Retailer can’t claim tax offset based on uncollectible debts

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The Minnesota Supreme Court recently ruled that a large home improvement retailer cannot claim a sales tax offset based on uncollectible debts from purchases made on its private label credit card. Menard, Inc., v. Comm’r of Revenue, 955 N.W.2d 284 (Minn. 2021). The home improvement retailer, Menard, attempted to offset its sales tax liability pursuant to Minnesota Statues § 297A.81, subd. 1. Section 297A.81 allows a taxpayer to offset against its current sales tax liability taxes “previously paid as a result of any transaction the consideration for which became a debt owed to the taxpayer that became uncollectible during the reporting period.” Minn. Stat. § 297A.81, Subd. 1.

The facts in this case were undisputed. Menard operates home improvement retail stores in Minnesota and other Midwestern states under the name of Menards where it sells home improvement products to retail customers. Menard entered into an agreement with Capital One, N.A. (“Capital One”) to offer its customers a private label credit card, the Menards BIG Card (“Menards Card”). Capital One solely determined who qualified for the Menard’s Card and the credit limit approved for each customer.

Capital One owned the cardholders’ accounts, collected the outstanding debt due, and had the exclusive right to receive all payments made by the cardholders. When a customer purchased merchandise from Menard on the Menards Card, the purchase price and sales tax was charged to the Menards Card and the buyer became indebted to Capital One for the total amount. Menard provided Capital One with daily data on what purchases were made on the Menard’s Card, and any associated sales tax charged. Capital One reimbursed Menard for the purchase price and sales tax, within a few days, less an agreed-upon discount fee based on returns and chargebacks. Menard then reported and paid the sales tax to the Minnesota Department of Revenue.

Pursuant to the parties’ agreement, Capital One agreed to share its financing income in the form of interest charges on account balances and late fee charges. In return, Menard agreed to accept a share of the net losses incurred from charge-offs and bankruptcy write-offs, net of certain recoveries that Capital one made. Capital One reduced the amount of financing income it paid to Menard by Menard’s share of the net program losses.

While Capital One deducted the delinquent account balances on its federal income tax returns as bad debts under I.R.C. § 166(a)(1), Menard did not. Instead, Menard claimed its share of the net program losses on the “other deductions” line on its federal tax returns. On its state tax filings, Menard claimed an offset against its current sales tax liability based on its share of the net program losses. The Minnesota Commissioner of Revenue (“Commissioner”) audited Menard and disallowed the sales tax offsets claimed by Menard on the basis that the bad debts belonged to Capital One, not Menard. The Commissioner assessed Menard with additional sales tax and interest.

Menard appealed the Commissioner’s assessment to the Minnesota Tax Court of Appeals (“Tax Court”) and both parties filed cross-motions for summary judgment on stipulated facts. The Tax Court granted the Commissioner’s summary judgment motion affirming the Commissioner’s assessment on the basis that there was no uncollectible debt owed to Menard. Menard appealed the Tax Court’s decision to the Minnesota Supreme Court.

The parties made several arguments to the Supreme Court. Menard claimed that it acted as a guarantor of bad debts of Capital One when it agreed to reduce its financing income by a portion of the net program losses. Menard argued that as a guarantor it was entitled to claim a bad debt deduction under federal law and, therefore, was entitled to claim an offset of its Minnesota sales tax liability for that same amount.

The Commissioner argued that as Capital One, not Menard, was the sole owner of the cardholder accounts and entitled to all payments on the accounts, there was no debt owed to Menard. The Commissioner also argued that because the agreement to share financing income and net losses did not result in a transfer to Menard of any ownership rights or responsibility for the cardholder debt it did not impose a guaranty obligation on Menard.

The parties agreed that the language of section 297A.81 was plain and unambiguous and that it allowed for a “current sales tax liability” to be “offset against a sales tax liability ‘previously paid as a result of any transaction the consideration for which became a debt owed to the taxpayer that becomes uncollectible’”. While it was undisputed that Menard paid the sales tax owed from transactions on the Menards Card to the Commissioner, it was also undisputed that Capital One had paid Menard for both the purchase price and the sales tax liability within days of the customer’s transaction. After that point, there was no debt owed to Menard and Capital One had the sole right to any funds collected from the customers. The court reasoned that it could not conclude that Menard had paid sales tax on a “transaction the consideration for which became a debt owed to” Menard but paid sales tax on transactions for which it was made whole by Capital One and Capital One owned the remaining debt.

Menard contended that the proper focus was not on Capital One’s ownership of the account indebtedness, but rather on Menard’s share of the net program losses. By sharing in the program losses, Menard claimed it “essentially guaranteed” a portion of the cardholder’s debts. Thus, as a guarantor, Menard argued that it was “eligible” to take a bad debt deduction under I.R.C. § 166 for its share of the net program losses and thereby able to claim an offset of the sales tax liability in the same amount under Minn. Stat. § 297A.81, subd. 1.

Menard did not, however, actually ever take a deduction under section 166 for the Capital One cardholder debt and, as the issue was not before the court, the court did not determine whether or not Menard was actually eligible for a section 166 deduction. It is notable, however, that the facts provide that Capital One deducted the full amount of cardholder account debt under section 166 on its tax returns and did not reduce the amount of the claimed deduction by the amount Menard claimed it was eligible to deduct under section 166.

The court disagreed with Menard’s argument that it was in effect a guarantor of the cardholder’s debt. The court reasoned that while the parties’ agreement allowed Menard to share in the profitability based on a formula that used both net profits and net losses, it was Capital One who was owed the debt by the cardholders. Capital One, not Menard, continued to own the cardholder accounts and all indebtedness, had the sole right to all customer payments on those accounts and was responsible for collecting on the accounts. Nothing in the agreement between Menard and Capital One provided that Menard guaranteed any portion of the cardholders’ debt and the court found that the record did not support that there was a guaranty.

In addition, the conduct of the parties also influenced the court’s decision. The court reasoned that if Menard was a guarantor of the debt, and Menard’s share of the net program losses paid that debt, then Capital One would not have any debt to deduct as Menard’s payment would have satisfied the debtors’ obligation. But in fact, Capital One deducted the total amount of the defaulted accounts as bad debts under I.R.C. § 166 on its income tax returns and did not reduce that amount by Menard’s share of the net program losses. The court relied upon a Fifth Circuit decision that explained that a guarantor can only claim a bad-debt deduction if, but for the guarantor’s payment of the underlying debt, the creditor could have claimed such a deduction. Baker Hughes, Inc., v. U.S. 943 F.3d 255, 260 (5th. Cir. 2019). If Menard was a guarantor, then its payment of the debt, in the form of a net payment calculated under the parties’ agreement, would have satisfied the debtors’ obligation and Capital One would not have had a bad debt deduction for the amount paid by Menard.

At first glance, the Menard case seemed similar to the Washington Supreme Court’s decision in Lowe’s Home Centers, LLC v. Dep’t of Revenue, 455 P.3d 659 (Wash. 2020) and Menard argued the court should follow the Lowe’s decision. Like Menard, Lowe’s entered into an agreement with various banks to issue its customers private label credit cards and the banks owned and administered the credit card accounts. The Washington Supreme Court held that because Lowe’s, as a guarantor, was eligible to claim a bad debt deduction under I.R.C. § 166, it could claim a sales tax offset under Washington’s bad debt statutes.

The court, however, found that the facts were distinguishable. The terms of the banks’ agreements with Lowe’s provided that Lowe’s was “responsible for Net Write-Offs,” that were defined as “bad debt guarantees.” The Lowe’s agreements also required the banks to subtract the amount that Lowe’s paid from the amount the banks could collect from the cardholders. Also, unlike Capital One, the banks in the Lowe’s case did not claim bad debt deductions under section 166 on their federal income tax returns for the repayments Lowe’s made to the banks; rather, Lowe’s deducted those bad debts. It was based on these facts that were materially different from Menard’s agreement with Capital One, that the Washington Supreme Court found that Lowe’s guaranteed a portion of the cardholder’s defaults.

The court determined that because Menard was not a guarantor, and did not essentially act as a guarantor, of the account holders’ debts that Menard was not owed an uncollectible debt that could be used to offset sales tax owed to the State of Minnesota. This was clearly a costly argument for Menard in the form of the additional tax payments and interest as well as the legal expenses incurred in bringing this matter to the Minnesota Supreme Court. Had the parties considered the tax consequences of the arrangement in advance, the agreement could have been structured differently and provided a basis for each party to claim the deductions they believed they were entitled to claim.

Karen Olson is of counsel at Spencer Fane LLP in Minneapolis.