Retailers May Recoup Sales Tax and Gross Receipts Tax on Bad Debts

A recent Washington Supreme Court ruling in favor of a taxpayer seeking a refund of sales and business and occupation (B&O) tax paid in connection with bad debts from defaulted private label credit card purchases, could be a refund opportunity for retailers with similar circumstances.

Many retailers sell goods or services on credit and a portion of these accounts may become uncollectible after sales tax has been remitted to the state tax authorities. For example, if a customer purchases goods from a retail store on credit, the state’s sales tax on the full purchase price of the goods is still due upon purchase. This means the retailer would pay the full purchase amount including sales tax up front regardless of whether a customer defaults on future payments. Fortunately, states allow a refund or credit to be taken when the account is written off as a bad debt for federal income tax purposes. However, states take different approaches when determining eligibility for a refund or credit because the requirements vary among states. In many cases, the issue becomes more complex when a retailer contracts with a third-party financing institution.

Defaulted Private Label Credit Card Purchases

A retailer scored a recent victory on this issue in Lowe’s Home Centers, LLC v. Washington Dept. of Rev., No. 96383-5 (Wash. Jan. 16, 2020). The Washington Supreme Court affirmed that the retailers are entitled to claim bad debt refunds on retail sales tax and B&O tax when its customers default on private label credit cards payments. The retailer, Lowe’s Home Centers, LLC (Lowe’s), contracted with banks that offered private label credit cards to the retailer’s customers. The banks offered credit to cardholders who purchased Lowe’s goods and would send full payment and related sales taxes to Lowe’s within two days of a credit purchase. Lowe’s then remitted the taxes to the Washington Department of Revenue (DOR). Although the banks assumed most of the risk concerning defaulting cardholders, Lowe’s contracted to mitigate this risk by acting as guarantor. Lowe’s agreed to reimburse the banks when credit card holders defaulted on the payments, up to a 7% cap. As such, Lowe’s claimed bad debt deductions on its federal income tax returns and filed a refund claim on overpaid retail sales tax and B&O tax with the DOR.

Under Revised Code of Washington (RCW) 82.08.037, sellers are entitled to a credit, refund, or deduction for sales tax or B&O tax previously paid on “bad debts” under Internal Revenue Code Sec. 166. There are four requirements which include: a taxpayer must 1) be a seller 2) be making sales at retail 3) be entitled to a refund for sales taxes previously paid on a bad debt and 4) have a bad debt that is federally deductible. At issue in the case was whether Lowe’s was entitled to a refund of sales and B&O taxes related to the reduced profit share as a result of meeting its obligation as a guarantor of the bank’s bad debt.

The DOR argued that the retailer’s profit-sharing agreement did not satisfy Washington state’s statutory definition of “bad debts” because Lowe’s no longer held debt “directly attributable” to its B&O or sales tax payment to the DOR. However, the court noted that the term “directly attributable” did not exist in the statute. Moreover, a seller making a credit sale to a customer who later defaults on payments would have remitted sales tax to the state that it could not recover from a customer. Because Lowe’s agreed to act as a guarantor of the debt obligation and made payment of principal or interest in discharge of that obligation as a guarantor, that payment is treated as a debt becoming worthless in the taxable year in which payment was made, the court found. As a result, the court concluded that Lowe’s qualified for the bad debt deduction for federal tax purposes and should also qualify for Washington tax purposes.

The Washington high court ruled for the taxpayer because Lowe’s arrangement as a guarantor to reimburse losses incurred from defaulting customers demonstrated that Lowe’s is still the seller burdened with the loss, despite third-party involvement. The court held Lowe’s was entitled to the bad debt deduction and qualified for a refund of overpaid B&O and sales taxes from the DOR.

Assignability of the Bad Debt Deduction or Refund

Previously, retailers were not prohibited from assigning the right to a bad debt deduction related to defaulted payments on finance contracts. But in 2010, the Washington State Legislature amended its bad debt statute (RCW 82.08.037) to specify that the seller has the right to claim a credit or refund only if the original seller in the transaction that generated the bad debt has sold or assigned the bad debt contract to a third party with recourse. The original seller may claim a credit or deduction after the financing contract is reassigned by the third party to the original seller. However, there are other states that allow the retailer to assign the right for a refund without the recourse clause in the contract.

The Takeaway

Although the decision in the Lowe’s case is specific to Washington, retailers should be aware of refund opportunities that exist for sales tax paid in connection to bad debts. Depending on the facts and circumstances, retailers may be entitled to a refund of sales tax paid in connection with defaulted payments on financing contracts. Retailers offering financing arrangements will need to carefully analyze various state statutes and their financing contract structure to qualify for a bad debt refund on sales tax paid. In addition to determining whether a business has a guarantor arrangement or assignment of right as a retailer or third-party financial institution, businesses operating in multiple jurisdictions may also need to apportion bad debts at the state and local level. Furthermore, businesses should be explicit about their financial information and contract agreements they have with other parties to maximize sales tax and gross receipts tax deductions or refund opportunities. Andersen will continue to monitor state guidance on the issue and will provide updates when available.