Lessons in Language: Delaware Bankruptcy Court Weighs In on the Treatment of Tax Refunds Under Tax Sharing Agreements

Contributed by Debra McElligott
This month, the United States Bankruptcy Court for the District of Delaware added to the expanding universe of opinions regarding the ownership of tax refunds issued pursuant to a tax sharing agreement.  Parting with the most recent decision on the issue, the Bankruptcy Court held that these refunds belonged to the debtor’s estate.
In Wilmington Trust v. FDIC, holding company Downey Financial Corporation and its affiliates, including subsidiary Downey Bank, entered into a tax sharing agreement (TSA) providing that the holding company would file consolidated tax returns for the group.  Under the agreement, each entity separately calculated its estimated taxes and paid that amount to the holding company, which deposited the money into its operating account and paid taxes on a consolidated basis.  In the case of a refund, the TSA imposed an obligation on the holding company to pay each affiliate its share within seven business days.  The TSA did not further restrict the holding company’s use of the refund.
In November 2008, the Office of Thrift Supervision seized Downey Financial Corporation and appointed the FDIC as receiver of Downey Bank.  Downey Financial Corporation then filed a petition for relief under chapter 7 of the Bankruptcy Code.  After the bankruptcy, the chapter 7 trustee filed consolidated tax returns, which he amended and supplemented over the next two years, resulting in a refund of over $373 million for the years 2003 through 2008.  The FDIC filed competing tax returns seeking the same amount, claiming that Downey Bank generated substantially all of the taxable income reported by the consolidated group to the IRS between 2003 and 2008.  In October 2010, the trustee commenced an adversary proceeding against the FDIC seeking declaratory judgment regarding the ownership of the tax refund under section 541(a)(1) of the Bankruptcy Code.  The trustee, along with indenture trustee Wilmington Trust, claimed that the refund was property of the debtor’s estate; while the FDIC claimed the tax refund belonged to Downey Bank’s receivership estate.
To decide the question, the bankruptcy court considered whether the language of the TSA unambiguously created a debtor-creditor relationship between the holding company and the bank.  The court, relying heavily on the opinion of the United States Bankruptcy Court for the Central District of California in Spiegel v. FDIC (In re IndyMac BanCorp), ruled that it did for three reasons.  First, the language of the TSA created payment obligations between the holding company and its affiliates using the words “payment” and “refund.”  Second, the TSA did not contain any escrow provisions, segregation requirements, or restrictions on the holding company’s use of the tax refund.  Finally, the TSA gave Downey Financial Corporation “complete and unrestrained decision-making” with regard to tax matters.  In response to the FDIC’s argument that the “mere use of certain words” in the TSA should not determine who owns the tax refund, the court stated that a number of additional factors influenced its decision.  Among these were that the TSA did not contain a provision establishing a trust or agency relationship, and that the holding company had sole discretion to file taxes, distribute overpayment, and hold any refund for longer than one week.  After considering all of these facts, the court found that the TSA unambiguously established a debtor-creditor relationship as a matter of law.
The bankruptcy court’s opinion poses an interesting contrast to the Eleventh Circuit’s recent holding in Zucker v. FDIC (In re BankUnited Fin. Corp.), which came to the opposite conclusion on this issue.  The Downey court specifically addressed the BankUnited opinion, stating that a variety of facts distinguished the respective TSAs.  The court noted that the TSA in BankUnited was ambiguous with regards to both (i) when the tax refund would be forwarded and (ii) whether the holding company owned the refund before forwarding it.  Because the contract was ambiguous, the court in BankUnited decided to consider the parties’ intent.  It found no language suggesting that the holding company intended to retain the refunds as a company asset and become indebted to the subsidiary.  Rather, the TSA used terminology like “income tax payable” and “income tax receivable,” and provided that refunds would be allocated among and paid to the proper group members.  Additionally, the parties to the BankUnited TSA structured the agreement so that the subsidiary bank paid the taxes and was liable to other group members for the refund; the holding company’s role was merely to file the return and receive the refund.
Unlike the BankUnited TSA, the court found that the Downey Financial TSA unambiguously established a timeframe for refund and the holding company’s restriction-free ownership.  The contract’s language demonstrated the intent of the parties to enter a debtor-creditor relationship, as it “create[d] a series of intercompany ‘payments’ and ‘reimbursements’” that could have been different from the amount of the refund received.  Finally, the holding company had sole discretion over the relevant functions, eliminating any concern regarding proper distribution of the refund.
The Downey Financial opinion reaffirms that the language of the contract controls when determining whether parties have created a debtor-creditor relationship under a tax sharing agreement.  The opinion is noteworthy because the court focused not only on the specific language of the two TSAs in question, but also on the distribution concerns created by the different resulting transactional structures.  To that end, the opinion sheds more light on what types of provisions may influence courts in deciding whether a debtor-creditor relationship is created.