The following post comes to us from Diane Lourdes Dick, Assistant Professor of Law at Seattle University School of Law, and is based on her recent article entitled “Bankruptcy’s Corporate Tax Loophole,” 82 Fordham Law Review 2273 (2014).  A full version of the paper can be found here and here. 

My forthcoming article in the Fordham Law Review reveals how bankruptcy-specific exceptions in the tax laws effectively transform a corporate debtor’s valuable tax attributes into marketable property that, in many cases, gives the bankruptcy estate its intrinsic value. Yet bankruptcy law’s most vital safeguards neglect to fully take into account these tax assets, leaving them vulnerable to siphoning by dominant stakeholders who are in a position to extract excess returns. This scenario is not purely hypothetical; Solyndra and Washington Mutual, among others, have used Chapter 11 to divert the value of tax losses and credits to a select group of stakeholders in contravention of bankruptcy’s distributional norms.

The problem stems from an ambiguity at the intersection of federal tax and bankruptcy law. Certain tax laws are designed to work in conjunction with the Bankruptcy Code, enabling companies to resolve financial distress without harsh tax consequences. For instance, an intricate web of compliance and enforcement provisions of the Tax Code normally ensures that tax attributes function more like revocable, nontransferable legal entitlements and less like private property. However, these special provisions ease the restrictions for certain indirect transfers of tax assets by corporate debtors in Chapter 11 cases. In this way, the tax laws allow the debtor’s valuable tax attributes to become marketable property.

Of course, while the tax laws allow indirect transfers of the debtor’s valuable tax attributes, these transfers must take place pursuant to a confirmed Chapter 11 plan and are therefore – at least theoretically – subject to bankruptcy law’s broader limitations on transfers of the debtor’s wealth. In other words, while the tax laws may function to bolster the value of the bankruptcy estate, it ought to be squarely within the domain of bankruptcy law to account for and distribute this value to satisfy claims against the estate. Indeed, an important goal of bankruptcy law is to provide for the fair and orderly distribution of the debtor’s property in accordance with established legal and equitable principles.

Astonishingly, however, the debtor’s valuable tax attributes slip through the cracks of one of Chapter 11’s most important safeguards, the “fair and equitable” test for contested Chapter 11 plans. The analysis requires, in pertinent part, that the court evaluate whether the Chapter 11 plan provides each impaired and dissenting creditor with at least as much as it would have received in a hypothetical Chapter 7 liquidation. But testing a Chapter 11 plan against a hypothetical liquidation naturally omits the debtor’s valuable tax attributes from consideration, as they would be extinguished when the liquidated debtor is subsequently dissolved. This means that the “fair and equitable” analysis ignores the very existence of what may be the debtor’s most valuable asset. For instance, disclosures accompanying Chapter 11 plans typically exclude valuable tax attributes from the liquidation analysis.

Considering the substantial value placed on these tax assets, how can our law relegate them to an excluded, miscellaneous category? In practice, this astonishing ambiguity at the intersection of federal tax and bankruptcy law means that impaired dissenting classes must rely on their relative bargaining power in private negotiations – without the benefit of statutory safeguards – to determine whether and how valuable tax attributes will be allocated. As I argue in the Article, this extraordinary gap not only facilitates inequitable allocations of economic benefits and burdens in Chapter 11 but also causes a much broader, systematic misallocation of resources. In particular, it contributes to an overall reduction in social welfare, as parties in a position to exploit the information asymmetry and control the restructuring are able to monetize the debtor’s tax assets as excess returns and then use them to shelter income from unrelated assets. My Article recommends statutory revisions to the federal tax and bankruptcy laws to neutralize the tax consequences of corporate restructuring decisions. Moreover, I address the need for more thoughtful attention to the overlap of commercial bankruptcy and corporate tax laws.