In its decision in In Re Downey Financial Corporation, the Third Circuit ruled that under California law, a tax-sharing agreement (TSA) between Downey Financial Corp. and its subsidiary, Downey Savings and Loan, F.A., created a debtor-creditor relationship and assigned the $370 million tax refund to Downey Financial Corp.’s Chapter 7 bankruptcy estate.
The Third Circuit panel said that the TSA clearly established a creditor-debtor relationship by meeting three factors:
- It created mutually interchangeable payment obligations between both parties;
- There were no use restrictions and no escrow or segregation obligations; and
- The party responsible for filing taxes — Downey Financial — had full and sole discretion regarding tax matters.
This most recent decision mirrors that of the Ninth Circuit in IndyMac, which found that tax refunds paid to a bank holding company pursuant to a tax-sharing agreement were the property of that holding company’s bankruptcy estate. However, these decisions contrast with other Circuits (Sixth and Eleventh) that have applied different state laws to reach opposite conclusions from similar TSA language.
This ambiguity in the courts’ interpretation of tax-sharing agreements reinforces the need for groups of companies to clarify the treatment of tax refunds in bankruptcy to avoid litigation.
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