2015-Issue 23 – Whose refund is it? What happens if the parent of a consolidated group receives a refund that came about from the use of a subsidiary’s loss — must it be paid to the subsidiary? When the group is one big happy family, perhaps this seems a rather odd question to ask. But what if things unravel, the family is no longer happy, and the members are pit against each other?
The clearest example of what can go awry is when the parent and its subsidiary, each having third-party creditors, file separately for bankruptcy. If the Internal Revenue Service (IRS) pays the parent a refund, the critical question is whether the parent receives the refund as an agent on behalf of its subsidiary or as a debtor of its subsidiary. If the parent receives the refund in the capacity of an agent, then it belongs to its subsidiary’s bankruptcy estate. If not, the refund is property of the parent available to its creditors with the subsidiary being one of the claimants.
Over the last few years, litigation stemming from the bankruptcies of the 2008 financial crisis has been making its way through the system. The cases provide stark examples of substantial refunds being up for grabs because of ambiguities in the disputed tax sharing agreements (TSAs) making it uncertain as to whom they belong. Critically, they underscore the importance of having a well-drafted TSA to protect the members’ interests.
Overview of Consolidated Group Filings
Very generally, when a parent corporation and its subsidiaries file a consolidated return, each member of the group computes its income or loss as if it were a stand-alone taxpayer. The results are then combined in one return as if the members were essentially a single taxpayer.
A principal advantage of filing a consolidated return is that the losses of one member may be offset against the income of another to reduce the group’s overall tax liability. Under Treas. Reg. Section 1.1502-77, the parent of the group acts as an agent for the group and is responsible for filing the return, paying the group’s tax and receiving any refunds. These agency rules, however, do not affect the ownership of tax refunds or attributes as discussed above.
Allocation of the Consolidated Tax Liability
While tax law provides rules for how losses are used within the consolidated group and how refunds are paid, federal law provides no guidance as to the ownership of those refunds. The Internal Revenue Code and Treasury Regulations do have rules for allocating the consolidated tax liability among the group members, but those are only for the purposes of computing the stock basis and earnings and profits of the respective members. Indeed, nothing in the Internal Revenue Code or regulations compels a member of a consolidated group to compensate the group or another member (including the parent) for its share of the consolidated group’s tax or the use of another member’s losses.
Tax Sharing Agreements
Even though federal law does not compel members to pay or reimburse each other for their respective shares of the tax liability or benefit they are contributing to the group, members may enter into a private TSA among themselves specifying how the consolidated tax liability is allocated and requiring them to settle up with each other for the economic impact.
TSAs are generally modeled using one of the methods prescribed in Treas. Reg. Section 1.1502-33(d) or Treas. Reg. Section 1.1502-32(b)(3)(iv)(D) and typically cover such items as:
- The requirement to compute current and deferred income taxes on a separate entity basis;
- The amount and timing of payments for current taxes and estimated tax payments (payment for deferred taxes may be prohibited);
- Reimbursements for losses including the amount and timing;
- Matters related to a member leaving the group.
Nevertheless, TSAs are very difficult to draft because tax rules are so complex, and it is impossible to draft for every possible contingency. TSAs do not tend to be standardized, and, like intercompany loan agreements, since they are put together among friendly controlled entities, they are often loosely drafted and/or poorly executed in operation. Consequently, they can be ripe for litigation.
Banking Refund Litigation — Ambiguity in Tax Sharing Agreements
Since the financial crisis, there have been many disputes between holding companies and failed insured depository institutions (IDIs) over the ownership of tax refunds received by the parent holding company while in bankruptcy but generated through the use of the subsidiary-IDI’s losses. In general, the disputes have arisen because the TSAs have been unclear as to the status of the relationships among the parent and its subsidiaries created by the TSA.
The cases have been met with mixed results, with some courts finding the tax refunds properly belonging to the subsidiary — with the parent receiving the refund as an agent on the subsidiary’s behalf. See, for example, FDIC v. Zucker (in re NetBank, Inc.), 729 F.3d 1344 (11th Cir. 2013), which found that the parties intended under the tax sharing agreement that the parent hold the refund as agent for the subsidiary; Zucker v. FDIC (In re BankUnited Fin. Corp.), 727 F.3d 1100 (11th Cir. 2011): “Although the TSA does not contain a provision expressly requiring the Holding Company to forward tax refunds to the Bank on receipt, it is obvious to us that this is what the parties intended”; FDIC v. Amfin Fin. Corp., 757 F.3d 530 (6th Cir., 2014), reversing and remanding 490 B.R. 548 (N.D. Ohio 2013), as FDIC evidence might establish an agency relationship under Ohio law.
Others courts have found the refund to be property of the holding company because language in the TSA created a debtor-creditor arrangement rendering the subsidiary-IDI as an unsecured creditor of the parent. See, for example, Cantor v. FDIC (In re Downey Financial Corp) 115 A.F.T.R.2d 2015-610 (3rd Cir. 2015), which found that the tax sharing agreement “unambiguously created a debtor/creditor relationship” between parent and its subsidiaries; FDIC v. Siegel (in re IndyMac Bancorp, Inc.) 113 A.F.T.R.2d 2014-1844 (9th Cir. 2014), which found that the TSA neither establishes a principal-agent nor trust relationship under California law, and that the absence of language creating a trust arrangement is explicitly an indication of a debtor-creditor relationship.
Notably, silence in the TSAs about the nature of the relationship among the parties has led courts to opposite conclusions by taking asymmetrical lines of inquiry. For example, in BankUnited and Amfin, the absence of language creating and safeguarding a debtor-creditor relationship was a key factor causing the courts to infer an agency relationship must exist (despite the absence of language expressly creating one). Yet in IndyMac and Downey, the absence of explicit language creating a trust relationship, requiring funds to be segregated or limiting the parent’s discretion to control the refund indicated a debtor-creditor relationship, was intended (despite an apparent absence of language expressly creating one).
In response to this uncertainty, last June, the Department of the Treasury, the Federal Reserve Board of Governors and the FDIC issued an addendum to the Interagency Policy Statement on Income Tax Allocation in a Holding Company Structure. The addendum instructs IDIs and their holding companies to review and revise their tax allocation agreements to ensure that the agreements expressly acknowledge that the holding company acts as an agent for the IDI with respect to any refund received. The addendum also includes sample language that can be included in their TSAs.
Alvarez & Marsal Taxand Says:
Certainly it behooves people to review their tax sharing agreements with the foregoing ambiguities in mind — especially before the next financial crisis hits and it’s too late. But this article touches on only one aspect of tax sharing agreements that can lead to uncertainty. When disputes arise over the ownership of refunds or compensation for the use of losses among group members, many other questions should be considered. For example:
- How well have the terms of the TSA actually been followed in practice? Is the TSA faithfully followed and do members regularly settle with each other? Are the computations correct?
- If the parent uses a subsidiary’s loss, how much of the loss should the subsidiary be compensated for — all of it? None of it? Or something in between? When should the payments be made and should they be readjusted with the passage of time?
- Can the subsidiary block its parent from using its loss without compensation because the parent would be unjustly enriched?
- What happens if the group does not have a written TSA in place? Might the actions of the group imply one?
Why fix the roof when it’s not raining? TSAs are easy to ignore, but once it rains, it’s too late to plug the holes.
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