The U.S. Bankruptcy Court for the District of Delaware recently ruled that a tax-sharing agreement created a debtor-creditor relationship between parties to the agreement.
In In re Downey Financial Corp. v. FDIC, No. 10-53731 (Bankr. Del. Oct. 8, 2013), Downey Financial Corp. (DFC) filed for bankruptcy in November 2008. At approximately the same time, DFC's wholly owned subsidiary, Downey Savings and Loan Association (Downey Bank), was placed in receivership and taken over by the Federal Deposit Insurance Corporation (FDIC).
Up until the bankruptcy filing and the FDIC takeover, DFC, Downey Bank and certain other group members (the DFC Group) had filed consolidated tax returns for U.S. federal income tax purposes and had allocated tax liability and refunds pursuant to a tax-sharing agreement (TSA). After filing for bankruptcy, DFC carried back certain tax net operating losses of the DFC Group to prior tax years, which resulted in a substantial refund. Federal tax refunds are paid directly to DFC, as the common parent of the DFC Group. DFC was then obligated under the TSA to allocate and transfer the tax refunds to the various members of the DFC Group, including Downey Bank.
The issue before the Bankruptcy Court was whether DFC's obligation to transfer tax refunds to Downey Bank under the TSA created a debtor-creditor relationship or an agency-trust relationship. If a debtor-creditor relationship was established, the tax refunds would become property of the DFC bankruptcy estate and Downey Bank would be required to pursue its claim as one of several creditors. On the other hand, if an agency-trust relationship was established, DFC would be considered a mere agent or conduit for Downey Bank and, as such, would be required to transfer to Downey Bank its entire allocable share of the refund without subjecting the refund to claims from other creditors.
The court analyzed the language and terms of the TSA, and determined the agreement created a debtor-creditor relationship. As a result, the tax refunds became property of the DFC bankruptcy estate. Correspondingly, the tax refunds became subject to the claims of DFC's creditors, and Downey Bank was relegated to the status of a creditor and forced to pursue its claim alongside other DFC creditors.
The holding in In re Downey Financial Corp. v. FDIC turned in large part on the Bankruptcy Court's interpretation of the TSA, which was a contract between the parties. In other cases with similar facts, courts have reached different conclusions. For example, the 11th Circuit Court of Appeals considered a similar situation and determined in In Re BankUnited Financial Corp. v. FDIC that an agency-trust relationship was created by the parties' TSA. Under the 11th Circuit's decision, the tax refunds did not become property of the bankruptcy estate. Rather, the common parent received the tax refunds as a conduit and was required to transfer the subsidiary's allocable share of the tax refund to the subsidiary.
The nature and wording of a TSA can result in significant financial consequences to the members of an affiliated group that elects to file consolidated tax returns for U.S. federal income tax purposes. Courts generally rely on principles of contract law to interpret the terms of such TSAs. Consequently, the parties to TSAs should contemplate their respective rights and obligations, including potential consequences if the parties' financial situations deteriorate and one or more parties to the agreement file for bankruptcy.
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