On February 25, 2020, the United States Supreme Court in Rodriguez v. Federal Deposit Insurance Corporation1 struck down a judicial federal common law rule—known as the Bob Richards rule—that is used by courts to allocate tax refunds among members of a corporate affiliated group where the group does not have a written tax sharing agreement in place, or, at least in some federal Circuits, where an agreement fails to allocate the refunds unambiguously. The opinion by Justice Gorsuch holds that federal common law should be reserved for special circumstances where it is “necessary to protect uniquely federal interests,” such as admiralty law or disputes between U.S. states, rather than situations implicating the Bob Richards rule where state law should provide an adequate remedy instead.
Although tax refunds have become less important in recent years because U.S. federal net operating losses for a particular year generally are ineligible to be carried back to prior taxable years,2 tax refunds still can be one of the most valuable assets of companies in bankruptcy. Identifying the entity that is the legal owner of the tax refund is important, and the swings in bankruptcy recoveries could be impacted dramatically, particularly where not all members of the consolidated group are debtors in a bankruptcy case. Specifically, at issue for consolidated tax refunds is whether (a) the “designated agent” (which typically is the parent) of a consolidated group is entitled to one hundred percent of a tax refund, such that, absent substantive consolidation of the various debtor estates (which is rare on a non-consensual basis), the designated agent’s direct creditors would be entitled to the full benefit of the refund, or (b) the other members of the consolidated group are deemed to own portions of the refund directly through the allocation set forth in the tax sharing agreement, such that the creditors of each of the relevant debtors would share in the recovery (again assuming no substantive consolidation).
By striking down the Bob Richards rule, the Supreme Court clarifies that an allocation of a tax refund among entities in a consolidated tax group should no longer be assumed to exist as a matter of federal common law. As a result, following this decision, more importance should be placed on carefully drafting tax allocation agreements to specify that the designated agent3 of the consolidated group receives the refund as agent or in constructive trust for the loss-generating subsidiary (and not in the designated agent’s own right).
Section 1501 of the Internal Revenue Code permits an affiliated group of corporations to elect to file a consolidated federal income tax return. Under section 1.1502-77(d)(5) of the Treasury regulations, any federal income tax refund arising with respect to any consolidated return year must be paid to the consolidated group’s designated agent, absent a written agreement to the contrary, and the payment to the designated agent discharges any liability of the government to any member of the consolidated group with respect to such refund. It is common for members of a consolidated group to enter into a written tax allocation agreement to specify the manner for allocating income tax expenses and distributing tax refunds among the members of the consolidated group.
The decision in Rodriguez relates to a dispute between a parent corporation and its subsidiary over the legal entitlement to a $4 million federal income tax refund—in particular whether (a) the consolidated group’s common parent, as the designated agent of the consolidated group, was entitled to the tax refund or (b) the common parent received the tax refund as agent or in constructive trust for the loss-generating subsidiary (with the subsidiary having a contractual claim against the common parent). The parent corporation, United Western Bancorp, Inc. (UWBI), is a debtor in a Chapter 7 bankruptcy, with Simon Rodriguez representing the bankruptcy estate as Chapter 7 trustee. The subsidiary, United Western Bank (UWB), previously suffered significant losses and is now under receivership with the FDIC. Rodriguez and the Federal Deposit Insurance Corporation (FDIC) disagree about the proper application of the written tax allocation agreement, with each claiming ownership of the entire federal income tax refund under an alternative application of the Bob Richards rule, discussed below.
The Bob Richards Rule
The rule stems from a Ninth Circuit decision, In re Bob Richard Chrysler-Plymouth Corp., 473 F.2d 262 (9th Cir. 1973), which various federal courts have applied in bankruptcy cases for more than four decades. As initially conceived, the Bob Richards rule provided that, in the absence of a written tax allocation agreement, a tax refund should belong to the member of the consolidated group which provided the losses or deductions for the refund claim in the first place. With the passage of time, the Bob Richards rule evolved. Now, in some jurisdictions, including the Tenth Circuit, Bob Richards doesn’t just supply a stopgap rule for situations where group members lack an allocation agreement, it represents a general rule always to be followed unless the parties’ tax allocation agreement unambiguously specifies a different result.
Rodriguez, on behalf of UWBI, claimed that, as the designated agent of the consolidated group, UWBI was legally entitled to the tax refund. The bankruptcy court agreed with Rodriguez. However, the district court and Tenth Circuit sided with UWB and the FDIC, holding that the tax allocation agreement created an agency relationship between UWBI and UWB, and the tax sharing agreement's intended treatment of tax refunds therefore did not differ from the Bob Richards rule, which resulted in the tax refund belonging to UWB (instead of having a contractual claim as a general unsecured creditor against UWBI under the tax sharing agreement).
Justice Gorsuch states that judicial lawmaking in the form of federal common law “plays a necessarily modest role under a Constitution that vests the federal government’s ‘legislative Powers’ in Congress and reserves most other regulatory authority to the States.” Moreover, federal judges must ensure that any new federal common law is “necessary to protect uniquely federal interests” or is otherwise expressly authorized by Congress.
The court found no support for applying the Bob Richards rule to protect uniquely federal interests, whether in this case or in any other foreseeable situation. The opinion notes that the government may have a uniquely federal interest in how it receives a payment of taxes, or to whom (and in what manner) it delivers the actual payment of a tax refund (e.g., see section 1.1502-77(d)(5) of the Treasury regulations outlining applicable procedures). But Justice Gorsuch posits, somewhat rhetorically, “what unique interest could the federal government have in determining how a consolidated corporate tax refund, once paid to a designated agent, is distributed among the group members?” The opinion answers the question by observing that the FDIC failed to point to any unique federal interest the rule might protect, and noting that state law is “well equipped” to handle disputes involving corporate property rights, such as the allocation of the tax refund in this situation. In short, the opinion holds that the Bob Richards rule is not a legitimate exercise of federal common lawmaking. Whether this case might yield the same or a different result without an application of Bob Richards is a matter left for the appeals court to take up on remand.
Impact of the Court’s Decision
Following the Court’s decision in Rodriguez, courts will be forced to decide whether (a) the group’s designated agent holds the income tax refund in its capacity as agent for the consolidated group (or in constructive trust) or (b) the designated agent is the legal owner of the tax refund (with the subsidiary having a claim against the parent under the tax sharing agreement along with the designated agent’s other creditors). The Bob Richards rule created a predictable outcome for over four decades by treating the tax refund as belonging to the member of the consolidated group which generated the losses or deductions that gave rise to the refund, unless the tax sharing agreement unambiguously provided otherwise. Now, in situations where disputing parties lack a tax sharing agreement that clearly provides that the designated agent of the consolidated group receives the refund as agent (or in constructive trust) for another member of the consolidated group, courts will be forced to look to applicable state law, which likely will create results that are unpredictable and differ state-to-state.
Accordingly, members of a consolidated group and their creditors should carefully review the group’s tax sharing agreement in order to ensure that it is clear that any tax refunds received by the designated agent are received only in its capacity as agent for the consolidated group (or in constructive trust for the member of the consolidated group that generated the applicable losses or deductions). In the absence of a clear tax sharing agreement regarding refunds, members of a consolidated group and their creditors will need to review applicable state law in order to identify the person that is legally entitled to the tax refund.
1 No. 18-1269 (Feb. 25, 2020).
2 Section 172(b)(1)(A)(i).
3 Section 1.1502-77 of the Treasury regulations provides that one member of the consolidated group is designated as the sole agent that is authorized to act on behalf of the consolidated group regarding all matters relating to the federal income tax liability for the consolidated return year. The Treasury regulations provide that, except as otherwise provided in the Treasury regulations, the agent for a current year is the common parent of the consolidated group, and the agent for a completed year is the common parent of the consolidated group at the close of the completed year.
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