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Delaware Bankruptcy Court Holds That Tax Refund Received By Debtor Is Property Of The Estate, Not Held In Trust For Non-Debtor Subsidiary Under Tax Sharing Agreement

October 11, 2013

Earlier this week, Judge Sontchi issued an opinion in Giuliano et al. v. Federal Deposit Insurance Corporation, Adv. Proc. No. 10-53731 (CSS) (Bankr. D. Del. Oct. 8, 2013).  The opinion holds that a tax sharing agreement (“TSA”) between chapter 7 debtor Downey Financing Corp. (the “Debtor”) and its non-debtor subsidiary, Downey Savings and Loan Association, F.A. (“Downey Bank”), created a debtor-creditor relationship between the parties.  As a result, a substantial tax refund received by the Debtor was determined to be property of the Debtor’s estate.  This opinion is noteworthy because it follows on the heels of two Eleventh Circuit Court of Appeals decisions issued this summer on the same subject which the Court distinguished.  The combination of these three opinions gives guidance on the interpretation of tax sharing arrangements among debtors and non-debtors.

The Chapter 7 Trustee filed consolidated tax returns pursuant to the terms of the TSA.  Later it was determined that a substantial tax refund (the “Tax Refund”) was due to the consolidated filers on account of the carry-back of Downey Bank’s net operating losses.  The Federal Deposit Insurance Corporation, which had been appointed as the receiver of Downey Bank shortly before the bankruptcy filing of the parent, filed a claim against the Debtor in an unliquidated amount for, among other things, Downey Bank’s allocation of the Tax Refund to be paid pursuant to the TSA.  In response, the Trustee commenced an adversary proceeding, seeking a declaratory judgment regarding ownership of the Tax Refund under section 541 of the Bankruptcy Code.  

The ultimate question was whether the TSA created a debtor-creditor relationship between the parties, thereby resulting in the Tax Refund being property of the Debtor’s estate, or whether the TSA created an agency or trust relationship between the parties, resulting in the Tax Refund not being property of the Debtor’s estate and being payable in full to the Debtor’s subsidiaries in accordance with the terms of the TSA.  The Delaware Bankruptcy Court had not previously ruled on this issue; accordingly, Judge Sontchi relied heavily on a three-factor test established by the United States Bankruptcy Court for the Central District of California in In re IndyMac Bancorp, Inc., 2012 WL 1037481 (Bankr. C.D. Cal. Mar. 29, 2012), to determine whether a particular document or transaction establishes a debtor-creditor relationship or a different relationship (such as a trust, mere agency or bailment relationship). IndyMac Bancorp, at *13.  The three factors are whether (1) the TSA creates fungible payment obligations among the parties, (2) there are escrow obligations, segregation obligations or use restrictions under the TSA, and (3) the TSA delegates the tax filer under the agreement with sole discretion regarding tax matters.  Id.  

The Court found that the IndyMac factors demonstrated a debtor-creditor relationship between the Debtor and Downey Bank, not a trust or agency arrangement.  The Court was persuaded by the facts that (i) there was not a concrete provision in the TSA establishing a trust or agency relationship; (ii) the Debtor had sole discretion to prepare and file the consolidated tax return, and to determine whether overpayments by any of the consolidated filers should be refunded to such entity or applied to the overall tax liability of the consolidated group; and (iii) the Debtor had the ability to hold any refund that it received for more than a week.  Moreover, certain words used in the TSA, such as “payment” and “reimbursement,” also led the Court to find that the Debtor owns the Tax Refund.  Finally, the Court went on to find that the FDIC did not meet its burden of demonstrating that a trust relationship was intended by the parties, or that the parties’ course of performance indicated a trust or agency relationship.  For all of these reasons, the Court ruled that Downey Bank merely has a claim against the Debtor’s estate for its allocated portion of the Tax Refund.  

This summer, the Eleventh Circuit Court of Appeals issued two seemingly contrary opinions regarding similar fact patterns, which the Bankruptcy Court distinguished in making its ruling in Giuliano.  In Zucker v. FDIC (In re Bank United Fin. Corp.), 2013 WL 4106387 (11th Cir. Aug. 15, 2013), and FDIC v. Zucker (In re NetBank, Inc.), 2013 WL 4804325 (11th Cir. Sept. 10, 2013), the Eleventh Circuit examined tax sharing agreements similar to Downey’s TSA and found that they did not create a debtor-creditor relationship between a holding company and its subsidiary.  In distinguishing these cases, Judge Sontchi found that the specific language in the tax sharing agreements examined by the Eleventh Circuit differed from the language in the TSA in certain key ways, making clear that the parties did not intend to create a debtor-creditor relationship, but rather intended to ensure that any tax refunds were allocated properly and delivered to the consolidated filers in full.  The grounds for distinguishing the Eleventh Circuit cases might be instructive for practitioners drafting future tax sharing agreements who are concerned about the bankruptcy of one member of the tax sharing group.