The Importance of Clear Tax Allocation AgreementsApril 29, 2020
In Rodriguez v. Federal Deposit Insurance Corp., the United States Supreme Court ruled on February 25, 2020, that a $4.1 million tax refund belonged to the bankruptcy estate of a failed Colorado bank’s parent company, United Western Bancorp, Inc. (“UWBI”), rather than to its subsidiary, United Western Bank (the “Bank”). The Federal Deposit Insurance Corporation (“FDIC”) is the receiver for the Bank.
The issue was whether a tax refund should go to the Bank or to its corporate parent where UWBI had filed consolidated federal income tax returns for itself and its subsidiaries. The Internal Revenue Service (the “IRS”) had issued the refund payment to UWBI. The issue arose because the tax allocation agreement to which UWBI and the Bank were parties was ambiguous. While the IRS permits an affiliated group of corporations to file a consolidated federal return, the IRS regulations do not identify how refunds should be distributed. As a result, corporate groups that choose to jointly file generally have tax allocation agreements. Problems arise when there is no such agreement or where the terms of the agreement are ambiguous. Here, the issue was the latter; UWBI and the FDIC disputed whether the tax refund was property of the Bank or UWBI. While rarely an issue outside of bankruptcy, the allocation question may become more pronounced within in insolvencies where different members of a consolidated filing group may assert conflicting claims to a tax refund.
The $4.1 million refund originated from a $35.4 million net operating loss that the Bank suffered in 2010 and carried back to its 2008 tax year. After the Bank suffered huge losses, its parent company, UWBI, was forced into bankruptcy. The Office of Thrift Supervision closed the Bank in 2011 and appointed the FDIC as receiver for the Bank. UWBI commenced a chapter 11 case in 2012, which was later converted to a chapter 7 liquidation. When UWBI filed its chapter 11 petition, the tax refund was still pending. After the refund was issued, UWBI argued that it was entitled to it because it had filed consolidated returns that included the Bank. The FDIC argued that UWBI was merely an agent for the Bank, and therefore, was not entitled to the refund. The FDIC also argued that, as receiver, it was entitled to the federal tax refund because it stemmed from the Bank’s losses.
In ruling for the Bank in the litigation below, the Tenth Circuit relied on the federal common law rule known as “the Bob Richards rule,” from In re Bob Richards Chrysler-Plymouth Corp., 473 F.2d 262 (9th Cir. 1973), a Ninth Circuit case that held that, in the absence of a tax allocation agreement, a refund from a joint return belongs to the party that incurs the underlying losses, unless the agreement “unambiguously” states otherwise. As a result, the Tenth Circuit concluded that a tax refund from a joint return should go to the Bank, as its losses gave rise to that refund.
The Supreme Court reversed the Tenth Circuit’s ruling and applied Colorado state property law, rejecting the Bob Richards rule. In its unanimous ruling, written by Justice Gorsuch, the Court resolved a split among the circuits, with the Fifth, Ninth, and Tenth Circuits following Bob Richards, and the Second, Third, Sixth, and Eleventh Circuits disagreeing and rejecting the application of federal common law to such disputes. The Court reasoned that there is no “uniquely federal interest” in determining how a corporate tax refund is distributed among group members, and that federal common law should not control how this question is answered. The Court’s rationale was that there was no need for federal common law to supply the rule of decision because the issue of ownership of the tax refund was, in its view, a state law question. The Court distinguished between determination of the parties’ property rights, a matter of state law, and how tax returns are filed with (and how tax refunds are distributed by) the federal government, in which the federal government has a clear and compelling interest.
Members of a consolidated group for federal income tax purposes should always have a clear tax sharing agreement that specifies who owns the tax losses. While this is true for all businesses that file consolidated returns, it may have resonance for private equity funds where portfolio companies often have a multi-level corporate structure. In the absence of a tax sharing agreement, members of a consolidated group may not be aware of how state law would treat ownership of tax refunds and a tax sharing agreement is a prudent way.
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