CERTIFIED PUBLIC ACCOUNTANTS
 
FRAUD EXAMINERS  
 
RESTRUCTURING ADVISORS

 

News

Delaware Court Provides Guidance Regarding Tax-Sharing Agreements

June 2, 2015 | By Simon E. Fraser (Cozen O'Connor) | American Bankruptcy Institute

A consolidated group of entities will often enter into a tax-sharing agreement in order to simplify their interactions with taxing authorities. In general, tax-sharing agreements (TSAs) provide that the parent entity will act on the others' behalves by filing consolidated returns, remitting aggregate payments from the group and receiving refunds on behalf of one or more members of the group. The language of each particular TSA governs the members' various rights and duties within the group, including the duties of the parent to remit tax refunds to the rightful group member.

When the parent in a tax-sharing group becomes a bankruptcy debtor, a dispute might arise over the estate's ownership rights in tax refunds under the sharing agreement. As a recent Delaware bankruptcy court opinion illustrates, the exact wording of the agreement can have significant consequences regarding what entity will be deemed the owner of the refunds in the bankruptcy context.

BACKGROUND

In Giuliano v. FDIC (In re Downey Financial Corp.), the debtor was a nonoperating holding company and was party to a TSA with its affiliates, including its nondebtor subsidiary (the "subsidiary"), a defunct bank that at all relevant times was being overseen by the Federal Deposit Insurance Corp. as receiver (the "FDIC-R"). Under the TSA, the debtor acted on behalf of the other group members by filing consolidated returns, making group payments and receiving and disbursing refunds.

After the debtor's bankruptcy case began, the appointed chapter 7 trustee filed various federal income tax returns pursuant to the TSA, which yielded a tax refund of approximately $373 million resulting from the carry-back of the subsidiary's net operating loss. Pursuant to the TSA, the debtor was to receive all refunds in the first instance, then disburse the refunds to the appropriate members of the group, acting essentially as a clearinghouse. Relying on this fact, the trustee asserted that the debtor's estate was the rightful owner of the refund because the government would pay the refund to the estate in the first instance.

The FDIC-R challenged the trustee's right to the refund, arguing that because the refund was attributable to the subsidiary's operating losses, it was property of the subsidiary as opposed to the debtor. Although under the TSA the debtor has the right to receive the refund in the first instance, the FDIC-R argued that the debtor cannot actually accede to full ownership rights in the refund. Rather, the debtor should be considered to hold the refund in trust for the subsidiary. Accordingly, the FDIC-R argued, the refund should be paid over to the subsidiary in its entirety.

The trustee did not deny that outside of bankruptcy, the debtor would have an obligation pursuant to the TSA to transfer the refund to the subsidiary. However, the trustee asserted that in the context of the debtor's bankruptcy case, this obligation took the form of a mere general unsecured claim in favor of the subsidiary for the amount of the refund - entitled to only a pro rata distribution. The trustee reasoned that pursuant to the TSA, the debtor's estate acceded to full ownership of the refund and that the debtor's obligation to remit the refund to the subsidiary under the TSA merely gave rise to the debtor/creditor relationship, as opposed to a trust relationship, between the debtor and subsidiary. The trustee commenced an adversary proceeding seeking a declaratory judgment that the debtor's estate was the owner of the refund and that the subsidiary was entitled only to a general unsecured claim for the amount of the refund.

SUMMARY OF THE HOLDING

On cross motions for summary judgment, the bankruptcy court held that the debtor's estate was the owner of the refund, and that the subsidiary was entitled to only a general unsecured claim against the estate for the amount of the refund.

ANALYSIS

The Court Analyzed the TSA

The outcome turned on whether, under the TSA, the debtor acceded to full ownership of refunds in its possession (giving rise to a debtor/creditor relationship between the debtor and the ultimate payee of the refund), or whether the debtor held refunds in trust for the ultimate payee. If the answer was the former proposition, then the subsidiary would have only a general unsecured claim in the debtor's bankruptcy case. If it was the latter, then under 541(d) of the Bankruptcy Code, the debtor would be considered to hold no equitable interest in the refund and would have a duty to convey the refund to the subsidiary in its entirety.

The court found that the TSA was unambiguous and therefore began its analysis by explaining that the plain language of the TSA controlled the nature of the debtor's interest in the refund. The court set out the following three-part test to determine whether a given TSA creates a debtor/creditor relationship between the initial recipient of a refund and the ultimate payee, as opposed to a trust or other sort of relationship:

"The three factors are whether (1) the TSA creates fungible payment obligations among the parties; (2) there are no escrow obligations, segregation obligations nor use restrictions under the TSA; and (3) the TSA delegates the tax filer under the agreement with sole discretion regarding tax matters."

If the answers to the three factors are affirmative, then a court should find that a debtor/creditor relationship with respect to refunds exists between the parties under the particular TSA.

Beginning its analysis with the first factor, the court stated that "courts have repeatedly found that the use of such terms as 'reimbursement,' or 'payment' in a tax-sharing agreement evidences a debtor-creditor relationship. The reason is that such terms create 'ordinary contractual obligations ...'" Examining the TSA, the court stated that "the TSA creates a system of intercompany 'payments' and 'reimbursements' that [might] differ materially from the amount of any tax refund actually received by [the subsidiary]." The court noted that the TSA provided that "[i]n the case of a refund, [the debtor] shall make payment to each [group] member for its share of the refund ... within seven (7) business days after the refund is received by [the debtor]," and goes on to provide that the debtor "shall have the right, in its sole discretion ... to determine whether any refunds to which the consolidated group [might] be entitled shall be paid by way of refund or credited against the tax liability of the consolidated group."

Relying on the TSA's use of the terms "payment" and "reimbursement", as well as the fact that the debtor had discretion in either remitting or crediting refunds to group members, the court held that the TSA created fungible payment obligations among the parties with respect to refunds and, therefore, that the first factor of the test favored a holding that the TSA created a debtor/creditor relationship, as opposed to a trust relationship, between the debtor and subsidiary.

In regards to the second factor, the court stated that other "courts have repeatedly found that the lack of provisions requiring the parent to segregate or escrow any tax refunds and the lack of restrictions on the parent's use of the funds while in the parent's possession further evidences a debtor/creditor relationship." Examining the TSA, the court found that it "contain[ed] no escrow provisions, segregation requirements or restrictions on [the debtor's] use of any tax refund ...," that it imposed no duties on the debtor to keep any refunds in trust, and that the debtor had complete dominion over any refunds in trust, and that the debtor had complete dominion over any refunds in its possession until it paid them over to the appropriate member of the group. Accordingly, the court found that the second factor favored a holding that the TSA created merely a debtor/creditor relationship between the parties.

Finally, the court examined the third factor, which "is whether contractual provisions give a 'parent sole discretion to prepare and file consolidated tax returns and to elect whether or not to receive a refund. '" Again examining the plain language, the court stated that the TSA gave the debtor "sole discretion over (1) the manner in which tax returns are prepared and filed, (2) whether any tax refund should be paid or credited against future tax liability, and (3) how to resolve disputes with the taxing authorities." The court found that the TSA "does not subject [the debtor] to the direction or control of any member of the [group] and does not establish a principal-agent relationship between the members of the [group] and [the debtor]." Accordingly, the court held that the third factor favored a holding that the TSA created merely a debtor/creditor relationship between the parties.

Having found that all three factors of the test favored a debtor/creditor - as opposed to a trust - relationship between the debtor and subsidiary, the court held that the debtor's bankruptcy estate should be considered to "own" the refund. The court also stated that the subsidiary had but a general unsecured claim against the estate for the amount of the refund.

THE COURT DISTINGUISHED TWO ELEVENTH CIRCUIT DECISIONS

In the two months prior to the U.S. Bankruptcy Court for the District of Delaware's decision in Downey Financial, the U.S. Court of Appeals for the Eleventh Circuit issued two separate decisions in which it analyzed tax-sharing agreements similar to the TSA in the context of the parent entities' bankruptcies, and reached the opposite conclusion from the Delaware bankruptcy court (i.e., the TSAs at issue should be interpreted as requiring the parents to hold refunds in trust for the ultimate payees). Accordingly, in those cases the Eleventh Circuit held that the parents/debtors did not own the refunds and that the refunds were instead the property of the nondebtor subsidiaries.

The Delaware court's Downey Financial opinion distinguished these two Eleventh Circuit decisions. First, in BankUnited , the TSA at issue provided that the nondebtor subsidiary, as opposed to the parent/debtor, was obligated to distribute refunds to the appropriate group members, even though the parent/debtor was to receive all of the refunds from the government in the first instance. The agreement simply assumed that the parent would immediately transmit all of the refunds to the subsidiary upon payment by the government and provided that the subsidiary was liable to the other members for each member's rightful refund. It was principally for this reason that the court of appeals found that the parties' intent was for the parent to act merely as an agent in shuttling refunds from the government to the subsidiary. Accordingly, the debtor/parent in BankUnited, as a mere agent for the refunds' rightful owners, never acceded to "ownership" of the refunds.

In contrast, the Delaware court explained that under the TSA, the debtor (i.e., the parent itself) was tasked with distributing refunds to the other group members. In making this distinction, the court appeared to regard the duty to perform the act of apportioning and distributing refunds among the group as an indicium of "ownership."

Next, the Delaware court distinguished the Eleventh Circuit's NetBank decision by noting that the TSA in that case contained references to the parent acting in an agency capacity with respect to refunds ultimately payable to other group members. In contrast, the TSA did not refer to the debtor as acting as an "agent" or in any similar capacity.

In addition, the Delaware court noted that the court of appeals in NetBank had looked beyond the plain language of the sharing agreement to the "Interagency Statement on Income Tax Allocation in Holding Company Structure" (the "policy statement"), to which the sharing agreement at issue had referred. The policy statement "counsels against entering into a tax allocation agreement that would grant ownership to the parent of refunds attributable to the [subsidiary]." The sharing agreement in NetBank, the Delaware court explained, contained a provision stating that "[t]his Agreement is intended to allocate the tax liability in accordance with [policy statement]..." Based on this reference, the court of appeals in NetBank inferred that the parties' intent was to follow the policy statement's advice against allowing the parent to accede to ownership of refunds in its possession.

In contrast, the Delaware court noted that the TSA made no mention of the policy statement. From this silence, the Delaware court inferred that the parties were indifferent to the policy statement's counsel against parent ownership of refunds.

THE SIGNIFICANCE OF THE DECISION

The Delaware bankruptcy court's decision in Downey Financial shows the importance of using very specific language in drafting TSAs. If subsidiaries wish to protect their rights to refunds under a TSA in the event that the parent becomes a debtor in bankruptcy, they should ensure that their agreements are clear and explicit in providing that the parent holds all of the refunds in trust for the particular group member to which the refund is ultimately due, and that the parent never accedes to ownership of refunds.

Schedule a Consultation

All of GMCO’s members, managers, and staff discover innovative solutions to direct your business toward success.

learn