Federal tax refunds generated from investment or operating losses can represent a sizeable claim for an individual taxpayer or a consolidated taxpayer group. Ownership of tax refunds among consolidated members is not dictated by federal law, the Internal Revenue Code or regulation, but can be specified in tax-sharing agreements among affiliates. In In re Downey Financial Corp.,[1]the bankruptcy court recently considered whether a tax refund was the property of a debtor’s estate pursuant to a tax-sharing agreement (TSA), or if it should be held in trust for its nondebtor subsidiary. After considering the terms of the TSA and the nature of the claims of each party, the court found that the tax refund belonged to the debtor pursuant to the TSA, and that the nondebtor subsidiary held only a claim against the estate for its share of the refund.
Background
On Feb. 29, 2000, Downey Financial Corp. (DFC) entered into a TSA with its subsidiary, Downey Savings and Loan Association (Downey Bank), a federal chartered bank. DFC’s assets and the majority of its revenues were based on investments in and revenues generated by Downey Bank. During 2008, DFC filed a voluntary petition for chapter 11 relief in the U.S. Bankruptcy Court for the District of Delaware and Downey Bank was placed in receivership by the Federal Deposit Insurance Corp. (the “receiver”). As part of Downey Bank’s receivership, substantially all of Downey Bank’s assets were sold to another financial institution.
The dispute between DFC and Downey Bank stemmed from tax refunds due to DFC as the parent to Downey Bank. Specifically, in 2008, the trustee in DFC’s bankruptcy case filed a consolidated tax return claiming ordinary losses related to the worthlessness of its investment in Downey Bank, which was approximately $1.7 billion. For the tax years ending 2003-07, the trustee amended the consolidated federal tax returns and filed carryback claims, requesting refunds totaling $314.3 million (the “tax refund”).
The receiver filed a protective unliquidated claim against DFC for the tax refund on the basis that Downey Bank’s net income was the source of substantially all the tax payments that gave rise to the tax refund. In response, the trustee sought a declaratory judgment identifying DFC as the owner of the tax refund under § 541 of the Bankruptcy Code, and Wilmington Trust Co., as the indenture trustee in the DFC bankruptcy case, intervened as plaintiff. DFC argued that they owned the tax refund, and that Downey Bank was entitled only to its pro rata share. Downey Bank, on the other hand, argued that the TSA was ambiguous and did not expressly transfer ownership of the tax refund to DFC, that DFC had a trust relationship with Downey Bank and that Downey Bank was therefore entitled to the entirety of the tax refund. The receiver specifically argued that the prior course of performance between DFC and Downey Bank created a trust relationship, asserting the following:
- tax refunds were historically treated as property of Downey Bank;
- DFC’s books and records did not account for the tax payments consistent with a debtor/creditor relationship; and
- Downey Bank owned the tax refunds since the refund checks were deposited in the bank.
Analysis
As a starting point, the bankruptcy court distinguished its finding from a recent Ninth Circuit case,[2] wherein the court of appeals ruled that since no TSA existed, tax refunds received by a holding company were held in trust for consolidated group members. Next, the bankruptcy court applied U.S. v. Westland’s Water Dist.[3] found that the interpretation of the TSA depended on the mutual intent of the contracting parties. In reviewing the TSA, the bankruptcy court found that the agreement specified the methods for (1) allocating the consolidated tax liability, (2) reimbursement and payment of the consolidated tax liability, and (3) filing tax returns. The court noted that DFC was obligated to remit any refunds to affiliates within seven business days of receipt and that the TSA had no further restrictions on DFC’s use of refunds (with no requirements to escrow or segregate the amounts). In addition, the refund checks were made payable to DFC, yet deposited in Downey Bank’s accounts.
Finally, the bankruptcy court applied the three-factor test set forth in IndyMac Bancorp[4] to determine if a debtor/creditor relationship was established: (1) whether there were fungible payment obligations among the members; (2) whether there were escrow obligations, segregation obligations or other use restrictions; and (iii) whether DFC had sole discretion regarding tax matters.
In applying the first IndyMac test to the TSA, the bankruptcy court found that DFC had the discretion to allocate tax refunds among its affiliates. In this analysis, the court considered two recent Eleventh Circuit Court of Appeals opinions. In In re BankUnited Fin. Corp.,[5] the Eleventh Circuit Court of Appeals held that BankUnited’s TSA was ambiguous since it did not specify: (1) the ownership of the tax refund; (2) when the holding company must forward a tax refund to its banking subsidiary; and (3) when the holding company would retain a tax refund. The bankruptcy court distinguished its rulings from BankUnited as the TSA in this case provided that DFC would make the tax payments, receive the refunds and allocate tax benefits. The bankruptcy court also distinguished the Eleventh Circuit’s opinion in In re NetBank Inc.,[6] wherein the court found that NetBank’s TSA specified that the holding company was an agent for tax refunds.
In considering the second IndyMac test, the bankruptcy court noted that the TSA in this case did not contain any escrow requirements, segregation requirements or use restrictions. The court further noted that in this case, DFC had unrestricted dominion and control over tax refunds for more than one week.
In applying the last IndyMac factor, the bankruptcy court found that the TSA gave DFC sole discretion in the manner in which tax returns are prepared and filed, but did not resolve how tax refunds should be applied or credited against future tax liabilities, nor how to resolve disputes with taxing authorities. The bankruptcy court specifically rejected the receiver’s arguments that the TSA created a trust relationship between Downey Bank and DFC. The court found that the TSA did not expressly create a trust as DFC was given sole authority to control the funds, the tax returns and the use of tax refunds for seven business days. Therefore, the tax refund was property of the debtor’s estate.
[1] In re Downey Financial Corp., No. 08-13041 (Bankr. D. Del. 2013).
[2] In re Bob Richards Chrysler-Plymouth Corp. Inc., 473 F.2d 262 (“Richards”).
[3] 134 F. Supp .2d 1111.
[4] 2012 WL 1037481 (Bankr. C.D. Cal. March 29, 2012).
[5] 2013 WL 4106387 (11th Cir. Aug. 15, 2013) (“BankUnited”).
[6] 2013 WL 4804325 (11th Cir. Sept. 10, 2013) (“NetBank”).