In Lowe's Home Center,¹ the Washington Supreme Court (Court) reversed an appellate court in holding that a retailer is entitled to a refund of sales tax and business and occupation tax (B&O) paid on uncollectible debts from private-label credit cards (PLCCs) when the retailer contractually guaranteed the debt up to a certain percentage of sales.

The Court's ruling creates a refund opportunity for retailers with comparable facts.

Background

Lowe's Home Center, LLC (Lowe's) entered into contracts with two banks to offer PLCCs to Washington customers. Following the credit card purchase, the banks sent full payment and related sales taxes to Lowe's, which then remitted the tax to the Washington Department of Revenue (DOR). Although the banks undertook most of the risk of defaulting credit card holders, Lowe's mitigated the risk to the banks by guaranteeing the debt up to a certain percentage of sales. Specifically, as guarantor, Lowe's was contractually obligated to pay a fee of up to 7% of the average net credit card receivable to cover the banks' losses from uncollectible debts.

On its federal income tax returns, Lowe's claimed a bad debt deduction under IRC Section 166 equal to the 7% reduction in profit.

Washington requirements

Washington sales tax law, like many other state laws, allows a deduction for sales tax related to bad debts. To qualify for a sales tax refund on bad debts under RCW Section 82.08.037(1), which was in effect for the tax years at issue,² all the following conditions must be met:

1. The taxpayer is a seller
2. The taxpayer makes retail sales
3. The taxpayer is entitled to a refund for sales tax previously paid on bad debts
4. The bad debts are deductible for federal income tax purposes

The DOR agreed that Lowe's satisfied the first and second requirements.

To qualify for the third requirement, Lowe's argued that its contractual payments to the banks covering the banks' losses qualified as "sales taxes previously paid." The Court agreed, reasoning that Washington law does not require the paid tax to be "directly attributed" to the sale, as the DOR argued. Because Lowe's remitted tax from a retail sale and guaranteed the banks for unpaid sales tax, the Court found the third requirement satisfied.

To satisfy the fourth requirement, Washington requires the worthless debts to be deductible for federal income tax purposes.³ The Court determined that Lowe's satisfied the fourth requirement because the contractual guarantee it provided to the banks subjected Lowe's to an enforceable legal duty for the payment that is "treated as a business debt becoming worthless in the [tax] year in which the payment is made" under IRC Section 166(a)(1).

Bad debt cases distinguished

The Court distinguished its ruling in Lowe's from the Washington Court of Appeal's ruling in Home Depot⁴ on the basis of fact. In Home Depot, the financier and the retailer agreed that the financier was the exclusive owner of the credit card accounts and bore the total risk of loss on the accounts. The Home Depot court acknowledged that Home Depot paid the bank a "service fee." The service fee, however, did not qualify as a bad debt deductible under IRC Section 166, so Home Depot did not meet the third and fourth prongs of the bad debt deduction requirements under the Washington statute. Unlike the situation described in the Home Depot opinion, Lowe's was subject to specific contractual language requiring it to guarantee the accounts. Because this guarantee qualified as a bad debt eligible for deduction under IRC Section 166, the Court concluded that Lowe's qualified for the sales tax bad debt deduction.

B&O tax refund

The Court also found that Lowe's qualified for the bad debt deduction for B&O taxes on retail sales under RCW Section 82.04.4284 because, "similar to its 'sales tax' payments, Lowe's incurred bad debt." RCW Section 82.04.4284(1) states, "In computing tax, there may be deducted, from the measure of the tax, bad debts, as that term is used in 26 U.S.C. [Section]166 … on which tax was previously paid." Using the same reasoning for sales tax purposes, the contractual guarantee for worthless payments qualified as a bad debt under IRC Section 166 for purposes of claiming a B&O tax refund.

Implications

To the extent that a taxpayer has facts similar to those addressed by the Court in the Lowe's ruling — namely, it is subject to contractual provisions that fall within the definition of a bad debt eligible for deduction under IRC Section 166 (e.g., guarantor of private label/co-branded credit card loss) — refund opportunities may exist for the amount written off as bad debt for both Washington B&O and sales tax purposes. The statute of limitations for filing refund claims in Washington is four years for both sales and B&O tax purposes.

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ENDNOTES

¹ Lowe's Home Centers, LLC v. Wash. Dept. of Rev., No. 96383-5 (Wash. Jan. 16, 2020).

² RCW Section 82.08.037 was amended in 2010 to overturn the Court's decision in Puget Sound National Bank v. Dept. of Rev., 123 Wn.2d 284 (1994), which affirmed the authority of a third party to take the bad debt deduction on assigned debts. Specifically, the state law amendment prohibits third parties that assume debt from taking the bad debt deduction. Because Lowe's did not assign its rights to a third party, the 2010 legislative changes to RCW Section 82.08.037 are not relevant.

³ IRC Section 166(a)(1) allows a deduction for "any debt [that] becomes worthless within the [tax] year." It permits a deduction for "bad debts owed to the taxpayer" and states that, for this purpose, bad debt shall be taken into account as a deduction for debts that become worthless. Treas. Reg. Section 1.166-1(a).

⁴ Home Depot USA, Inc. v. Wash. Dept. of Rev., 215 P.3d 222, (Wash. Ct. App. Aug. 25, 2009).