June 22, 2020 / North America
The world has changed significantly over the last few months due to the economic disruption caused by COVID-19. As a result, businesses need to reevaluate their existing policies and agreements on sharing of U.S. income taxes between members of a corporate group. In a growing economic environment, these policies and agreements may not have had a great deal of economic importance. But, based on the recent change in the economy, and the change in law regarding the ability to claim federal income tax refunds, these policies and agreements may become significantly important.
When a group of corporations file a federal consolidated 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 contractual arrangements and corporate law) to determine which member is entitled to the asset. Similarly, if a parent corporation engages in business through a disregarded entity or partnership, the refund would be issued to the parent corporation.
Many groups of corporations that file a consolidated or combined income tax return have a tax sharing agreement or policy (TSA). These agreements sort out which members of the group are responsible for paying the consolidated or combined tax liability, and which members will receive the benefits of any refund. Some agreements even cover what happens when one member with profits uses the tax attributes (e.g., a net operating loss) of another member. More information on TSAs can be found at Tax Sharing Agreement and Tax Sharing Agreement: Choreography of Conduct.
Before 2018, corporations were able to carry back net operating losses (NOLs) two taxable years (and in some cases ten taxable years) for a refund. The ability to carry back NOLs was repealed by the so-called Tax Cuts and Jobs Act (TCJA). Recently, the CARES Act restored the ability to carry back NOLs (but only for NOLs generated in 2018 through 2020 taxable years). These temporary rules allow corporations to carry back NOLs up to five taxable years.
Several other provisions (separately or in conjunction with the change in the NOL carryback rules) could result in significant refunds for some companies. The “retail glitch” was fixed retroactively to 2018, allowing companies to increase their depreciation deductions for qualified improvement property. The CARES Act also generally increased the limit on the deductibility of business interest from 30 percent of adjusted taxable income to 50 percent for 2019 and 2020 taxable years. Although not a recent change, 100 percent bonus depreciation is still generally available for new and used machinery and equipment purchased before January 1, 2023.
Based on the change in the economy, all companies have to consider the possibility of having to restructure their debt obligations. In recent years, debt financing arrangements have become more complicated. There are many more situations now where a parent corporation owes money to one group of creditors and one or more subsidiaries owes money to a different group of creditors. As a result, there will be many situations where various parties will need to negotiate issues related to the ownership of a consolidated tax refund (and as to ownership of a refund between a corporation and a wholly-owned LLC, which is generally disregarded as separate from its owner for U.S. income tax purposes).
Based on this new environment (of a shaky economy) and availability of tax refunds, disputes as to ownership of a tax refund (or use of tax attributes) are inevitable. Groups of multiple companies should revisit their existing TSAs. It is important in this environment to establish if a TSA exists (whether in contractual form or as a statement of policy). If one does exist, diligence should be performed as to whether the TSA has been consistently followed. If a group discovers that there is no TSA or it has not been consistently followed, steps should be taken to rectify any blemishes early in the process. Ideally this would take place before a liquidity event occurs and before any tax refund is received (or claimed)…
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