When several corporations are consolidated into one large group, the parent company deals directly with the IRS, paying the tax liabilities for the group and receiving any refunds. Tax allocation agreements are often used by the members of a consolidated group in order to determine how to allocate and distribute such funds. The authors detail the issues corporations need to consider when drafting such agreements, including how the carryback and carryforward of net operating losses have been affected by the Tax Cuts and Jobs Act of 2017.
A consolidated group’s parent corporation acts as the group’s agent in all federal income tax matters [Treasury Regulations section 1.1502-77(a)]. In this role, the parent corporation pays the group’s tax liability, receives its tax refunds, and interacts with the IRS on the group’s behalf. Therefore, the parent corporation must remit taxes to the IRS whenever group members generate income sufficient to produce a cash tax liability, regardless of whether the group members pay the parent for their share of tax. When a group receives a cash refund because, for example, it carries back a general business tax credit or a pre-2018 net operating loss (NOL), the refund will be paid to the parent regardless of whether the parent generated the credit or loss. [As explained below, the Tax Cuts and Jobs Act of 2017 (TCJA) eliminates the carryback of most federal corporate NOLs generated in tax years ending after December 31, 2017.]
Absent a binding agreement, members are not obligated to pay the parent for their share of the group’s tax liability, and the parent is not obligated to compensate members for the use of their tax attributes. To ensure that members receive adequate compensation for the group’s use of their tax attributes, and that their assets are not depleted by excessive tax payments to the parent, many tax advisors recommend that groups enter into legally binding tax allocation agreements that specify how cash tax payments and refunds will be settled among members. Having a written tax allocation agreement in place is particularly important when a group includes members that are regulated entities, have minority shareholders, or have external debt with separate company financial covenants.
Treasury Regulations section 1.1502-33(d) provides several methods for allocating the consolidated tax liability among group members for earnings and profits purposes, and section 1.1502-32(b)(4)(iv)(D) prescribes how to do so for purposes of computing a parent company’s tax basis in the stock of a subsidiary member. There is, however, no tax guidance regarding whether and how individual members actually settle their share of the group’s tax liability. The government may feel little need to provide such guidance because the consolidated return regulations hold all members severally liable for the group’s tax liability [Treasury Regulations section 1.1502-6(a)]. These regulations give the IRS the authority to collect the group’s entire consolidated tax liability from any member if the parent does not pay the liability. It should be noted that members cannot use a tax allocation agreement to avoid several liability; that is, the IRS can collect the entire amount of the group’s liability from a member even if, under the terms of the tax allocation agreement, the member is only obligated to pay a small percentage of the total tax due.
The purpose of this article is to identify some of the federal income tax issues that should be considered when drafting or reviewing a tax allocation agreement. There are many different ways in which tax allocation agreements can be written, and these differences can have significant economic consequences.
Allocation and Payment of Consolidated Tax Liability
Tax allocation agreements should be drafted to ensure that profitable group members bear their share of consolidated tax liabilities. One way to do this is to allocate the group’s liability based on each member’s stand-alone tax liability or on the basis of each member’s taxable income as a percentage of consolidated taxable income. Often times, a stand-alone approach is required when a group includes a regulated member. Typically, the rates regulators allow a utility to charge are based in part on its cost of service, including taxes. If taxes are allocated in a manner other than on a stand-alone basis, utility customers may pay rates that reflect costs or benefits of other nonregulated members of the consolidated group. Consequently, in many states a regulated member’s share of its group’s tax liability cannot exceed the tax liability the entity would have owed to the IRS as a stand-alone taxpayer. Only a few states provide for a sharing of nonregulated tax benefits through consolidated tax sharing adjustments, a discussion of which is beyond the scope of this article.
Consider a parent corporation (Parent) that owns 100% of the stock of two subsidiary corporations (Subsidiary 1 and Subsidiary 2). The parent corporation is a pure holding company and does not generate any separate company gains or losses. Assume the consolidated group has a tax allocation agreement in place that allocates the group’s tax liability based on each member’s separate company tax liability (i.e., members are required to pay the parent an amount equal to the amount of tax they would owe if they had filed a separate return for the year).
Exhibit 1 summarizes the consolidated group’s taxable income for Year 1, which is $1,000; its tax liability is $210. Under the tax allocation agreement, Subsidiary 1 would be obligated to make a $210 payment to Parent, which would remit this money to the IRS on the group’s behalf.
Year 1 Taxable Income
Compensating Members for Use of Tax Attributes
One advantage of filing a consolidated tax return is that members’ losses can be used to shelter other members’ income; if a member’s loss is absorbed by the consolidated group, however, the member will be unable to use that loss to shelter income that it generates in the future. Therefore, tax allocation agreements should address whether and how group members are compensated for the use of their tax attributes (e.g., operating losses, excess capital losses, tax credits).
In Year 2, the consolidated group has no taxable income because Subsidiary 1’s current year taxable income of $1,000 is fully offset by Subsidiary 2’s current year loss of $1,000 (Exhibit 2). As was the case in Year 1, Subsidiary 1 is required to pay the parent an amount equal to the tax it would owe if it had filed a separate return for the year ($210). In Year 2, however, the question arises as to whether Subsidiary 2 should be compensated for the group’s use of its $1,000 loss. The answer depends upon the terms of the tax allocation agreement. In the absence of a tax allocation agreement, Subsidiary 2 will be hard pressed to force Parent to make it whole for the loss of a potentially valuable tax attribute.
Year 2 Taxable Income
If a tax allocation agreement does exist, it could require that Parent compensate Subsidiary 2 when Subsidiary 2’s loss is absorbed by the group. Under this approach, a subsidiary is compensated for the loss of its tax attributes regardless of whether those attributes would have currently benefited the subsidiary. Alternatively, some tax allocation agreements take a “wait-and-see” approach. Under this approach, Subsidiary 2 would not be compensated for the use of its loss in Year 2. Instead, the group would wait and see if Subsidiary 2 later generates income sufficient to have allowed it to use its loss, assuming that the loss was not previously absorbed by the consolidated group. If Subsidiary 2 continues to generate losses, it may never be compensated for the benefit the group obtained from its Year 2 loss. Given the potentially significant difference in the timing of payment, care should be taken to ensure all parties understand when members will be compensated for the use of their attributes.
Because consolidated groups are not static, additional issues may arise when a member leaves a group that has an agreement that takes a “wait-and-see” approach. For example, if the tax allocation agreement takes a “wait-and-see” approach to compensating members for the use of their losses, and Subsidiary 2 deconsolidates from the group at the end of Year 2, then absent any special provision in the agreement, Subsidiary 2 will likely never be compensated for the group’s use of its loss. To address this issue, many tax allocation agreements include deconsolidation provisions. For example, an agreement could require Parent to reimburse Subsidiary 2 immediately upon deconsolidation for the tax benefit of its losses previously absorbed by the group or absorbed by the group in the parent’s year of deconsolidation. Alternatively, the agreement could require Parent to reimburse Subsidiary 2 for any tax liability it incurs in a postconsolidation year if the liability would not have been incurred had Subsidiary 2 retained its separate company attributes that were previously absorbed by the group. Tax allocation agreements should also address what happens if a member joins a consolidated group and has separate company tax attributes (e.g., loss and credit carryfor-wards) that may benefit the group.
Provisions Related to Loss and Credit Carryforwards
A consolidated net operating loss (CNOL) is created whenever consolidated group members’ losses exceed profitable group members’ taxable income. Under the TCJA, corporate NOLs that are generated in tax years ending after December 31, 2017, cannot be carried back, but instead can be carried forward indefinitely. (Under the prior rules, corporate NOLs were generally eligible for a two-year carryback and a twenty-year carryforward.) In addition, many other unused consolidated tax attributes (e.g., excess capital losses, tax credits) can be carried forward and used to reduce the group’s future tax liability. If a tax allocation agreement compensates members for the use of their tax attributes, it is important that it also provides rules for determining the order in which members’ attributes are used.
In Year 3, the consolidated group generates a $3,000 CNOL, $1,000 of which is allocated to Subsidiary 1 and $2,000 of which is allocated to Subsidiary 2 (Exhibit 3). In Year 4, the consolidated group generates $2,000 of taxable income, all of which is allocable to Subsidiary 1 (Exhibit 4).
Year 3 Taxable Income
Year 4 Taxable Income
Under the TCJA, for NOLs arising in tax years beginning after December 31, 2017, the amount of an NOL carryforward that a corporation may deduct in a single tax year is equal to the lesser of the available NOL carryforward or 80% of the group’s pre–NOL deduction taxable income. Therefore, the group can use $1,600 of the CNOL (the lesser of the $3,000 available carryforward or 80% of the group’s $2,000 pre-NOL deduction taxable income) to offset its Year 4 consolidated taxable income. Note that both Subsidiary 1 and Subsidiary 2 contributed to the CNOL that is being carried forward to and used in Year 4. To determine whether Subsidiary 1, Subsidiary 2, or both are entitled to compensation for the use of their losses, it is necessary to determine whose losses are being absorbed.
There are many ways in which tax allocation agreements could address this issue. For example, the agreement could specify that loss carryforwards be absorbed in a first-in, first-out, pro rata fashion. The consolidated tax return regulations provide that losses permitted to be absorbed in a consolidated return year generally are absorbed in the order of the taxable years in which they arose and on a pro rata basis [Treasury Regulations section 1.1502-21(b)(1)]. In the above example, this means that the group will be treated as absorbing $533 ($1,000 Year 3 separate company loss ÷ $3,000 Year 3 consolidated loss × $1,600 CNOL) of Subsidiary 1’s loss and $1,067 ($2,000 Year 3 separate company loss ÷ $3,000 Year 3 consolidated loss × $1,600 CNOL) of Subsidiary 2’s loss.
Alternatively, a tax allocation agreement could allocate reimbursement based on which member generates the taxable income that allows the group to use the carryforward. Under this method, the group would be treated as absorbing all of Subsidiary 1’s Year 3 loss, because Subsidiary 1 generated 100% of the income that allowed the group to use the carryforward. Because Subsidiary 1’s share of the loss carryforward is fully absorbed, the group would then turn to Subsidiary 2 and use $600 of its $2,000 share of the CNOL. A third alternative, which may be required if Subsidiary 1 is a regulated entity, would require Parent to pay the entire refund to Subsidiary 1, because it would have been able to use its entire loss carry-forward to offset its Year 4 taxable income.
In the example above, $1,400 ($3,000 CNOL carried forward to Year 4 − $1,600 CNOL used to offset Year 4 taxable income) of the group’s CNOL remains at the end of year 4. If the remaining loss is attributable to a member that subsequently leaves the group, several complex issues arise. While a detailed discussion of these issues is beyond the scope of this article, consider the following circumstances: If a parent sells a subsidiary member’s stock at a loss and the member deconsolidates, the consolidated returns rules may allow the parent to reattribute some of the member’s tax attributes. [See Treasury Regulations section 1.1502-36; see also Internal Revenue Code (IRC) section 108 and Treasury Regulations section 1.1502-28.] In effect, this allows the parent corporation to retain the departing member’s tax attributes and prevents that member from being able to use those attributes in subsequent separate-return years. In order to prevent this from occurring, a buyer may require, prior to the close of the transaction, that the group’s tax allocation agreement be modified to include language that expressly prohibits the parent from reattributing a member’s tax attributes.
Allocation and Distribution of Tax Refunds
If a tax credit or a pre-2018 NOL is carried back, the IRS will return a tax refund to the parent corporation, regardless of which member generated the credit. In order to ensure that members receive compensation for the use of their attributes, a tax allocation agreement should specify how tax refunds are allocated and distributed among group members.
Assume that in Year 2, Subsidiary 2 generates a $100 tax credit that cannot be used in Year 2. The group can carry back the credit to partially offset it its Year 1 tax liability; consequently, the group will receive a $100 tax refund, which will be paid to Parent.
If the group did not have a tax allocation agreement in place, Parent would not be required to remit the $100 refund to Subsidiary 2. If an agreement does exist, it could require that Subsidiary 2 be compensated when its $100 tax credit is carried back and absorbed by the group (i.e., in Year 2). Alternatively, the agreement could take a “wait-and-see” approach to the distribution of tax refunds. Consistent with the discussion above, under this approach the group would wait and see if Subsidiary 2 later generated sufficient income such that it could have benefited from the credit had it not been previously absorbed by the group.
In addition to providing for the distribution and allocation of tax refunds, tax allocation agreements should also explicitly state whether the parent receives refunds in its capacity as the group’s agent or if the group intends for the parent to be the owner of any refunded amounts. Absent language that clearly communicates the group’s intentions, a parent corporation is more likely to be viewed as an owner if an agreement gives the parent discretion over whether to pay a subsidiary its share of a refund or credit that amount against the subsidiary’s future tax payments. Some courts have also argued that a parent corporation will be treated as an owner if the agreement does not expressly require that refunds be segregated or restricted in use.
This issue becomes particularly important when a parent corporation or a subsidiary member files for bankruptcy. For example, if a parent corporation is in bankruptcy and the parent is viewed as the owner of the refund, the refund may become part of the parent’s bankruptcy estate. If the refund was generated upon the carryback of a subsidiary member’s loss, the subsidiary will need to pursue a claim against the parent in order to receive its share of the refund. Such a claim would, however, typically be classified as an unsecured claim and would only be paid after secured creditors and prior claims are satisfied. Conversely, if the bankrupt parent is viewed as an agent, the subsidiary, and not the parent, will be viewed as the owner of the cash received from the IRS. In this case, the refund does not belong in the parent’s bankruptcy estate, and there would be no need for the subsidiary to fight with other creditors for a share of the refund.
Don’t Forget State Taxes
Broadly speaking, tax allocation agreements should provide for the allocation and payment of the group’s consolidated tax liability, specify whether and how members are compensated if their tax attributes (e.g., losses, tax credits) are absorbed by the consolidated group, and provide for the allocation and distribution of tax refunds.
In addition to federal income tax issues, there are several state tax issues that consolidated groups should address in their tax allocation agreements; while a full discussion of state taxes is beyond the scope of this article, they can have important implications, and changes in state statutory rates or the corporation’s apportionment factors from the year in which a loss is generated and the year in which the loss is absorbed by the group can present tax allocation problems. In addition, state taxes of individual group members calculated on a standalone basis are often different than the state taxes of the group, and tax allocation agreements need to address how these differences are to be allocated. Therefore, groups should work closely with their attorneys and tax advisors to ensure that their tax allocation agreement adequately addresses both federal and state issues.