Article featured on Thomson Reuters' Taxnet Pro, June 2020

The world has changed significantly over the last few months due to the economic disruption caused by COVID-19. As a result, businesses need to reevaluate their existing policies and agreements on sharing of U.S. income taxes between members of a corporate group. In a growing economic environment, these policies and agreements may not have had a great deal of economic importance. But, based on the recent change in the economy, and the change in law regarding the ability to claim federal income tax refunds, these policies and agreements may become significantly important. 

When a group of corporations file a federal consolidated return, the IRS generally issues any consolidated tax refund to the parent of the group. It is then up to the group members (taking into account contractual arrangements and corporate law) to determine which member is entitled to the asset. Similarly, if a parent corporation engages in business through a disregarded entity or partnership, the refund would be issued to the parent corporation. 

Many groups of corporations that file a consolidated or combined income tax return have a tax sharing agreement or policy (TSA). These agreements sort out which members of the group are responsible for paying the consolidated or combined tax liability, and which members will receive the benefits of any refund. Some agreements even cover what happens when one member with profits uses the tax attributes (e.g., a net operating loss) of another member. More information on TSAs can be found at Tax Sharing Agreement and Tax Sharing Agreement: Choreography of Conduct.

Before 2018, corporations were able to carry back net operating losses (NOLs) two taxable years (and in some cases ten taxable years) for a refund. The ability to carry back NOLs was repealed by the so-called Tax Cuts and Jobs Act (TCJA). Recently, the CARES Act restored the ability to carry back NOLs (but only for NOLs generated in 2018 through 2020 taxable years). These temporary rules allow corporations to carry back NOLs up to five taxable years. 

Several other provisions (separately or in conjunction with the change in the NOL carryback rules) could result in significant refunds for some companies. The “retail glitch” was fixed retroactively to 2018, allowing companies to increase their depreciation deductions for qualified improvement property. The CARES Act also generally increased the limit on the deductibility of business interest from 30 percent of adjusted taxable income to 50 percent for 2019 and 2020 taxable years. Although not a recent change, 100 percent bonus depreciation is still generally available for new and used machinery and equipment purchased before January 1, 2023.

Based on the change in the economy, all companies have to consider the possibility of having to restructure their debt obligations. In recent years, debt financing arrangements have become more complicated. There are many more situations now where a parent corporation owes money to one group of creditors and one or more subsidiaries owes money to a different group of creditors. As a result, there will be many situations where various parties will need to negotiate issues related to the ownership of a consolidated tax refund (and as to ownership of a refund between a corporation and a wholly-owned LLC, which is generally disregarded as separate from its owner for U.S. income tax purposes). 

Based on this new environment (of a shaky economy) and availability of tax refunds, disputes as to ownership of a tax refund (or use of tax attributes) are inevitable. Groups of multiple companies should revisit their existing TSAs. It is important in this environment to establish if a TSA exists (whether in contractual form or as a statement of policy). If one does exist, diligence should be performed as to whether the TSA has been consistently followed. If a group discovers that there is no TSA or it has not been consistently followed, steps should be taken to rectify any blemishes early in the process. Ideally this would take place before a liquidity event occurs and before any tax refund is received (or claimed). 

Rodriguez v. FDIC

In the last 50 years, the ownership of a consolidated tax refund has become a major source of litigation. Potential claimants include creditors, affiliates, and shareholders. Currently, there is uncertainty in the law as to how to interpret TSAs and what to do when there is no TSA (or the TSA had not been consistently applied). 

Before this year, a case typically referred to as Bob Richards (In re Bob Richards Chrysler-Plymouth Corp., 473, F2d 262 [9th Cir.], cert. denied, 412 US 919 [1973]) was an important tool widely used by courts in helping to decide ownership of tax refund cases. The courts, in many instances, applied federal common law concepts to decide ownership of tax refund cases. Under Bob Richards, if one company had an NOL that was carried back to offset that same company’s income, that company was entitled to the refund. The doctrine was less clear in other circumstances.

On February 25, 2020, the U.S. Supreme Court in Rodriguez v. FDIC, 140 S.Ct. 713 (2020), repealed the Bob Richards doctrine and ended the practice of determining the ownership of a tax refund based upon federal common law. The decision of the Supreme Court was unanimous. Hereafter, the ownership of tax refunds will generally be determined based upon state corporate and contractual law. For more details on Rodriguez, click here.

Although Bob Richards was an imperfect and limited tool, now the courts don’t even have that. Where settlement negotiations fail, bankruptcy and other courts are likely going to have to make determinations of state law (and in certain situations, have to decide which state’s law is relevant). This will be a difficult task since few states have relevant precedents as to the ownership of a tax refund or how a tax allocation agreement should be interpreted.

The Tenth Circuit in Rodriguez had previously (before the decision by the Supreme Court) based its decision, in part, on the basis that federal common law should be used to decide ownership of a refund. As a result, the case went back to the Tenth Circuit to decide the case solely by reference to state corporate law. 

The Rodriguez case involved two members of a consolidated group that were under the jurisdiction of different courts in different proceedings. Like so many of the recent cases, a banking subsidiary failed and was taken over by regulators (in this case, the FDIC). The bank holding company then filed for bankruptcy. The bank holding company on behalf of a consolidated group carried back an NOL and claimed a refund from the IRS. The NOL and the earlier year taxable income both related to the bank. The FDIC claimed entitlement to the refund pursuant to a tax sharing agreement between the parties. 

The result in Rodriguez was litigation between the FDIC (as receiver for the bank) and the bankruptcy trustee for the bank holding company, that ultimately resulted in five published court decisions. The Tenth Circuit, after remand by the Supreme Court, again decided the case in favor of the FDIC.[1] This time, the decision was solely based on Colorado law. The tax sharing agreement in question was clear as to the ownership of the refund. It belonged to the bank (and the FDIC) based on use of the bank’s NOL that was carried back for refund. 

Since the bank holding company was in bankruptcy, the court also had to determine the nature of the relationship between the bank and the bank holding company. If the bank holding company received the refund as agent for the bank, then the bank was entitled to the money. However, if the relationship was a debtor-creditor relationship, then the bank would only be an unsecured creditor and secured creditors would have priority over the bank. 

The Tenth Circuit made an exhaustive analysis of the tax sharing agreement and eventually concluded that the agreement was ambiguous as to the nature of the relationship. Some provisions suggested an agency relationship and other provisions suggested a creditor relationship. The ambiguity was eventually resolved in favor of the bank, as the agreement provided that any ambiguity was to be resolved in favor of any insured depository institution (i.e., the bank). As a result, the court held that the FDIC, as receiver of the bank, was entitled to the refund. 

A&M Taxand Says

Before the decision in Rodriguez, it was already difficult to predict how a court would decide a case concerning the ownership of a consolidated tax refund. Now without the unifying common law doctrine enunciated in Bob Richards it will be even more difficult to predict an outcome. 

Since the potential outcome in court is unpredictable, companies should determine if they have an existing tax sharing agreement or policy. Any existing agreements and policies should be revisited to determine if the outcome is desirable and if they have been applied consistently. The time to fix any blemishes is now, before third parties get involved. 

[1] Rodriguez v. FDIC, No. 17-1281 (10th Cir. May 26, 2020)