Financial company wins summary judgment on bad debt deductions

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A financial company seeking bad debt deductions on defaulted contracts has won partial summary judgment at the Indiana Tax Court.

Now-retired Tax Court Judge Martha Wentworth wrote the Thursday opinion in Indiana Finance Financial Corp. v. Indiana Department of State Revenue, 20T-TA-17.

The case involves Oak Motors Inc., a car dealership operator.

After it executed installment sales contracts to finance customer purchases, Oak Motors would sell its contracts and assign all rights and obligations to its affiliate, Indiana Finance Financial Corporation. Indiana Finance paid 65%-70% of the original amount financed for the contracts, meaning it received a 30%-35% discount.

Several Indiana Finance customers defaulted on their contracts, leading to repossession of the cars. The vehicles were then either sold at auction or directly back to Oak Motors.

On its 2017 and 2018 state and federal tax returns, Indiana Finance claimed a deduction for bad debts on the defaulted contracts. It also sought a refund on the state sales tax that Oak Motors paid to the Department of Revenue, which had become an uncollectible receivable for Indiana Finance following the defaults.

The Department of Revenue accepted Indiana Finance’s bad debt calculations reflecting the federal market discount treatment for installment payments but rejected the same treatment for the repossessed property, finding that Indiana Finance was required to reduce its unpaid balances in the default contracts by 100% of the value of that property.

“In other words,” Wentworth wrote, “the Department denied that part of Indiana Finance’s two refund claims that applied the Market Discount Rules to the Repossessed Property, thereby reducing the uncollectible amount by only 70%, rather than the full 100% of the Repossessed Property’s value.”

The department denied Indiana Finance’s subsequent protest as well as two supplemental refund claims. Consequently, it recalculated Indiana Finance’s adjusted tax basis by reducing the unpaid balances of its defaulted contract receivables by the full value of the repossessed property.

Then at a hearing in January 2020, the department determined Indiana Finance was not entitled to any relief.

Indiana Finance took the case to the Tax Court, challenging the denials of $163,044 in sales tax from its original refund claims and $258,584 in sales tax from its supplemental refund claims.

Both parties moved for summary judgment, which the Tax Court granted in favor of Indiana Finance only as to its original refund claims.

The question of the case, Wentworth wrote, is how the Indiana Bad Debt Statute — Indiana Code § 6-2.5-6-9 — treats repossessed property. Subsection (d) of the statute was at particular issue.

She pointed to Indiana Dep’t of State Revenue v. 1 Stop Auto Sales, Inc., 810 N.E.2d 686 (Ind. 2004), which held that an auto dealership could deduct only that portion of its receivables equal to the amount written off for federal income tax purposes because “the Legislature intended that only the net debt that is unable to be collected may be deducted.” That concept is known as the “net debt principle.”

She also pointed to SAC Finance, Inc. v. Indiana Department of State Revenue, 24 N.E.3d 541 (Ind. Tax Ct. 2014), known as SAC II, which held that the use of the Market Discount Rules to calculate the Indiana bad debt deduction prevents writing off more than what was actually paid for the uncollectible receivables.

“Acknowledging that its original refund claim calculations do not reflect a literal reading of Subsection (d) to exclude Repossessed Property, Indiana Finance insists its calculations reflect Subsection (d)’s spirit and intent, as recognized by this Court in SAC II, to follow the mechanics of IRC § 166 on all payments it received. Indiana Finance explains this interpretation is logical because it avoids the absurd result of reducing sales tax refunds by the market discount income portion of the Repossessed property,” Wentworth wrote. “The Court agrees. To find otherwise would set the Net Debt Principle on its head.

“Indiana Finance paid 70% of face value for the defaulted contracts,” Wentworth continued. “If the basis in those contracts were also reduced by market discount income (the profit from the transaction between Oak Motors and Indiana Finance), there is a substantial possibility that Indiana Finance would not receive a refund attributable to what it had paid.

“Accordingly, adjusting Indiana’s bad debt amount to subtract market discount income, amounts Indiana Finance never paid, is contrary to the Net Debt Principle.”

Alternatively, the Department of Revenue asked the Tax Court to overturn SAC II, but the Tax Court declined.

“… (T)he Department’s unsupported arguments and invitations to scrutinize the validity of Indiana Finance’s federal income tax calculations and deductions do not persuade the Court to overrule its own precedent and grant summary judgment to the Department,” Wentworth concluded. “Rather, the Court finds that Indiana Finance is entitled to summary judgment with respect to its original refund claims that calculated its bad debt deductions under the Indiana Bad Debt Statute for the years at issue by excluding only the portion of the Repossessed Property that was not market discount income.”

The case was remanded to the Department of Revenue.

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