majority shareholder, also a
subsidiary of BJ Parent, entered into an "Agreement on
Provision of Free Financial Aid" on November 26, 2008,
whereby BJ Parent would transfer funds in the form of FFA to
BJ Russia on behalf of the majority shareholder. The
agreement stated that "[t]he Shareholder confirms hereby
that its financial assistance is free and that it does not
expect [BJ Russia] to return the funds to the
Shareholder." The parties agree that BJ Russia had no
obligation to repay BJ Parent for the provision of the FFA.
The FFA was characterized in a BJ Russia shareholder meeting
as a "free capital contribution" from BJ Parent to
BJ Russia. BJ Russia used at least part of the $52 million BJ
Parent wired to BJ Russia to partially repay a loan from
another BJ Parent subsidiary. As a result of the FFA, BJ
Russia's net assets increased, resolving the
undercapitalization problem identified in the Ministry
Parent claimed the $52 million FFA provided to BJ Russia as a
"bad debt expense" on its United States income tax
return for fiscal year 2008. The Internal Revenue Service
("IRS") disallowed the deduction. The IRS stated
that BJ Parent failed to support that this transaction should
be considered a "bad debt or guaranteed debt" as
allowed by Section 166 of the Internal Revenue Code. Taxpayer
BJ Parent also had not shown that payment should be
deductible as an ordinary and necessary business expense
under Section 162 or entitled to a deduction under any other
section of the Internal Revenue Code. Instead, the IRS
considered the payment to be a capital contribution.
Hughes, as the successor in interest to BJ Parent, filed this
suit in the United States District Court for the Southern
District of Texas. It sought a refund for 2008 in the amount
of $17, 654, 000, plus interest. Baker Hughes alleged that BJ
Parent was entitled to a bad-debt deduction under 26 U.S.C.
§ 166 for the payment it made to BJ Russia. The district
court later permitted Baker Hughes to assert an ...