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March 4, 2014

2014-Issue 9—Today, we are finding more and more tax departments are party to one or more tax sharing agreements with a non-related party. Whether there was a spin-off from another affiliated group, an equity sale or even a sponsored IPO with a tax receivable agreement in place, today, tax sharing agreements are more common than not. Some of the tax departments don’t realize they are a party to a tax sharing agreement, while others know about them generally, but don’t know the obligations or requirements under the agreements — they are in a file somewhere. Those agreements are bombs waiting to detonate.

Often they don’t. Maybe no dispute arises under the tax sharing agreements because both parties to the agreement have similarly forgotten about them. Or maybe historical liabilities are not changed and no other items were managed, and so they just expire without any fanfare.

But what if the other party has not forgotten? What if someone finds the agreement after the office move, or when the new VP of tax takes office? What if there are items that do change? What if “purchased” attributes are used or historical positions are challenged? What if the relationship of the parties has soured or if their financial condition has changed and they are looking for sources of cash? Any of these issues could lead to an inquiry into the other party’s conduct under the tax sharing agreement.

At a high level, and as we have discussed previously, tax sharing agreements are designed to manage an item or items (including historical tax liabilities, use of consolidated attributes, economic responsibility for certain tax contingencies and even the payment for economic benefit of attributes taken from another party) between related parties or non-related parties that were related at one point in time. They are either potential assets or liabilities to one of the parties to the agreement and likely have a reporting or a review obligation as well. Because of their potential to have a material impact on financial statements or even a company’s cash position, it is wise to approach your conduct under a tax sharing agreement with the right constituents on your team — tax, legal and accounting at a minimum. This is no time for spontaneous dancing around the tax sharing agreement by anyone on the team. Choreography of conduct is required.

Choreography of Conduct

Establish your asset or liability exposure. Let’s assume your tax department is operating under a tax sharing agreement that in your mind can only present a liability for your company. You are either economically responsible for past taxes or are providing an indemnity for some particular contingent tax due to a transaction. You might even owe a former parent for use of an attribute or a step-up provided as part of the “separation” transaction. Whatever the reason, if you are in a liability position, first, be sure you are in a liability position. Is there any set of facts that could also throw you into an asset position? Even if it just happens to net down your ultimate liability, be sure that all aspects of the tax calculations required and possible positions have been taken into account.

Review reporting obligations under the tax sharing agreement. What are your obligations to report your tax positions to the other party? Understand them completely. Do they require reporting after tax returns are filed? Maybe you have to report after the statute of limitations runs. Is there a “with and without” calculation required? What about audits or notice of audits? Establish a known process to report to the other party in a proper format and on a timely basis. More importantly, establish your positions early and remain consistent in how you present your data to the other party. You are an advocate for your company, but remember to act in good faith under the agreement. There is likely an express provision requiring good faith and fair dealing, and most state laws have a similar statute or equitable laws requiring good faith in dealing in the absence of express provisions in the tax sharing agreement.

Coordinate with the appropriate legal and financial reporting team. An estimate of your rights or obligations (assets or liabilities) under a tax sharing agreement should be considered in the GAAP income tax provision, legal reserves and long-term commitments and contingencies disclosures at a minimum. Do you really have a net operating loss (NOL) for your benefit, or does the economic benefit belong to another party? Do you reserve it for financial statement purposes? Do you set up a contingent payable to the other party? You should also review with your legal department any determination under the tax sharing agreement of contingent assets and liabilities that you are calculating prior to making any GAAP entries or disclosures. Certainly, you should do this before disclosing any potential liability or asset to the other party under the tax sharing agreement. All of you should work with the financial reporting team to be sure you are disclosing enough to discharge your GAAP responsibilities. Even in a situation where there are no disputes, having this process in place will be valuable if a dispute develops later. The legal team will want to do their best to establish any privilege possible if litigation is a possibility. The point is, it’s better to have them involved upfront while there are no problems. Trying to fit prior actions into your litigation position (or a claim of privilege) is not the best course of action.

Beware of the unforeseen. Unforeseen situations that are not expressly provided for in the tax sharing agreement can affect how the parties operate under the agreement. Bankruptcy is a good example of an unforeseen situation that is usually not addressed in the tax sharing agreements. Why, you ask? Easy: it’s too complicated to figure out unless you are in the “zone of insolvency” and have been estimating the potential cancellation of debt, related attribute reduction, change of control (and its bankruptcy exceptions), duplicated loss rules, etc. Other unforeseen items could include acquisition by another affiliated group or entry into business that impacts items under the agreement, etc. The point here is when unforeseen events arise, the tax, legal and financial reporting team need to reconvene and discuss how the events might change your mind on the potential liability, calculations and disclosures under the agreement.

Consider regulatory implications. Some companies are affiliated with regulated entities or perhaps even party to a tax sharing agreement with a regulated entity. Often the tax accounts and accounting are structured to reasonably give the regulated entity as much credit for taxes as possible as early as possible so as to bolster Tier 1 capital. Deferred taxes are generally not included in Tier 1 capital, so often unregulated affiliated entities pay cash (currently settle) to the regulated entity for all of its tax attributes, whether they are currently used or deferred (excess credit position, not the right amount of consolidated appetite, etc.). The Federal Deposit Insurance Corporation (FDIC) has a policy on income tax allocation agreements (see Financial Institution Letter 124-98, Intercorporate Income Taxes, November 24, 1998). It generally requires that the regulated entity be treated on a stand-alone basis and actually receive any refunds that the parent or non-regulated affiliate might receive on behalf of the regulated entity. It also was recently amended to clarify that refunds received on behalf of a regulated entity are held in trust for the regulated entity and that the entity receiving the refund from the IRS receives it as agent for the regulated entity (to the extent of the regulated entity’s stand-alone refund amount). See Financial Institution Letter 61-2013, December 20, 2013. The point is to be aware of changes to your tax sharing agreements if they are with regulated entities. Also, don’t let your conduct with regulated entities affect your conduct under other agreements that don’t involve regulated entities. It’s a double-edge sword that might change how you deal with the non-regulated entities. Just consider it.

Alvarez & Marsal Taxand Says:

Tax sharing agreements are more common than not today. Consistent treatment, full disclosure telling the story you want to tell and proper GAAP reporting under the agreement will put you in the best light if a dispute arises. It’s not a waste of time to scenario-play for contingencies that aren’t provided for under the agreement (like bankruptcy, etc.) to understand how your positions might change. Whether you are impacted by regulated entities or not, the law concerning tax sharing agreements is developing and taking a front seat in regulated (and bankruptcy) matters. Stay on top of the law affecting these agreements. Work together with your legal and accounting team to be sure all aspects of the tax sharing agreement are considered for legal reserves, commitments and contingencies, and other disclosures. By doing your work contemporaneously and in concert with each other, your choreography of conduct should produce the best and most defendable positions under your tax sharing agreements.

For More Information:

Robert J. Filip
Managing Director, Seattle
+1 206 664 8910

Charles Henderson IV
Managing Director, Atlanta
+1 404 720 5226

Tyler Horton
Managing Director, Washington DC
+1 202 688 4218

Sean Menendez
Managing Director, Miami
+1 305 704 6688

Mark Young
Managing Director, Houston
+1 713 221 3932

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As provided in Treasury Department Circular 230, this publication is not intended or written by Alvarez & Marsal Taxand, LLC, (or any Taxand member firm) to be used, and cannot be used, by a client or any other person or entity for the purpose of avoiding tax penalties that may be imposed on any taxpayer. 

The information contained herein is of a general nature and based on authorities that are subject to change. Readers are reminded that they should not consider this publication to be a recommendation to undertake any tax position, nor consider the information contained herein to be complete. Before any item or treatment is reported or excluded from reporting on tax returns, financial statements or any other document, for any reason, readers should thoroughly evaluate their specific facts and circumstances, and obtain the advice and assistance of qualified tax advisors. The information reported in this publication may not continue to apply to a reader's situation as a result of changing laws and associated authoritative literature, and readers are reminded to consult with their tax or other professional advisors before determining if any information contained herein remains applicable to their facts and circumstances.

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