The Arizona Superior Court denied Home Depot a bad debt deduction related to customer credit card transactions. Home Depot USA Inc. v. Arizona Department of Revenue, TX 2006-000028 (Dec. 10, 2010). The court reviewed three conditions that must be met under Arizona law in order for a bad debt to be deducted: 

  1. The transaction upon which the bad debt deduction is being taken was reported as taxable;
  2. The debt arose from a debtor-creditor relationship based upon a valid and enforceable obligation to pay a fixed or determinable sum of money; and 
  3. All or a portion of the debt is worthless. Id.

In determining whether Home Depot could claim the deduction associated with its private label credit card transactions, the court relied on a decision of the Arizona Appeals Court and interpreted the first and second conditions as  limited only to those persons who made the sale and originally reported the tax. Id. (DaimlerChrysler Services North America, LLC v. Arizona Dep’t. of Revenue, 210 Ariz. 297, 302 (Ariz. App. 2005)). While Home Depot made the sales and reported the tax, it did not incur the bad debt directly. The finance company paid Home Depot the amount of each transaction, less a negotiated percentage that included the overall cost of bad debt for all transactions.

Home Depot argued that it and the finance companies that administer the private label credit cards acted as a unit, which entitled Home Depot to the deduction. This argument failed because the record reflected an arm’s length business transaction between Home Depot and the finance companies. Also, Home Depot claimed that the denial of the deduction would result in unjust enrichment to the state because the finance company was also denied the deduction. The court was not persuaded and instead focused on whether Home Depot was “impoverished” by the denial of the deduction. The court held that, under the terms of the transaction with the finance companies, Home Depot was not impoverished but would instead get a windfall if the deduction were allowed. Lastly, Home Depot’s equal protection claim failed because the court did not find it unreasonable to limit the deduction for a bad debt transaction to the party who actually incurred the loss from it. The fact that no party would ever be able to claim the bad debt deduction for sales tax amounts that had been paid to the state by the retailer, but never received from the purchaser, was irrelevant to the court. Although it is the Arizona courts’ interpretation of the state’s bad debt deduction requirements, rather than the plain language of the statute, that resulted in the denial of the deduction in this case and the failure of any party to be able to claim the deduction, the court passed the buck and referred this “policy decision” to the legislature.

The Arizona decision follows similar cases in other jurisdictions over the last two years. Courts in Alabama, Ohio, South Carolina, and Washington have all ruled that a retailer could not take a bad debt deduction for payments made through a third-party finance company’s credit card.  Even when courts ruled in favor of the retailers, as in Michigan and Washington (under an earlier law), the legislatures later overturned the court decisions through new statutory provisions. 

In these cases, taxpayers have tried almost every statutory interpretation argument they can make, and the arguments have all fallen on deaf ears. It is unclear when these bad debt deductions would now apply, because the courts’ interpretations have eviscerated all meaning from the deduction provisions. This is bad tax policy because it unjustly enriches the state; the purchases are ultimately not being paid for and the state should not be entitled to the tax from the retailer or the finance company when the tax is never paid to them.

While the discussion above focuses on the plight of retailers, the finance companies on the other side of the transactions have fared no better. On January 18, the U.S. Supreme Court denied a petition for certiorari in Ford Motor Credit Co. v. Dep’t of Treasury, letting stand a Michigan Court of Appeals decision holding that a finance company could not take a bad debt deduction for sales taxes associated with auto loans in default because it did not remit the sales tax to the state. This denial comes on the heels of a similar decision in California. HSBC Retail Servs. v. State Bd. of Equalization, CA A125995 (Cal. App. Nov. 18, 2010).