Article featured on Thomson Reuters’ Taxnet Pro, February 2020

On February 25, 2020, the U.S. Supreme Court in Rodriguez v. FDIC unanimously ended the practice of determining the ownership of a tax refund based upon federal common law. Hereafter, the ownership will generally be determined based upon state corporate law, which takes into account contractual arrangements (e.g., tax sharing agreements) between the parties.

Where a group of affiliated corporations join in the filing of a federal consolidated income tax return, the IRS generally issues any consolidated tax refund to the parent of the group. It is then up to the group members (taking into account corporate law and contractual arrangements) to determine which member (or members) of the affiliated group is entitled to the refund. This determination has become a major source of litigation with potential claimants including creditors, affiliates, and shareholders.

Many of the recent cases (including Rodriguez) involve the FDIC. In a recurring situation, a banking subsidiary fails and is taken over by regulators. The bank holding company then files for bankruptcy. The bank holding company on behalf of a consolidated group carries back a net operating loss (NOL) and claims a refund from the IRS. The FDIC claims entitlement to the refund claim pursuant to a tax sharing agreement between the bank holding company and other members of the consolidated group. The result is ligation between the FDIC (as receiver for the bank) and the bankruptcy trustee for the bank holding company. Even though many cases involved the exact fact pattern described above, the results have not been consistent or predictable.

The Ninth Circuit in 1973 in Bob Richards determined that where there was no tax sharing agreement, then federal common law would decide the owner of the tax refund. Generally, that meant that a company that incurred a loss that resulted in a tax refund was entitled to the tax refund. Additionally, the courts have generally decided the ownership of a tax refund based on the tax sharing agreements entered into between the parties. However, certain courts, including the Tenth Circuit in Rodriguez, expanded Bob Richards to be the default rule, even if there was a tax sharing agreement in place, unless the sharing agreement unambiguously provided for a different result. Where one of the parties involved was in bankruptcy, the analysis became more complicated. In the cases involving the FDIC, the courts had to determine the relationship of the parent corporation and the subsidiary vis-à-vis the tax refund. If the parent was receiving the refund from the IRS as an agent of the subsidiary, then the subsidiary would be entitled to the full amount of the refund. However, if the subsidiary was a mere creditor then it had to share the refund with other creditors. The courts used various factors in determining the agent-principal vs. debtor-creditor issue, including (i) the words of the applicable tax sharing agreement, (ii) state corporate law concepts, and (iii) federal common law. Going forward, this third factor, federal common law, will not be used to decide these cases.

Next Steps

The case has been remanded to the Tenth Circuit. They will have to now decide the case without taking into account federal common law concepts.

A&M Taxand Says

Before the decision in Rodriguez, it was already difficult to predict how a court would decide a case concerning the ownership of a consolidated tax refund. Without the unifying common law doctrine enunciated by the Bob Richards court, it will be even more difficult to predict an outcome.

The Supreme Court’s decision was surprising in that it vacated use of the federal common law doctrine to decide ownership tax refund cases. The doctrine had been widely used by most courts for almost 50 years.

The decision in Rodriguez illustrates the importance of having a well-drafted tax sharing agreement. Due to the Tax Cuts and Jobs Act, there may not be as much of a need to determine the ownership of a tax refund due to the limited circumstances in which a taxpayer can carry back tax attributes for a refund. Nonetheless, a well-drafted tax sharing agreement is essential and A&M Taxand can help review your existing agreement and, if needed, assist in preparing a new one.